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Council of Financial Regulators

The Implications of Brexit – July 2016

3. Medium to longer-term implications for Australia and the world

3.1 Growth prospects and risks

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.

Large Banks' Non-performing Loans

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Banks' Share Price to Book Value Ratios

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Overall, 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.

3.2 The United Kingdom and European Union relationship following Brexit

The process for the UK to leave the EU is complicated and unprecedented. The medium-term implications for Australia and the world from Brexit will depend on how long it takes for the UK and the EU to reach agreement on their post-Brexit relationship and the nature of this agreement, which in turn will influence the effect on output and adjustment for the UK and EU economies. There are a range of alternative models that could form the basis for this post-Brexit relationship, which essentially trade off access to the EU single market against independence from EU membership obligations. The UK already occupies a unique position in the EU with existing carve-outs in its membership that have the effect of exempting it from the commitment to ‘ever closer union’. The UK is not part of the euro area or the Schengen area that permits passport-free travel for European citizens.

Though formal renegotiations have yet to commence, the EU has already publicly stated its non-negotiable positions on a post-Brexit relationship. This centres on access to the EU's single market and the adherence to its key pillars:

  • the four freedoms of the movement of goods, services, labour and capital;
  • the approximation of relevant laws, regulations and administrative provisions between member states;
  • EU-wide competition policy administered by the European Commission; and
  • a system of common external tariffs.

The EU has clearly stated that there would be no ‘à la carte’ option on the single market for the UK.[3] The UK's approach to these negotiations is yet to be outlined, but a central tension appears to be a trade-off between EU single market access and the free movement of labour.

3.2.1 Possible models of UK-EU relationship post-Brexit

Based on existing arrangements the EU has with non-member states, there are three broad possible alternatives to EU membership for the UK (Table 3).

Table 3: Possible alternative models for UK-EU relationship
European Economic Area Bespoke bilateral agreement WTO membership
More access to EU single market
More independence from EU obligations
A Norway-type arrangement with the EU, which includes:

  • a high level of single market access;
  • limited say over EU rules, but adherence to the ‘four freedoms’ of the single market; and
  • no access to the EU's FTAs, being outside the EU's customs union.
Bilateral agreements similar to Switzerland's, which includes:

  • access to some EU sectors; and
  • most trade would be tariff and quota-free but subject to the EU customs union.

Switzerland has not been granted broader access to EU financial (and other) services, but must adhere to the freedom of movement.

  • Default option with access to the EU single market through WTO membership.
  • Bilateral trade subject to the EU's external tariffs.[4]
  • UK not have to follow EU obligations and directives, pay contributions to the EU budget, or adhere to the ‘four freedoms’.

3.2.2 Economic impacts of the agreement and the negotiating process

The expected effect of any of these models on the UK economy will be observed through a number of channels including trade, foreign investment, the labour market and incomes. Loss of single market access would have a negative effect on the UK economy over the medium to long-run to varying degrees across both the traded and non-traded sectors from factors such as higher transaction costs to foreign divestment and company relocation from the UK to the EU. That said, the enhanced policy autonomy may provide greater flexibility for implementing productivity-enhancing reforms over the longer-term.

The extent of the trade and investment impacts will mostly depend on how much access to the single market the UK loses. The effects on EU economies will depend on the extent of their relationship with the UK – Ireland and the Netherlands are likely to be most affected according to IMF analysis.[5]

It will take time for the UK to identify its fundamental economic, political and strategic interests and thereby balance the need to reflect the decision to leave the EU while maintaining mutually beneficial engagement with the EU.

Equally, as negotiations proceed and the EU arrives at the type of relationship that satisfies its interests, the economic and institutional durability of the EU could be tested. This may offer both challenges and opportunities for strengthening the EU by motivating collective action on Europe-wide issues such as structural reforms to reinvigorate and rebalance its economy and enhance the financial stability of the euro area. That said the negotiation process itself could take away the critical political capital for such reforms.

As negotiations unfold and both the EU and UK's interests are explored and tested, markets may shift their consensus on what is a likely possible post-Brexit relationship. If this shift in expectations is rapid, there is potential for another period of market adjustment.

3.3 Implications for international economic co-operation

Brexit will have important ramifications for international economic cooperation. Most immediately, there are a wide range of institutional agreements that underpin cooperation in a range of policy areas. More broadly, the UK and major European economies are prominent members of the G20 and International Financial Institutions and protracted exit negotiations could come at the expense of broader political and economic cooperation in the short to medium term.

