Hard Brexit maths – walking away

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Macro Letter – No 77 – 19-05-2017

Hard Brexit maths – walking away

  • The UK’s NIESR estimate the bill for Hard Brexit to the UK at EUR 66bln
  • I guesstimate the cost of Hard Brexit to the EU at EUR 62bln
  • Legal experts for both sides suggest UK obligations cease on Brexit
  • A Free-trade deal with the EU may not begin until after March 2019

…How selfhood begins with a walking away…

C. Day-Lewis

It has been estimated that if the UK accedes to EU demands for a further EUR 100bln in order to begin the process of establishing a bi-lateral trade deal with the EU post-Brexit, it will cost the UK economy 4.4% of GDP. According to estimates from the NIESR, to revert to WTO Most Favored Nation terms (the Hard Brexit option) would only cost between -2.7% and -3.7% of GDP (EUR 61bln to EUR 84bln).

In January UK MP May stated:-

No deal is better than a bad deal.

It looks, on this basis, as though the UK may indeed walk away from its purported EU obligations.

A more considered analysis from, the politically influential Brussels based thin-tank Bruegel – Divorce settlement or leaving the club? A breakdown of the Brexit bill – suggests a more modest final bill:-

Depending on the scenario, the long-run net Brexit bill could range from €25.4 billion to €65.1 billion, possibly with a large upfront UK payment followed by significant EU reimbursements later.

This substantial price range is due to the way the UK’s share of liabilities is calculated. At 12% (the UK’s rebate-adjusted share of EU commitments) it is EUR 25.4bln. At 15.7% (the UK’s gross contributions without a rebate adjustment) it rises to EUR 65.1bln.

The House of Lords legal interpretation – Brexit and the EU budget:-

Article 50 provides for a ‘guillotine’ after two years if a withdrawal agreement is not reached unless all Member States, including the UK, agree to extend negotiations. Although there are competing interpretations, we conclude that if agreement is not reached, all EU law—including provisions concerning ongoing financial contributions and machinery for adjudication—will cease to apply, and the UK would be subject to no enforceable obligation to make any financial contribution at all.

This suggests all of the UK’s commitments to the EU are linked to membership. If that legal interpretation is correct, there would be no Brexit bill at the moment of departure. Apparently EU legal experts have arrived at similar conclusions. The Telegraph – €100bn Brexit bill is ‘legally impossible’ to enforce, European Commission’s own lawyers admit has more on this contentious subject.

Setting aside the legal obligations in favour of a diplomatic solution, what is the price range where a potential agreement may lie? The cost to the UK appears to be capped at EUR 84bln in a worst case scenario. One may argue that the ability of Sterling to decline, thus improving the UK’s terms of trade, makes this scenario unrealistically high, but as I discussed in – Uncharted British waters – the risk to growth, the opportunity to reform historic evidence doesn’t support the case very well at all:-

Another factor to consider, since the June vote, is whether the weakness of Sterling will have a positive impact on the UK’s chronic balance of payments deficit. This post from John Ashcroft – The Saturday Economist – The great devaluation myth suggests that, if history even so much as rhymes, it will not:-

If devaluation solved the problems of the British Economy, the UK would have one of the strongest trade balances in the global economy…. the depreciation of sterling in 2008 did not lead to a significant improvement in the balance of payments. There was no “re balancing effect”. We always argued this would be the case. History and empirical observation provides the evidence.

There was no improvement in trade as a result of the exit from the ERM and the subsequent devaluation of 1992, despite allusions of policy makers to the contrary. Check out our chart of the day and the more extensive slide deck below.

Seven reasons why devaluation doesn’t improve the UK balance of payments …

1 Exporters Price to Market…and price in Currency…there is limited pass through effect for major exporters

2 Exporters and importers adopt a balanced portfolio approach via synthetic or natural hedging to offset the currency risks over the long term

3 Traders adopt a medium term view on currency trends better to take the margin boost or hit in the short term….rather than price out the currency move

4  Price Elasticities for imports are lower than for exports…The Marshall Lerner conditions are not satisfied…The price elasticities are too limited to offset the “lost revenue” effect

5  Imports of food, beverages, commodities, energy, oil and semi manufactures are relatively inelastic with regard to price. The price co-efficients are much weaker and almost inelastic with regard to imports

6 Imports form a significant part of exports, either as raw materials, components or semi manufactures. Devaluation increases the costs of exports as a result of devaluation

7 There is limited substitution effect or potential domestic supply side boost

8 Demand co-efficients are dominant

 

But what is the economic impact on the EU? CIVITAS – Potential post-Brexit tariff costs for EU-UK trade postulates some estimates:-

Our analysis shows that if the UK leaves the EU without a trade deal UK exporters could face the potential impact of £5.2 billion in tariffs on goods being sold to the EU. However, EU exporters will also face £12.9 billion in tariffs on goods coming to the UK.

