Brexit: Now Comes the Hard Part

According to James McCormack Global Head of Sovereigns at Fitch Ratings, nearly nine months after the UK voted in a referendum to leave the EU, the British government will soon provide notice to the European Council of its intention to withdraw under Article 50 of the EU Treaty, marking the beginning of exit negotiations. As contentious as the last year has been, first in debates on the merits of Brexit leading up to the referendum, and more recently amid criticisms of the government’s negotiating priorities and strategy, the period ahead promises to be even more combative.

Being the first country to leave the EU, the UK has no pre-established path to follow, and will forge ahead knowing only that Article 50 stipulates a two-year period to negotiate and ratify an agreement on the terms of exit, unless Member States unanimously agree an extension. There are five primary challenges facing the UK that are identifiable from the outset.

Timing is Tight, and the Exit Bill Looms

Most fundamentally, the UK will not be in full control of the negotiating agenda, and specifically the order in which issues will be addressed. Prime Minister May has said that a comprehensive free trade agreement with the EU is one of the government’s objectives, and that a smooth and orderly Brexit means having it in place by the end of the negotiating period. Most observers agree that two years is a short time to negotiate a free trade deal, but the actual time available to do so could prove even shorter, as some European leaders have suggested that the UK’s post-exit trade arrangements can only be negotiated once the most important terms of its exit have been agreed, which could take several months.

This may simply be an early negotiating tactic, but if less time is available, it becomes more likely a transition agreement would be needed to avoid what the prime minister has called “a disruptive cliff edge”. However, such an agreement would also take time to negotiate, and, once in place, it could reduce the urgency of reaching a final agreement, possibly drawing out negotiations well beyond two years.

The second major challenge faced by the UK will be settling the financial terms of its EU departure, or its “exit bill”, which EU leaders have indicated will be among the issues they seek to resolve up front. The main elements to be discussed will be future EU spending commitments agreed when the UK was a member state and EU officials’ pensions, and a figure of EUR60 billion has been bandied among European leaders. The amount will certainly be disputed by the UK, but it will have a strong incentive to agree to terms quickly and move on to more contentious and important issues, even though the concept of post-membership payments to the EU will be portrayed by some in the UK as an early and unnecessary concession.

Scotland and Other Internal Divisions

The three remaining challenges are domestic, and centre on Scotland, the lack of a unified national position on Brexit and the need to manage expectations.

The Scottish Parliament’s Culture, Tourism, Europe and External Relations Committee has published a report calling for “a bespoke solution that reflects Scotland’s majority vote to remain in the single market”. It would greatly complicate both the negotiations with the EU as well as border and logistics issues if such a bespoke arrangement were in place post Brexit. The lingering risk of a second independence referendum raises the stakes in how the UK government deals with any Scottish requests, and will require policymakers’ careful attention when government resources will already be stretched.

Beyond Scotland, it has been made clear in a variety of forums that the UK is not entering Brexit negotiations with unified views of the most desirable outcomes. In considering future UK trade arrangements, for example, Parliament’s International Trade Committee recently recommended joining the European Free Trade Area, and there are sure to be a raft of other proposals put forward on this issue alone from public and private sector groups. In the midst of negotiations, open debates within the UK can expose domestic political pressure points that could be strategically exploited by the European side. It may be of some comfort that the EU will be subject to similar internal disagreements, but the upshot of this is likely to be delays in formulating negotiating positions — an unfavourable outcome for the UK.

The final UK challenge as negotiations begin is managing expectations and uncertainties. Prime Minister May promised “no running commentary”, but there will be leaks, as with any negotiation. Progress will not be linear, in the sense that the UK and EU will appear alternatively to be closer to achieving their objectives, and financial markets may react accordingly. Domestic opponents of the UK government are likely to be quick to attribute any economic underperformance or market turbulence to shortcomings in the government’s approach to negotiations. The biggest associated risk is that the balance of public opinion shifts to a decidedly more negative view of Brexit, lending support to ideas already circulating on either a greater role for Parliament in approving the final negotiated agreement or another opportunity for the electorate to formally express its view.

The possible impact of the Brexit on the financial landscape

Dr Andreas Dombret Member of the Executive Board of the Deutsche Bundesbank spoke about the potential impact of the Brexit on the financial sector.

Let’s start with the potential impact of the Brexit on the financial landscape. First and foremost, this means talking about market access. We should not forget that this is a two-way street, and so I will talk about market access in both directions. But the centre of attention is certainly on market access for UK based financial institutions to the EU, as this potentially has the largest impact for banks and other financial institutions. It affects all institutions, both from the UK and the rest of the world, which currently use London as a hub for their continental European business.

The debate on market access was transformed in mid-January. Prime Minister May made it clear that the UK is looking for a clean break from the EU’s single market. For the financial industry, this means that the current model of using London as a gateway to Europe is likely to end. Banks from third countries need a licensed entity inside the European Economic Area to gain access to the whole area, known as “passporting”. Shortly before the Prime Minister’s speech, CityUK already dropped demands for maintaining access through passports.

Instead, many are now hoping for an equivalence decision to fill the gap left by passporting rights. If the European Commission deems the regulatory and supervisory regime in the UK to be equivalent to that in the EU, market access would be partly retained. However, I am rather sceptical about whether equivalence decisions – may they be likely or not – offer a sound footing for long-term location decisions of banks. Equivalence is truly different from single market access.

