The Algebris Bullet

The Silver Bullet | The Divided Kingdom

In an episode of the 1980s TV show ‘Yes Minister’, Cabinet Secretary Sir Humphrey Appleby is asked why the UK joined the EEC, to which he answers, “To create a disunited Europe. […]  We had to break the whole thing up, so we had to get inside. We tried to break it up from the outside, but that wouldn’t work. Now that we’re inside we can make a complete pig’s breakfast of the whole thing: set the Germans against the French, the French against the Italians, the Italians against the Dutch. The Foreign Office is terribly pleased; it’s just like old times.”

While the episode paints a cynical picture of British politics, one almost wishes it were true because at least then we would be reassured that the government had a plan all along.

But unfortunately, recent events have made it clear that neither the government nor the Leave campaign have a plan and British politics is in turmoil. PM Cameron has resigned with no clear successor, the Labour party is in disarray as MPs call for Corbyn’s resignation, Scotland is likely to have a second independence referendum, and Northern Ireland may follow suit. Predicting how the political chips now fall is tricky business. But what is clear is that the political outcome will dictate how the UK negotiates its Brexit – if at all it comes to that.

We see three scenarios ahead. The most likely scenario is that a moderate candidate is elected leader of the Conservative party, following which Article 50 is triggered and a gradual / “soft” Brexit is negotiated. A second less likely scenario is that Article 50 is blocked in Parliament, new elections produce a pro-EU government and the referendum results are ignored (a Bremain scenario). A third, but unlikely scenario, is a “hard” Brexit: UK-EU relations deteriorate to antagonistic levels, leading to lower trade and restrictive tariffs.

1.“Soft” Brexit (high likelihood): This means the UK negotiates for European Economic Area (EEA) membership, as Norway, Iceland and Liechtenstein have, or joining the European Free Trade Area (EFTA) like Switzerland.

Adopting the Norwegian model would result in the least deviation from the status quo. As an EEA member, the UK could retain access to the European single market for both goods and services. In particular, the EEA agreement would allow the UK to continue enjoying passporting rights to provide cross-border financial services within the EU. Maintaining these rights is critical for the UK economy, as the services industry accounts for around 78% of UK GDP and financial services alone accounts for 8% of its total gross value added (Parliament).

However, EEA membership still requires free movement of people, which may be a sticking point in negotiations if the UK

government pushes hard for immigration limits. In addition, adopting the Norwegian model does not mean that the UK is no longer bound by EU laws. According to a 2012 report by the Norwegian government, Norway had incorporated approximately three quarters of all EU legislative acts. This is despite Norway having no direct interference/inputs in the design of EU legislation. Another negative impact of resorting to EEA membership is that London may no longer be able to perform Euro clearing.  While the UK in 2015 won the case to stop the ECB from directing Euro-clearing houses to relocate to the Eurozone, the ruling could be challenged if the UK exits the EU. The direct economic loss of relocating Euro-clearing houses is likely to be small, but it could lead to a gradual shift of Euro-denominated financial activities from London to continental Europe.

Joining the EFTA would allow free trade in goods and general liberalisation of trade in services, but membership does not guarantee passporting rights for financial services. Swiss financial firms are active in EEA countries, but under the provisions of special bilateral treaties. Switzerland has signed over 100 bilateral agreements with the EU, many of which require it to comply with EU laws, including an agreement guaranteeing free movement of people. The UK will likely need to negotiate similar bilateral arrangements with the EU.

2.Bremain (moderate/low likelihood): Cameron has clearly signalled that a second referendum is not on the table. Therefore, the UK could remain in the EU if a Bremain candidate unwilling to pull the trigger on Article 50 wins in new elections or parliament blocks Article 50 altogether. There’s a moderate/low chance that MPs block Article 50. This is because the referendum isn’t legally binding, an overwhelming majority of MPs favour Remain, and Leave’s narrow win brings into questions the democratic validity of a Brexit. While a decision to Bremain may ultimately benefit the UK economy, interim political uncertainty is likely to weigh on investment and growth, and leave the UK in a long Brexit limbo (Brimbo).

3.”Hard” Brexit (low likelihood): EU officials have called for a fast trigger of article 50, leaving little wiggle room for informal negotiations. While a tough stance is justifiable to avoid other countries following suit, a “hard” Brexit and antagonistic UK-EU relations is the scenario that would cause the most damage to the British economy. Cameron estimated that the UK would need up to a decade to renegotiate trade terms with the EU. During this period, both the UK services and manufacturing sectors are likely to be hit. The UK economy is geared towards the services sector (78% of GDP), a tenth of which is financial services. The UK’s financial services sector (1.1m workers, 8% GVA) is likely to lose the right to “passport” its services to EU clients. Large banks are likely to relocate to Europe, as some banks have already indicated they would, and the law and consultancy firms that cater to banks are likely to follow suit. The UK’s manufacturing sector, which has been in a structural decline since the 1970s, may receive a boost from a weaker GBP, but the net benefit is likely to be limited. Eastern European countries, with access to the single-market, may still be a more competitive destination for some manufacturers. In a survey by the Society of Motor Manufacturers and Trades, 77% of auto industry respondents said EU membership was “best for businesses”. Car manufacturers contributes to around 11% of the UK’s exports.

