BREXIT: LOOMING UNCERTAINTY

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1 INTERNATIONAL SERVICES BREXIT: LOOMING UNCERTAINTY Paul Toth, Senior Vice President, Foreign Exchange, PNC Courtney Roberts, Vice President and European Treasury Management Director, London, United Kingdom, PNC The true impact of Britain s recent vote to exit the European Union may not be clear for years perhaps decades as conditions are negotiated and nations adjust to the change. What is clear is the need for individuals and corporations to understand the risks and opportunities as an uncertain situation evolves. pnc.com/ideas

2 KEY MILESTONES These events may influence how and when the UK leaves the European Union. Q4 2016: UK Labour leadership competition results may impact the ability to move forward with invoking Article 50 of the Lisbon Treaty Q1 2017: Expected time frame for Article 50 to be triggered, which would push the UK exit from the EU to Q Other important EU country elections: Italy (October 2016), Germany (February 2017), France (May 2017) Britain s Brexit vote on June 23, 2016, upended expectations, with 51.9% of voters backing the leave campaign versus 48.1% backing remain. The result sent shock waves through the markets and created an unstable political environment in the United Kingdom (UK) in the weeks following. Status of Brexit Today Today, a new British Prime Minister (PM), Theresa May, is in place and negotiation teams are being assembled within the UK and the European Union Council. The main reasoning behind the campaign to leave the European Union involved public finances and how much the UK provides to the EU budget annually, trade agreements where EU rules and regulations dictate the safety and protocol for the UK s products and services, and lastly, immigration. Today, EU citizens are able to move freely among the member states, including the UK. Since 2004, the UK has had a large influx of EU migrants and numbers have been significantly increasing in the last few years. UK citizens argue that this puts a stress on their public services such as education, healthcare, housing, jobs and other sectors. UK Negotiating Strategy While the referendum result was not legally binding, May has stated that the UK should move forward with invoking Article 50 of the Lisbon Treaty. Article 50 lays out the procedure for an EU member state to begin the two year negotiations with the European Council prior to exiting. PM May has stated that she will not invoke Article 50 before the end of 2016 in order to provide the UK government s leaders time to plan their negotiations with the EU Council. Access to the EU Single Market (free trade area), passporting capabilities and free movement of people are key items up for negotiation. Reaction of Financial Markets The financial markets reacted to the Brexit vote initially with a sharp drop in the pound, tumbling equities, falling gilt yields and predictions about interest rates being slashed. The pound sterling fell 11% on the initial announcement and has rangetraded within a 4% band since then. 2

3 The magnitude of the currency depreciation is expected to put continued upward pressure on inflation to the tune of 1%. Furthermore, the Financial Times Stock Exchange (FTSE 100) fell nearly 10%, but unlike the currency, has already recovered all losses and is up 17 percent since the referendum. While the initial rebound was positive, the equity markets are expected to remain volatile as investors take time to reassess the macro economic conditions and earnings potential of UK companies. While there was much initial concern over the financial impact of the Brexit vote, the actual impact has been fairly benign. The Brexit results had a modest impact on Eurozone business and consumer sentiment in the two months following the June 23 referendum. The European Commission s Consumer Confidence Indicator dipped in the August release; however, it was only slightly weaker than the average in 2016 prior to the referendum (January to May). The Brexit referendum affected consumer confidence less than the Brussels terrorist attack in March and resulting early 2016 financial volatility. Eurozone consumers assessments of employment and the general economic outlook softened in March, but have been mostly steady since then. Brexit and geopolitical uncertainties continue to pose downside risk to the Eurozone outlook, but the area s economy is so far weathering these shocks resiliently. On balance, recent consumer sentiment data makes the European Central Bank s (ECB s) Governing Council more likely to extend the duration of its quantitative easing program by six months. If they extend the program, then purchases would continue at an 80 billion euro monthly pace through September 2017 (the current minimum end-date is March 2017). Also, the central bank s recent guidance leads us to believe that euro short-term interest rates are likely to remain negative until at least the second half of 2018 if not even longer. Access to the EU Single Market (free trade area), passporting capabilities and free movement of people are key items up for negotiation. Modeling the Way Forward Will the UK still have membership to the EU single market? The free trade area only imposes tariffs on non-eu countries, and it allows businesses, such as financial institutions, to passport services to other EU member states without any hindrance to business. Passporting allows a firm registered in the European Economic Area (EEA) to do business in any other EEA state without needing additional authorization in each country. It eliminates the cumbersome process of gaining redundant registrations, a process that can be both lengthy and costly for a business. 3

