Brexit – no special deal for The City of London financial centre

By Kavaljit Singh, Madhyam(opens in new window) (India)

Britain is finally leaving the European Union. At the European Council summit held in Brussels on 14-15 December 2017, EU leaders formally approved the negotiating guidelines to move to the second phase of Brexit negotiations after confirming “sufficient progress” had been achieved in the first phase of negotiations. On 8 December, the UK and the European Union reached a withdrawal deal concerning three key issues – citizens’ rights, the Northern Irish border and the financial settlement (the “divorce bill”). The EU leaders have endorsed the joint report(opens in new window) issued by the UK and the EU on December 8 and adopted guidelines(opens in new window) to move to the second phase of Brexit negotiations. The guidelines pertain to twin issues – a transition period after Britain’s exit from the European bloc and elements of a future trade agreement between the UK and the EU.

During the transition period, the UK will have to accept the full jurisdiction of the European Court of Justice and adhere to all four “freedoms” of the EU Single Market – free freedom of goods, services, capital, and people. Besides, the UK will continue its membership of the Customs Union which implies the UK cannot sign new trade agreements with other countries (outside the EU) during the transition period

Myriad challenges ahead        

As pointed out by Donald Tusk, President of the European Council, “The most difficult challenge is still ahead… The second phase will be more demanding, more challenging than the first phase.”

It is possible that a future trade deal between the UK and the EU will not be ready by the end of the transition period, given the complexities involved in negotiating a broad-based trade and investment agreement. Hence, both parties may remain engaged in trade talks long after the UK has left the EU.

On the other hand, the UK’s approach to Brexit has remained unclear right from the beginning. There is a lack of clarity on the part of Theresa May’s government as to what kind of future trade arrangement it wants to achieve with the European bloc.

Some Cabinet colleagues, including Chancellor Philip Hammond, have advocated a Norway-style relationship with the EU. By opting for a Norway model, the UK may receive access to Single Market but will have no say over EU rules. However, the country’s political establishment may be averse to such an arrangement, as Brexit is supposed to be about “taking back control.”

No “cherry-picking”

David Davis, Secretary of State for Exiting the European Union, has recently outlined a new Brexit approach called “Canada plus plus plus.” Signed in 2016, the Comprehensive Economic and Trade Agreement (CETA) is a free trade pact between Canada and the European Union that mostly covers trade in goods, along with cross-border trade in services. From the UK’s perspective, the proposed deal with the EU should be bespoke with far deeper commitments to liberalising trade in services, particularly financial services, than offered under CETA and other FTAs signed by the EU. “All we want is a bespoke outcome. We will probably start with the best of Canada, the best of Japan and the best of South Korea…and then add to that the bits that are missing – which are the services,” he says.

Can the UK secure a bespoke trade deal, effectively “cherry picking” the most attractive elements from EU’s existing trade agreements with other countries? The chances of a bespoke trade deal are very bleak. In the past, Angela Merkel and other EU leaders have explicitly stated that there will be no “cherry-picking”. In a recent interview with Prospect(opens in new window) magazine, Michel Barnier, the EU’s chief negotiator for Brexit, has ruled out any possibility of a bespoke deal for the UK. “We won’t mix up the various scenarios to create a specific one and accommodate their wishes, mixing, for instance, the advantages of the Norwegian model, member of the Single Market, with the simple requirements of the Canadian one. “No way”, he warned. Harsh words indeed.

Offensive interests in financial services

The UK has offensive interests in pursuing a trade deal with the EU (and other trading partners) aiming at unrestricted cross-border trade and investment in services, especially financial services. The reasons are obvious. Over the last 50 years, the British economy has undergone rapid change with the sharp decline in country’s industrial and manufacturing base. Services currently account for nearly 80% of the UK’s economy. In 2016, the UK enjoyed a £14bn trade surplus in services with the EU, largely on account of financial services, followed by legal, tax advice and business services. The UK also runs a substantial trade surplus in financial services with many other countries. The UK is the next biggest exporter of financial services in the world, followed by the US and Japan. London alone accounts for 51% of the total financial and insurance sector gross value addition in the UK. The City of London remains Europe’s financial capital, providing a wide range of financial products and services across the continent and beyond.

International banks use London as a hub and entry point seeking access to the EU’s Single Market. That is why a large number of international investment banks are located in London and they serve European (and international) markets by providing cross-border bank lending, forex trading, bond trading, OTC derivatives trading and international insurance. Apart from banks, London is also the European capital for managing alternative funds (hedge funds, property funds and private equity funds which are themselves mostly based in tax havens).

As close to 25 percent of the UK’s financial sector business involves the Single Market, the UK government is concerned about the potential loss of business and jobs since financial “passporting privileges”, a key component of the Single Market will no longer be available post-Brexit. “Third country” regulations impose more restrictions on non-EU financial services than on financial services with “EU passports” that allow free access to any EU member state once one member state has approved it. In other words, banks and other financial services providers located in the UK may not be able to serve clients across the European bloc without any restrictions, if the country loses access to the bloc’s Single Market.

In case the UK is unable to clinch a trade deal that includes financial services, then banks and other financial players are likely to move certain parts of their business and offices to Dublin, Paris, Frankfurt or other European cities. However, research conducted by the Financial Times(opens in new window) (13 December 2017) shows that fewer than 4,600 jobs may move from London in preparation for the Brexit. Of course, it is still too early to speculate on the potential loss of jobs, but the Financial Times analysis shows that the previous claims that tens of thousands of jobs could move away from London after Brexit may not hold true.

Rebalancing the economy: a missed opportunity

The financial sector accounts for 10.7% of the UK economy, the highest among all G7 economies. However, the total number of people employed in the financial sector is only 3.1% of all those employed in the UK. Further, despite having such a bloated financial sector, the UK merely spends 15% of its GDP on investment, far less than other G7 countries. This poses a fundamental conundrum that needs further exploration – is financialisation contributing to value creation (in terms of facilitating non-financial innovation and long-term investments in productive sectors) or enabling value extraction?

Brexit offers a unique opportunity to the UK to rebalance its economy, which is excessively dependent on financial services, and to shape its future economic relations with the rest of the world based on mutual benefits and common prosperity. The UK needs to grab this opportunity. The UK’s financial sector should be primarily geared towards sub-serving the real economy and channelling resources into productive sectors. Unfortunately, rebalancing the domestic economy is not on the government’s policy agenda.