Exporters to the UK in 22 of the 27 remaining EU member states face higher tariffs costs when selling their goods than UK exporters face when selling goods to those countries.

German exporters would have to deal with the impact of £3.4 billion of tariffs on goods they export to the UK. UK exporters in return would face £0.9 billion of tariffs on goods going to Germany.

French exporters could face £1.4 billion in tariffs on their products compared to UK exporters facing £0.7 billion. A similar pattern exists for all the UK’s major EU trading partners.

The biggest impact will be on exports of goods relating to vehicles, with tariffs in the region of £1.3 billion being applied to UK car-related exports going to the EU. This compares to £3.9 billion for the EU, including £1.8 billion in tariffs being applied to German car-related exports.

The net Trade Effect of a Hard Brexit on the basis of these calculations is EUR 7.7bln in favour of the UK.

Then we must consider the UK contribution to the EU budget, which, if the House of Lords assessment is confirmed, will be zero after Brexit. This will cost the EU EUR7.8bln, based on the 2017 net EU budget of EUR 134bln, to which the UK is currently the second largest contributor at 5.8%.

Next there is the question of the impact on EU27 economic growth. These headwinds will be felt especially in the Netherlands, Ireland and Cyprus but the largest absolute cost will be borne by Germany.

According to a February 2016 study by DZ Bank, a Hard Brexit would be to reduce German economic growth by -0.5%, from 1.7% to 1.4% – EUR 18.5bln. Credit Agricole published a similar study of the impact on the French economy in June 2016. They estimated that French GDP would be reduced by -0.4% in the event of a free-trade agreement and -0.6% in the event of a Hard Brexit – EUR 13.2bln. The Netherlands Bureau for Economic Policy Analysis (CPB) estimated the cost to the Netherlands at -1.2% – EUR 8.2bln. Italian Government forecasters estimate the impact at -0.5 to -1% – taking the best case scenario – EUR 8.3bln. A leaked Spanish Government report from March 2017 (interestingly, the only estimate I have been able to uncover since the Brexit vote) indicates a cost of between -0.17% and -0.34% of GDP – again, taking the best case – EUR 2bln. Ireland, given its geographic position, shared language and border, has, perhaps the closest ties with the UK of any EU27 country. Back in 2016 the Irish ERSI estimated the impact on Ireland at only -1%, I suspect it might be greater but I will take them at their word – EUR 2.6bln.

In the paragraph above I have looked at just five out of the EU27. Added together the cost to just these five countries is EUR 52.8bln, but I believe it to be representative, they accounted for 84.74% of EU GDP in 2016. From this I arrive at an extrapolated cost to the EU of a Hard Brexit of EUR 62.3bln.

The European Commission has indicated that the cost for the UK to begin negotiating the terms of a new free-trade agreement with the EU may be as much as EUR 100bln. The cost to the UK, of simply walking away – Hard Brexit – is estimated at between EUR 61bln and EUR 84bln per annum. The cost of Hard Brexit to the EU is estimated (I should probably say guesstimated, since there are so many uncertainties ahead) at EUR 62bln. A simple cost benefit analysis suggests that both sides have relatively similar amounts to lose in the short term. And I hate to admit it, but looked at from a negative point of view, in the long run, the UK, with its structural current account and trade deficit, may have less to lose from simply walking away.

Conclusion and Investment Opportunities

Brexit negotiations are already and will remain deeply political. From a short-term economic perspective it makes sense for the UK to walk away and re-establish its relationships with its European trading partners in the longer run. Given the UK trade deficit with the EU it has the economic whip-hand. Working on the assumption that Jean Claude Junker is not Teresa May’s secret weapon (after all, suggesting ever higher costs for negotiating a free-trade deal makes it more likely that the UK refuses to play ball) one needs to step back from the economics of the situation. The politics of Brexit are already and will probably become even more venal. For the sake of the UK economy, and, for that matter the economies of the EU, I believe it is better for the UK to walk away To those of you who have read my previous articles about Brexit, I wish to make clear, this is a change of opinion, politics has trumped economic common sense.

