IREF - Institute for Research in Economic and Fiscal issues
Fiscal competition and economic freedom
The reaction of financial markets to the Brexit vote was well covered by the press. After initial sharp falls, stock markets throughout the world rallied. Despite the seemingly general consensus that the referendum result exposes not only the UK but many of its European trading partners to uncertainty, within a week most financial markets had returned to their pre-Brexit levels, except for the FX markets where there has been continued weakness in sterling, particularly against the dollar, the rate touching 1.31 compared with 1.48 on the day of the vote.
The fall in sterling’s value has affected confidence in the UK’s highly leveraged property market. A surge of investor withdrawal requests from commercial property funds caused Standard Life Investments to suspend trading in its £2.9 billion fund, quickly followed by Aviva and M&G’s shuttering of their respective funds. Fund investment formats are billed as offering high liquidity, these suspensions are bad news and, if not soon reversed could start a run on other property sectors.
If sterling remains weak, why have the other markets recovered much of the lost ground? On June 24th US shares experienced their largest single day fall in ten months, by June 27th the Euro Stoxx 600 index was down by 10% in two trading days. However, within two weeks the Dow Jones Industrial Average had more than regained all lost ground, although Europe remained down..
Our interpretation is that the Brexit outcome was an excuse for traders and speculators to adopt “risk off” positions (sell shares, buy bonds), leading to the turbulence. However, central bankers quickly came out in a show of strength declaring they would shore up markets. The Federal Reserve issued a strong message of support on June 24th:
“The Federal Reserve is prepared to provide dollar liquidity through its existing swap lines with central banks, as necessary, to address pressures in global funding markets, which could have adverse implications for the U.S. economy”
Bank of England Governor Carney stated on June 30th that he expected the Bank’s Monetary Policy Committee, of which he is only Chair, to cut interest rates over the summer. He also claimed that central banks are not “out of ammunition”, a remark interpreted by observers to imply that sterling QE might be redeployed. Even the Bank for International Settlements, a consistent critic of overly loose policies (March 2016 Newsletter), appeared supportive of central bank intervention. General Manager Jaime Caruana stated he “was confident that the crisis could be contained”.
An even greater impact of these central bank statements has been on bond markets.. UK government bond yields touched record lows of -0.88% in ten years, and around zero in two years. Germany’s two year government bond yields minus 0.67%. The US ten year bond has fallen by 0.9% in the past year and now stands at 1.41%.
If it appears to the reader somewhat incongruous that a vote for secession by UK voters should have prompted a display of such international central bank interconnectedness, then consider the declared position of the dominant political force in Scotland – the Scottish National Party. Having lost a referendum on Scottish independence from the UK in September 2014, the SNP quickly announced that the 62% Scottish majority for Remain means that another referendum for Scottish independence should take place. Despite such claims having little constitutional authority, given the leadership upheavals afflicting the three largest British political parties (measured by 2015 votes cast), it is quite conceivable that the SNP’s wish may be granted.
Even if granted, the SNP has a problem; whether to campaign on keeping sterling or joining the euro. There are two risks to pursuing the sterling option:
a) Timing. A second independence vote may not take place until after the UK has split from the EU; the EU is regarded as unlikely to grant Scotland an “opt out” from the euro, especially if Scotland were to apply to accede as an already independent country;
b) Resistance from the Bank of England. In 2014, despite SNP insistence that an independent Scotland would be part of a sterling “monetary union” with the rest of the UK, this option was roundly dismissed by the Bank. It is quite possible that this had a material impact on voters, since the SNP then appeared to have no Plan B. It tried to deal with this firstly by claiming that the Bank of England was bluffing, and secondly by threatening to walk away from Scotland’s share of the UK national debt if a deal were not agreed.
