Brexit: The mother of all babalases

Arrested development: Pro-European Union protestors gather in Trafalgar Square, London, this week to express their anger and disappointment at Britain’s decision to leave the EU. (Paul Hackett/Reuters)

Arrested development: Pro-European Union protestors gather in Trafalgar Square, London, this week to express their anger and disappointment at Britain’s decision to leave the EU. (Paul Hackett/Reuters)

The world woke up after the British voted to leave the European Union last week much like revellers after a raucous party: surveying the damage with a massive headache and blearily asking: “How the hell did that happen?” and “What’s it going to cost to fix it?”

  As the clean-up gets going, it is clear that the financial services sector – and Britain’s in particular – has the biggest babalas.

  London stands to lose its position as a leading light of the financial world if the United Kingdom follows through on a Brexit and, according to experts, this spells bad news for Britain, given the large part financial services plays in its economy.

  According to research released earlier this year by TheCityUK – a lobby group for the sector – the UK’s financial and related professional services made up about 12% of the country’s economic output in 2014 and employed more than 2.2-million people countrywide. The sector contributed 11% of Britain’s tax receipts in 2014-2015 and contributed more than all other net export industries combined, through the £72-billion trade surplus it generated. This is quite significant for a country with a consistently high trade deficit. It has exceeded 6% for the past two years while its overall current account deficit has been more than 5% over the same period, according to S&P Global Ratings.

  Adrian Saville, chief strategist at Citadel Asset Management, likened the importance of the UK’s financial services sector to the mining sector in South Africa.

  “Its spillover, multipliers and linkages make it a critical component [of the UK economy],” he said, adding that if the financial centre dissolved, the UK economy would come under “incredible pressure”.

  British banks experienced massive declines in their share prices following the referendum, with some forced to temporarily halt trading on the London stock exchange on Monday. Although they made recoveries later in the week, major UK banks such as Barclays and the Royal Bank of Scotland saw their share prices decline by about 20% and more respectively.

  The British government had its credit rating downgraded from the coveted AAA to AA status by S&P and Moody’s changed its ratings outlook on 12 banks and building societies from stable to negative.

  The Brexit result has sparked fears of a recession. Britain has a large trade deficit, but a currency that has remained strong over time, according to Kokkie Kooyman, portfolio manager at Denker Capital.

  With a Brexit vote, the UK is likely to lose the easy access it has to the 27 EU countries to which it exports.

  “It’s safe to say that Britain’s exports are likely to decline,” said Kooyman, which means its trade deficit will probably worsen, increasing the prospect of job losses and the start of a recession.

  The effect on the banks was partly driven by these expectations; a recession is never good for banks because it leads to rising bad debts and slower loan growth, he said.

  The potential loss of London’s position as financial hub, with easy access into European markets, was another factor, he added. If large banks and financial services companies are forced to relocate to mainland Europe this could mean further job losses in London and a lowering of property prices.

  Asmita Parshotam, a researcher for the economic diplomacy programme at the South African Institute of International Affairs, said one of the advantages the UK enjoyed through its membership of the EU was the ability to freely operate banks, insurance companies and similar firms on mainland Europe – provided there was an established base in the UK. This is known as “passporting”, and applies to Swiss and United States banks as well.

  “However, if Brexit does indeed go ahead, non-EU banks would now be required to establish a subsidiary in EU member states and satisfy all these requirements accordingly, in addition to satisfying UK financial regulations, thereby increasing their regulatory burden,” Parshotam said. The absence of passporting could result in some banks moving their operations to other European cities for ease of business.

  “On a long-term basis, there could also be potential implications in terms of [foreign direct investment] flows into the UK’s financial services sector,” she added.

  There is much uncertainty over how Britain will now negotiate its exit from the EU. It must start with Britain invoking Article 50 of the Lisbon Treaty, which governs how an EU member voluntarily leaves the union. This mechanism has never been used, said Parshotam, and is uncharted territory for the UK and the EU.

  Key member states, including Germany and France, have indicated that they are not prepared to engage in talks until Britain initiates formal withdrawal proceedings, Parshotam pointed out.

  Although the timeline for exit negotiations is about two years, given the stature of Britain’s economy and its role in the EU, there are already suggestions that this is an unrealistic timeframe, she said.

  In the meantime, Britain remains bound by all the rules and normal activities of the EU, said Parshotam, but British representatives to the European Council will not participate in debates or any voting related to their withdrawal.

  But Saville argued that, given the profound effects a Brexit will have on the UK’s economy and its financial services sector in particular, Britain would find a way to remain in the EU and “London would find a way to accommodate this”.

  It could mean finding a sweetheart deal to retain its access to the wider European market, he suggested, or even backtracking on the results of the referendum.

  Virgin boss Richard Branson, whose group of companies lost a third of its value early this week, has already called for a second poll, while the Guardian reported that US Secretary of State John Kerry expressed scepticism that the UK’s political leaders, including those at the helm of the leave campaign, even knew how to begin a Brexit.

  The hit taken by the UK financial sector has rippled down to South Africa’s banks, but the risk of any severe contagion for the local industry appears limited, analysts agreed.

  One area of concern was the extent to which South African banks’ offshore funding comes from Britain, said Kooyman, but given that the sector also sourced funding from Europe – and Switzerland specifically – this was likely to have “a marginal effect”.

  Investec has some exposure to the UK, given that a large proportion of its profits come from its British banking and wealth management business, Kooyman added.

  Questions have also been raised regarding the effect of Brexit on Barclays’s sale of its Barclays Africa (ABSA) business.

  According to Jean Pierre Verster, portfolio manager at Fairtree Capital, Brexit was unlikely to have an effect on the transaction.

  One of the main reasons alluded to for the sale, Verster said, was compliance with UK banking regulations, specifically the level of capital requirements that needed to be held against subsidiaries.

  “These have not changed,” he said. A positive effect on the proceeds that Barclays would receive could come from the conversion of rands to pounds, as a result of the weakening of sterling, he added.

  Nedbank’s exposure came through its relationship with its parent, Old Mutual, which is in the process of a large demerger of its businesses.

  But earlier this week Old Mutual chief executive Bruce Hemphill said that, although the Brexit vote and the resultant volatility it had caused “may impact the performance of the underlying businesses”, the group’s strategy had not changed.

  Matthew Pirnie, primary credit analyst at S&P Global Ratings, said although a number of local banks did have direct links through various subsidiaries in the UK, and would have to remain aware of what their exposure was and how the UK economy was performing, there was little risk of any major Brexit contagion for South African banks.

  More troubling for local banks were the indirect risks that Brexit posed, argued Pirnie, such as another potential wave of investor risk aversion.

  “Any risk aversion will strengthen the dollar, strengthen gold and weaken emerging market currencies,” he said, adding that it would lead to inflation and possible interest rate hikes, which could affect South African banks.

 

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