Sharon Donnery: Brexit and global capital markets
Remarks by Ms Sharon Donnery, Deputy Governor (Central Banking) of the Central Bank of
Ireland, at Chatham House, London, 23 March 2017.
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Introduction
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It is a pleasure to be invited to Chatham House to discuss Brexit and global capital markets.
In my remarks today, I would like to first turn to history to better understand the emergence of
centres for capital. I will then touch on what Brexit may mean for the 'City of London' as a global
market for capital. Finally, I will address some of the potential macroeconomic implications of the
UK's decision to leave the EU and exit the Single Market, for both the UK and Irish economies,
and for Ireland as a location for financial services.
History of centres for capital
The fortunes of centres for capital change. Take the example of a world-leading commercial and
financial centre of the past: Venice. Venice rose in status because it was able to make full use of
its location, servicing important trading routes between Europe and the East. By the fourteenth
century markets for debt, and secondary markets for debt, equity, and mortgage instruments
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existed. Their development was accompanied by financial innovations such as bankruptcy laws
distinguishing illiquidity from insolvency; double-entry accounting; deposit banking; and a reliable
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medium of exchange - the Venetian Ducat. However, the emergence of alternative trade routes
with the discovery of the New World and Vasco de Gama's voyage to India endangered the
economic supremacy of the Italian city.
The Venetians were not blind to the changing geopolitical landscape. To retain its importance as
a leading trading and financial centre, Venice encouraged the excavation of Suez Canal, but
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without success. Moreover, Venice failed to modernise its naval force, which was not equipped
to navigate in oceanic waters. The Mediterranean soon lost its importance as European trade
rerouted to the oceans, signalling the decline of the fortune of the Italian city and the advent of new
opportunities for the Atlantic powers.
Subsequently, the Netherland's economic prominence led to Amsterdam becoming the world's
leading trading and financial centre, from the end of the sixteenth century. However, the
Napoleonic Wars, French Occupation and relegation in terms of the financing of international
trade and issuing foreign loans, led to a decline in its status as a 'capital of capital'. It could not
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compete or adapt to competition from new centres such as London or Paris.
Turning to London, the need to finance successive wars - the Spanish War of Succession, the
Austrian War of Succession, and the Seven Years War - gave rise to a financial revolution in the
eighteenth century. The establishment of the Bank of England - although private at the time -
enhanced the state's opportunity to borrow, and led to the establishment of a genuine capital
market which attracted savings, and where joint-stock companies and government securities
were traded.
London consolidated its position as a leading international financial centre in the nineteenth
century following Britain's expansion as the dominant player in the world economy after the
Napoleonic Wars. Productivity gains from technological innovations (such as mechanisation of
textiles, use of coal in the metallurgical industry and use of steam) during the industrial revolution
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further enhanced its position as an already great trading and colonial power.
Brexit and global capital markets
The City's international pre-eminence developed over 250 years. Agglomeration benefits in terms
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of labour and scale reinforced the City's attractiveness. The UK now receives the second
largest FDI inflows in the world and the largest in the EU. Over half of the stock of UK FDI is in
financial services. Most financial transactions in the EU - three quarters of the hedging activity,
more than three quarters of the FX activity, half of the lending and half of the securities
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transactions - take place in the UK, irrespective of where the counterparties are based. In this
context, it is fair to say that both central banks and firms must grapple with sizeable and specific
issues associated with Brexit.
Broadly speaking, it is not unreasonable to assume that much of this FDI is predicated on UK
access to the Single Market, and a portion will be diverted to other Member States when Britain
leaves. However, estimating the impact of Brexit on the geography of international financial
centres is complex. In this regard, research undertaken by staff at the Central Bank of Ireland
shows location decisions of non-bank financial FDI are driven by the very same factors that are
traditionally regarded as determinants of investment decisions in more traditional sectors of the
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economy. Specifically, the research finds that barriers between the home and host, market
size, regulation and taxes, as well as other traditional gravity variables such as sharing a
common border, currency, language and legal system have an impact on firms' location
decision. These results are interesting given the perception that this sector is very footloose and
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not tied to a specific geographic location.
In addition, the importance of factors other than taxation in driving non-bank FDI location
decisions mitigates concerns that FDI in the non-banking financial sector simply flows to low tax
locations or to those with less stringent regulation. The same results hold when looking at
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research on bank FDI.
Some more specific challenges for firms to grapple with include, what will happen to the existing
passport regimes and whether third country equivalence can be relied upon in a post-Brexit
scenario. In these cases, the potential solutions which might be arrived upon vary depending on
the applicable legislative requirements. In other words, what this means for European financial
services will depend on the sector and firm type.
