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Theresa May: This draft was not final Brexit deal

Prime Minister Theresa May addresses the House of Commons shortly after the United Kingdom and the European Union agreed on draft text of a Brexit withdrawal agreement.

Posted: Nov 16, 2018 5:40 AM
Updated: Nov 16, 2018 5:56 AM

A sharp decline in the value of the pound and plummeting bank stocks are sending a clear message: a chaotic Brexit will plunge the UK economy into recession.

Dramatic market reaction to the resignation of key UK government ministers on Thursday underscores the steep price that Brits are likely to pay if the country crashes out of the European Union without a divorce deal.

The resignations mean that Prime Minister Theresa May is unlikely to gain parliamentary support for the Brexit deal she has negotiated with the European Union. The risk of a chaotic exit from the bloc has risen sharply as a result.

The pound fell as much as 2% against the dollar to below $1.28 before trimming those losses slightly after May said she would fight to save her deal. Shares in UK banks declined sharply, with Lloyds (LYG) and Barclays (BCS) shedding over 4% and Royal Bank of Scotland dropping nearly 10%.

"That's quite a serious escalation and the markets are reacting very violently, [because] the risks of a more disorderly situation are increasing and are very material," said John Wraith, head of UK rates strategy at UBS.

Wraith said the United Kingdom will plunge into recession next year if the government fails to secure an orderly break with its largest trading partner. He predicted the UK economy would be up to 10% smaller in 2023 than if the country had remained in the European Union.

"It's a big number, but it is a big problem," he said.

The fear is that Britain could tumble out of the European Union without a transition deal to keep it temporarily inside the bloc's market for goods and services and customs union.

That would mean new trade barriers, and disruption to supply chains for food, medicines and manufactured goods. Analysts expect a sharp decline in business confidence, real estate prices and an even weaker pound. Airlines may not be able to fly.

The International Monetary Fund warned Wednesday that a disorderly exit would "lead to widespread disruptions in production and services." Rating agency S&P has told Brits to expect "a short, sharp recession."

"Nobody can be sure of the extent of any hit to activity, but we think it could be as high as 3% of GDP, with an outright recession probable," wrote analysts at research firm Capital Economics.

Companies have raced to prepare for the worst as negotiations dragged on in recent months. The United Kingdom is due to leave the European Union on March 29, 2019, but the prolonged talks left businesses in the dark on terms of future trade.

BMW (BMWYY) has made plans shut its Mini factory in England for one month of maintenance immediately after Brexit because it can't be sure of getting the parts it needs. Pharmaceutical companies are stockpiling medicines.

Financial services firms are likely see their access to EU markets reduced under any Brexit scenario, but a messy exit would be most dangerous.

Households would also be harmed by a chaotic Brexit. The value of the pound would slump further, hiking the cost of imported products. Inflation would rise.

S&P estimated that annual household incomes would drop by £2,700 ($3,440) on average in each of the three years following a messy breakup.

The IMF warned that a decline slump in the value of the pound would hit consumer and business confidence.

"[That] in turn would have adverse impact on the balance sheets of households, firms and financial intermediaries," it said.

Bank shares were particular hard hit on Thursday because of worries that borrowers would struggle to pay back loans if the economy slumps following a messy Brexit.

RBS, for example, has already set aside £100 million ($125 million) to cover the fallout from Brexit.

While a recession is likely under the worst Brexit scenario, the United Kingdom would probably dodge a financial crisis.

"The UK banking system is incredibly resilient and well capitalized," said Wraith. "If you look at the stress tests they all passed — they include way worse scenarios than we envision even in the worst case Brexit scenario."

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