Bracing for Brexit
At the end of February 2016, Prime Minister David Cameron announced that Britain would have a referendum on 23rd June 2016 to vote on whether it will remain in the European Union (EU). The referendum will be a simple “Leave” or “Remain” vote and the announcement came after the finalization of negotiations on Britain’s relationship with EU, in which Cameron secured a number of key concessions considered a pre-requisite for the government to support a “Remain” campaign.
In the event of a “Leave” vote, withdrawal of Britain from the EU would come into effect by triggering Article 50 of the EU Treaty by the British government. In this case, Britain immediately loses its vote in the EU, so the decision on the exit deal is in the hands of the 27 remaining countries. The initial timeframe for the negotiations of Britain’s new trading and institutional relationship with the EU is two years. This period can be prolonged but the approval of all remaining member states is needed.
Britain would need to renegotiate trade agreements with the EU and the rest of the world. It is quite possible, according to some quarters, that Britain’s trade with Europe (and the rest of the world) would continue without interruption and that many countries would be eager to sign new trade agreements with the UK quickly. On the other hand, other countries have been quite outspoken in indicating Britain would have to ‘take its place in the line’. However, from an EU perspective, indications are that there would be little incentive to give favourable trade agreements to Britain without full compliance to all EU regulations, and it could also impose a harsh settlement to discourage an exit by other countries. . It’s hard to disseminate the political posturing from the likely realities, but official UK reports suggest that this whole process could take up to a decade. Such a long period of uncertainty would clearly increase volatility in the financial markets, and have a significant impact on inward investment to Britain, and it’s GDP.
Most recent polls suggest that the result is going to be very tight. The results are converging after “Remain” showed and early advantage and the trend currently seems in favour of “Leave”*. The majority of polls show that a high percentage of voters (around 20%) are still undecided and these votes will clearly be a decisive factor. In general, however, people are more inclined to preserve the status quo, i.e. to remain in a ‘reformed EU’. Therefore, Brexit can perhaps be classified as a low probability-high impact event that requires a proper risk assessment and contingency planning by companies that operate in Britain or those that have significant business ties with the UK market. Equally, a decision to remain is not a guarantee that the ‘status quo’ will be preserved and many companies will be evaluating the impact of both scenarios from a risk perspective.
Economic implications relevant for treasury
Remaining in the EU poses certain disadvantages to Britain, such as limited freedom over the borders and negotiation of discrete trade agreements, significant payments to the EU budget and constraints from the EU rules and regulations. On the other hand, severe regulatory and legal uncertainty about the post-Brexit existence of Britain has the potential to negatively impact the British economy. The negative outlook of the financial market on Brexit and its economic consequences is evidenced already in the value of sterling, which has depreciated considerably against US dollar and euro since the referendum announcement.
Import and export activity is an important contributor to Britain’s economic growth. Currently there is a negative trade balance with a deficit on goods, but a surplus on services. Figure 1 below depicts the changes in British trade balance in the year 2015. Britain has historically strong ties with the other EU countries; 44.6% of Britain’s total exports go to the EU and 53% of all goods and services imported to the UK come from the EU.
Figure 1: UK’s Trade Balance
There are several existing models being cited (Norway, Switzerland, Canada) that might be adopted by Britain in the event of Brexit, but currently there is no clear view which of these, or alternatives, Britain might select to retain access to the EU Single Market. None of the existing models seem to be attractive for a post-Brexit Britain. Free access to the EU Single Market requires almost full compliance with EU regulations, which is very unattractive to the “Leave” campaigners. Other options currently do not guarantee a free trade of services, which are vital to the British economy. However, a customized trade agreement for Britain with the EU is also not probable because the EU is not likely to grant it. Due to this uncertainty about the future trade relationship, Brexit is likely to result in lower trade in the short term. Weaker trade could significantly impact the liquidity and profitability of the UK based companies and the non-UK companies that are dependent on exports to Britain. Cash flows from export and import activities could be interrupted and they would be more volatile. Consequently, companies might face (short-term) liquidity problems especially shortly after the Brexit negotiations start. Increased import costs, sterling depreciation and regulatory uncertainty can also have a negative effect on demand for imported goods when there is an option to buy locally, and is also likely to lead to increased inflation. In general, if Brexit causes Britain’s economy to go into a recession, as has been suggested might be a possible result by the Governor of the Bank of England and the Head of the IMF, there would be increased unemployment and a deprived domestic demand that could affect revenue of any company that is doing business in the UK. Additionally, the tax regime could become less attractive for UK companies under this scenario.
