INTERNATIONAL FINANCIAL MANAGEMENT

CASE BREXIT

The Brexit can be considered as one of the most surprising events of 2016 with a great
impact on the (financial) world. The goal of this case is to consider how this break-up
could impact the different topics we have discussed in class in a UK and EU context.

Group 4

Corne Tom
De Becker Ward
De Ketelaere Yves
De Rese Milan
Goddyn Louis
Inghelbrecht Pieter-Jan

Prof Dries Heyman

Dries.Heyman@UGent.be
Hannes Stieperaere
Hannes.Stieperaere@UGent.be

Academic year 2016-2017

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Table of content
Trade and trade agreements ....................................................................................... 1
Trade with countries outside the EU ........................................................................................ 3

Exchange rate ............................................................................................................... 4

Consequences on the exchange rates ........................................................................................ 4
Why has the pound fallen? ....................................................................................................... 4
Impact on foreign investors ...................................................................................................... 5
Has the pound bottomed out? .................................................................................................. 6

Financial markets ......................................................................................................... 7

The future for London as financial centre of Europe ................................................................... 7
Implications Listing regime Brexit .............................................................................................. 8
Passporting as influence on foreign listing ................................................................................. 8

Foreign investments .................................................................................................... 9

Brexit: knock-on impact on investments .................................................................................... 9
FTA not a good substitute ....................................................................................................... 10
Brexit: reduction in productivity.............................................................................................. 10

Taxes ............................................................................................................................ 11
A closer look at the trading relationship .................................................................................. 12
Conclusion .............................................................................................................................. 12

Bibliography ................................................................................................................ 13
Murphy, J. (2016). British stocks hit record high-but not in dollar terms. .......................... 13

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Trade and trade agreements

Until today the EU is still the UK’s largest trade partner, accounting for just under half
of all exports (pie chart 1), and is the origin of more than half of all the UK’s imports
(pie chart 2). The exports of the UK to the EU account for 9% of the British GDP, which
is responsible for 2.3 million jobs in the UK, according to a report of ING (2016). But if
we look to the countries that the UK trades freely with because they have a free trade
agreement with the EU, we see that 63% (instead of the 44%, graph 1) of Britain’s
goods export are linked with the EU (Woodford, 2016). So if the UK would leave the
EU they would need to negotiate new trade agreements to prevent tariffs and other
non-tariff trade barriers that would harm growth.

Figure 1 UK exports of Goods & services (Source: ONS)

In terms of trade and trade agreements the UK has three options to negotiate a new
trade deal with the EU:

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1. World Trade Organization Option

The first option the UK would have is that they can operate under the rules of the
WTO. This option is a more pessimistic option, it’s often called the “World trade
Organization Option”. In this scenario we assume that the UK wasn’t able to negotiate
a new trade agreement with the EU and therefore trade must be governed by the World
Trade Organization (WTO) rules. This implies larger increases in trade costs because
in this option, the UK would face so-called “Most Favoured Nation” import tariffs when
exporting to the EU, just like the US. Similarly, the EU would have to pay these tariffs
when exporting to the UK.
The WTO has also made less progress on reducing non-tariff barriers than the EU. So
in this option the impact of a Brexit would mean for the UK (Dhingra et al., 2016):

 Higher tariffs on imports

 Higher non-tariff barriers to trade (arising from different regulations, border
controls, etc.
 The UK may not participate in future steps that the EU takes towards deeper
integration and the reduction of non-tariff barriers within the EU.

This scenario is the worst-case scenario because in this option the UK has failed to
negotiate a free trade agreement with the EU. Such an outcome is possible if the EU
wants to play hard ball in order to stop other countries from leaving the EU (Woodford,
2016).

2. European Economic Aria Option

A second option is to join the European Free Trade Association (EFTA) along with
countries like Norway, Iceland,... and sign up for the European Economic Area (EEA),
which would allow the UK to participate in the single market without tariffs (ING, 2016).
The European Economic Area was established in 1994 to give European countries that
are not part of the EU a way to become members of the Single Market (Dhingra &
Sampson, 2016). Being a member of the EEA means that you have a free trade
agreement with EU. If the UK would become a member of the EEA they would remain
in the single market while not participating in other forms of European Integration. The
single market provides free movement of goods & services, capital and people. In this
option the increase in trade costs will be much lower than the increase in costs in the
first option.
However, they would still have to make a financial contribution to the EU and they are
also obliged to adopt all the laws and legislation relating to the single market without
having a say on these laws.