The implications for the UK financial markets over the next 22 months is uncertainty, although May’s decision to adopt a Hard Brexit starting point has mitigated a substantial part of these risks. Sterling is likely to act as the principle safety valve, however, a fall in the trade-weighted value of the currency will feed through to higher domestic inflation. Short term interest rates, and in their wake Gilt yields, are likely to rise in this scenario. Domestic stocks are also likely to be vulnerable to the negative impact of currency weakness and higher interest rates on economic growth. The FTSE 100, however, with 70% of its earnings derived from outside the UK, should remain relatively immune.

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What are the prospects for UK financial markets in 2016?

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Macro Letter – No 47 – 04-12-2015

What are the prospects for UK financial markets in 2016?

  • The EU referendum may take place as early at as June next year
  • Financial markets appear to be ignoring the vote at present
  • The tightening of bank capital requirements is almost over
  • Higher tax receipts have tempered the pace of fiscal tightening

In assessing the prospects for UK financial markets next year I will focus on three areas, the EU referendum, the stability of the financial system and the state of government finances.

The EU Referedum

As we head into 2016 political and economic commentators are beginning to focus on the potential impact of a UK exit from the EU would have on the British economy. Given the size and importance of the financial services sector to the economy, I want to investigate claims that a UK exit would be damaging to growth and lead to a rise in unemployment. For a more general overview of the referendum please see my July 3rd post – Which way now – FTSE, Gilts, Sterling and the EU referendum?

In February a report by the UK Parliament – Financial Services: contribution to the UK economy opened with the following statement:-

In 2014, financial and insurance services contributed £126.9 billion in gross value added (GVA) to the UK economy, 8.0% of the UK’s total GVA. London accounted for 50.5% of the total financial and insurance sector GVA in the UK in 2012. The sector’s contribution to UK jobs is around 3.4%. Trade in financial services makes up a substantial proportion of the UK’s trade surplus in services. In 2013/14, the banking sector alone contributed £21.4 billion to UK tax receipts in corporation tax, income tax, national insurance and through the bank levy.

The GVA was down from a 2009 high of 9.3%. For London the GVA was 18.6%. In international terms the UK ranks fourth, behind Luxembourg, Australia and the Netherlands in terms of the size of its financial services sector. As at September 2014, 1.1mln people were employed in the sector. According to research by PWC financial services accounted for £65.6bln or 11.5% of total government tax receipts in 2013-14.

Last week the Evening Standard – ‘Brexit’ would lead to loss of 100,000 bank jobs, says City – cited senior banking figures warning of the potential impact of the UK leaving the EU:-

Mark Boleat, policy chairman at the City of London Corporation, said: “If as a country we were to vote to leave, then London’s position as a leading financial centre would remain but without doubt there would be an impact on our relative size and the jobs we support.”

Confidential client research from analysts at US investment bank Morgan Stanley, seen by the Standard, warned that “firms for whom the EU market is important” would need to “adjust their footprint” in London if the Eurosceptic cause was victorious.

Sir Mike Rake, deputy chair of Barclays and chairman of BT, said: “It is extremely difficult to quantify the number of jobs that would be lost and the time frame over which that might happen but leaving the EU would severely damage London’s competitiveness and our financial services sector.”

There have been growing hints from financial institutions that they are starting to plan for Britain quitting the 28 member club.

Both HSBC, which announced a review of the location of its global headquarters in April, and JP Morgan are reportedly in talks about moving sections of their businesses to Luxembourg in part because of the threat of Brexit.

Deutsche Bank, which employs 9,000 people in Britain, has set up a working group to review whether to move parts of its business from Britain in the event of a UK withdrawal. 

US asset management group Vanguard, which has a City office, has admitted that Brexit would have a “significant impact” on its operation across Europe and has already started planning for it.

Many senior bankers are concerned that they would lose the financial services “passporting” rights enjoyed by fellow EU members.

A fascinating historic assessment of the opinion of the UK electorate towards the EU is contained in this week’s Deloitte – Monday Briefing, they  anticipate a referendum date of either June or September 2016, in order to avoid coinciding with a French (March/April) or German (September) election in 2017:-

Since Ipsos MORI started polling on this issue in 1977 on average 53% of voters in a simple yes/no poll have supported membership and 47% have opposed it. The yes vote reached a low of 26% in 1980 rising, over the following decade, to a peak of 63% in 1991, shortly before the pound’s ejection from the European Exchange Rate Mechanism.

In June of this year Ipsos MORI showed UK public support for the EU, again on a straight yes/no poll, at an all-time peak of 75%. Since then it has fallen away in parallel with heightened UK public concerns about immigration. The most recent Ipsos MORI poll, from mid-October, showed the yes vote at 59%.

