The Implications of Brexit – July 2016
2 Short-term implications for Australia and the world
2.1 Financial market reactions
The vote to exit the EU was a surprise to financial markets. Financial markets were very volatile in the days following the referendum. There were very sharp falls in bond yields and equity prices (particularly bank share prices) and large movements in foreign exchange markets (particularly a depreciation of the pound). Despite this, market functioning was generally orderly, and asset prices have largely stabilised and in a number of cases retraced their initial falls.
|Exchange rate(a)||10-year govt bond yield||Share prices – broad market(b)||Share prices – banks||Interbank spreads||Bank CDS premia|
|(per cent)||(bps)||(per cent)||(per cent)||(bps)||(bps)|
| * As at close of business 5 July
(a) Against US dollar, TWI for the US
(b) FTSE350 for UK
Monetary policy expectations have generally been wound back in the developed economies. Comments from Bank of England (BoE) Governor Carney and market pricing suggest that the likelihood of monetary easing by the BoE has risen since the referendum, consistent with the weaker near-term and longer-run outlook for the UK economy as a result of the ‘Leave’ vote (see below for further details on the economic effects of Brexit). Speculation of further easing measures by the European Central Bank (ECB) has also risen. Market-implied expectations for the US federal funds rate have been scaled back sharply following the Brexit vote, with the next policy tightening now not priced in until 2018.
Major market sovereign debt yields fell sharply in the days following the Brexit vote. A little harder to understand development was the particularly large decline in UK 10-year government bond yields, despite S&P and Fitch downgrading the UK's credit rating and Moody's placing the country on negative outlook. Spreads on bonds issued by governments in the euro area periphery to German government bonds widened following the Brexit vote, alongside concerns about the implications of the UK exit for the stability of the EU.
Falls in sovereign yields have helped to keep borrowing costs in developed bond markets at very low levels, despite a small widening of spreads. In corporate bond markets, spreads for both investment and non-investment grade bonds in developed markets widened following the Brexit vote, especially in the UK. Similarly, spreads for bank funding (relative to risk-free rates) widened a little following the referendum, with a larger widening in the UK. The cost of borrowing US dollars in foreign exchange swap markets and repo markets generally increased following the vote. Nevertheless, money market functioning remained orderly.
Global equity prices fell sharply following the Brexit referendum, although the initial falls have been in many cases wholly retraced. UK equity prices fell by less than those in many European countries as the depreciation of the UK pound was seen as supporting the earnings of internationally focused companies. The share prices of euro area banks and UK banks with a predominantly domestic focus have fallen by 15–30 per cent. At the same time, yields on riskier types of debt issued by these banks and the price of credit default insurance have increased, but by less than during the pronounced market volatility in early 2016.
Foreign exchange markets were also volatile following the UK referendum. Heightened risk aversion contributed to an appreciation of the US dollar, Japanese yen and Swiss franc, while the UK pound, euro and other currencies depreciated. The UK pound has depreciated by 11 per cent against the US dollar since the referendum, to be at its lowest level since 1985. Foreign exchange markets functioned well given the outcome and the size of the price movements.
The Brexit result has prompted concerns about the outlook for UK property prices, particularly commercial property. In the days following the result a number of UK commercial property funds have responded to increased withdrawal requests by suspending redemptions.
In emerging markets, yields on local currency-denominated sovereign bonds generally increased somewhat following the Brexit vote. Spreads on US dollar-denominated emerging market corporate bonds widened, and equity indices fell. Emerging market currencies depreciated following the outcome. These movements have generally been wholly or partly unwound in the days since.
Australian financial markets also reacted strongly to the UK referendum.
- Long-term interest rates fell sharply after the referendum outcome, with the 10-year bond yield reaching a then record low of 1.95 per cent.
- Bank bond yields also fell, despite a slight widening in spreads to benchmark rates.
- Spreads between bank bill and OIS rates widened slightly following the Brexit result, but remain below those seen in late 2015.
- There was a short-lived increase in market expectations for a near-term easing in monetary policy.
- Australian equity prices fell by 3.2 per cent on the day of the referendum outcome, but have since retraced the fall; the share prices of companies with large UK exposures, including some financial institutions, fell particularly sharply.
- The Australian dollar was volatile on the day of the referendum outcome, initially appreciating before depreciating as the ‘Leave’ result became likely, but it is a little higher on a trade-weighted basis than at the start of June.