What is important is that regardless of where an entity seeks to relocate, firms should expect a
rigorous assessment of the applicable regulatory standards and intrusive ongoing supervision of
their activities. Regulatory authorities in the EU operate as part of the European System of
Financial Supervision (ESFS) and, as such, should apply European legislative requirements in a
uniform manner. A commonality of approach will be very important to ensure that the risk of
regulatory arbitrage is mitigated and any financial stability risks which could arise as a result of a
diminution of regulatory standards are avoided. ECB Banking Supervision, the EBA, ESMA and
EIOPA have critical roles in supporting consistent and coherent financial supervision and the
effective implementation of the rules in the financial sector across the EU and across sectors.
We are confident that location decisions will be driven by factors such as infrastructure, skills,
legal framework, and cultural factors, rather than any regulatory 'race to the bottom'.
The potential macroeconomic impact of Brexit
We now know Article 50 will be triggered next week. Although the short-term risks of Brexit were
overestimated by some, it is important that we do not underestimate the risks over the medium
and longer term.
Estimates of the potential long term economic cost of a UK departure from the EU range from a
relatively limited impact (with an orderly departure and a reasonable transition period) to the
potentially very damaging prospects of a so called 'hard Brexit'. Under such a scenario goods
trade between the UK and the EU would be subject to tariff and non-tariff barriers leading to a
significant decline in trade volumes. With the UK outside the Single Market and without passport
rights, trade in financial services would be adversely affected. Moreover, incentives for
businesses both domestic and foreign to invest in the UK would also be undermined.
The UK's revealed preferences, set out in broad strokes in the government's recent White Paper,
seems to plot a middle course between a soft and hard Brexit extremes. However, the devil will
be in the detail which will only become clear in the negotiations that will follow. More recent
history - in Hong Kong or Singapore, for example - suggests that the dominance of international
centres of finance is driven by global factors, rather than national economic developments. The
international nature of the City suggests London's resilience as a global capital market will be
less reliant on the state of the British economy post-Brexit.
Brexit is likely to see some relocation of financial services to Dublin. Authorisation-related activity
in Ireland has continued to increase including queries from banks, markets firms, queries
regarding payments and electronic money, and insurance authorisations. To date, these have
largely been exploratory. For example, in the case of Ireland, the semi-annual growth rate of the
number of Irish resident investment funds since the UK referendum in June-2016 to
Decemeber2016 stood at 3.13 percent. This is close to the longer-term trend seen since December-2012.
This may serve as evidence that, to date, there have not been significant location spillover
effects. In the main, firms are waiting until Article 50 is triggered before taking concrete decisions
on activity and location.
Taking a long term perspective, while the UK remains a very important market for Ireland, the UK
share of Irish exports has been on downward trend for decades, matched by an upward trend in
the share off exports going to rest of the EU. Prior to Irish accession to the EU, the UK accounted
for over 50 per cent of Irish exports. This has fallen to under 20 per cent for services and under
14 per cent for goods exports. By contrast, the EU, excluding the UK now accounts for close to
three times the volume of goods exports to the UK and around twice the volume of services
exports to the UK. This trend is unlikely to be reversed and is more likely to become more
pronounced following the UK's departure from the EU.
Conclusion
The decision to leave the EU will impact significantly on the trading arrangements between the
UK and EU, with effects also for investment and capital flows and potentially the structure of
European financial markets.
Although, some European jurisdictions will potentially see considerable change in light of the
UK's exit, what is not anticipated is for a 'new London' to emerge. Given more recent
technological developments, it is unclear whether agglomeration effects are as important as they
once were. The answer to that question will contribute to determining the extent to which financial
services will fragment across a number of European cities.
The rise and fall of Venice and Amsterdam shows that what determines the fortunes of 'capitals
of capital' depends on their ability to cope with external shocks and global developments and
ultimately their ability to adapt to the changing landscape of history. The future importance of the
'City of London' will therefore depend not only on the agreement between the EU and the UK, but
also on how London will position itself in the post Brexit world.
Ibid.
4
See Grygiel, J. J. (2006). Great powers and geopolitical change. JHU Press, pp. 51-87.
5
See Cassis, Y., & Collier, J. (2010). Capitals of Capital: The Rise and Fall of International Financial Centres
1780-2009. Cambridge University Press, pp. 09-15.
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Ibid.
7
See Ball, M., & Sunderland, D. T. (2002). An economic history of London 1800-1914. Routledge, p.335.
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See for example Wright, W. (2016). The Potential Impact of Brexit on European Capital Markets: A Qualitative
Survey of Market Participants. New Financial.
9
See Davies, Ronald B. and Killeen, Neill (2015). Location Decisions of Non-Bank Financial Foreign Direct
Investment: Firm-Level Evidence from Europe, Central Bank of Ireland Research Technical Paper No.4.
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Ibid., p.5.
11
Claessens, Stijn, and van Horen, Neeltje (2014). Foreign banks: Trends and impact. Journal of Money, Credit
and Banking, 46(s1), pp.295-326.