There are three major drawbacks to equivalence decisions. First, they only cover the wholesale business of banks. Second, given the fact that banks need time to build up a new entity elsewhere, an equivalence decision would have to be taken quite soon to actually have a bearing on the location decisions of banks. Third, equivalence decisions are reversible, so banks would be forced to adjust to a new environment in the event that supervisory frameworks are no longer deemed equivalent. These drawbacks lead me to the overall conclusion that equivalence decisions are not a reliable substitute for passporting.

So it seems that the prospects for EU market access through the UK look rather dim. To ease the pressure on financial institutions, a transition period could help. It would reduce risks and increase planning security for banks, which would be economically beneficial. Furthermore, it could support a smooth relocation process by taking pressure off both supervisors and banks, for example by making “first mover advantages” less important. This being said, transition periods would be a politically sensitive topic in the negotiations, and it is unclear how likely such an agreement might be.

As mentioned earlier, we should not forget about the access of European banks to the UK, which is also an important issue. For German banks, for example, the UK is the second-most important foreign market, right after the US. It will be up to the UK Prudential Regulation Authority to decide under what circumstances European banks can retain access to the UK. Whether the UK would be prepared to unilaterally grant access for EU financial institutions in order to retain the attractiveness of London as a financial centre, remains an open question. And let me add that it is of course not regulation alone that plays a role when European banks decide on opening a branch or a subsidiary in the UK. It is also a question of what kind of entity their counterparties and clients want to do business with.

Let me summarise the prospects for market access, at least from my point of view. Continued passporting rights are rather unlikely, and an equivalence decision would be a somewhat imperfect substitute. A transition period could ease some of the pressure, but it clearly is a sensitive issue.

Could a free trade agreement be the solution? According to their Brexit white paper, the UK government will strive for an ambitious free trade agreement with the EU as a long-term solution. But regardless of the fact that negotiating comprehensive free trade agreements is an arduous and time-consuming task, financial services are an especially tricky area. So far, the EU has never fully integrated finance in its free trade agreements with third countries.

Where does this lead us? So far, while acknowledging and accepting the divorce, policymakers are trying to find ways to hold the UK and EU economic areas and jurisdictions together. And they will continue trying so. The reason is that most of us are convinced that harmonised rules eliminate unnecessary frictions and act as a powerful catalyst for business across national borders – for the real economy as well as the financial sector. However, looking at the facts that I’ve just laid out we also have to acknowledge that it is at least questionable whether this undertaking will be easily achieved. Financial institutions should take into consideration that, in the end, there might well be two separate jurisdictions in which they operate, and that these jurisdictions might diverge over time – or instantly, once the divorce has gone through.

BoE Stimulus Cushions But Will Not Offset Brexit Shock

The Bank of England’s (BoE) decision to cut rates, expand its bond buying and set up a new funding scheme for lenders is a proactive policy response to the EU referendum. But it is only likely to cushion, rather than fully offset, the shock to UK growth that June’s Brexit vote will cause, Fitch Ratings says.

City-at-Night

The balance sheet expansion goes beyond our expectations and includes innovative measures to mitigate potential unintended consequences of policy easing.

The BoE cut the base rate to 0.25% from 0.5% – the first change in over seven years. It will expand UK government bond purchases by GBP60bn, and will purchase up to GBP10bn of UK corporate bonds. The BoE also announced a new Term Funding Scheme (TFS) aimed at ensuring the base-rate cut is passed through to borrowers.

We incorporated lower rates into our post-EU referendum update of our UK macro-economic forecasts, cutting our end-2016 policy rate forecast to 0.25% from 0.75%.

The BoE had already reduced the counter cyclical capital buffer for UK banks. Combined with a rate cut and increased quantitative easing, such measures forestall the risk of a significant tightening in credit conditions that would compound the impact of the Brexit vote.

But they will not outweigh the impact on investment as firms reduce capital spending due to sharply heightened uncertainty surrounding the UK’s future international trading arrangements outside the EU and related political and regulatory uncertainty. We expect investment to be 15% lower by 2018 relative to our May forecast.

The referendum will take a significant toll on the economy despite sterling’s fall potentially supporting exports. This is reflected in our latest growth forecasts of 1.7% in 2016 (down from 1.9% in May) and 0.9% in 2017 and 2018 (from 2.0%). The BoE’s assessment suggests sizeable concerns about the near-term outlook as a number of survey-based indicators have deteriorated dramatically. They are now forecasting 0.8% GDP growth in 2017, down from 2.3% in the May Inflation Report.

The BoE’s purchases of corporate bonds may boost investor appetite for higher-yielding instruments, but UK corporates have little need to raise significant new debt. Slightly lower funding costs will be less of a factor for corporate credit profiles than weak growth and sterling depreciation.

The BoE is cognisant of the potential consequences of very low interest rates on the financial sector. The TFS will enable eligible institutions to borrow central bank reserves at close to the Bank Rate. Funding costs will be lowest for banks that maintain or expand net lending.

This reduces the risk that the rate cut further squeezes margins at UK banks as they face additional pressure on revenues from a contraction in investment and slowdown in consumer spending. Nevertheless, while restating his opposition to negative interest rates, BoE Governor Carney emphasised that there was scope to increase all of today’s measures.

