‘Brexit’ could hit U.K. economy, financial sector
A potential ‘Brexit’ poses a risk to growth prospects for the U.K.’s financial services and export sectors, significantly denting the current net trade surplus in insurance and financial services of more than 3% of GDP. This is one of the stronger points of the U.K.’s relatively vulnerable balance of payments performance since the 2008-2009 global financial crisis.
S&P’s base-case scenario is that the U.K. will remain in the EU after the referendum, which is to be held by the end of 2017. Even if a Brexit did occur, it is likely that some of the negative economic implications would be ameliorated by alternative arrangements, such as bilateral free trade agreements or membership of the European Free Trade Association (EFTA). There is, nevertheless, a risk of more adverse outcomes in the event of an “out” vote if the U.K. failed to negotiate alternative arrangements successfully.
By end-2017, the U.K. will hold referendum on whether to leave the EU.
If the U.K. leaves, we believe this could have significant negative economic implications due to the effect on the U.K. financial services industry.
However, the impact depends crucially on what alternative free trade arrangements the U.K. government could agree with its European partners.
While London sould maintain its status as a global financial centre, global banks could ultimately consider other locations as bases for their European operations.
The impact for domestically orientated U.K. banks would likely be modest, mainly related to the knock-on effect on the vitality of the U.K. economy and the creditworthiness and activity of its actors.
For insurers, a Brexit would likely entail additional costs of doing business in Europe, although S&P does not expect their operations would be significantly curtailed.
Despite the financial crisis, the financial services sector is still a major contributor to the U.K. economy, providing an estimated 1.4 mln jobs, 12% of income tax and national insurance receipts to the Treasury, and more than 3% of GDP in net export receipts. A Brexit would likely lessen foreign direct investment (FDI) inflows, particularly to the financial services sector, and entail additional
a costs to doing business. A potential U.K. departure from the EU therefore poses a business risk for this sector.
A Brexit is likely to be detrimental to FDI into the U.K., particularly into the financial services sector. Although the City of London has been a major financial centre for centuries, it has grown ever more rapidly over the past few decades. The U.K. financial system’s total assets have grown from less than 1x GDP in the 1960s to more than 4.5x GDP today, with most of that increase taking place between 1979 and 2006. The initial spur for U.K. banking services was U.S. regulation and tax policy in the 1960s and 1970s and the genesis of the Eurobond market. But the second wave of growth coincided with the U.K.’s accession into the European Economic Community in 1973 and the Big Bang deregulation of financial markets in 1986.
The rapid increase of inward investment into the U.K. economy follows a similar exponential pattern. At an estimated $1.6 trln, the stock of inbound FDI (excluding special purpose entities) to the U.K. is the third-highest in the world. It represents 6.3% of the global total, well above the U.K.’s 4% share of global GDP. High FDI inflows into the U.K. have increased the capital stock in an economy that stands out for low investment. The proportion of capital expenditure to total expenditure is low, at an estimated at 17% of GDP. This lags all OECD peers with the exception of Luxembourg, Italy, Ireland, Portugal and Greece.
The U.K. furthermore attracts the highest financial services-related FDI among rich countries. At 30% of total inward FDI (based on OECD data), this is equivalent to 17% of GDP. Nearly a half of the FDI into the financial services sector comes from EU investors.
Thus, a Brexit would put at risk this FDI to the financial services. If such an exit resulted in large-scale disinvestment from the City of London it would undermine the enormous success of the U.K.’s financial services industry.
While global banks may have a greater incentive to tilt away from London in the event of the U.K. leaving the EU, the effect on the domestic banking system would be less harsh and would depend on the wider economic fallout from a Brexit.
London is the principal global hub for banking and financial markets, and non-EU banks typically make it their springboard for conducting operations in the EU. At present, almost a fifth of global banking activity is booked in the U.K. There are now 150 deposit-taking foreign branches and 98 deposit-taking foreign subsidiaries in the U.K. from 56 different countries. Foreign banks make up about half of U.K. banking assets on a residency basis. Foreign branches account for about 30% of total resident banking assets and about one-third of interbank lending. This is 225% of U.K. GDP.
Most of these banks are based in London because other global financial institutions are also based there. This in turn reflects everything that makes London a financial sector cluster:
- The infrastructure and exchanges.
- A deep pool of international talent, and a historically welcoming attitude toward highly skilled immigrants. - Legal and business services suppliers. - A highly advantageous middle time zone with overlap in Asia and the Americas.
- A legal system that has a centuries-long
clearing houses track record in preserving property rights and creditors’ rights, and innovating legal structures for tradeable securities.
These strengths are unlikely to changed were the U.K. to leave the EU.
Still, the U.K.’s EU membership is also a strength for its financial services industry because U.K.-domiciled banks make active use of their U.K. authorisation to provide banking and trading services across the EU and European Economic Area (EEA), known as passporting rights. Without these rights, there is a risk that enough major global banks could choose to route their business through other financial centres in the EEA that retain those rights. Even assuming that an exited U.K. was prepared to enter the EEA or find a way to preserve passporting, the trend in global regulation is moving toward basing risk management functions inside their jurisdiction — be it Frankfurt, Paris, Madrid, Milan, or New York. A Brexit could
be accelerate this trend within Europe.
Therefore, while London would likely retain its global status as a leading financial centre, post-Brexit the centre of gravity in European financial markets could well move further toward Frankfurt, Paris, Dublin, or beyond. This trend would potentially accelerate if the U.K. was outside an EU free trade area or if free movement of labour were curtailed. In response, overseas banking groups could be expected to relocate some of their trading operations from London. Indeed, they may even take more wideranging action to centre their European operations on subsidiaries inside the remaining EU.
Important pieces of the European financial sector infrastructure are hosted by London, including stock and derivatives exchanges, and clearinghouses. Earlier this year, the EU General Court overturned a European Central Bank (ECB) decision that would have forced clearinghouses clearing eurodenominated contracts to be domiciled within the eurozone. By ceasing to be an EU member, the likelihood of the U.K. being challenged again on the ECB’s location policy would rise.
Over time, the importance of financial centres follows the trajectory of its host economy’s wealth and trading reach. This suggests that, whatever happens in the next few years in Europe, in the long-term Asia is more likely than continental Europe to pose greater competition to London.
A Brexit would also have important implications for financial services companies in Scotland. A national vote to leave the EU would, for example, likely increase the probability of a Scottish exit from the U.K., given limited popular support in Scotland for the U.K. to leave the EU.
The U.K. currently has a highly successful financial services sector. In 2014, its trade surplus in insurance and financial services totaled an estimated 3.3% of GDP. Trade with the EU accounts for more than 40% of net earnings of the financial services sector, excluding insurance. And this figure does not reflect third-party deals that ultimately depend upon the U.K.’s distribution arms in the rest of the EU.
Given that the U.K. operates the secondlargest current account deficit in the world, to put at risk one of the few net exporting sectors via a highly politically charged referendum would in pose substantial risks to the balance of payments, the currency, and the economy.