Already there are indications that the SNP may be prepared to embrace the euro, despite obviously having decided prior to 2014 that their chances of winning were higher by keeping sterling. It seems to us that independence from the UK is a higher priority for the SNP than EU membership. If the SNP could find a way to keep sterling we believe they would campaign on such basis. It does seem remarkable that they overlooked the currency board solution which has served Bulgaria so well since its currency crisis of 1996 to 97.
The operation of the Bulgarian Currency Board is simple. It receives and holds euros and issues Bulgarian leva. It retains the euros and therefore each leva is backed by these euro reserves. The effect of this is to render the leva immune from speculative currency attack. A similar structure could be adopted by an independent Scotland to ensure the retention of sterling as the national currency. Two important consequences would follow:
a) Scotland would be subservient to the monetary policies of the Bank of England;
b) the London central bank would be under no obligation to bail out or support Scottish banks.
Given that the two highest profile 2008 failures, Royal Bank of Scotland and Lloyds, are both Scottish, the second point may be causing the SNP to pause and consider.
No sooner had the market turbulence noted above erupted than problems in continental banking reappeared. The Italian authorities used the destabilising Brexit vote as justifying their proposal to inject euros 40 billion in equity into troubled banks, but in contravention of the rules requiring shareholders and certain creditors to be bailed- in first. With shares in its only systemically important bank, Unicredit, down by 30% in a month, and Monte Dei Paschi also suffering again, Italy cited fears of possible bank runs as justifying its request for permission to inject equity into banks.
This request immediately created conflicts with the European Commission who asserted the rules. Italy responded that its banking system is unique, both in terms of non-performing loan levels which, at 17% of bank assets are nearly ten times the comparable US level, and in terms of the level of unguaranteed capital instruments held by ordinary customers, reportedly euros 187 billion.
The EC offered, as a concession, permission for Italian authorities to offer euros 150 billion in the form of liquidity support to its banks; but Italy responded that recapitalisation is required since liquidity is not the problem.
The story reminds us that the politicisation of bank solvency has downsides. To give the Italian authorities credit they enforced the bail in rules regarding four small failed banks last December, but the public reaction was strong and public funds were set aside to bail out some of those bailed in (January 2016 Newsletter). This experience has caused many commentators to doubt whether Italy will enforce bail-in rules.
And why should they, some will ask, when Germany continues to take little apparent action regarding Deutsche Bank which passes all the European tests? In the days after Brexit both the IMF and the US central bank declaimed Deutsche Bank as the riskiest financial institution on the planet, and the one posing the greatest risks to the financial system. DB was one of only two of 33 banks tested to fail the US authority’s stress tests. Such concerns naturally led the IMF to call for greater monitoring and supervision of DB’s exposures, and particular attention was drawn to its Living Will.
Deutsche Bank is also one of only four foreign banks required to submit Living Wills to the US authorities. Living Wills, to recap, are a requirement imposed on all banks designated as systemically important. Each bank must set out the steps to be taken to manage its potential insolvency in a manner so as to avoid disruption to the orderly functioning of the financial system. Of course, that aspect of each of the four’s Living Will which will most concern US authorities is each’s US specific plan. Interestingly, Deutsche Bank’s July 2015 plan for its US operations envisages either a massive bail-in, or a new ‘bridge bank’ supervised by the US Federal Agency for Financial Market Stabilisation (FMSA). However, Deutsche Bank considers it more likely that any bail in would be co-ordinated by German authorities, with the FMSA merely supervising liquidity injections into the US from abroad. This would be facilitated by the bail-in procedure and no support would be required by the governments of either Germany or the US. For that reason, the Living Will contains the words:
“DBAG does not expect the implementation of the U.S. Resolution Plan to be required”..
As shares in Deutsche Bank touch 30 year lows, it is open to question whether markets believe this. Further, as the anti- Deutsche Bank rhetoric intensifies, the risk increases that this year’s Living Will is rejected. This might in turn pressure the German government to consider recapitalisation, making it difficult to continue to resist Italy’s chosen path.