4 BRITISH POUND STERLING VS. US DOLLAR MAR APR MAY JUN JUL AUG 2016 Chart Source: The EU Council has stated in the weeks following Brexit that the UK will not be able to retain access to the single market without at least accepting free movement of people and contributing to the EU budget. We expect that the EU Council will be very tough in their negotiations with the UK, in order to preclude other countries from considering leaving the EU as well. We have laid out several potential models, but the actual implementation will be based on voter sentiment and the ability of UK negotiators to get them passed. Impacts to Business Strategy Short- and long-term contingency planning is going to be a crucial part of managing through the impacts of Brexit. Ideally, corporations should try to stay as agile as possible and conduct what-if modeling analysis to prepare for all possible scenarios. Some examples of this include short-term and longer-term revenue and profit modeling taking into consideration a UK economic slowdown and access to the European marketplace. 4 ANALYSIS OF POTENTIAL POST-BREXIT MODELS MODEL TYPE MODEL COUNTRY DESCRIPTION THE LIKELIHOOD OF IMPLEMENTATION EEA + EFTA (European Free Trade Association) Norway Membership to the EU single market Does not contribute to the EU budget but required to contribute to EEA grants and funding of specific policy programs. Requires implementation of EU legislation covering free movement of goods, services, persons and capital. No influence over development and adoption of new rules Low: Pro-exit sentiment was driven by opposition to free movement of people within the EU and EU regulation on business. Non EEA + EFTA Switzerland Bilateral agreements with the EU allowing the UK to pick and choose areas where the UK would gain benefits from accessing the EU Single Market; corresponding legislation would apply. UK demonstrates equivalence with relevant EU legislation where areas of market access are not covered by bilateral agreements. Influence limited over EU legislation Low: Arrangement still includes free movement of people, which was a factor in pro-exit sentiment. FTA Canada Preferential access to the EU Single Market eliminating most tariffs Excludes regulations on some exports Medium: More likely to create their own bespoke model but would probably exclude financial services passporting WTO United States No free movement or financial contribution No EU regulations but traded goods still have to meet EU standards Medium: Default arrangement initially if negotiation period extends beyond two years or if compromise cannot be reached Hybrid N/A Preferential access to the EU Minimized tariffs Restricted movement of people Exclusion of regulations High: The UK will most likely attempt to draw from other models but seek to structure their own unique deal.

5 Businesses should consider performing profitability scenario analyses based on exposure to currency movements, decline in consumer and/or business confidence, and the workforce impact of an EU exit. For example, industries such as retail, hospitality, travel and consumer products are likely to be most affected by consumer confidence, whereas financial services, business services, real estate and construction may be more affected by business confidence declines. Businesses should seek to understand what the potential tax implications will be in the short- and long-term around these factors. Identifying specific drivers such as the location of key suppliers and customers, as well as evaluating the entire supply chain, will be essential. For instance, you may be receiving EU subsidies today that could be withdrawn after the UK leaves the EU. One example is the farming industry in the UK, which is very dependent on EU subsidies. There is also a great deal of research done in the UK on behalf of pharmaceutical companies. In January of this year, the European Investment Fund put 24.8 million British pounds towards the commercialization of scientific inventions, including new medicines. Therefore, it will be important to identify and understand the parts of the supply chain that may be affected by the withdrawal of certain subsidies. Key Location Considerations Another important factor is identifying where your employees are located and what type of citizenship and visas they have. The UK may not have access to free movement of people going forward and there is no guarantee of acceptance for current UK citizens living in the EU or vice versa, EU citizens living in the UK. As mentioned in the proposed model section above, trade agreements may be modified or eliminated, forcing US manufacturers with factories in the UK to start paying tariffs on goods sent from England to EU countries. Those goods would also have to go through customs. Thus it will be beneficial to evaluate the additional time and cost to business operations that could favor your European competitors. Businesses should consider performing profitability scenario analyses based on exposure to currency movements, decline in consumer and/or business confidence, and the workforce impact of an EU exit. 5