The financial service sector would suffer the most from the uncertainty about the access to the European Single Market. Currently, financial services are a significant contributor to British prosperity where London acts as a bridge between US and EU in derivatives trading and clearing of euro-denominated payments. After a Brexit, Britain’s financial services sector might not be deemed equivalent to those in the Eurozone under the EU regulatory regime, which can make it difficult for them to reach the EU market. Euro-zone based institutions might try to take greater share of euro-denominated trading and settlements within Eurozone, taking business away from Britain. This could have an influence on the capability and costs of the British banks providing international cash management services.
The threat of a shortage of capital flows from foreign investment makes it difficult to finance the British current account deficit, which would be a concern for foreign investors. After Brexit, there might be an interruption of capital inflows and an abrupt increase in outflowing cash from the UK. Lower foreign direct investments and reduced portfolio inflows into UK assets could be expected. A restriction of the free movement of people in post-Brexit Britain is another factor that would make Britain less attractive for investments in a Brexit scenario. A number of companies have already indicated their intentions to relocate their businesses, headquarters, jobs or some activities outside the UK (Rolls Royce Motor Cars, BMW Group, Deutsche Bank, HSBC, JP Morgan Chase, and ING). There could also be ‘flight to safety’ impact with a run for the US dollar or other “safe haven” currencies in FX markets that would cause their sharp appreciation. Consequently, companies that are financed in US dollars (or other “safe haven” currencies) could incur higher interest expense.
The value of sterling and British economy
Continued high sterling volatility is forecast at least until the referendum and, it will likely continue if Britain chooses to exit the EU, although financial analysts conclude that a lot of uncertainty about Brexit is already priced in. Figure 2 below shows the development of the GBP/USD exchange rate development over the last year. Figure 3 depicts the same for the GBP/EUR exchange rate.
Financial analysts conclude that a lot of uncertainty about Brexit is already priced in. Thus, in the case that Britain stays in the EU, an appreciation of sterling against the euro might be expected. On the other hand, it is not clear whether sterling will continue depreciating against euro even in the case of Brexit. The EU will lose a strong member and an important trading partner in a period of high downside risks including a significant decline in commodity prices, geopolitical unrest and the refugee crisis. Hence, it is plausible that Brexit would have a negative impact on the EU economy and sterling will appreciate against the euro, while both currencies lose their value versus the US dollar and other major currencies. A depreciating sterling has so far had a positive effect on UK equities as the FTSE comprises mostly multinationals whose substantial overseas earnings benefit from a depreciating sterling. In the event of a Brexit, the primary threat of depreciating sterling for British companies and subsidiaries lies in import costs. Long term sterling depreciation will lead to inflation, which can in turn lead to depressed domestic demand. This has also implications for the non-UK based companies that have significant exports to Britain mainly in terms of revenue decrease and higher FX risk. Moreover, high sterling volatility has already impacted the costs of insuring portfolios and business activities against further decline in sterling.
A study by the Bank of England concluded that membership of the EU benefited the economic growth of the UK. Other independent analysts also expect slower economic growth in a post-Brexit Britain. Overall, depreciation of sterling puts pressure on Britain’s budget and current account deficit. Credit rating agencies are warning that Brexit could cause a downgrade of Britain’s credit score and there have been predictions of a decrease in economic output by 2% causing recession and increased inflation. Consequently, companies would face increased counterparty risk with British suppliers and customers. It is predicted that financial institutions would encounter the highest increase in credit spread. Increased costs of funding in sterling could be expected, which can have implications for liquidity and working capital management. After a Brexit, bank financing and capital markets may dry up to some extent and the financing costs could be higher, which would increase refinancing risk.
