Brexit-lite and Brexit proper
Post-Brexit discussion suffers from a serious vacuum. Although the British people have voted by a narrow margin to leave the European Union, the next prime minister has not been appointed, and no one knows exactly how he/she and his/her team will organize the negotiations. Two main options (both with many potential variants) are emerging,
- Brexit-lite (“the Norwegian/Swiss option, plus or minus”. The government gives priority to maintaining access to the EU’s Single Market, although seeking (like Norway and Switzerland) to restore parliamentary sovereignty and judiicial supremacy (i.e., that the highest court in the UK is its own Supreme Court, not the European Court of Justice in Luxembourg). Control over new regulations would be with the UK Parliament, but EU regulation would have to be respected in much of the economy and not just on exports to the EU. The UK would pay some money (“danegeld”) to the EU. Given the politics of the situation, the UK would want significant concessions on “freedom of movement”, so that it did indeed control its borders, but something like “freedom of movement for workers only” night be devised.
- Brexit proper. The government says that access to the Single Market is not essential, as the UK can trade satisfactorily with the EU under World Trade Organization rules. It says this, even if UK exports would be subject to the “common external tariff”. Of course the UK restores parliamentary sovereignty and judicial supremacy. It also oversees all new business regulation, although exports to the EU must anyhow comply with EU regulation. The UK pays no money to the EU and recovers full control of its borders.
It would over-simplify matters to say that Brexit-lite is the preferred option for the Eurosceptic Tories, while Brexit proper is the approach favoured by UKIP. But an over-simplification of that sort would not be outright misleading. My surmise is that the prime minister will be Boris Johnson and that the outcome will be Brexit-lite. If the prime minister is Theresa May, the outcome will be Brexit-extremely-lite. UKIP will protest that the British people have again been betrayed and deceived, but its vote share in the 2020 general election is very difficult to conjecture. The size of the danegeld will be a sensitive issue. (My further surmise is that, with the EU’s economic importance [and hence its share of UK exports] declining Brexit-lite may become Brexit proper in due course, perhaps after another decade or two. But who knows? Questions are being raised about the EU’s own internal cohesion.)[private]
Three-year LTROs for UK banks?
The most disturbing economic sequel to the 23rd June vote was the credit down-rating faced by both the British government and the banking system. In my view, the downgrade was weird. Over 160 countries are outside the EU, and it has never been proposed that their EU non-membership was relevant to their credit standing. Why should the UK be treated differently from all those nations that are not geographically in Europe and not geopolitically in the EU? Are Canadian and Japanese banks less credit-worthy because Canada and Japan are not EU members?
Anyhow the markets sensed on the morning of 24th June that the credit rating agencies would soon downgrade the UK and its banking system, and heavy selling of Barclays and RBS led to their suspension. (I say “the markets sensed that!.”, but perhaps there was insider trading. Of course I have no direct proof, but am not reassured that the credit rating agencies are regulated by the European Commission. The Commission is unlikely to probe as hard into an issue of this sort as a parliamentary committee, and that is one reason it is better [in my view] to belong to a fully functioning and effective parliamentary democracy instead of being in the EU.)
The problem is that the credit downgrades affect the ability of Barclays and RBS to fund their assets. In this sense the worries of late 2008 have resurfaced. May I suggest a simple answer? The Bank of England should make available to UK banks facilities of exactly the same kind as Mario Draghi, as president of the European Central Bank, made available to Eurozone banks in December 2011. It should offer three-year low-cost funds (“long-term refinancing operations”) to any British bank which has funding strain because of the post-referendum credit downgrade. If the European Commission objects that such facilities would be anti-competitive (as it did with Northern Rock and RBS in the crisis period a few years ago), the Bank of England should merely point a finger at the ECB and Draghi’s LTROs. The UK will cease to be under the Commission’s thumb in late 2018 or 2019. It will then be outside the EU, and one would hope that the credit rating agencies will grow up and treat UK banks in the same way that they treat Japanese, Australian and Canadian banks.
We know of course that the Bank of England was aware before the vote of the risks that might arise from the credit downgrades. We can be confident that it has already discussed with the major banks how best to maintain business if funding strains do materialize. Mark Carney deserves to be praised for anticipating the potential difficulties here, as was clearly implied by his statement on Friday morning. If three-year LTROs can be accessed by the British banks, they should have no trouble running their businesses in the transitional period between now and 2019, and the share price collapses will prove unjustified.
The global monetary situation
The global monetary situation is far less exciting that the post-referendum-day shenanigans, but is actually more important for financial markets in the rest of 2016. I will split the subject into two.
First, 4% a year is a more or less ideal rate of broad money growth in developed countries, with a trend rate of output growth of 1% – 2% and an aim to keep inflation around 2%. Amazingly, and no doubt more by happenstance than design, 4% a year is at present common to the USA, the Eurozone, Japan (just about) and the UK. See the chart below.
Second, sharp changes in broad money growth ought to be avoided in all countries, because they tend to precipitate undesirably large movements in asset prices and then to affect economic activity. I have to report that money growth has dipped abruptly in both China and India in the last two months for which data are available. This may be a blip, or it may be the beginning of something significant.
I am not an expert on the Indian banking system, but I suspect that (like all banking systems) good political connections help top bankers achieve ttheir rather mercenary ends. (Sorry, the world is a wicked place.) The Governor of the Reserve Bank of India, Raghuram Rajan, has made demands that, just like their counterparts in the nations subject to the Bank for International Settlements’ Basle rules, India’s commercial banks should “tidy up their balance sheets” and operate with higher capital/asset ratio. Specifically, he has pressed for earlier recognition that bad loans are indeed bad. Given the plight of the banks in the Basle rule world (as exemplified by Barclays and RBS at the moment), India’s top bankers did not like the sound of Rajan’s entreaties. They have lobbied the government and managed to have him removed. Rajan will not have a second term in office, after his first term ends in September.
Rajan’s removal is positive for broad money growth in late 2016 and 2017, and it seems plausible that the March-May slowdown will not persist. The outlook in China is more problematic, since the current leading functionaries in the Communist Party are clearly puritanical and authoritarian in outlook. The talk of limiting dependence on debt is really talk against the expansion of bank credit, but steady expansion of bank credit is essential to the steady growth of broad money. The numbers need to be monitored on a regular basis.