Brexit Q&A

Blue Quadrant Research Team
Market Commentary

A Brexit Q&A with Blue Quadrant Capital Management

The so-called “Brexit” referendum is fast approaching, scheduled to take place on June 23. Do you have a view which way the vote will go and is it relevant for investors?

We don’t have a firm view and we think more than likely the UK bookies probably offer the best indication of which way the vote will go!  They suggest the “Remain” camp will prevail. If we had to make a call we would also suggest that Remain will prevail simply because a significant % of likely voters (around 10%) are still undecided and historical precedent suggests that undecided voters tend to opt for the status quo at the last minute. But it is very close.

So, there is a real chance that the UK could actually vote to leave the EU, but what does this mean in practice?

Well, the UK already has its own currency, so it really just pertains to the legal, trade and regulatory aspects. As an EU member, some of the UK laws and regulations would need to comply or “harmonize” with EU policies and regulations.

That doesn’t sound like such a big deal, why all the fuss?

Well, the UK enjoys certain advantages from being part of the EU. For instance, it is generally easier to trade or do business with other EU member nations, if you have similar laws and regulations or uniform product and service standards. The UK also would not immediately enjoy free trade access to EU markets in the event of Brexit, which could hurt UK manufacturers and exports, specifically those who derive a large share of their revenues from the EU region.

Ok, but still it doesn’t sound like the end of the world?

Indeed, it would not be the end of the world nor for that matter the EU or the UK. However, we think it is the general political message that is being sent that concerns investors. More broadly, a vote in favour of Brexit could trigger demands for a similar referendum in other EU member nations, where anti-EU sentiment has also risen in recent years.

We are also seeing rising populist sentiment in many developed countries, in part a function of economic stagnation, but on the other hand also driven by a pushback against integration and immigration. The pushback against globalization will raise the risk for many multi-nationals that could inevitably become the main targets of any anti-globalization or “protectionist” regulations that are enacted.

A major reason that many working class people in the UK could consider voting to leave the EU is the concern with regard to more open borders and immigration and perhaps linked to that the perception of increased vulnerability to other threats such as terrorism. The UK elites arguing in favour of Brexit point to the loss of sovereignty that comes from being an EU member nation.

Are these valid concerns?

The more pertinent question is whether you can change the inevitable. Integration and globalization are secular and almost intractable forces being driven primarily by technological innovation and integration. We can only push back against these forces so long and in the final analysis integration, reducing barriers to trade and the free movement of capital and labour are generally net positives in terms of raising economic potential and living standards.

The European Union (EU) is undoubtedly one of the greatest political achievements in the last century and the large integrated free trade zone that has formed out of this multilateral co-ordination has brought substantial benefits to the region. It has also been a powerful force for promoting and sustaining human rights and liberal values and extending these values into previously autocratic regions such as Eastern Europe after the fall of communism.

An expansion in the size or number of these types of integrated regional blocs around the world would undoubtedly spur further efficiencies and prosperity.

But there is currently increasing political push back against this type of integration?

Indeed. we think the formation of the Euro or single currency before the formation of a bona fide fiscal union (or at least greater political union) has created a significant structural defect in the current EU system. There are also valid concerns over the loss of national sovereignty. For instance, perhaps the way in which the Greek crisis was and is being handled, has created perceptions that smaller or peripheral nations will end up becoming irrelevant within an EU system dominated by larger countries such as Germany and to a lesser degree France.

There is little doubt that the EU as it exists in its present form requires substantial structural reform in many aspects. The question for UK citizens is can they best effect such reform from within or outside the EU and will they be able to manage the negative consequences of not being a full EU member.

Do you think they can?

In the short-term perhaps, although at the margin there must be some cost if trade and business interactions with other EU members contain a greater degree of let’s say transactional “friction”. This suggests that unless the UK is able to sign very favourable trade and business treaties with the EU, there must be some long-term cost, however, small it may be. Will it push the UK economy into recession or a prolonged stagnation? Probably not.

Nevertheless, there is also the risk to the UK banking system and London’s role as a major banking centre. The impact on London and the financial system is probably one of the great “unknowns” and could, in theory, represent the biggest risk from a vote in favour of Brexit.