Recommendations for treasurers
As outlined above, Brexit can have considerable impact on the economy, businesses and subsequently on corporate treasury. While a clear majority of UK business leaders recently polled by British Chambers of Commerce are in favour of a “Remain “result, the gap is narrowing with a significant jump in support for Brexit being noted. This might be interpreted as an indication that following analysis, more businesses are concluding that a Brexit result would have a lighter impact than originally thought, nevertheless as no two businesses are ever the same, from a treasury perspective, a comprehensive risk assessment of this event would also be prudent and recommended. Although, it is hard to predict the exact effect that Brexit would have on corporate treasury, there are some specific actions that treasury can undertake to mitigate the identified risks and reduce uncertainty.
The most obvious recommendation concerns management of FX risk, liquidity risk and counterparty risk. Companies could benefit from stress testing the impact of a Brexit on their key financial parameters, which could give more insight into the relative magnitude of different risk categories. Due to the current high economic and political uncertainty, stress testing this event can be a valuable exercise for corporate treasury even if a Brexit does not happen.
With regard to FX risk management, treasurers should ensure that all currency exposures are identified and managed. However, hedging instruments may come at higher costs at least until the referendum. Inclusion of currency adjustment clauses in contracts with customers and suppliers is an alternative approach to FX risk management that avoids hedging costs.
From the more strategic perspective, multinational companies might consider drawing up contingency plans for relocation of their headquarters, reviewing their tax and legal structures, considering alternative treasury and trading models, changing their functional currency, or switching suppliers (matching revenues with costs accrued in the same currency) to limit the economic risks associated with Brexit.
A further risk that needs to be managed is liquidity risk. As outlined before, Brexit can increase the volatility of both incoming and outgoing cash flows. Thus, it is important to safeguard sufficient liquidity in the period of uncertainty. If there is a need for (sterling) refinancing, it should be executed well before the referendum. Several strategies can be used to deal with increased counterparty risk during Brexit. Companies trading with Britain can establish credit limits with their customers, take out credit insurance against suppliers/customers and limit overall exposure to the UK market. Additionally, treasurers could limit individual credit as well as operational exposure to UK banks, which can be undertaken in connection with any refinancing.
In relation to both FX and liquidity risk, improvement of the visibility of cash is crucial in order to determine exposure to Brexit. Treasurers should review whether financial contracts with different counterparties would be affected by Brexit. It would be also worthwhile to determine the level of reliance on UK banks from a cash management point of view. There might be a need to switch banking partners, or at least secure access to alternative banks that are based in the Eurozone.
Following the advice of the ICMA (International Capital Market Association) the drawing up of contingency plans connected to a strategic view on a post-Brexit Britain is recommended. As already mentioned, companies can assess the possibility of the relocation of the headquarters, treasury function/activities, staff and future investments. Specifically for the treasury function, it could be more effective to have a treasury centre in the EU to avoid uncertainty about regulations or alternative sales/trading models based outside the UK, for example commissionaire structures or, re-invoicing centre’s etc. to avoid uncertainty about trade regulations and costs. However, in this case, the new Base Erosion and Profit Shifting (BEPS) regulations should also be taken into consideration.
Whatever the outcome of Brexit and all the uncertainty that surrounds it, treasurers can be sure of one thing. There will continue to be more questions than answers over the coming weeks, and treasury will have a major role to play in any contingency planning as strategic advisor to the CFO and board. Closer integration between treasury and the business will be the key to facilitating the gathering of information from throughout the company on exposures, enhancing visibility and control over liquidity and working capital, and being in a position to fully evaluate potential risk mitigating options. As Warren Buffet once put it: ‘the future is not what it used to be’.
* Source: whatukthinks.org poll of polls from ICM, ORB, Opinium,YouGov between 26th April and 8th May 2016
Figure 1. UK’s Trade Balance. Reprinted from Office for National Statistics, Retrieved April 11 2016, from https://www.ons.gov.uk/economy/nationalaccounts/balanceofpayments/datasets/publicationtablesuktrade
Figure 2. GBP/USD Spot Exchange Rate May 2015-April 2016. Reprinted from Bloomberg, Retrieved April 11 2016, from http://www.bloomberg.com/quote/GBPUSD:CUR
Figure 3. GBP/EUR Spot Exchange Rate May 2015-April 2016. Reprinted from Bloomberg, Retrieved April 11 2016, from http://www.bloomberg.com/quote/GBPEUR:CUR