18 July 2016

Policy Network: The impact of Brexit on the City and the British economic model

Summary of Key Points 

• Before the EU referendum, the City of London benefited hugely from access to the European Single Market. For example, in 2013 Britain ran a £19.9 billion surplus in financial services with the EU. The City is home to 35% of the EU’s wholesale financial activity, 78% of its foreign exchange turnover, and 74% of over-the-counter derivatives trading (City UK).

• However, throughout the 2000s broad swathes of the British population felt they had not benefited from the EU’s Single Market to the same extent. In the post-2008 context, large sections of British society experienced stagnant living standards. They also felt powerless to control immigration. These problems intensified after 2005 and after 2012 when EU immigration to Britain increased markedly.

• During the EU referendum campaign, the Remain campaign’s message about economic uncertainty struggled to counteract the Leave campaign’s claim that it could win back ‘control’ over Britain’s borders and political system. In part this was because much of the population felt they did not benefit from the status quo and partly because it was difficult to build support around a campaign that Brexit might ‘hurt the City’. • Now the EU referendum has passed, the City is in a position to advance its interests once again and shape the post-Brexit environment. It is likely to push for ‘passporting rights’ which would mean it would continue to have access to the Single Market in financial services. Brief No. 1 – The impact of Brexit on the City and the British ecconomic model 6 • However, it is worth bearing in mind that the euro zone itself is highly vulnerable to a future economic downturn. In this context, the City could become a ‘safe haven’ for investors fleeing instability within the Single Currency area. 

• The City of London remains one of the world’s leading financial centres at the present moment.

• During the 2000s, the British government’s choice to not join the euro did not harm the City of London. Indeed, since the introduction of the euro and up until the 2008 financial crisis, the size of the financial sector in the UK increased from 5.5% of GDP to 10% of GDP. In contrast, the financial sector in the euro area remained at around 5% during this period.

• However, this position is potentially threatened as a result of the Brexit vote in the EU referendum. In particular, the City’s status may come under threat if it cannot continue to access the EU’s Single Market in financial services

• In addition, in the post-Brexit environment the UK government will have to negotiate new trading arrangements with non-EU countries. This could result in higher tariff and non-tariff barriers for City firms depending on the details of the arrangements which are arrived at.

• As such, the status of the City looks very uncertain in the months and years following Britain’s choice to leave the EU.

Conclusion

• The City is at the core of the British dilemma over Europe because it is the power engine of the British economy. Over the past decades, Britain’s growth has relied to a large extend on foreign capital and the export of financial services – the condition for which was to accept free movement of people. British voters’ decision to leave the EU shows that they are ready to pay the economic price for regaining some control over immigration. The next few years of negotiations will test the solidity of this choice. As the backlash against immigration and free markets is widely shared across the EU, the odds are that Britain will manage to legitimise its demand for new migration rules and the price to pay might not be as high as predicted.

• The likely loss of ‘passporting rights’ would make business in the EU more complicated for London-based financial firms, but it does not mean the end of the road for the City. By opening subsidiaries in EU member states, British firms will be able to keep a foot in the Single Market. Moreover, under the principle of ‘equivalence’, financial firms based in third countries will have partial access to the EU’s Single Market (for instance, under the incoming MiFID II and MIFIR regimes). However, this will be conditional upon Britain continuing to apply the EU’s existing and upcoming legislative body without any change, and to political goodwill – French financial markets representatives will press French government to be ruthless with the City. Britain will need to display a lot of goodwill and cooperative spirit. 

• The City can also count on the new British government’s determination to protect what it sees as a key element of its prosperity. If access to the Single Market is to be seriously damaged, Britain intends to remain an attractive place for foreign capital by other means. Suggestions that the corporate tax rate might be cut down to 15% confirm the fear in some EU continental countries that Britain will become an aggressive tax haven at its borders. Whether this is realistic given Britain’s fragile fiscal situation is questionable, but this will in any case provide the British government with a significant leverage tool in the upcoming negotiations with the EU. 

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