Building societies and banks whose business models rely heavily on net interest income and where liquidity buffers are held largely as cash at the BoE are most exposed to lower-for-longer rates. Their net interest margins are generally highly correlated to base rates, and given their low-risk, low-yield model, lower spreads could affect profitability.

The effect on insurers will depend on whether longer-dated bond yields continue falling. UK non-life insurers may feel the most direct impact because they tend to invest in shorter-duration bonds, and their asset portfolios are reinvested relatively quickly into prevailing yields. This would lower investment income, putting pressure on earnings and potentially driving higher premiums, but insurers would balance this against potential loss of market share.

UK life insurers’ balance sheets are less exposed to interest rates or bond yields, because the duration of their assets and liabilities are closely matched. Lower rates and yields could further reduce demand for annuities, but could modestly help demand for unit-linked or with-profits products given the low rates on bank savings.

The Implications of Brexit for Australia

The Council of Financial Regulators (CFR) has issued a report to Government on the potential impact of Brexit on the Australian economy. It takes into account developments up to and including Tuesday 5 July. They conclude that the outcome of the vote on 23 June represented an appreciable negative shock, but the impact on domestic and international financial systems and markets was well-contained and orderly. On the evidence to date, they say it suggests that the domestic and international financial reform agenda adopted following the financial crisis is on the right track.

The CFR is comprised of the Reserve Bank of Australia (RBA); the Australian Prudential Regulation Authority (APRA); the Australian Securities and Investments Commission (ASIC); and the Treasury. The report is informed by CFR agencies’ close consultation with their respective counterparts in the UK, Europe and other jurisdictions.

It is uncertain how the UK’s exit will proceed and what the associated impacts on the stability of the rest of the EU will be. This will be a source of continuing uncertainty and market volatility for some time, against the backdrop of an already fragile global economy. Significant shocks could also come from other sources. While the Australian financial system has weathered the immediate reaction to the vote well, the event underscores the importance of pressing ahead with further reforms to enhance our system’s resilience.

The short-run negative effect on economic activity in Australia, through channels such as reduced trade, lower commodity prices and financial linkages, is expected to be very limited for several reasons. The effect on global activity is expected to be small, Australian trade is oriented more towards Asia than Europe, and Australian banks have limited direct exposure to the UK and Europe and are well-placed to handle disruptions to funding markets.

The medium- to longer-term implications for the UK and Europe, and the global economy more broadly, will depend on the degree and persistence of uncertainty, and the length and outcome of negotiations on exit. In the UK, business investment growth was already weak prior to Brexit and is likely to weaken further, at least until the nature of any future trade agreement with the EU, by far the UK’s largest export market, is known. Some firms may also choose to relocate from the UK to EU countries if their businesses depend on access to the single market. Concerns over job security and negative wealth effects will be a drag on household spending. Prior to Brexit, the IMF indicated that should Britain vote to leave the EU, GDP in the EU could be lower by up to 0.5 percentage points and GDP in the rest of the world could be up to 0.2 percentage points lower by 2018.2 There is a significant degree of uncertainty around the estimated economic impact of Brexit. The IMF forecast a wide variation in output losses across individual economies, reflecting differing trade and financial exposures to the UK, as well as the policy space to respond to negative spill-overs.

Beyond the central forecasts, the Brexit result has arguably added to global tail risks, particularly through heightened risk in Europe. The result could potentially strengthen exit momentum within euro area countries, which if successful would be considerably more disruptive given the common currency. Ongoing banking sector fragility also remains a potential trigger for political discord and financial instability. European banks have been grappling with weak profitability and a high stock of non-performing loans for many years, which has been reflected in low share price valuations. Market movements reflect increased apprehension about banks in a number of European countries post Brexit, most notably Italy, where the Italian Government has been denied permission by the EU to inject capital into its banking system. The newly established European bank resolution framework, which favours bail-in of private creditors and substantially precludes government support, is largely untested.

Brexit-LoansOverall, tail risk considerations aside, the implications of Brexit for the Australian economy are not likely to be significant, but will depend upon the nature and length of the transition to new arrangements. Australia has proved resilient during past periods of financial market volatility and remains well placed to manage the economic and financial market response from the UK referendum outcome. Additionally, Australia has a relatively small direct trade exposure to both the UK (2.8 per cent of goods and services exports) and the rest of the EU (4.6 per cent of goods and services exports). However, Australia’s major trading partners have larger exposures to these markets. For example, the EU (including the UK) accounts for 15.6 per cent of China’s goods  exports and 18.2 per cent of the US’s goods exports. A sharp slowdown in the EU economies with spill-overs into other major economies would place downward pressure on the demand for Australia’s exports.

The Australian economy may also be affected if the UK transition out of the EU is not orderly and uncertainty remains heightened for a significant period. This poses some downside risk to the domestic outlook, with negative wealth and confidence effects having the potential to affect household consumption and business investment.

The strengthening of the banking system’s capital position over recent years to meet the new ‘Basel III’ requirements represents a material increase in the banking sector’s ability to withstand a significant deterioration in asset quality. The Financial System Inquiry highlighted the importance of ensuring the soundness of the financial system. The Government endorsed its recommendation that capital standards be set such that bank capital ratios are ‘unquestionably strong’. While Australian banks are well-capitalised, a further increase in capital ratios is likely to be required over the coming years to satisfy the ‘unquestionably strong’ benchmark. The Government has also endorsed the implementation by APRA, over
time and in line with emerging international practice, a framework for loss absorbing and recapitalisation capacity.