Being a member of the EEA would also mean that workers from other EU member
states would continue to be able to live and work in the UK (ING, 2016). This option is
not likely to happen because the whole point of leaving the Brexit was to gain extra
freedom which in this option would not be possible.

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3. Swiss Option

A third option and the most likeable option would be to follow Switzerland’s lead. It is
an EFTA member, but did not sign up to the EEA. This way the UK does not have to
depend to EEA rules and can therefore try to negotiate its own immigration rules with
other EU countries. It can also be an EFTA member, which can provide the UK free
trade with the EU in all non-agricultural goods. So this would mean that the UK would
establish free trading relations with the EU and access to the single market through a
series of bilateral treaties following the example of Switzerland. This bilateral treaty
approach would give the UK the flexibility to choose the EU initiatives in which it wants
to participate (Dhingra & Sampson, 2016).
The Swiss option also has disadvantages, for example, the UK would not have free
trade in services with the EU. This would be a big disadvantage for the economy of the
UK because the UK has a comparative advantage in services. The UK would still have
to pay a fee to participate in EU programmes, but the contribution would be lower than
if it were a EEA member. So this option is the most likeable option to happen but it
would be the subject to tough negotiations between the UK and Europe.

Trade with countries outside the EU

Will the Brexit also damage the trade of the UK with countries outside the EU? The
answer is yes, because the UK would lose leverage and they will be a lower priority
trade partner than the EU for the major economies. They would lose the strength in
numbers at the WTO when settling disputes with countries like China (Global counsel,
2015). However, the trade policy under the Brexit model is unlikely to be much different
from the EU’s but the UK will lose strength in comparison with the strength they had
when being a member of the EU. It will be more difficult to access markets after the
Brexit. Also, after the Brexit the UK will no longer be a member of the TTIP. So the UK
will also lose bargaining power in their negotiations with the US. It is unlikely that the
UK alone would have similar leverage as when being a member of the EU (Dhingra &
Sampson, 2016).

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Exchange rate

Sterling has plummeted to its lowest level in more than three decades against the dollar
in the aftermath of the Brexit vote. Figure 2 shows the consequences on the exchange
rates. The Red line is the GBP/EUR pair and the black line represents the GBP/USD
pair. An initial sharp drop in both pairs has been followed by several slumps and a
persistent overall decline. The overall sharp drop means people wanting to exchange
pounds into other currencies are getting significantly less than before Brexit. On the
other hand, people wanting to buy pounds are finding the current levels attractive.
Recently, the pound showed some strength against the euro and some minor strength
against the USD as you can see on the chart below. This could indicate sterling may
have bottomed out. The reason why the GBP/USD (black line) recent rise is far less
impressive than the GBP/EUR pair is of the strength of the dollar relative to the euro.
Further we will discuss following topics:

 Why has the pound fallen?

 Impact on foreign investors
 Has the pound bottomed out?

Consequences on the exchange rates

Figure 2: impact Brexit on GBP/EUR and GBP/USD (stockcharts.com)

Why has the pound fallen?

It is interesting to understand why the pound has made such a tremendous move
downwards. Strong economies have stable and strong currencies because investors
want to put their cash into countries where growth opportunities look promising. That
explains why good economic news, such as good GDP figures, strengthens a currency.
Investors believe Britain's decision to leave the EU has reduced the country's growth
prospects. As a result, the pound could fall further if investors suddenly start pulling
huge amountso of cash out of the country.

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Impact on foreign investors
With global markets becoming even more interconnected, we thought it was interesting
to analyse the impact of the exchange rate on foreign investments, in this case
American investors.
Currencies do matter when dealing in foreign markets. Britain is a very good example
of that. The black line in the chart below shows the FTSE 100 Index closing at a record
high on 4 October 2016. Nearly three-quarters of profits in the large cap FTSE come
from British exports which are helped by a plunging currency. The plunging pound,
however, has hurt Americans investing in that country. The green area in the chart
below shows MSCI United Kingdom iShares (EWU). Notice how badly the EWU has
lagged behind the FTSE. Since the start of the year, FTSE has gained 13%. The EWU,
however, has risen barely one per cent. That’s because the EWU is quoted in U.S.
dollars. The -13% drop in sterling this year against the dollar virtually wiped out any
potential stock profit for American investors who bought British shares. That's why it's
important to keep an eye on foreign currency direction when investing in a foreign
market. When people buy stocks in a foreign country like Britain, they are also buying
the plunging pound. The subject foreign investments will be discussed later in more
detail.

