14. Brexit

Even though markets have hit all time highs and Britain is doing quite well, the Brexit has far-reaching impacts on the British economy but they are hard to detect because the Bank of England has supported its economy tremendously. 

Before we start with the last entries of this blog series about money and banking, I want to show you, how you can use the concepts to understand what is going on in the real world. I have drafted that article 4 months ago but I have updated it and we are still not what happens. The decision about the Brexit made me sad. In my opinion, the European Union is about peace, freedom, stability and solidarity. Unfortunately, many different people voted for a change without really thinking about all the long term effects. England benefits a lot from being in the European Union, enjoying the passporting rights (I will explain what they mean later) and they are making a lot of money being the financial heart of Europe. Even though the Brexit happened half a year ago it is still in the process and I am going to explain what a Brexit most likely mean for the British (financial) economy.

I have read her majesty's  treasury analysis, which has researched the immediate economic impact of leaving the EU. It was published in May 2016. The report states that:

“A vote to leave would cause an immediate and profound economic shock creating instability and uncertainty which would be compounded by the complex and interdependent negotiations that would follow. The central conclusion of the analysis is that the effect of this profound shock would be to push the UK into recession and lead to a sharp rise in unemployment.”

As you can clearly see the treasury report is against leaving the EU and states that a big economic shock will lead the UK into a recession and I am going explain in detail why the economy will suffer.

There will be 3 key factors affecting the economy

The Transition Effect

The ‘transition effect’: the emerging impact of the UK becoming less open to trade and investment under any alternative to EU membership. The EU is based on four fundamental rights between its member countries: 

 

1. Free movement of goods

2. Freedom of movement and residence

3. Freedom of service and 

4. Freedom of movement of payments and capital. 

 

As we know England and especially London being the heart of European Finance benefits tremendously from banks worldwide doing their clearinghouse, Eurodollar activities (If you don't remember what clearing houses or Eurodollars are, click on the link to the older blog articles) and other financial transactions needed within the EU. That is called passporting. 

The passporting right entitles a firm to carry on permitted activities in any other member country of the European Economic Area, providing cross-border services without needing another permission. This right allows banks in England to trade, clear or offer financial services to every member without the need of another license or to pay a toll. Especially if Theresa May is going to continue with her hard Brexit, England will lose that right and that is the reason why so many banks are already planning to move to Paris or Frankfurt to continue offering service within the European union, so they can continue offering their services.

After the Brexit, financial markets experienced a high level of uncertainty, because no one knew what is going to happen to the UK economy. The big investment banks are actually already moving people from London to Dublin, Frankfurt, and Paris. Due to the fact that they will have higher costs for borrowing and lending money in the European market. Inflationary pressures already affected exporting and imported goods. They became more expensive, whereas British goods are cheaper for an overseas consumer because the Sterling lost so much of its value.

The Uncertainty Effect

 The ‘uncertainty effect’: The rise in uncertainty following the referendum. Even by now no one knows what is going to happen because nothing like this happened before. The markets are moving up and down due to actions, speeches, and promises of the British Parliament, but no one knows what will happen next and how exactly the Brexit will affect the economy plus investors are risk averse so especially in turbulent times they rather invest into treasury bills and save assets, which is not helpful for the economy.

The Financial Conditions Effect

The ‘financial conditions effect’: The extent of financial market volatility, that is also linked to the two points above and we have seen the sterling and the volatility of the most important indices moving a lot lately.

The Treasury Report

The ‘financial conditions effect’: The extent of financial market volatility, that is also linked to the two points above and we have seen the sterling and the volatility of the most important indices moving a lot lately.

Why is Inflation going to rise?

Why is the inflation going to raise? Inflation means the rise of prices of goods and services due to the declining purchasing power of a currency. As we see here, the sterling has been depreciating, so you can buy less with your sterling than before as well as prices have been on the rise. Maybe you have heard of Marmite a very popular bread spread that raised its price due to the fall of the sterling as well as frozen goods became more expensive.

 

Consumer price inflation has run below the 2 % goal for a while but ascended sharply in September. 

This is likely to be the start of a strong upward movement (and it actually was), as oil and energy price rises kick in and the depreciation of the sterling starts to affect consumer prices. The Bank of England has forecast that consumer price inflation will probably peak up to 2.7% late last year. Experts have conflicting views about whether sterling’s value will stay where it is, fall further or improve. Second, forecasters disagree about how companies will be able to deal with higher costs — from the weaker currency and increasing domestic costs.

Policy Package

In the three months since the vote happened, economic indicators have recovered from their lows, which followed the referendum immediately and the preliminary estimation of the GDP growth in Q3 was above expectations. These data suggests that the near-term outlook for economic activity is stronger than expected three months ago. 