6 Banks in London and elsewhere may take the next two years to create contingency plans that will allow them to operate out of other EU countries where they have licensing, but at least for now they are not making any sudden moves. Although it could be years away, Britain s exit from the European Union risks stripping companies of their ability to freely store information about EU residents on British soil, potentially creating a new barrier to trade. Under current EU law, an independent country needs to convince the EU that it guarantees individual privacy up to EU standards for companies there to retain unfettered access to everything from European payroll records to EU residents cellphone location data. But the UK faces hurdles, including a possible review of its surveillance practices. This could be a huge hurdle for technology firms and their customers unless the UK negotiates a specific privacy deal. There is also some opportunity here for businesses that are seeking to deploy capital. With some UK and EU companies taking a major hit to their stock price recently, this change could create an opening for opportunistic firms that are looking to grow. Banking Relationships Today, the EU has a passporting regime that allows banks to run the bulk of their European trading operations out of the UK. But passporting may no longer be applied after the negotiations, and could impact a variety of financial institutions including asset management and insurance companies. London, in particular, is heavily populated by US and global banks. Brexit could affect their services, including access to euro payment systems, such as SEPA, which is the equivalent of the US s ACH system, and TARGET2, which is the EU s wire platform. Companies will also want to examine the health and credit quality of their banking partners against their current policies. Banks in London and elsewhere will take the next two years to create contingency plans that will allow them to operate out of other EU countries where they have licensing, but at least for now they are not making any sudden moves. Consider speaking to your financial services providers in the market to understand how your relationship and products and services may be impacted post-brexit. 6

7 Considerations for Importers and Exporters Importers and exporters should closely examine the currency environment in which they are conducting business. Shortly after Brexit, the pound sterling was trading nearly 12% weaker than pre- Brexit. For US companies importing from the UK, this is a great opportunity to increase volumes at discounted rates or switch from conducting business in US dollars to pound sterling. Additionally, if a merger or acquisition in the UK was a consideration in the recent past, now is a great time to elevate that topic to the top of the to-do list for the fourth quarter of this year. Conversely, exporters sending product to the UK should be cognizant that the relative cost to pay in US dollars has risen by 12% due to the depreciation of the pound sterling. By pricing in local currency and managing the currency risk through foreign exchange hedging, margins can be maintained, and customers can be insulated from the effects of a battered currency. Both importers and exporters will be affected by the recent fluctuation in the GBP/USD exchange rate so it is important to properly leverage the available tools to mitigate the currency risk. It is always recommended that you consult with your foreign exchange representative to develop a strategy that suits your individual company s risk tolerance. KEY TAKEAWAYS As Brexit evolves, it will be important to: Identify how all components of your supply chain are impacted by potential changes. Understand the relative impact of exchange rates. Conduct scenario analysis, taking into consideration currency movements, consumer and business confidence, and workforce impacts of an EU exit. Ascertain the impact of passporting on your employees and business registrations. ABOUT THE AUTHORS Paul Toth, Senior Vice President, Foreign Exchange, PNC Toth is a Senior Vice President in PNC s foreign exchange group. He currently serves as regional foreign exchange sales manager responsible for leading a team of foreign currency specialists that provides international cash flow management and derivative hedging solutions to PNC s corporate client base. Toth has been with PNC for 15 years and prior to that worked in the trading and sales areas of the Bank of Montreal, Harris-Nesbitt, and Merrill Lynch. He received a master s degree in business administration from the University of Pittsburgh with a concentration in finance. Courtney Roberts, Vice President and European Treasury Management Director, London, United Kingdom, PNC Roberts is responsible for supporting corporate customers doing business in Europe. She has held key positions in compliance, supply chain operations, product management and international banking at PNC Bank during the past 9 years. Roberts holds a master s degree in business administration and a bachelor s degree from the University of Pittsburgh. She has a certificate for the High Potential Leaders Executive Program from Harvard Business School and has spoken at a number of Association of Financial Professionals (AFP) and industry conferences. NOTE: This paper reflects an update on the topic of Brexit following PNC s Ideas and Insight webinars titled Historical Changes in Europe and The Impact of the Brexit Vote and the Road Ahead. Recordings can be found at READY TO HELP At PNC, we combine a wider range of financial resources with a deeper understanding of your business to help you achieve your goals. For more information regarding this article or foreign exchange strategies in general, please contact your Relationship Manager or visit pnc.com/ideas. The information contained herein ( Information ) was produced by employees of PNC Bank, National Association ( PNC Bank ). Such Information is not a research report nor is it intended to constitute a research report (as defined by applicable regulations). 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