APRA is also introducing further reforms to strengthen the resilience of the banking system. Of particular note, on 1 January 2018, APRA will implement the Basel III Net Stable Funding Ratio (NSFR) to discourage banks from being overly reliant on less stable sources of funding. The NSFR will be part of APRA’s prudential liquidity rules and will complement the Liquidity Coverage Ratio – introduced on 1 January 2015 – that requires banks to hold sufficient ‘high quality liquid assets’ to withstand a 30-day period of stress. APRA is currently consulting with the industry on the design of the NSFR and intends to finalise proposals by the end of 2016.

Consistent with the Government’s response to the FSI, further work is needed to clarify and strengthen regulators’ powers in the event a prudentially regulated financial entity or financial market infrastructure faces distress. A recent peer review by the Financial Stability Board identified some gaps and deficiencies in the Australian resolution framework and work is progressing on this as a matter of priority.

More broadly, such episodes of significant shocks and market volatility reinforce the value of Australia’s financial (and economic) policy frameworks. The separation of responsibility for prudential regulation and market conduct regulation (between APRA and ASIC), the operation of independent monetary policy and a floating exchange rate continue to serve us well.

What does Brexit mean for UK housing?

From The Conversation.

Britain’s housing market is in a sorry state. With house prices forecast to fall, house building grinding to a halt and buyers pulling out of purchases amid job security fears, post-Brexit uncertainty has been worsened by the contrasting “visions” that won the vote.

These opposing visions are now evenly represented in Theresa May’s cabinet. The more liberal Leave campaign wanted greater economic freedom, with less government and “Brussels bureaucracy”. Its supporters have quickly retreated from any pledge to bring down immigration, which would compromise access to the EU single market.

The others in the Leave side, however, are happier to resist market forces, even accepting some short term sacrifice of living standards to restore “sovereignty”, and a sense of community they view as eroded by too much free movement. For these “grassroots” Leavers, concerned about social cohesion and quality of life, lower house prices are a key Brexit bonus. Controls on arrivals from the EU and strict barriers against refugees are intended, in part, to reduce the demand for homes and related public services.

This could, in turn, make housing more affordable to existing residents, with wages rising as fewer compete for available jobs. And if the economy slows, interest rates will fall further, potentially improving mortgage affordability.

Will Brexit lead to a buyers market? Toby Melville/PA Archive/Press Association Images

Houses could well become easier to buy if, as both factions promised, average incomes now rise due to “unshackled enterprise” and less competition for jobs. Those pursuing homes to live in may also find there are fewer rival buyers treating property as just another investment. Rule changes in April had already quelled buy-to-let demand. Absentee foreign buyers who had inflated prices in and near London might now look to buy in other capitals that will remain within the EU.

However, UK borrowing costs may still have to rise if the weaker pound rekindles inflation. Even with a near-zero base rate, households might soon find borrowing harder if, as the Remain camp warned, EU labour protections are now withdrawn and incomes grow more slowly in the long run. Official growth forecasts have until now assumed continued net immigration of well over 250,000 per year, but as May was the architect of Conservative pledges to stem this inflow, that too may change.

No relief for Generation Rent

Making housing more expensive has been central to economic recovery strategy since 2010. This is because rising prices benefit homeowners, who are still a large majority of voters. Many younger voters priced out of the market will now hope that affordable housing can be part of May’s version of Conservatism. But while her swift installation might dispel the uncertainty that stalled pre-referendum investment – including housing starts – her new economic plans will have to rule out a sustained drop in prices, as this would hit household spending too hard at a time when other sources of demand are also weakening.

Households are already approaching a level of borrowing which proved unsustainable before 2008. So longer-term house price growth is unlikely to exceed national income growth, which most forecasters calculate will slow down as the UK starts its slow path out of the EU.

And even if Brexit does not restrain production and income growth, it is likely to weaken house buying demand by hitting the profitability of banks, whose recovery from crisis is still being slowed by tougher regulation, new entry and alternative forms of business borrowing.

So while many landlords suspect that Brexit will end the long escalation of housing costs both for buyers and renters, this is unlikely to make it any easier for the average household to find an affordable home.

The housing market has felt the immediate effect of Brexit chill. David Cheskin/PA Archive/Press Association Images

This is because although rising investment might speed up residential building and renovation, it would leave house builders vying for resources with commercial construction and other industries – even if the general labour supply is not constrained by lower immigration.

In short supply

The long run up in house prices reflects a chronic failure to build enough new homes, often traced to restrictive planning laws that reflect local concerns much more than eurocratic meddling.

To ensure profit, developers always have an incentive to release new homes more slowly than the market needs them. And neither local authorities nor housing associations are currently able to fill the gap. So while the estimated 11m adults and 3m children in inadequate accommodation in England indicates a real need for more houses to be built, the market is far from ready to deliver them.

The immediate adverse impact on housebuilders’ and housing associations’ finances is likely to offset any state sponsored home building drive, despite the new chancellor’s quick retreat from Treasury budget-balancing pledges. And if anything, the risk of post-Brexit slowdown now strengthens the government’s incentive to boost housing demand without comparably raising supply.

