Brexit and financial services

There is no sector more important to the prosperity of the UK economy than the financial services sector. Together with related professional services like legal, accountancy and management consultancy, the sector accounts for 12% of UK GDP and employs 2.2 million people. It also accounts for some £67bn or 11% of total government revenues, and generates £77bn in net exports - making UK the world's largest net exporter of financial services.

The realisation that the government is pursuing a hard or as I prefer to call it clean Brexit that involves the UK leaving the single market (and customs union) has raised fears that financial services will be severely damaged especially if also there are no transitional arrangements.

But it may surprise many to know that there is no single market for services and certainly not in financial services. There is no single banking market, no single insurance market, no unified capital market, and no European stock exchange.

The issue of passporting has received a lot of publicity when discussing financial services post-Brexit. Passporting was designed to overcome the lack of a single financial services market by allowing a financial institution authorised in one EU member state to market financial products in other EU countries. It is open to non-members states too in theory at least, and after Brexit, UK and UK-based banks and finance companies would be free to set up subsidiaries (if they have not done so already) in the EU to trade throughout, though the presence would have to be meaningful, something to be debated. Another route to maintaining business in London will be so-called "equivalence" of regulation. This will be useful for the City in any transitional arrangements agreed, though I do think we should not be tied to this in the longer run, particularly as we will have no say on the regulations, and also that we will likely go down the path of greater deregulation.

Even under this passporting system, retail financial services remain virtually entirely national and heavily protected. So leaving the EU will have no impact here for the UK. With respect to the wholesale sector, banks do not need a passport to access the City's foreign exchange market or it's interbank market, while companies can buy reinsurance at Lloyd's or do business with corporate financiers in London. It has been estimated that just 20% to 25% of wholesale business is related to the EU and only part of that is facilitated by passporting.

So what about the issue of the settlement and clearing of euro-denominated instruments I here you ask? The trading of such business would stay in London, as this is where the liquidity and infrastructure is. Europe is just not a credible competitor. But the eurozone has long coveted the euro-denominated clearing business which - along with non-euro clearing - is dominated by the LCH clearing house in London. The European Central Bank previously attempted to take such activity back in a failed landmark legal case in 2015. But there are now potentially renewed attempts to do so. Yet there are real dangers to moving the business within the eurozone. Many experts have noted a forced repatriation of the clearing would increase systemic risk and substantially increase the costs of clearing.  Economies of scale allow for so-called "netting", a process that reduces margins. Also such denying of London the right to clear euros would have to be applied globally, but this would likely lead to retaliation especially from the US.

Despite the jostling among European cities including Paris, Frankfurt, Berlin, Luxembourg and Dublin, there is no real rival in Europe to London as a global financial centre. It's dominance is only threatened by New York as one can see in more detail From Z/Yen's excellent Global Financial Centres Index report. London is supported by its expertise and knowledge in financial services and key support services such as Law and accountancy; by the use of the dominant English language and the attractions of living in a vibrant and exciting city; by its infrastructure; by low taxation; and the sheer size, depth and liquidity of its financial markets. The biggest challenge remains from New York which is supported by a larger domestic economy, and could get a boost from new US President Trump's plans for greater deregulation including getting rid of Dodd-Frank which was imposed seven years ago, and by lower taxes.

There is a growing realisation in some quarters of the continent that trying to hurt the only large financial centre in Europe will damage the EU perhaps as much as the UK. Germany's finance minister Schauble warned against punishing the UK generally not least because of the unrivalled London financial centre. A leaked European report warned that failing to protect the City would indeed hit Europe's economy.

The City of London is very resilient, agile and great at adapting. It survived the 1930s and two world wars. It prospered after Big Bang and was unaffected by the UK's decision to not join the Euro, becoming the undisputed financial centre of Europe despite the fears of many. I remain optimistic even if the EU does its best to undermine it, that the City will remain pre-eminent being highly innovative and doing what is necessary to retain its competitiveness perhaps through lighter regulation and lower business taxation. It can escape EU regulation on Bankers' bonus caps and the financial transactions tax and perhaps impose lower capital buffers. It will be important however to remain open and in particular retain full access to talent overseas which has been acknowledged by the government, with even the Labour opposition realising this with its purported plans to introduce regional immigration plans.

There will certainly be some shifting of business but it will be on a small scale compared with the impact of other developments and evolving new areas of business and new products eg renminbi-related products or in the already thriving fintech (financial technology and innovation) industry.  London will remain one of the two global financial centres.

UK economic growth prospects rosy in the short-term and in the long-term

Late last year I wrote that UK GDP would grow by nearly 2% a figure that compared with a consensus of some 1.2% then and as of yesterday about 1.3%. My optimism surprised many. Today I am a little nervous as the notoriously inaccurate/pessimistic Bank of England revised up its forecast to 2% also, having forecast it at 1.4% in November and just 0.8% in August. Who knows they might even hike it back to the pre-referendum forecast for 2017 to 2.3%! And now watch the consensus forecast rise too because of the classic group mentality.

My own optimism that growth would barely slow if at all in 2017 was based on a number of factors:

Firstly, consumer spending will undoubtedly slow somewhat as a result of the squeeze in real personal disposable incomes from higher inflation via a weaker exchange rate but not as much as expected. Consumers not surprisingly remain pretty confident in this new pre-Brexit world and continue to spend as we have seen from Q4 data. Expect consumer borrowing to rise and the savings ratio to fall back even more, while unemployment will remain close to current lows, facilitating a rise in consumer spending close to 2% from 2.8% last year.

Secondly expect the weaker pound to have a significant impact in raising net exports. Competitive devaluation can still be effective in driving export volumes up and I believe we can see the same positive impact as in 1991. This is likely to be reinforced as a result of only a weak upturn in inflation here and a pick up in global growth. Indeed business surveys have reported strengthening export order books.

Thirdly the drag from a tight fiscal stance was eased a little in the Autumn Statement which loosened the fiscal rules. We are seeing a modest increase in infrastructural investment spending.

Fourthly,  the monetary policy stance will remain easy with base rates unlikely to be raised from their ultra low 0.25% anytime soon. The Bank is likely to remain wary of going too soon in hiking rates fearful of the consequences, and is reinforced by its relaxed views about inflation, particularly with respect to any feed-through into wages or inflation expectations.

Finally, the economy had a strong growth momentum going into 2017 with Q4 GDP up a preliminary 0.6% y/y. Simple base effects will leave average growth higher this year than if we had seen a slowdown as others expected for H2 2016.

In a future blog I will look at our longer term growth prospects which I believe are good.