More recent polls suggest a further narrowing of the yes lead. Across eight polls carried out in November the yes vote averaged 52% and the no vote 48%.  

The yes vote is, by and large, younger and more affluent than the no. Opposition to the EU rises sharply among the over 40s, an important consideration given that voter turnout is higher among older voters. Conservative voters tend to be more eurosceptic than Labour voters; white voters tend to be more sceptical than non-white voters.

… “don’t knows” averaged around 15% of all voters, more than enough to tip the vote decisively.  

The last referendum on UK membership of what was then the European Economic Community (EEC) was held in 1975, just two years after the UK joined the EEC. The vote was an overwhelming victory for EEC membership, with the electorate voting by 67.2% to 32.8% to stay in.

… In an intriguing paper economists David Bowers and Richard Mylles of Absolute Strategies Research (ASR) outline how the political landscape has shifted in the last 40 years.

… in 1975 the debate was about membership of a trading bloc, the Common Market. For sure, the commitment to “ever closer union” was in the Treaty of Rome, but in 1975 few in the UK, especially in the yes campaign, paid much attention to it. Since then the EU has grown from 9 to 28 members, expanded into Central and Eastern Europe, created the Single Currency and acquired more characteristics of a federal union.

…In 1975 the UK economy was in a shambles, slipping into the role of sick man of Europe. In the previous three years the UK had endured a recession, double digit inflation, endemic industrial unrest and the imposition of a three-day working week to save scarce energy supplies. British voters in 1975 looked enviously to the prosperity and stability of Germany. Today the UK is seeing decent growth, while the euro area grapples with the migration crisis, sluggish activity and the difficulties of building a durable monetary union. On a relative basis the performance of the UK economy looks, for now at least, pretty good.

…The Maastricht Treaty of 1992 established the right of people to live and work anywhere in the EU, but… it was EU enlargement into Central and Eastern Europe in 2004 that caused immigration into the UK to rise markedly, pushing migration up the list of UK voter concerns. More recent migration from North Africa and the Middle East, and the growing problems facing the Schengen nations, have added new concerns.  

The final factor…was the enthusiasm of the majority of the press for the Common Market in 1975. The press gave the then Prime Minister, Harold Wilson, largely uncritical coverage of his negotiations for a “better deal” in Britain’s relationship with the Community. (Historians tend to the view that Wilson actually achieved little in his negotiations with the Community; but he deftly turned meagre result into a public relations triumph). The lone dissenting voice in a general mood of press enthusiasm for the EEC was the Communist Morning Star. This time round it seems likely that a number of major papers will take a euro sceptic line.

The most recent poll, published by ORB last week in the wake of the Paris attacks, found 52% in favour of exit.

Financial Stability

This week saw the release of the Bank of England – Financial Stability Report – December 2015 – it suggests that the UK economy has moved beyond the post-crisis phase, the risks are, once again, external in nature:-

The global macroeconomic environment remains challenging. Risks in relation to Greece and its financing needs have fallen from their acute level at the time of the publication of the July 2015 Report. But, as set out in July, risks arising from the global environment have rotated in origin from advanced economies to emerging market economies. Since July, there have been further downward revisions to emerging market economy growth forecasts. In global financial markets, asset prices remain vulnerable to a crystallisation of risks in emerging market economies. More broadly, asset prices are currently underpinned by the continued low level of long-term real interest rates, which may in part reflect unusually compressed term premia. As a consequence, they remain vulnerable to a sharp increase in market interest rates. The impact of such an increase could be magnified, at least temporarily, by fragile market liquidity.

Domestically, the FPC judges that the financial system has moved out of the post-crisis period. Some domestic risks remain elevated. Buy-to-let and commercial real estate activity are strengthening. The United Kingdom’s current account deficit remains high by historical and international standards, and household indebtedness is still high.

Against these elevated risks some others remain subdued, albeit less so than in the post-crisis period to date. Comparing credit indicators to the past alone cannot provide a full risk assessment of the level of risk today, but can be informative. Aggregate credit growth, though modest compared to pre-crisis growth, is rising and is close to nominal GDP growth. Spreads between mortgage lending rates and risk-free rates have fallen back from elevated levels.

They go on to note that the Tier 1 capital position of major UK banks was 13% of risk-weighted assets in September 2015, below the levels advocated by the Vicker’s Commission but above Basel requirements. The Financial Policy Committee (FPC) are expected to impose a 1% counter-cyclical capital buffer in the near future, but otherwise the fiscal tightening, which has been in train since the aftermath of the financial crisis has finally run its course.