Uncertain times

Even if eventually controlled, immigration could actually temporarily rise to beat anticipated restrictions – putting increased demands on housing supply.

How will a change in borders impact the labour market? Shutterstock

Although, this influx of people might actually help to boost labour supply and allow construction to quicken – but only if building firms can hire them. Housebuilders’ sagging share prices in the wake of the referendum suggest they might not.

And although lower immigration from the EU would eventually ease demand for housing, it would also reduce access to those legendary Polish builders, who will be hard to replace with local labour.

Always hazardous, economic forecasting is especially uncertain in relation to housing because buyers’ and suppliers’ finances are in line for both positive and negative shocks, on an uncertain timescale. But as a sharp fall in prices will only occur if the economy turns downwards, it would not bring the boost to affordability that Generation Rent awaits.

Author: Lecturer in Economics, The Open University

Bank of England maintains Bank Rate at 0.5%

At its meeting ending on 13 July 2016, the The Bank of England’s Monetary Policy Committee (MPC) voted by a majority of 8-1 to maintain Bank Rate at 0.5%, with one member voting for a cut in Bank Rate to 0.25%.  The Committee voted unanimously to maintain the stock of purchased assets financed by the issuance of central bank reserves at £375 billion.   The MPC sets monetary policy to meet the 2% inflation target and in a way that helps to sustain growth and employment.

Committee members made initial assessments of the impact of the vote to leave the European Union on demand, supply and the exchange rate.  In the absence of a further worsening in the trade-off between supporting growth and returning inflation to target on a sustainable basis, most members of the Committee expect monetary policy to be loosened in August.  The precise size and nature of any stimulatory measures will be determined during the August forecast and Inflation Report round.

Financial markets have reacted sharply to the United Kingdom’s vote to leave the European Union.  Since the Committee’s previous meeting, the sterling effective exchange rate has fallen by 6%, and short-term and longer-term interest rates have declined.  Reflecting the fall in the level of sterling, financial market measures of inflation expectations have risen moderately at short-term horizons, but only to around historical averages, and have fallen slightly at longer horizons.  Markets have functioned well, and the improved resilience of the core of the UK financial system and the flexibility of the regulatory framework have allowed the impact of the referendum result to be dampened rather than amplified.

Official data on economic activity covering the period since the referendum are not yet available.  However, there are preliminary signs that the result has affected sentiment among households and companies, with sharp falls in some measures of business and consumer confidence.  Early indications from surveys and from contacts of the Bank’s Agents suggest that some businesses are beginning to delay investment projects and postpone recruitment decisions.  Regarding the housing market, survey data point to a significant weakening in expected activity.  Taken together, these indicators suggest economic activity is likely to weaken in the near term.

Twelve-month CPI inflation was 0.3% in May and remains well below the 2% inflation target.  Measures of core inflation have been stable at a little over 1%.  The shortfall in headline inflation is due predominantly to unusually large drags from energy and food prices, which are expected to attenuate over the next year.  In addition, the sharp fall in the exchange rate will, in the short run, put upward pressure on inflation as the prices of internationally traded commodities increase in sterling terms, and as importers pass on increases in their costs to domestic prices.

Looking further forward, the MPC made clear in its May Inflation Report, and again in the minutes of its June meeting, that a vote to leave the European Union could have material implications for the outlook for output and inflation.  The Committee judges that a range of influences on demand, supply and the exchange rate could lead to a significantly lower path for growth and a higher path for inflation than in the central projections set out in the May Report.  The Committee will consider over the coming period how the outlook for the economy has changed in light of the referendum result and will publish its new forecast in its forthcoming Inflation Report on 4 August.

The MPC is committed to taking whatever action is needed to support growth and to return inflation to the target over an appropriate horizon.  To that end, most members of the Committee expect monetary policy to be loosened in August.  The Committee discussed various easing options and combinations thereof.  The exact extent of any additional stimulus measures will be based on the Committee’s updated forecast, and their composition will take account of any interactions with the financial system.

Against that backdrop, at its meeting ending on 13 July, the majority of MPC members judged it appropriate to leave the stance of monetary policy unchanged at present.  Gertjan Vlieghe preferred to reduce Bank Rate by 25 basis points at this meeting.

Property fears after Brexit vote are a sign of wider UK housing problems

From The Conversation.

Immediately after the UK voted to leave the European Union, a number of lead economic indicators went into reverse. Notable among them were housing, property and real estate shares that fell sharply both in the housebuilding sector and among banks with large property lending exposure. This was seen as a simple response to economic uncertainty; fears emerged of falling house prices and slowing activity in the property market.

This week the big story has been the weakening position of major real estate funds, primarily investing in commercial property – office buildings, shops, warehouses. The firms which manage the funds, Standard Life for example, are concerned that if investors rush to withdraw their money, there will be insufficient capital to repay them. At first, a number of funds reduced the amount that investors could get back. Now, at least six of them – including Standard Life, Aviva and M&G – have suspended trading altogether. This has not happened since the global financial crisis.

Commercial property is in the firing line. Hazel Nicholson/Flickr, CC BY

While it reflects the basic illiquidity of commercial property compared to the short-term needs of worried investors – it clearly speaks to a much more profound concern about the economy and the exposure to housing and property.