For now, a limbo of political uncertainty and negative business sentiment will continue to weigh on the pound, UK asset prices and growth. This means further BoE currency intervention, more monetary easing and potentially a delay in fiscal consolidation. However, the UK’s dual deficits (current account and fiscal), high public and private debt, weak household finances and rising inequality will likely lead to a painful adjustment process – the loss of its last triple-A rating from S&P is just the start.

The policy response: limited ammunition

The Bank of England has promised over £250bn of extra liquidity and has likely intervened in the currency market to support the pound. However, it has limited dry powder. The BoE in May had a total of $167bn of gross reserve holdings, including $27bn of its own currency reserves and $140bn of official reserves it manages for the Treasury. This is less than 6% of the UK’s 2015 GDP, and only slightly higher than its 2015 current account deficit (£96.2bn, 5.2% of GDP). This means the BoE will not be able to support the pound. We see the BoE cutting rates to negative in a “hard” Brexit scenario, to zero in a “soft” Brexit scenario and keeping rates lower for longer in a Bremain scenario. In a hard Brexit scenario, the BoE may reactivate QE and/or the Funding for Lending Scheme.

Fiscal policy: no emergency funds available. Before the referendum, Chancellor George Osborne suggested that there would need to be a “punishment” Budget after a leave vote to cut spending and impose an additional £30bn tax rises to keep the deficit in check under a recessionary scenario. In his post-referendum speech on Monday, he did not rule out such a “punishment” Budget and suggested any new plan will be announced in the autumn. However, further spending cuts will be politically unfeasible amid other economic headwinds. It is also difficult to raise taxes. Currently the top 1% of earners pay around a quarter of total income taxes and higher income taxes could push these people to leave the country. A hike in corporate taxes will be equally unpalatable when many businesses already have relocation plans given the uncertainty over the new deal with the EU.

British consumers are likely to be hit the hardest. Thanks to government subsidies like the Help-to-Buy programme, household leverage (household debt to income) continues to rise and is projected to reach around 164% of GDP by 2021. At the same time, this also means a majority of households’ wealth is tied to properties, which are likely to suffer from price depreciation. Households are likely to get a harder squeeze on their disposable income and will cut back on discretionary spending given their high debt, declining property equity and slow wage growth.

Political contagion: a rise in support for anti-EU, protest parties

Irrespective of whether the UK eventually leaves or remains in Europe, the ripple effects of the referendum are likely to influence EU voter sentiment in the future; especially that of French and German voters who head to the polls next year. The most likely implication of the referendum results is that anti-EU sentiment may be invigorated, leading to more support for protest parties across Europe. As an indication of the growing political clout of these parties, France’s PM met with France’s anti-EU leader Le Pen over the weekend to discuss the Brexit fallout.

On the other hand, the referendum may also serve as a reality check for protest voters. The impact of the referendum’s result reverberated across European financial markets. The stock market’s tumble may have influenced Spanish citizens’ votes at last weekend’s general election, which saw a resounding victory for the centre-right, mainstream party PP and a decline in support for the left-leaning, protest party Podemos (contrary to the opinion polls, leading up to the elections).

Conclusion: a Divided Kingdom

Britain outpaced most European countries over the past two decades, becoming the prime destination for Europe’s services industry and for new firms. As a businessman recently said, “The UK is the door to Europe. But without Europe, it’s just a door.

The city of London, the wealthy and the old have benefited from the UK’s asset-rich but wage-poor recovery. The rest of the country, the young and the have-nots have been left behind. Pointing the finger at the EU has been an easy political strategy to capitalise on this rising division, with the referendum becoming a symptom of the people’s deep-rooted frustration. Yet the irony is that the economically vulnerable families who voted ‘leave’ will likely be the most hurt by a weaker currency, rising inflation and job losses from divestments. Recent news reports suggest that not only banks but car companies too are planning to relocate their offices.

For investors, the Brexit vote will likely trigger another round of low rates from central bankers’ QE-infinity bazooka, as politicians scramble to implement low-unemployment policies while doing as little as politically possible to fix the structural problems.

The English patient has been sick for a long time, and Brexit was never the right medicine. Solving the UK’s economic and social imbalances requires a lot more than building a border or removing an unpopular prime minister. After decades of short-term policies, it is time voters stop believing false promises and politicians focus on building a more balanced growth model. Unfortunately, this remains a distant dream. We have a Divided Kingdom outside of the European Union.


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