The UK banking sector has large liabilities that amount to a multiple of UK GDP (200% – 300%). Although in this case, the UK banking sector has offsetting assets attached to these liabilities, in a situation where confidence in the UK financial sector is eroded, the ability of the UK banking sector to maintain this level of leverage could be questioned. With a negative net investment position and current account deficit (near a historic high of around 5% of GDP), the prospect for a large devaluation in the pound, certainly relative to the US Dollar exists.

Given large fiscal deficits and high debt levels, should the Bank of England fail to raise rates in this environment, inflation and associated government borrowing costs could spike.

Broker Dealer Currency Mismatches

Broker Dealer Currency Mismatches

But again if the Pound were to devalue enough would it not “rebalance” the economy?

The UK is net debtor nation meaning that it owes more to foreigners than is owed to it by foreigners. In 2015 the UK’s net negative investment position was estimated at around GBP 380bn or 20% of GDP.  It is also in part a key driver of the UK’s current account deficit, of which the income deficit comprises a large proportion. The income deficit simply means that UK residents earn less from their investments abroad than non-resident investors do from owning assets in the UK.

Furthermore, the country’s net external debt was estimated at around 500% of GDP. External debt is debt issued by the country’s government, corporate and banking sector and owned or owed to foreigners.

Wow, that is pretty big.

Yes, it is, but again not necessarily a problem, if there are matching foreign assets, of which by and large there are.

So what is the problem then?

Well, if the debt owed to foreigners is denominated in your local currency, being a net debtor nation is not that big of a problem. As the currency depreciates, the value of your foreign assets rises relative to the value of your foreign debts and eventually if your currency depreciates enough you become a net creditor! This is something that has recently happened to South Africa by the way.

But if the debt you owe is denominated in foreign currencies, you could have a real problem and in the UK a large proportion is and mainly related to the UK banking sector. As London has grown as a global banking sector so have the country’s banking assets as a % of GDP.

In order to grow their assets, UK banks have had to fund themselves in international markets, taking on foreign currency debt, given that there are simply not sufficient local deposits to fund such large-scale banking operations.

Again, where the currency risks in terms of assets and liabilities are matched (they may at least nominally be hedged), this is not a problem. In a 2015 financial stability report, the Bank of England provided some reassurance outlining that the value of foreign currency-denominated foreign liabilities is less than the value of foreign-currency-denominated assets. This would suggest that in theory at least, a devaluation in the Pound, would improve the country’s net investment position although it could take a substantial devaluation relative to these foreign currencies that comprise the UK’s foreign currency external debt (likely USD, EUR and Swiss Franc) to achieve a meaningful re-balancing and eventual narrowing in the current account deficit, in the absence of a debilitating increase in interest rates.

Furthermore, a shift in the relative value of the currencies that comprises the UK’s foreign currency debt is also potentially important. If a large proportion of the UK banking sector’s foreign currency debt is denominated in US Dollars and most of its foreign assets are denominated in currencies that may depreciate verse the US Dollar, than a large appreciation in the US Dollar, could invariably lead to a situation where the UK’s foreign currency liabilities eventually exceed the value of its foreign currency assets. Indeed, there is evidence that this is presently the case.

That seems problematic, but you can detail the risk more specifically perhaps?

Well, if the UK’s foreign currency liabilities exceed the value of its foreign assets, then no degree of depreciation in the Pound would restore or improve its net investment position. And then, in theory, the only way to restore the UK’s current account balance to a surplus and put a “floor” under the Pound would be for the Bank of England to raise interest rates, possibly quite significantly. This would put the economy into recession, crimping domestic demand and thus forcing the country to run a trade surplus.

That is a fairly disturbing scenario. Could this really happen?

As we said earlier, we just don’t really know. In part, it is very difficult to know, at least “real-time” the nature or composition of the combined banking sector’s balance sheet. Perhaps the probability is small and therefore not meaningful. But it does highlight real longer-term risks associated with an over-sized banking system based in a country running a current account deficit and therefore reliant on external funding.

At the margin, this will detract from the attractiveness in investing in the UK or at least in sectors such as financial services, property, and construction. On the other hand, a large-scale devaluation in the pound would probably be of significant benefit to UK exporters and manufacturers.

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