Most of us are not heavily exposed to property funds, but many of us are homeowners or hope to be. The risk of falling house prices in the post-referendum environment may threaten highly leveraged mortgages where home owners have taken on lots of debt. The most immediate risk is of “negative equity”, when the value of the house is lower than the loan amount outstanding.

Normally, such “underwater” loans prevent people moving home, but in the absence of repayment difficulties they are not an immediate problem. You just have to wait it out until prices turn. However, the current situation is complicated and potentially more worrying.

This is because of the government’s £31 billion commitment to various Help-to-Buy schemes, £12 billion of which in effect guarantees the exposed part of mortgage loans should prices fall. A sustained price fall which becomes associated with increased defaults on mortgages could mean the government has to make good those guarantees after repossessions on affected properties.

Taking a pounding

Falling house prices in the short run will also reduce existing owners’ capacity to support potential first time buyers: the bank of mum and dad (or granny and grandad) stepping in to help. This will further reduce access to home ownership because younger households increasingly face unaffordable deposit demands before they can get a mortgage. At the moment, access to the levels of cash needed often depends on rather arbitrary good fortune, timing and location. It often boils down to whether your family have the means to lend or give you what’s needed.

Much has been made of the high level of speculation and overseas investment in London’s vertiginous housing market. There were already signs that the market was weakening cyclically prior to the referendum. Subsequently, however, we saw last week that some foreign banks were refusing to lend to their nationals for property investment in the UK. The depreciation of sterling may be encouraging such purchasers into the market, but only if they can find the means to borrow.

In this way we see that a UK housing market dominated by an open, world city in London, does become linked to currency movements and international capital flows, despite the fundamentally local nature of housing and real estate.

No more happy hunting ground? Davide D’Amico/Flickr, CC BY-SA

Home to roost

Falls in share prices, the forced intervention in real estate funds and worries about lending and government exposure to the downside of help-to-buy guarantees explain why the Bank of England says that the Brexit risks are crystalising and is moving to do something about it. However, it is hard not to draw the conclusion that the red flags going up across the housing and banking sectors reflect the underlying or chronic problems we know beset the housing market in Britain:

• Market imperfections in the form of the long term inability to build in sufficient numbers to address growing housing demand.

• Dwindling public investment in social and affordable housing in a period of high and rising housing need.

• Tax raids on the private rental market by targeting buy-to-let investors just when they are playing a critical role by filling the gap between the market and the non-market sectors.

• Tighter mortgage lending in the wake of the mortgage review that sought to reduce future lending risks after the global financial crisis.

• Privileged tax advantages to home owners which lock them in and create a society of insiders and outsiders. This worsens intergenerational inequalities and crowds out other forms of more productive business investment

Broken system. Ben Salter/Flickr, CC BY

Combining these points helps explain the underlying volatility in the housing market. It allows prices and market volumes to fluctuate more than the economy as a whole, while long-term real house price inflation encourages speculation in property assets and serves to frustrate people’s housing and labour mobility choices.

Governments and opposition parties must take concerted long-term action to normalise housing as an asset and a commodity. The policy world must recognise the need to approach housing more constructively, treating it as an entire system win which housing consumption rather than tenure matters most.

Frankly, we must seek to bring an end to a culture where politics is premised on defending existing asset owners’ housing capital rather than providing sufficient housing in the right places at prices and rents ordinary people can manage at different life-cycle stages. If not, we will be condemned to repeat these crises periodically, alongside slowly worsening chronic problems of exclusion, non-affordability and poisonous widening inequality.

Author: Kenneth Gibb, Professor of Housing Economics, University of Glasgow

There Are Limits To Monetary Policy – Carney

In a speech entitled “Uncertainty, the economy and policy“, given by Mark Carney, Governor of the Bank of England, he highlights that waves of uncertainty are washing over the UK economy, and these waves are getting larger. The result of the referendum is clear. Its full implications for the economy are not. But the question is not whether the UK will adjust but rather how quickly and how well. As risks have risen, further monetary policy interventions are likely, but he says there are limits to how much can be achieved with these levers.

CArney-Uncertainty… The decision to leave the European Union marks a major regime shift. In the coming years, the UK will redefine its openness to the movement of goods, services, people and capital. In tandem, a potentially broad range of regulations might change.

Uncertainty over the pace, breadth and scale of these changes could weigh on our economic prospects for some time. While some of the necessary adjustments may prove difficult and many will take time, the transition from the initial shock to the restructuring and then building of the UK economy will be much easier because of our solid policy frameworks.

At times of great uncertainty, households, businesses and investors ask basic economic questions. Will inflation remain under control? Will the financial system do its job?

In recent years, economic uncertainty has been elevated because of fragilities in the financial system and overhangs of public and private debt.

These challenges have been compounded by deeper forces that have radically altered the balance of saving and investment in the global economy. In the process, these have moved equilibrium interest rates into regions that monetary policy finds difficult to reach. Whether called ‘secular stagnation’ or a ‘global liquidity trap’, the drag on jobs, wages and growth is real.

All this uncertainty has contributed to a form of economic post-traumatic stress disorder amongst households and businesses, as well as in financial markets – that is, a heightened sensitivity to downside tail risks, a growing caution about the future, and an aversion to assets or irreversible decisions that may be exposed to future ‘disaster risk’.