Figure 3: Difference between the EWU and the FTSE (stockcharts.com)

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Has the pound bottomed out?

With the pound finally finding some support after a very challenging couple of months
a valid question at present is whether or not the pound has now bottomed out? Good
question, but as there are so many uncertainties regarding the Brexit it’s impossible to
predict exactly how, when, or even if sterling will recover. However, here are some key
things to keep an eye on.

First of all, as monetary stimulus weakens a currency, the decision of the Bank of
England (BoE) in November not to cut interest rates further, has been seen as a sign
of confidence in the UK.

Secondly, last week Brexit secretary David Davis, spoke out about the single market
and suggested that he may look to make payments to the EU in order to keep rights to
the single market. With the tone of a soft Brexit becoming more likely, there could be
strong upside movement for sterling if it seems that the UK will get a favourable trade
deal with the EU.

Lastly, markets have been driven by recent political events. Therefore, they are largely
ignoring key economic reports. At some point, these reports will begin to have an
impact on currency movement. If enough data suggests that the UK is in a strong
position, for example that companies are continuing to hire and invest in Britain and
not planning to relocate overseas, the pound could jump.

The overall consensus seems to be that the pound has bottomed out, at least in the
short term. Therefore, we may see a stronger pound the upcoming weeks. In the long
term however, it would appear that the pound is not out of the woods. As there is still
a lot to negotiate, we may see that the pound starts falling again. After all, if everyone
understands the bearish argument who is left to sell?

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Financial markets
The future for London as financial centre of Europe
London earned his title as financial centre early in history because of many different
factors. Its great economic climate for financial businesses constructed with the
common law, attractive tax rates and many more advantages has attracted many
European insurance companies, hedge funds, institutional investors and so on. The
British financial market has grown much faster than the OECD average since its trade
with the EU, and about 1/3th of its financial exports are to the EU (IMF, 2016). This
means that Britain owes a lot to the EU when it comes to its financial sector.

When they leave the EU, their position as financial centre of Europe will be very difficult
to maintain. After the Brexit some of the biggest banks cautioned that they will move
out staff. It is argued that it has advantages that are built over centuries that are difficult
to replicate (Mr McFarlane) but most said a relocation from London to a European
country is inevitable. If London loses its strengths it would have a negative impact on
UK based firms but also for European firms who depend on UK services.

The type of Brexit will also have a great influence on whether the financial industry will
keep a lot of activity in London. A soft Brexit could mean Britain keeps its access to the
EU market for goods and services but the many pro and contra leaders make it
impossible to speculate on this outcome. If it loses its access, specialised investment
firms and asset managers will need to disentangle their operations, split up their capital
base and create separate licensed operations within the EU (lanno L 2016). This
previously discussed disadvantage makes an open-ended Brexit the only strategy with
positive outlooks. We conclude that many international banks have the same view.
That’s because the British bankers’ association wrote a report to press Theresa May
for this open-ended transition pact (Financial Times 9dec 2016). Although the
speculations on which European city could be a replacement has already begun.

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Implications Listing regime Brexit
Before the Brexit, the UK’s London Stock Exchange (LSE) had to meet up with the
applicable European Union legislation related to listing of securities. This legislation
applies to all members of the European Economic Area (EEA) regulated markets. If an
issuer wanted to list securities on the LSE’s Main Market, they had to prepare a
prospectus that: (a) meets the content and format requirements of the Prospectus
Directive, (b) Is approved by the issuer’s “home member state” in the EEA and (c) is
published in accordance with Prospectus Directive requirements (Yonge, & Brod,
2016).

It’s not clear yet what the situation will be after the Brexit. The UK can decide to stay
as a member of the EEA or they can consider to leave the EEA. If they remain as a
member, there won’t be many changes in regulation. The UK will have to keep
answering to the same regulation as before the Brexit. They can join the EEA again by
first re-joining the European Free Trade Association (EFTA). The only difference will
be that the UK can’t participate in the decision making of the prospectus and listing
regulation. A more likely situation is that the UK will leave the EEA to achieve more
political autonomy. This probably won’t have an immediate direct effect on the
requirements for, and the implications of, a UK listing (other than passporting).

Most likely, the UK will retain its current international standards for future listings. In
this way they won’t harm their reputation and won’t prevent future potential companies
from listing on the LSE. The LSE has the largest contingent of foreign stocks and it is
in its own interest to keep it so. UK listing rules and regulations will probably change
over time from the EU requirements because both will act in its own best interest.