Despite intraday volatility Australian financial market functioning has been orderly. Market depth in the 10-year bond futures contract was resilient, even though intraday volatility was as high as that seen during the peaks of the global and European crises. In Australia's equity and futures markets, no extreme volatility controls (including trading halts) have been triggered on ASX or Chi-X equity trading platforms since the referendum result. Short-selling activity on the Australian equity market has remained at relatively low levels, despite a spike in total volume sold short on Friday 24 June.
On Monday 27 June, the Australian Office of Financial Management's tender for five year bonds was well subscribed with coverage over four times.
Key financial market infrastructure functioned well during a period of higher trading volumes and increased market volatility.
- The central counterparties (CCPs) that serve key markets in Australia were all well prepared to manage increased financial risk around the referendum, with clearing participants advised to expect intraday margin calls should large mark-to-market price moves occur. In the event, the significant price changes observed in equity and interest rate markets triggered large and extensive intraday margin calls to cover the associated exposures to the CCPs. All margin calls were met on time by participants, which ensured that the CCPs remained adequately covered.
- Australian CCPs also made additional initial margin calls in the afternoon of the Australian trading day on 24 June, to increase collateral held to cover forward-looking volatility ahead of the European and US trading days. These calls were met on time. In light of the outcome of the vote, this additional collateral was retained by the CCPs in the week following the vote. The CCPs are reviewing their initial margin requirements to ensure that they remain well placed to withstand a potentially extended period of heightened uncertainty and volatility.
- High-value payment and settlement systems in Australia experienced high processing volumes. All relevant systems accommodated these volumes with adequate capacity headroom and completed settlement without incident.
2.2 Policy and regulatory measures
2.2.1 International actions
Central bank actions associated with the UK referendum mainly relate to additional liquidity provision and foreign exchange intervention.
Prior to the Brexit referendum, major central banks – including the BoE, the ECB, the Bank of Japan (BoJ) and the US Federal Reserve – announced they were prepared to enact measures to address potential dislocation in markets, including the provision of local currency liquidity and foreign currency liquidity through the existing swap lines. Following the referendum result, several emerging market economies' central banks also announced they were ready to provide liquidity as required to prevent disorderly market conditions. Use of swap lines has been negligible.
The BoE offered three additional indexed long-term repo operations in the weeks around the UK referendum on top of its regular monthly auction. Demand in the auctions was generally low and pricing remained at minimum levels ahead of the referendum, before picking up slightly in the final operation after the referendum. The total amount allotted in June does not suggest a substantial need for additional liquidity. The BoE will hold weekly liquidity auctions until the end of September.
The BoE has also reduced its countercyclical capital buffer from 0.5 per cent to 0.0 per cent with immediate effect. In addition, the BoE has given a strong indication that it may ease monetary policy in the near term as part of a ‘host of measures and policies’ to support the UK economy.
On liquidity support, it is notable that the European Commission has reportedly authorised the Italian Government to guarantee up to €150 billion of new debt issuance by Italian banks to support their access to funding. Also, the Italian authorities are reportedly in discussion with the EU about a potential state-funded capital injection for Italian banks.
Following the referendum outcome, the Swiss National Bank conducted foreign exchange market intervention to mitigate further appreciation pressure on the franc. The central bank in Denmark also reportedly intervened in the foreign exchange market after the outcome to maintain its peg to the euro. A number of other central banks have also reportedly intervened to curb depreciation pressures on their currencies. In addition, the Japanese authorities have expressed concern about the sharp appreciation of the yen.
Market regulators the UK Financial Conduct Authority (FCA), US Securities and Exchange Commission and US Commodity Futures Trading Commission released statements confirming that they are monitoring developments in financial markets. The FCA has not announced any direct policy response, but has reminded firms to continue to abide by their obligations under UK law.
More broadly to manage the exit from the EU and the subsequent negotiations, the EU and UK each have established a taskforce of officials that will include examining, at a technical level, the terms and conditions regarding Britain's exit from the EU.
2.2.2 Australian CFR agency actions
Council agencies have intensified contact with foreign agencies throughout the period. For example, the RBA has engaged internationally through fora such as the Bank for International Settlements (BIS) Governors Meeting, specific conference calls on the issue among East Asian and Pacific Central Banks Deputy Governors, and the BIS Markets Committee, as well as numerous bilateral consultations, including with the Bank of England. ASIC has participated in an IOSCO Asia Pacific-Regional Committee conference call and had bilateral contact with the FCA. Treasury has engaged with G20 Finance Deputies and had discussions with authorities via its overseas-based officials, including in the US, UK, Japan and China as well as the Financial Stability Board (FSB), OECD and IMF. APRA has been in contact with the UK Prudential Regulation Authority and will meet with them this week, though international consultations have been low key as APRA does not consider that any Australian regulated entity is placed at risk as a result of Brexit.