Even before 23rd June, we observed the growing influence of uncertainty on major economic decisions. Commercial real estate transactions had been cut in half since their peak last year. Residential real estate activity had slowed sharply. Car purchases had gone into reverse. And business investment had fallen for the past two quarters measured. Given otherwise accommodative financial conditions and a solid domestic outlook, it appeared likely that uncertainty related to the referendum played an important role in this deceleration.

It now seems plausible that uncertainty could remain elevated for some time, with a more persistent drag on activity than we had previously projected. Moreover, its effects will be reinforced by tighter financial conditions and possible negative spill-overs to growth in the UK’s major trading partners.

As the MPC said prior to the referendum, the combination of these influences on demand, supply and the exchange rate could lead to a materially lower path for growth and a notably higher path for inflation than set out in the May Inflation Report. In such circumstances, the MPC will face a trade-off between stabilising inflation on the one hand and avoiding undue volatility in output and employment on the other. The implications for monetary policy will depend on the relative magnitudes of these effects.

Today, while the economy is more complex and our models less reliable, the Bank has identified the clouds on the horizon and can see that the wind has now changed direction.

Over the past few months, working closely with the Chancellor and with HM Treasury, we put in place contingency plans for the initial market shocks. They are working well.

Over the coming weeks, the Bank will consider a host of other measures and policies to promote monetary and financial stability.

In short, the Bank of England has a plan to achieve our objectives, and by doing so support growth, jobs and wages during a time of considerable uncertainty.

Part of that plan is ruthless truth telling. And one uncomfortable truth is that there are limits to what the Bank of England can do.

In particular, monetary policy cannot immediately or fully offset the economic implications of a large, negative shock. The future potential of this economy and its implications for jobs, real wages and wealth are not the gifts of monetary policymakers.

These will be driven by much bigger decisions; by bigger plans that are being formulated by others. However, we will relentlessly pursue monetary and financial stability. And by doing so we will facilitate the adjustments needed to realise this economy’s full potential.

 

Feds Perspective on Brexit

Fed Governor Jerome H. Powell’s address “Recent Economic Developments, Monetary Policy Considerations and Longer-term Prospects” included commentary on Brexit.

My baseline expectation has been that our economy is likely to continue on its path of growth at around 2 percent. I have also expected the ongoing healing in labor markets to continue, with healthy wage increases and job creation. As the economy tightens, I have expected that inflation will move up over time to the Committee’s 2 percent objective.

For some time, the principal risks to that outlook have been from abroad. Global economic and financial conditions are particularly important for the U.S. economy at the moment. Weakness in economic activity around the world and related bouts of financial volatility have weighed on the performance of our economy. Given the stronger performance of the U.S. economy, the trade-weighted value of the dollar has risen roughly 20 percent since 2014. Such a large appreciation of the dollar means that we will “export” some of our strength to our trading partners and “import” some of their weakness.

Growth and inflation remain stubbornly low for most of our major trading partners. European and Japanese authorities have limited scope to respond, with daunting longer-run fiscal challenges and policy rates already set below zero. In China, stimulus measures should support growth in the near term, but may also slow China’s necessary transition away from its export- and investment-led business model. Emerging market nations such as Brazil, Russia and Venezuela face challenging conditions.

These global risks have now shifted even further to the downside, with last week’s referendum on the United Kingdom’s status in the European Union. The Brexit vote has the potential to create new headwinds for economies around the world, including our own. The risks to the global outlook were somewhat elevated even prior to the referendum, and the vote has introduced new uncertainties. We have said that the Federal Reserve is carefully monitoring developments in global financial markets, in cooperation with other central banks. We are prepared to provide dollar liquidity through our existing swap lines with central banks, as necessary, to address pressures in global funding markets, which could have adverse implications for our economy. Although financial conditions have tightened since the vote, markets have been functioning in an orderly manner. And the U.S. financial sector is strong and resilient. As our recent stress tests show, our largest financial institutions continue to build their capital and strengthen their balance sheets.

It is far too early to judge the effects of the Brexit vote. As the global outlook evolves, it will be important to assess the implications for the U.S. economy, and for the stance of policy appropriate to foster continued progress toward our objectives of maximum employment and price stability.

I am often asked why rates remain so low now that we are near full employment. A big part of the answer is that, at least for the time being, the appropriate level of rates is simply lower than it was before the crisis. As a result, policy is not as stimulative as it might appear to be. Estimates of the real interest rate needed to keep the economy on an even keel if it were operating at 2 percent inflation and full employment–the “neutral rate” of interest–are currently around zero. Today, the real short term interest rate is about negative 1-1/4 percent, so policy is actually only moderately stimulative. I anticipate that the neutral rate will move up over time, as some of the headwinds that have weighed on economic growth ease.

Don’t believe the Brexit prophecies of economic doom

From The Conversation.

The shock and horror at the Brexit vote has been loud and vociferous. Some seem to be revelling in the uncertainty that the referendum result has provoked. The pound falling in value, a downturn in markets – it lends credence to the establishment’s claims before the referendum that a Leave vote would lead to economic Armageddon.

