Policy uncertainty and international financial markets : the case of Brexit

This study assesses the impact of the uncertainty caused by Brexit, on both the UK and international financial markets, for the first and second statistical moments (i.e. on changes and the standard deviations of the respective variables.) As financial markets are by nature highly interlinked, one might expect that the uncertainty engendered by Brexit also has an impact on financial markets in several other countries. By analysing the impact of Brexit on financial markets, we might also gain some insights into market expectations about the magnitude of the economic impact beyond the UK and which other country might be most affected. For this purpose, we first use both the Diebold and Yilmaz (2012) and the Hafner and Herwartz (2008) method to estimate the time-varying interactions between UK policy uncertainty, which to a large extent is attributed to uncertainty about Brexit, and UK financial market volatilities (second statistical moment) and try to identify the direction of causality among them. Second, we use two other measures of the perceived probability of Brexit before the referendum, namely daily data released by Betfair and results of polls published by Bloomberg. Based on these datasets, and using both panel and single-country SUR (seemingly unrelated regressions) estimation methods, we analyse the Brexit effect on levels of stock returns, sovereign credit default swaps (CDS), 10-year interest rates in 19 predominantly European countries, and those of the British pound and the euro (first statistical moment). We show that Brexit-induced policy uncertainty will continue to cause instability in key financial markets and has the potential to damage the real economy in both the UK and other European countries, even in the medium run. The main losers outside the UK are the 'GIIPS' economies: Greece, Ireland, Italy, Portugal and Spain.