Council agencies have also been actively engaging with domestic institutions and monitoring developments. For example, APRA is running regular requisitions for bank liquidity projections – a ‘fire drill’ requirement to provide up-to-date liquidity data with a one day turnaround that was incorporated into the prudential standards introduced post-crisis. APRA has also contacted the larger banks to discuss funding and liquidity, market risk exposures and margining, exposures to the UK and developments in offshore funding markets. The results from this work indicate that Australian bank liquidity has not been materially affected by Brexit. RBA and ASIC have engaged with ASX Clear about activity post Brexit.
2.3 Australian banks
The Australian banks are well placed to handle negative shocks such as the fallout from Brexit, with stronger capital positions, more stable funding, and higher liquidity buffers than before the global financial crisis. As noted elsewhere in this report, financial market functioning has remained orderly since the referendum outcome and the effect of Brexit on the Australian economy is expected to be very small. Accordingly, the direct impact on Australian banks' operations and resilience is expected to be minor.
2.3.1 UK and European Exposures
Australian banks' exposures to the UK and Europe are limited, particularly after NAB divested its UK operations in early 2016. On an ‘ultimate risk’ basis, exposures to the UK amount to just under $100 billion, of which one quarter is to UK-resident banks and the other three-quarters is to non-bank institutions (both public and private). Almost one third of this exposure is held by one major bank, with the other three majors accounting for a further 15–20 per cent each. Overall, this equates to around 2½ per cent of consolidated assets, or around half of Common Equity Tier 1 capital. Australian banks have an additional $50 billion exposure to the euro area, or 1¼ per cent of consolidated assets, mostly to Germany, the Netherlands and France, with these exposures spread relatively evenly across individual banks.
|Exposures to banks
||Exposures to non-banks
||Share of consolidated assets|
| * Other core includes Austria, Belgium, Finland and Luxembourg; all
other countries considered to be periphery.
Sources: APRA; RBA
|– Other periphery*||1||3||4||0.1|
|– Other core*||2||3||5||0.1|
2.3.2 Funding positions and other considerations
The fallout from Brexit could also affect Australian banks by raising the cost or reducing the availability of funding. As noted earlier, spreads on banks' short-term and long-term debt funding widened slightly following the Brexit result. But the functioning of short-term money markets in Australia has remained orderly. The Australian banks also maintain substantial liquidity buffers, and the RBA stands ready to provide liquidity to the system should it be required. Australian banks have also raised considerable amounts of longer-term debt in 2016 to date, which further suggests that they are well-placed to withstand any temporary disruptions to funding markets, should they arise.
Australian bank funding raised in UK debt markets amounts to about 5 per cent of total liabilities, down from around 10 per cent a decade ago. Some Australian banks use the UK to ‘passport’ into EU debt capital markets (and would have to make alternative arrangements to access those markets following the UK's exit). Reflecting this, roughly 45 per cent of Australian banks' foreign debt securities are issued in the UK (around $200 billion currently outstanding), although only 20 per cent of this is in pounds sterling (the largest share is in euros).
UK banks, and European banks more broadly, had already wound back their Australian operations considerably in the post-crisis period, and now collectively account for only 5 per cent of Australian banking system assets. This reduces any potential impact on economic and financial conditions in Australia if these banks were to respond to Brexit by pulling back further on their activities here.
2.4 Short-run economic effects on Australia and the world
A range of studies suggest that the short-run economic effects of Brexit will be negative, concentrated in the UK and to a much lesser extent Europe. The long-run economic effects are similarly expected to be negative (see Section 3 for more detail).
In the UK, economic activity is expected to be weaker in the short run as agents react to the weaker and highly uncertain long-run outlook, with factors such as the nature and timing of the final agreement between the UK and the EU, and the political leadership to negotiate that agreement, still highly unclear.
The IMF estimates that by 2017, UK GDP could be between 1 per cent and 3¾ per cent lower than if the UK had voted to stay in the EU. Key channels include reduced investment, hiring and spending by businesses and households, as well as the effects of lower asset prices (such as some equities and property). A lower exchange rate, and potentially easier monetary policy, should be at least partly offsetting and UK Chancellor Osborne has also signalled corporate tax cuts to support economic activity. Dampening effects from uncertainty, albeit much smaller, are also likely in Europe. Global economic activity is expected to be only modestly affected, notwithstanding the potential for heightened financial market volatility, capital flight towards perceived safe havens and reduced trade flows.
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.
- 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>