3.3.1 Specific areas of bilateral economic cooperation with the EU and UK

Australia has a wide range of institutional agreements both with the EU and UK, ranging from memoranda of understanding through to formal treaties and agreements. In a number of cases these will need to be reviewed and amended post-Brexit, or new agreements negotiated independently with the UK where they are currently relevant at the EU level.

Specific agreements include, but are not limited to:

  • a Memorandum of Understanding (MoU) with the European Commission on consumer protection;
  • information sharing across competition and consumer issues with the UK, including in relation to the oversight of major mergers and acquisitions;
  • recognition by the European Securities and Markets Authority of our clearing facility licensing and derivatives regulation frameworks and related MoUs; and
  • the Australia-EU Free Trade Agreement that is currently being scoped.

Australia will need to consider carefully how it can respond in the short term and position itself for the medium term as the form of the renegotiated UK-EU relationship model takes hold. While identifying areas of concrete action that can be pursued with the EU and UK, Australia can also assist by encouraging cooperation and progress through multilateral and international institutions. The next G20 Finance Ministers and Central Bank Governors Meeting will be held on 23–24 July 2016 and provides a timely opportunity for Australia to reaffirm to the UK our close relationship. There is also the opportunity for Australia to consider a fully-fledged free trade agreement with the UK.

3.3.2 Cooperation through multilateral fora and international institutions

The uncertainty and market disruption created by Brexit further emphasises the need to remain focused on progressing international efforts to strengthen financial stability and address risks. Protracted exit agreement negotiations may challenge the capacity of the UK and EU to engage fully in other international fora and institutions, such as the G20 and IMF. It may also make it more difficult to identify and pursue pan-European interests within that climate of negotiation. Together these factors have the potential to mute progress on international economic cooperation on key global economic and financial issues such as international tax, financial regulation and strengthening the global financial safety net. A key test of any reshaping of global cooperation will be seen as early as December 2016 with Germany taking over as G20 President and Italy hosting the G7.

Over the medium term, if Brexit reflects a broader introspection and re-evaluation of economic integration, strengthening the multilateral fora such as the G20 that boost economic cooperation, promote resilience and improve global economic governance is critical. While the global economy remains fragile, the IMF can also play a key role in promoting stronger global economic governance by being ‘a voice for global cooperation and collective action’[6] and maintaining its key role in global economic surveillance.[7] Ensuring stability and adequate resourcing of the international financial architecture and coordination between the layers of the global financial safety net will be priorities for Australia and where we may need to continue advocating strongly in global fora. Potential exists for Brexit to precipitate regulatory competition to capture market share in European financial services. Therefore, it may be necessary to use international fora to ensure that there is no competitive retreat by either the UK or the rest of the EU from commitments to international financial regulation reform.

3.4 Implications for financial policy settings

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, it suggests that the domestic and international financial reform agenda adopted following the financial crisis is on the right track.

Still, 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 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.


Footnotes
  1. International Monetary Fund, 2016, ‘United Kingdom selected issues: Macroeconomic implications of the United Kingdom leaving the European Union’, Staff Report on the 2016 Article IV Consultation, <http://www.imf.org/external/pubs/ft/scr/2016/cr16169.pdf>
  2. ‘Remarks by European Council President Donald Tusk after the informal meeting of 27 EU heads of state or government’, 29 June 2016, <http://www.consilium.europa.eu/en/press/press-releases/2016/06/29-tusk-remarks-informal-meeting-27/>
  3. The EU's tariffs levied under WTO rules in 2014 were around 5 per cent on average.
  4. International Monetary Fund, 2016, ‘United Kingdom selected issues: Macroeconomic implications of the United Kingdom leaving the European Union’, Staff Report on the 2016 Article IV Consultation, <http://www.imf.org/external/pubs/ft/scr/2016/cr16169.pdf>
  5. International Monetary Fund, 27 June 2016, ‘Remarks by the IMF's First Deputy Managing Director David Lipton’, <https://www.imf.org/external/np/speeches/2016/062716.htm>
  6. International Monetary Fund, 27 June 2016, ‘Remarks by the International Monetary Fund's First Deputy Managing Director David Lipton’, <https://www.imf.org/external/np/speeches/2016/062716.htm>

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