Passporting as influence on foreign listing

Shortly, passporting is the exercise of the right for a firm registered in the European
Economic Area to do business in any other EEA member state without needing further
authorization in each country (Investopedia). When the UK decides to leave the EEA,
they won’t longer be a member of the Prospectus Directive’s passporting regime for
prospectuses (Yonge, & Brod, 2016). When a prospectus gets approved in a member
state of the EEA, it applies to all member states. For the UK, the Financial Conduct
Authority (FCA) has to approve the prospectuses. If the UK would be no longer
member of the EEA, the EEA has to approve the prospectus after it has been approved
by the listing authority of the UK. This could lead to slow decision making and have a
negative effect on the volume of issuers that choose to list their securities on the LSE.

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Foreign investments

Entering the European Single Market meant the removal of the tariff and non-tariff
barriers. The removal of these barriers has made location and relocation decisions
much more important for policy-makers. European Union membership has raised the
foreign direct investments (FDI) by about 28%. Several papers show that there is a
statistically significant positive effect of being in the EU on inward FDI (Straathof,
Linders, Lejour, & Mohlmann, 2008; Campos, & Coricelli, 2015). First of all, these
foreign direct investments are very important for a country. It raises a country’s
productivity and therefore output and wages. Further, the foreign firms bring in money,
better technology and new managerial know-how. These things affect the output
directly in a positive way. Lastly, FDI also stimulates domestic firms to improve,
because of the tougher competition. One of the main reason of UK’s attractiveness for
foreign investors is the easy access to EU’s single market (Dhingra, Ottaviano,
Sampson, & Van Reenen, 2016). Therefore, it is very important to discuss the
(potential) impact of Brexit on this subject.

Figure 4: UK inward FDI investment position

Figure 4 shows the inward foreign direct investment position of the UK, it has increased
constantly since the accession to the EU and the birth of the Single Market. The stock
of FDI amounted in 2014 over £1 trillion, of which about the half of these inflows can
be attributed to other members of the European Union.

Brexit: knock-on impact on investments

Given that Brexit means the exit out of the EU and so out of the European Single
Market, it is possible that the UK shall face several drawbacks. There will be an
increase in tariffs and non-tariff barriers to trade with the EU, depending on what they
arrange about the post-exit phase. These increases probably will include a knock-on
impact on investments and especially on foreign direct investments, because these
barriers indicate a lower return on investment due to the extra costs (Ambler et al.,
2016). With these barriers, one of the main reasons of UK’s attractiveness for foreign
investments is gone, namely the easy access to EU’s single market.

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FTA not a good substitute
These findings were confirmed by Dhingra et al. (2016). They concluded that the Brexit
will bring higher costs off trade and this implies lower FDI. According to their model is
Brexit likely to reduce FDI inflows to the UK by about 22%, so leaving the EU will have
a smaller impact than joining. The UK could negotiate a free trade agreement (FTA)
with the EU, based on tariff free trade of goods. This is not possible for services (Ambler
et al.,2016). So if they reach a comprehensive trade deal with the EU on goods, the
impact on investments in the manufacturing and industrial sector could be reduced.
But even such a comprehensive trade deal, like the European free trade agreement
(EFTA), would not bring a big reduction of the negative consequences on foreign
investments. Since the larger share of UK’s economy exists out of the services sector
and the absence of an FTA in services. Dhingra et al. did not find any statistical
difference between being in EFTA compared with being completely outside the EU,
like the US or Japan (Dhingra et al., 2016).

Though the FDI location decisions are also influenced by things like factor costs, fiscal
incentives, exchange rate,… there is evidence that EU membership has contributed to
a considerable part of FDI by providing a larger market (Ambler et al., 2016).

Brexit: reduction in productivity

The lower level of foreign investments due to the EU exit will affect the level of
productivity. We learned from existing studies that foreign-owned companies in the UK
(FDI) have increased productivity levels, their average productivity is higher than the
UK-owned firms. This higher productivity of foreign-owned companies had affected the
productivity of UK-owned companies, it has raised the domestic firm’s productivity due
to higher competition, new technology,… Given that the Brexit will reduce the foreign
investments, this could mean that the UK could lose some of the possible additional
dynamic spillover effects concerning productivity. This reduction in economic output
results in a reduction of employment. So Brexit affects, through foreign investments,
economic output and employment. The UK unemployment rate will rise in both FTA
and WTO scenario, peaking around 7% FTA scenario and around 8% in the WTO
scenario. By 2030 unemployment has fallen back to approximately the same level as
in EU membership (Ambler et al., 2016).

