‘Brexit’ could hit U.K. econ­omy, fi­nan­cial sec­tor

Financial Mirror (Cyprus) - - FRONT PAGE -

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.

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