The Policy package included

• 25 basis point cut in the bank rate 

• Term Funding Scheme to reinforce the pass-through of the cut in Bank Rate, financed by the issuance of central bank reserves

• Purchase of stock of up to 10 billion Euro of sterling non-financial investment grade corporate bonds financed by the issuance of central bank reserves

• Increase in the stock of purchased UK government bonds, financed by the issuance of central bank reserves from 60 billion Euros to 435 billion Euros

When you look at the balance sheet of the Bank of England you can clearly see that the reserve balances have risen and as well as the loans to asset purchase facilities. That means the BoE is printing money to buy assets and give away loans, so the economy wouldn’t suffer too much. That is also the reason why many people think that the shock is devastating because the BoE is actively supporting the economy.

The Sterling Depreciated

The sterling exchange rate stabilized for a period following its initial post-referendum depreciation. Supported by the measures announced by the Monetary Policy Committee in August, more financial conditions and asset prices recovered from the deterioration seen straight after the referendum, accompanied by a sharp increase in corporate bond issuance. However, in the period since the beginning of October, the sterling effective exchange rate index has depreciated further. Market intelligence attributes these latter movements to perceptions that the United Kingdom’s future trading arrangements with the EU might be less open than previously anticipated, requiring a lower real exchange rate to improve competitiveness and support activity. Longer-term gilt yields (bonds issued by the UK) have risen notably, as have market-implied expectations of medium-term inflation.

The GDP has fallen

Now there will be less trading and doing business with EU member countries due to new toll, new standards and new restrictions, which makes trading more expensive and difficult and will affect the British economy badly, especially the financial sector will have a hard time coping with the loss of the passporting right. Due to the negative effect on the economy unemployment is going to rise. 

House Prices Have Fallen

Why are house prices going to fall? Because the markets are going to become less liquid and the borrowing rates are going to go up, which makes borrowing more expensive. In conclusion, people are less willing to consume and take out loans. Hence house prices are decreasing. I will explain it more using the Treynor model later.

 

The Treynor Model

Interest Rates Are On The Rise

The markets are going to be less liquid, because the government, the bond, the equity markets and the banks are now competing against each other for money. That drives up banks funding rates and the Repo rates. England had access to the entire world and could trade especially cheap and easy with the members of the European Economic Area. If this stops it will be harder to get cheap money for banks and dealers,  due to the lack of liquidity this in combination with the uncertainty will start a race to the bottom, because banks are too afraid to lend money to each other and the competition is a lot smaller. On top of that banks call for a higher Interbank borrowing rate, which then leads to higher repo rate. We can see this in the Treynor model. If the Interbank Rate is going up, the Repo Rate is going up as well. The interbank rate is going to rise due to higher settlement risk of the banks and the repo rate is going to raise due to a lack of liquidity. I have mentioned that the money supply is elastic and in times of economic boom it is expanding and in times of crisis, it is contracting. Right now we have a crisis so we have less money in the economy, which makes money more “expensive” because it is scarce.

In this table, we can clearly see that the Treynor model is right and matches the prediction. Borrowing rates or going to rise. There is no direct liquidity risk because the Bank of England is still going to act as the lender of last resort. It is just going to be more expensive to borrow money. As Bagehot states the Bank has to act as the lender of last resort and it already took that role of stabilizing the economy.

Assete Prices Are On The RisE

They are going down and raise at the same time. The prices are going down, because institutions are selling their assets, due to the fact that they are afraid of the volatility. So the dealers are taking them on their balance sheets, so their inventory shifts to the right side which drives down the prices. But the inside spread gets bigger as well, so the prices are rising at the same time. The inside spread depends on the risk premium, liquidity, and volatility. Therefore it is getting bigger due to the rise of volatility because no one really knows what is going to happen. That is why the dealers are taking a higher risk premium which makes the assets more expensive.

Conclusion

In conclusion, we can say that Brexit has far reaching effects on the British Economy, even though their monetary policies are working quite well to stabilize the country and the economy, even today no one knows exactly what’s next. Last year has been a year of political surprises and I feel that no one knows how to react and what is going to happen, so the markets were a little bit unstable at the end of last year but have recovered, increased and are at all time highs. Even though more people should have taken a closer look at the treasury analysis and the impact of the Brexit before they have voted to leave the EU.

 

Introduction

The first article: The hierarchy of money

The second article: Why do we need banks?

The third article: Why we need a central bank?

The fourth article: How can banks create money out of thin air?

The fifth article: Why do we need central banks especially in a crisis?

The sixth article: What are clearing houses?

The seventh article: What are Fed Funds?

The eighth article: What are dealers, brokers and repos?

The ninth article: Quantitative easing and open market operation

The tenth article: Eurodollars

The eleventh article: Discounts, Discounts, Discounts

The twelfth article:  Why dealers provide liquidity

The thirteenth article: Rates and the Treynor Model

Written by: Philine Paschen

Kommentar schreiben

Kommentare: 0