But there are plenty of reasons to reject the consensus that Brexit will be costly to the UK’s economy. Even though markets appear stormy in the immediate aftermath of the vote, the financial market reaction to date has more characteristics of a seasonal storm than of a major catastrophe.

We were told that the consensus of economic experts were overwhelmingly opposed to a Brexit. Lauded institutions – from the IMF, OECD to the Treasury and London School of Economics – produced damning forecasts that ranged from economic hardship to total disaster if the UK leaves the EU. Yet 52% percent of the British electorate clearly rejected their warnings.

Something that my professional experience has taught me is that when an “accepted consensus” is presented as overwhelming, it is a good time to consider the opposite. Prime examples of this are the millennium bug, the internet stock frenzy, the housing bubble, Britain exiting the European exchange rate mechanism (ERM) and Britain not joining the euro. In each of these examples, the overwhelming establishment consensus of the time turned out to be wrong. I believe Brexit is a similar situation.

Downright dangerous

The economic models used to predict the harsh consequences of a Brexit are the tools of my profession’s trade. Used properly, they help us to better understand how systems work. In the wrong hands they are also downright dangerous. The collapse of the hedge fund Long-Term Capital Management in 1998 and the mispricing of mortgage backed securities leading up to the 2008 financial crisis are just two of many examples of harmful consequences arising from the abuse of such models.

The output of these often highly sophisticated models depends entirely upon the competence and integrity of the user. With miniscule adjustment, they can be tweaked to support or contradict more or less any argument that you want.

The barrage of dire economic forecasts that were delivered before the referendum were flawed for two main reasons. First, they failed to acknowledge the risks of remaining in the EU. And second, the independence of the forecasters is open to question.

Let’s start with the supposed independence of the forecasting institutions. While economists should in theory strive to be independent and objective, Luigi Zingales from the University of Chicago provides a compelling argument that, in reality, economists are just as susceptible to the influence of the institutions paying for their services as in other industries such as financial regulators.

Peer pressure

Another challenge faced by economists is presented by the nature of the subject matter. Economics is a social science which, at its heart, is about the psychology of human social interactions. Many models try to resolve the difficulties that human subjectivity causes by imposing assumptions of formal rationality on their models. But what is and is not rational is subjective. In further recognition of this difficulty the sub-discipline of behavioural economics has evolved.

Herding is a concept that has been used to rationalise financial market bubbles and various other behaviour. It describes situations in which it seems rational for individuals to follow the perceived consensus. Anyone who has found themselves in a position where the majority of their company has a radically different view to their own will have experienced the difficulty of standing out from the crowd.

In 2005-06, variouspeople (including myself) presented the view that house prices would crash. While some audiences were sympathetic, the majority view at the time was both hostile and derisory. Challenging the received wisdom exposes you to feelings of isolation.

Received wisdom among academia has been that the EU is a force for good that should be defended at all costs. Respected colleagues are incredulous that anyone with their education and professional insights could think otherwise and remain part of the academic “in” crowd. In such an environment, it is very difficult to challenge this orthodoxy.

I – and the bulk of the UK population – might have been convinced by the pro-Remain economists if they had been a little more honest about the limitations of their models, and the risks of remaining inside the EU.

Market reactions

Despite reports of markets crashing following the Brexit result, when you put the current level of volatility in context of other shocks, market conditions are not as bad as they might seem. The FTSE 100 is still higher than it was barely two weeks ago and the more UK-focused FTSE 250 is currently higher than it was in late 2014. This is the kind of volatility that markets see two or three times a year.

The volatility index for the US S&P, known as the VIX or the “fear gauge”, is what is widely used to measure how uncertain global financial market participants are about the outlook for stocks. When the Brexit result was first announced, the VIX moved sharply, but has since settled in the mid-20s. To put this in context, the all-time average is 20.7, the all-time closing low is 8.5 and the all-time closing high on Black Monday in 1987 was 150. More recently during the financial crisis, it reached a closing high of 87.2 in November 2008.

VIX volatility chart. CBOE

Other financial indicators also moved rapidly as the referendum results came through. On the face of it, the Japanese market suffered a severe shock falling almost 8%. However, the 8% fall in the Japanese stock market is almost exactly matched by an 8% gain of the Japanese yen relative to the pound. Therefore, the net effect for UK-based investors in Japanese equities is close to zero.

The fall in the value of the pound following the Brexit result is also not as bad as it may first appear. The size of the fall was exacerbated by the previous day’s assumption that Remain would win. There is also precedent for a dramatic fall – after the ERM crisis – which proved beneficial for many British exporting companies and arguably helped sustain the economic recovery of the 1990s.

A lower pound benefits companies that add most of the value to their products inside the UK, and companies that sell their produce on international markets. This includes exporters like pharmaceutical company GlaxoSmithKline, drinks company Diageo and technology company ARM – all of which saw stock price gains on the morning after the vote. Companies that rely on imports and add little value within the UK will be hardest hit in the short term as they adapt to the exchange rate volatility.

There will undoubtedly be winners and losers from the UK’s decision to leave the EU. But indexes for volatility are already lower than they were in February this year, suggesting that markets are not abnormally worried about the outlook, and UK government borrowing costs are at an all time low. This is further reason to reject the pre-referendum consensus that Brexit would bring economic doom.

Author: Isaac Tabner, Senior Lecturer in Finance, University of Stirling