Stephanie Flanders: Does a post-Brexit EU really want London as its financial capital

Stephanie Flanders

Uncertainty over the EU referendum has already affected the UK economy via a sharp decline in the exchange rate since the start of 2016 and—probably—some delay in planned investment in the UK by domestic and foreign businesses says JP Morgan Asset Management chief market strategist for Europe. A Brexit would bring more negatives for investors and financial services professionals

Short-term impact – whatever the result

In recent statements and interviews, the governor of the Bank of England (BoE), Mark Carney, has reiterated that a possible Brexit vote poses the “biggest domestic risk” to the country’s economic outlook in the short and medium term.

Though the currency has recovered recently, the exchange rate remains 5.6 per cent lower on a trade-weighted basis than at the turn of the year. Sterling has declined further than can be explained simply by the fall in UK rate expectations relative to the US since the end of the year. During the referendum campaign, the cost of insuring portfolios and business activities against further sterling weakness has spiked to the highest level since 2010 and derivative markets are forecasting that sterling volatility will remain high well into the summer.

The other key consequence of the referendum for the economy is likely to be reduced investment, as businesses inside and outside the UK defer projects until the outcome has been decided. Recent figures show that UK investment declined by 2.1 per cent in the final three months of 2015, after growing by an average of 1.4 per cent in the preceding nine months. We cannot know how much of this slowdown was due to referendum fears, but it underscores that this is an unfortunate time to be giving businesses something else to worry about. A 25 per cent reduction in the volume of investment due to the referendum could theoretically knock 0.25 percentage points off the annualised rate of growth in the economy in the second quarter.

If Britain votes to “Bremain,” we would expect most of this hit to investment to be reversed. Sterling might also retrace some of the ground it has lost. However, it is not obvious to us that sterling would return to the levels seen in mid-2015, given the country’s still-significant current account deficit of just over 4 per cent of GDP.

So it would not entirely be business as usual after a vote to remain. But the direct macroeconomic impact would be modest and probably far outweighed by developments in the broader global economy..

Vote leave – short-term impact 

We can be fairly confident in the short run that UK equity prices would not stay the same, and nor would the value of the pound. UK equities could see a further 2 to 3 per cent sell-off, in addition to perhaps a further 10 per cent fall in the trade-weighted value of sterling. If the polls begin to point to a clear “leave” majority, much of this would have occurred before the vote itself.

How would this directly affect the economy? Research by JP Morgan Chase estimates that a negative result could take around 1 percentage point from the growth rate in the 12 months after the vote—a significant hit, given the baseline growth forecast of around 2 per cent in 2016. At the same time, the further decline in the exchange rate would tend to push inflation up.

Medium term, Brexit could in fact see higher official interest rates and lower growth, for a given rate of inflation, if leaving the EU lowered the country’s supply-side potential by reducing its openness to trade and hurting investment. However, in the short term we believe the negative hit on the economy would dominate the monetary policy response. The first rate rise would likely be deferred even further into the future, and the chance of a rate cut or other stimulus measures in the UK would go up.

Growth and investment in the rest of the EU would also be negatively affected, with countries such as Ireland seeing the largest impact given its heavy reliance on trade with the UK. The same JP Morgan Chase analysts see a hit to Eurozone GDP on the order of 0.2-0.3 percentage points over 18 months following a Brexit vote. Eurozone inflation might well be slightly lower on this scenario, due to the greater strength of the euro against sterling. The reverse would be true in the UK.

Vote leave – longer-term consequences

Along with this macroeconomic reaction, we can expect a microeconomic response on the part of businesses inside and outside the UK, as finance directors and other managers take stock of their supply relationships and consider how their costs, trading relationships, customer base and—in some cases—even their legal status might be affected by the decision. This is where the transition costs of moving to a post-EU regime would be felt most keenly and for many it will not provide much reassurance that it could take several years for the nature of that regime to be clear. That merely means businesses will be living with the uncertainty that much longer.

With more than 40 per cent of Britain’s trade going to other EU countries, the new relationship with the EU will be crucial to the impact for individual sectors. This is where the political economy gets tricky, because in practice there is a trade-off between sovereignty and market access—even if the supporters of Brexit suggest that the UK can have access to the single market without all the rules and regulations that come with it.

The closest to the current arrangement is the Norway option—membership of the European Economic Area (EEA), making a contribution to the EU and abiding by all single market rules including free movement of people. This is unlikely to appeal to those who want to see Britain break free of Brussels, since it involves all of the regulation that Britain has today but none of the influence. But this is important for the financial sector because only EEA membership would guarantee the continuation of “passporting” rights for UK financial services firms to do business in the EU.

The least onerous option, but also the least favourable from a business standpoint, would be to fall back on the mutual market access available to all members of the World Trade Organisation. This is also unlikely to be satisfactory, given the significant constraints it would impose on trade relative to the status quo. Outside the EU, the UK would also have to try to at least replicate the 50-odd trade agreements that the EU has negotiated with other parts of the world. This would be no small matter and would add to the uncertainty for businesses.

Most likely, the UK would end up with its own arrangement, somewhere between these two extremes. Britain has an enormous traded goods deficit with the rest of the EU, which has been widening recently, with imports from other parts of the EU growing much faster than imports from the rest of the world.

Supporters of Brexit say this guarantees a generous settlement for the UK, because the rest of the EU would not want to put that trade at risk. However, most of the deficit is with Germany and Spain, so it’s not guaranteed that the rest of the EU would see it that way, and political rancour over the decision to leave could also infect the negotiations. But Britain also runs a significant surplus in services trade including a £19bn surplus in financial services trade in 2014. Whether the UK would get an equally generous deal on services seems more doubtful.

Much depends on whether EU leaders believe it is in their long-term interest to maintain London as Europe’s preeminent financial centre. They might, and they might not. Switzerland is often cited as a model for Britain’s relationship with Europe outside the EU. Switzerland has negotiated around 20 bilateral agreements with the EU and dozens of sectoral deals. But in return it has implicitly had to accept free movement of labour from the EU, and it has no deals on financial or any other kind of services.

Longer term, the microeconomic impact of Brexit will be much more important than the macro. Investors should be especially alert to the outcome for UK financial services firms, many of which could be negatively affected. Manufacturers should benefit, at the margin, from the weaker currency. But uncertainty about the post-Brexit trading relationship will loom large for them too, and skill shortages could be a negative for some companies if inward migration from the EU is curtailed.