The other risks which concern the Bank are cyber-risks of varying types and, of course, the uncertainty surrounding the EU referendum.

Autumn Statement and Spending Review

Last week saw the publication of the UK Chancellor’s Autumn Statement and Spending Review. Mr Osborne was fortunate; the OBR found an additional £27bln in tax receipts which allowed him to reverse some of the more unpopular spending cuts previously announced. He still hopes to balance the government budget by 2020/2021. Public spending will rise from £757bln this year to £857bln in 2020/21. Assuming the economy grows as forecast, public spending to GDP ratio should fall from 39.7% to 36.5%.

Writing in the Telegraph Mark Littlewood of the IEA said:-

George Osborne has today made a one-way bet. His announcements are based on two predictions: continually low interest rates and sustained strong economic growth, making our debt repayments lower than anticipated and tax revenues higher than expected. These are not unrealistic assumptions, but if either go off course, the savings announced today will not go nearly far enough.

Market Performance

Stocks

Financial markets abhor uncertainty. Concern about collapsing FDI and Scottish devolution due to Brexit, will hang over the markets until the outcome of the vote is known: meanwhile rising rhetoric will discourage investment. Regardless of economic performance UK stocks are likely to underperform.

Back in July I believed the uncertainty about the UK position on the EU would have minimal effect:-

Unless the UK joins the EZ, currency fluctuations will continue whether they stay or go. Gilt yields will continue to reflect inflation expectations and estimates of credit worthiness; being outside the EU might impose greater fiscal discipline on subsequent UK governments – in this respect the benefits of EU membership seem minimal. The UK stock market will remain diverse and the success of UK stocks will be dependent on their individual businesses and the degree to which the regulatory environment is benign.

Here’s how the markets have evolved since the summer. Firstly the FTSE100 vs EuroStox50 and S&P500 – six month chart, at first blush, I was wrong, the FTSE  has underperformed EutoStoxx and the S&P:-

FTSE vs STOX vs SPX 6month

Source: Yahoo Finance

However, the FTSE250 tells a different story:-

FTSE100 vs 250 - 6m

Source: Yahoo Finance

This divergence has been in place for several years as the five year chart below shows:-

FTSE100 vs 250 - 5 yr

Source: Yahoo Finance

Here is the FTSE250 compared to EuroStox50 and the S&P500 – over the same five year period. The mid cap Index has followed the S&P, although in US$ terms its performance has been less impressive:-

FTSE250 vs EurStox and S&P - 5yr

Source: Yahoo Finance

Gilts and Bunds

During the period since the beginning of July the spread between 10yr Gilts and Bunds has ranged between 112bp and 145bp reaching its narrowest during the fall in equity markets in August and widening amid concerns about European growth last month. UK Inflation expectations remain subdued; this is how the MPC – November Inflation Report described it:-

All members agree that, given the likely persistence of the headwinds weighing on the economy, when Bank Rate does begin to rise, it is expected to do so more gradually and to a lower level than in recent cycles.

Sterling

The Sterling Effective Exchange Rate has traded in a relatively narrow range (please excuse the date axis, vagaries of the Bank of England’s data format – this is a one year chart):-

GiltBund JulNov

Source: Bank of England

During  stock market weakness in the summer Sterling strengthened. After weakening in October it rebounded, following the US$, in November.

Back in July I anticipated a weakening of Sterling:-

Ahead of the referendum, uncertainty will lead to weakness in Sterling, higher Gilt yields and relative underperformance of UK stocks. If the UK electorate decide to remain in the EU, there will be a relief rally before long-term trends resume. If the UK leaves the EU, Sterling will fall, inflation will rise, Gilt yields will rise in response and the FTSE will decline. GDP growth will slow somewhat, until an export led recovery kicks in as a result of the lower value of Sterling. The real cost to the UK is in policy uncertainty.

It may be that capital outflows are about to begin in earnest but I start to question my assumptions – the market seems to be caught between the uncertainty surrounding UK membership of the EU and doubts about the longevity of the “European Experiment” as a whole.

Conclusion

Gilts remain below their long run average spread over Bunds but the interest rate environment is exceptionally benign, making any pick up in yield attractive. The FTSE250 index appears to be ignoring concerns about collapsing commodities, slowing emerging markets – especially China – and the prospect of Brexit, but it may struggle to remain detached for much longer. Sterling also appears to have ignored the referendum debate so far. Or perhaps, the UK market is a relative “safe haven” offering exposure to European markets without the angst of Euro membership – either way I remain cautious until the political uncertainties dissipate.