Simionescu (2016) concluded that Brexit will have a large impact on the job creation
generated by FDI projects. Due to that, UK policies should create a more flexible labour
market and a stronger orientation toward other countries to overcome the deficiency in
competitiveness.

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Taxes
The UK’s vote to leave the European Union has just been the start signal for the
negotiations between Great Britain and the EU. According to article 50 of the Lisbon
Treaty, Great Britain has two years to renegotiate terms with the EU. As long as both
parties have not agreed on terms, there will remain uncertainty. This uncertainty
causes a ‘wait and see’ approach of both companies and public financial institutions.
Because of the uncertainty of the outcomes and enterprises that are holding back,
Great Britain can expect a lower growth in GDP. That is why Chancellor George
Osborn has abandoned his goal of reaching a surplus in the UK’s public finances by
2020.

Recent events have put some pressure on the negotiations. It seems that Great Britain
doesn’t want to negotiate from a position of weakness but from a position of strength.
That can be supposed from the UK’s list of demands and from Mrs. May her statement.
Prime Minister Theresa May stated that if the EU would not be lenient enough in the
coming negotiations, the UK could opt for a corporate taxation rate of 10%.

Lowering the corporate taxation rate to 10% would mean that the UK becomes a tax
haven and that it would be the first big player in the world economy with such low
corporate tax rate. Besides making the UK more attractive for business, this measure
would have negative outcomes too. Such as endangering the whole EU project, a
negative effect on GDP growth (as mentioned before), a negative effect on the public
finances of the UK, Scotland, Wales and Northern-Ireland. Since the Brexit could affect
Scotland negatively, Scottish First Minister Sturgeon called for a referendum if
Scotland’s interests are not protected in the negotiations. This referendum could lead
to Scottish independency. Scotland becoming independent would strengthen the
negative effects on the UK’s GDP growth.

As mentioned before the UK has a list of demands that contains, free market access,
no budget transfers and one-way openness at the borders. These three demands are
the most crucial points in the negotiations, but because of Mrs. May her statement
there are now four, namely corporate taxation rates. It’s not sure if all three demands
will be permitted and other statements like the one of Mrs. May won’t make the
negotiations more easily.

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A closer look at the trading relationship

As we saw on the first topic, the EU is by far the most important trading partner for the
UK. We are going to analyse the importance of the EU in terms of trading for the U.K.
for both export and import. When we look back at figure 1 (pie chart 1), concerning the
export of goods and services in 2014, we unmistakeable see that the EU is good for
44 percent of the U.K.’s export. Looking at the pie chart 2 of figure 1, concerning the
import of the U.K., we can conclude that of all imports 53 percent comes from the EU

Conclusion
For starters lets analyse the UK’s demands, first of all free market access. As we all
know, London is the centre for financial services in Europe, so leaving the EU would
mean the UK loses its permission to access the EU market, which implicates that the
centre of financial services would shift to another country which is member of EU. If
we further analyse the trading relationship between the UK and EU (charts above), we
can conclude that the EU is the UK’s largest trade partner by far. This means that when
EU puts restrictions and taxes on UK shipments, these would lose attractiveness and
consequently the UK could lose a lot of business. Obviously, the terms that both parties
will agree on, are from great importance of the UK.

Secondly, the UK doesn’t want to do any budget transfers to the EU. In 2014 the UK
contributed 8,5 billion British Pound to the European Union. A lot of British people don’t
want to pay to be part of the EU, they’d rather invest the money in their own country.
Of course there will remain budget transfers because of trading and taxes but maybe
not such a vast amount.

The third demand is having one-way openness at the borders, this would mean that
British people would be able to travel and work freely in the EU, but that European
citizens would have to get authorization to work in or even travel to the UK One of the
reasons that the UK demands this, is because there are lot immigrants and fugitives
who want to go to live in the UK

By analysing the demands, we can presume that it’s of great importance for the UK to
obtain good conditions or arrangements, which don’t put restrictions on their business.
The importance of these negotiations is the reason why Mrs. May has stated that they
would lower their corporate tax rate to 10%.

After analysing this situation critically, we conclude that the chance of this happening
is just to a small extent. The UK and EU are important trade partners, lowering their
taxes would not only put their public finances under great pressure, it would also
endanger the relationship between the UK and the EU as well as the union’s
relationship with Scotland.

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