Brexit, trade and the City. Paul De Grauwe

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2 Brexit, trade and the City Paul De Grauwe

3 Introduction The UK government seems to be determined to guide the country towards hard Brexit Its political objective is to take back control over borders, laws and money, i.e. it is an objective of full sovereignty. The PM claims that this is possible while going global, i.e. while at the same time pursuing free trade agreements that will keep the UK fully anchored into the global economy and all this while maintaining democratic decision making processes.

4 Impossible trinity These objectives of full sovereignty, democracy and globalisation are inconsistent. This follows from Rodrik s impossible trinity theorem This says that only two of the three objectives can be satisfied simultaneously If UK chooses for sovereignty and democracy it cannot have globalisation, i.e. it will have to move towards protectionism. The reason is that globalisation imposes rules on nations that reduce its sovereignty. Whether these rules come from Brussels or from elsewhere is of no importance

5 These inconsistent objectives pursued by the UK government have created a fantasy world in which this government continues to operate The awakening will be rude forcing the government to make hard choices. My prediction is that, as it is obsessed by the objective of full sovereignty, it will end up in a situation where it has to take on the WTO statutes that will lead to the imposition of import tariffs and full control over immigration This is the only option that preserves the objective of sovereignty and democracy.

6 It may turn out that there is a lot of posturing and that when push comes to shove the government will back down from its desire to go for full sovereignty. I will assume that the government will stick to its choice What are the implications from this choice for trade for the City?

7 Implications for trade New globalisation is very different from old globalisation (Richard Baldwin) Old globalisation was based on strong reduction of the cost of moving goods, while the cost of moving ideas and people did not decline at the same rate. The ICT revolution has changed this It has made it possible to substantially reduce the cost of moving ideas.

8 As a result, it became possible to unbundle production stages and transfer many of these to other countries This has created long global value chains that encompass many borders leading goods to frequently cross the same borders while with each border crossing new components have been added

9 A country that introduces protectionism (US, UK) cuts itself off from this global production networks and will see its competitiveness decline significantly Thus the UK, when leaving the single market, will cut itself off from the production network with Europe which is the most significant one. The UK government has created the myth that while it cuts itself from the European network and value chains It will easily replace this with new global networks. This is Wonderland Economics

10 Implications for the City Some notions on the economics of the City should be developed first These notions are Economies of scale Both internal and external to the firms They lead to corner solutions, i.e. a concentration of activities in one particular place (city or country) and multiple equilibria, i.e. many different outcomes are possible, depending on initial conditions and policies They also lead to great uncertainty about the outcome, i.e. which corner solution will be selected

11 Economies of scale Some activities in the City are characterized by large economies of scale Best example is clearing transactions The City is global base for clearing foreign exchange transactions. Clearing is executed through central counterparty (CCP). Three-quarters of all foreign exchange trading takes place in London As a result, the City enjoys economies of scale And it is very difficult to dislodge the City from this advantage Except with Brexit

12 According to Simeon Djankov(2017): Leaving the single market could have significant consequences for the City s role in clearing activities: United Kingdom would be treated as a third country in the European Union, affecting half of the City s business, (around 11 billion), and possibly resulting in the partial relocation of euro clearing activities to markets in the eurozone These are only static effects Dynamic effects come from economies of scale

13 Brexit could trigger a significant loss in economies of scale These could be acquired by competitors on the continent or elsewhere It is likely that this would be pushed by Eurozone authorities eager to profit from Brexit. As one of these competitors acquires significant economies of scale we move to another corner solution Put differently, Brexit could be the mechanism that tips the balance and moves the financial markets to another equilibrium

14 External economies of scale Economies of scale can be internal to the firm (each firm has to be large to enjoy declining average costs) or external to the firms. The latter is the case for the banking sector in the City where there are many banks enjoying external economies of scale coming from a pool of highly skilled people and services (e.g. legal services) This has led to clustering of banks in London (a corner solution)

15 Brexit could trigger a movement that will lead to new clusters elsewhere. Reason: los of passporting rights together with restrictions on immigration may lead many banks to relocate significant parts of their activities, reducing the external economies that banks enjoy in London, And creating new economies of scale elsewhere

16 Conclusion on Brexit and the City Given the nature of economies of scale and the potential for multiple equilibria Brexit could lead to large scale displacements of activities as the City loses key scale economies However, it is very difficult to predict how much relocation there will be and in what direction this will go

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18 Why I think Brexit is a negative sum event..even though shrinking the City is possibly a plus for the UK

19 The argument in short The City was and is the financial centre of a monetary union to which it does not belong This can be a source of frictions ( euro-clearing) But it is also an opportunity for risk diversification on both sides ( central bank cooperation, Irish bailout) Brexit in the City means more risk concentration in the euro area/ EU-27 And more of the regulatory race to the bottom that contributed to the financial crisis in

20 What would Brexit in the City mean? Primarily a loss of wholesale bank business 0 issuing and trading of debt and equity securities, 0 foreign exchange trading 0 and derivatives To the extent that these banks used London as a gateway to the remaining EU-27 This was facilitated by passporting under Single Market regulation (MiFID) Will be replaced by equivalence of a third country regime (eg banks operating from New York or Zurich)

21 How much of the City may go? An estimate by Sapir, Wolff, Véron (2017, Bruegel) On average, about 35 percent of London wholesale banking is related to EU27-based clients 0 about one fifth for UK-headquartered banks 0 a third for US-headquartered banks 0 and half for EU27-headquartered banks. Since about half of all UK banking is wholesale banking in London, about 1.8 trillion (or 17 percent) of all UK banking assets might be on the move as a direct consequence of Brexit. (p.3)

22 The City s role was a cause of friction No. of countries with resp. crisis Big Bang Maastricht Treaty Banking crises Currency crises Sovereign debt crises Source: ECB Working paper No.1485, 2012

23 The case of Central Counterparties (CCPs)

24 Risk sharing UK-EA during crisis UK government contributed 3.8 bn to 85 bn bailout package for Ireland; but nothing to Spanish bank rescue programme although UKheadquartered banks were quite exposed Source : BIS 6/2010

25 Where is London s wholesale banking directed at EU- 27 likely to go? Some business would relocate to New York The rest would relocate in the EU This is likely to benefit primarily Frankfurt, Paris, Dublin and Amsterdam

26 But is it a benefit to get parts of the City s business? Source: BoE, QuBulletin 2014/4

27 Still, a race to the bottom looms

28 A negative sum game For the UK: Loss of jobs and political influence in international financial regulation Central bank cooperation will continue but less smoothly Shrinking of City s business may reduce risk to taxpayer, however For the EA/ EU-27: Loss of a diverse voice in market regulation And first-class financial services for which UK underwrote a large part of the risks Some of the City s business may go elsewhere and thus reduce risk for Europe Source: