With the UK referendum on EU membership fast approaching, we take a look at some of the challenges corporate treasurers might be grappling with should there be a vote to leave. Has your treasury team considered what life might be like after Brexit?
Imagine, it is the morning of 24th June 2016 and, for the second time in just over a year, the polls have called it very wrong. Corporate treasurers around Europe are waking to the news that the UK has voted to leave the European Union (EU). Invoking the so-called ‘exit clause’ of the Lisbon Treaty a short while later, Prime Minister David Cameron meets with the European Commission (EC) to kick off a series of negotiations set to last for many years.
A lot of treasurers hearing the news that morning share something in common: they had not made contingency plans. Research such as Deloitte’s quarterly CFO survey warned, months before the referendum, that most UK corporates had not planned for a Brexit. Only 26% of the CFOs polled by the audit firm a few months before said their company had made or was in the process of making contingency plans for a possible UK exit from the EU. At the Association of Corporate Treasurer’s Cash Management Conference in February, treasurers spoke of how they had made efforts to raise the issue across their organisations – but had not gained much traction.
Treasurers outside the UK are even less likely to have planned for such an outcome. They will wish they had. If the UK was to leave the EU the whole of Europe would be effected and any company doing business in or with Europe will have to cope with the consequences.
Precisely what happens next is a matter of some conjecture, and one should be very cautious of precise numerical estimates of the economic impact of the UK deciding to leave the EU. What we can say with reasonable certainty, however, is that nearly every aspect of the treasurer’s work will be impacted. In those first meetings after the referendum treasurers on both sides of the English Channel will be carefully considering the impact of Brexit on everything from the company’s FX exposures to its banking relationships and long-term borrowing plans.
The most pressing concern for treasurers in the near term is likely to be foreign exchange volatility. Some have argued that any pressure on sterling following a vote to leave the EU will not last long. After all, exiting the EU, they say, should not drastically alter the UK’s economic fundamentals over the long term.
But that may be wishful thinking. On the other hand, an exit from the EU would mean (at least) two years of political negotiation throughout which many aspects of the UK’s economic, legal and regulatory relationship with its largest trading partner would be set to change. Corporates may decide to delay investment in the UK as a result. Then, as concerns grow around where the disruption will leave the UK’s large current account deficit, investor flows could begin to dry up. Economists warn that, if this scenario were to play out, a precipitous decline in the currency would be on the cards.
“I’m most concerned about the investment channel,” says James Knightly, Senior Economist, ING. “If you are a foreign business, given this two year period of extreme uncertainty, would you be putting money to work in the UK or would you be thinking about investing in continental Europe instead? If foreign direct investment (FDI) becomes less of a positive story, then that is really going to add to the concerns around the currency. We think sterling could fall quite sharply – against the euro it could be back at the levels last seen during the financial crisis.”
Oxford Economics also thinks the initial decline against the dollar could be quite significant. In a report published in March 2016, the research group presented the results of its modelling, according to which sterling will fall by 15% against the US dollar in the immediate aftermath of a vote to leave. By the time the negotiations conclude, the report forecasts the currency to recover and end 9% lower.
There is evidence that the referendum has been already weighing on the exchange rate, which since the beginning of the year is 6.4% lower on a trade weighted basis (a decline economists say cannot be explained simply by the recent fall in UK rate expectations). The cost of hedging business activities against further depreciation has also spiked to its highest level since 2010. The six-month implied volatility in sterling/dollar, a measure of expected moves in the exchange rate used to price options, rose to 12.2% in February 2016 – its highest level since late 2011, according to data from Reuters.
The pound is not the only currency likely to be impacted. As markets begin to digest the news that the UK is heading out of Europe, the euro is equally likely to come under pressure as fears mount about what other member states might be about to follow the UK out the door. Amid the mounting risk aversion in the markets, safe-haven currencies such as the Swiss franc and the Japanese yen could very well begin to appreciate against other currencies. For that reason, treasurers who failed to carefully consider the impact of a Brexit on their short-term hedging positions in the run-up to the referendum may find themselves in an unenviable position.
At the ACT’s Cash Management Conference, it was this particular scenario that seemed to be the greatest concern for treasurers. Julie Fabris, Treasurer for Britax Childcare Group, a UK-based manufacturer of children’s car seats, said this was one of the main areas she had been discussing with her team ahead of the referendum. “There is a lot of FX volatility out there and we have a lot of FX exposures,” she explained. “So the first thing in my mind is how to manage that. I think that’s only going to get worse, and you can already see it in the sterling/euro rates at the moment.”
Key Brexit questions treasurers should be asking
Working capital management
Source: Association of Corporate Treasurers: briefing note – Brexit. March 2016
Uncertainty costs money
Were the pound to become chronically weak, the Bank of England (BoE) might be encouraged to hike the UK benchmark borrowing rate to ward off inflation. But that is not the only reason why the pricing of credit could become a headache for UK corporate treasurers in a post-Brexit world.
First, there is a possibility that sterling debt is seen as riskier in the wake of a Brexit, prompting an increase in the price banks can borrow at relative to the BoE’s policy rate. Such an increase would most probably be passed on to non-financial corporate borrowers through higher risk weightings and higher margins.
Second, intercompany financing and the ability to borrow on European debt capital markets would be unaffected. The EU’s open investment approach is guaranteed by legislation that states all restrictions on the movement of capital between Member States and between Member States are prohibited. However, borrowing in foreign currency may be unattractive if sterling comes under pressure.
“If you are a foreign business, given this two year period of uncertainty, would you be putting this money to work in the UK or would you be thinking about investing in continental Europe instead?”
Thirdly, UK companies could face a credit downgrade. In a research note published in March, credit ratings agency Moody’s said that Brexit would create heightened uncertainty that would be credit negative for non-financial corporate issuers, a view shared by the other two major ratings agencies, Standard & Poor’s and Fitch. Meanwhile, Moody’s believes there will be little significant credit impact for EU-based issuers. It does note, however, that the uncertainty from Brexit would be felt across the EU, and especially in countries such as Ireland, the Netherlands, Germany and Belgium.
The pressure on ratings for UK issuers is not likely to be distributed evenly across the UK economy since the impact of a Brexit will not be the same for any two businesses. “It depends which sector you are thinking about,” says Colin Ellis, Managing Director – Chief Credit Officer, EMEA at Moody’s. “Each have their own issues in terms of possible regulatory change, the trade impact, investment impact and migration impact. For example, in the corporate world, the companies that might be most exposed in terms of the migration issue are food producers. Whereas if you are thinking about the trade question, then it is most probably manufacturers that are impacted.”
The small ray of hope for the corporate treasurers at this point is that all the questions Brexit raises around future access to markets and movement of labour are resolved quickly. Dorothy Livingston, Consultant at Herbert Smith Freehills LLP who says she has been receiving more enquiries from corporate clients about Brexit in recent months, summarises the problem succinctly. It is uncertainty that is the real challenge. “This carries the risks that, as in other situations of uncertainty, money may cost more and it may become more difficult to borrow on good terms on a long-term basis“.
This is before even getting to the more specific issue of what happens to the financing arrangements of companies currently benefiting from some form of EU subsidy or financing programme. “Businesses may, depending on the terms agreed if the UK leaves the EU, lose access to European Investment Bank (EIB) funding once we actually leave the EU,” Livingston adds. “That would remove a source of funding that has been heavily used by our infrastructure companies – there is not any equivalent UK institution to replace that. According to its website, the EIB has lent some €29bn to the UK in the last five years, with over 75% of this total going to energy, transport, telecommunications and water/sewerage/urban development.”
A strategic review of the composition of funding policies will therefore be essential for treasurers of UK companies in the event of a Brexit. And that is even before we take into account the impact of a Brexit on the principle source of funding for most European corporates: the banks.
In The City
The City of London is blessed with many competitive advantages lacked by other European financial centres such as Frankfurt and Paris. Neither of these cities has the same depth of labour market in financial services that London enjoys; nor does either possess the same scale of support services – lawyers, accountants, and consultants. These advantages will not disappear overnight if the UK leaves the EU.
That means treasurers will probably be spared a costly wholesale disruption of their banking activities from foreign banks deciding, in a post-Brexit world, to move their European headquarters or close their London operations altogether. That does not mean, however, that corporate banking relationships will be left entirely unaffected by the UK’s changing relationship with Europe.
Once again, uncertainty is the problem. What will the loss of EU passporting rights from London mean for the treasurer’s relationship banks’ commitment to various lines of business? What will the UK leaving the EU mean for the UK’s participation in the Single Euro Payments Area (SEPA)? Will companies still be able to collect euro payments from the UK post-Brexit and, if so, might these be subject to additional charges from the recipient banks?
The payments question is particularly significant because banks have been advising corporate clients that it is in their interests to open accounts in London. Since the volume of transactions flowing via London into Europe is so great, the banks have long argued that centralisation of this sort makes a lot of sense from an operational efficiency perspective.
Whether it would continue to make sense in a post-Brexit world is uncertain. Although the UK is not a member of the euro it is as a member of the EU, of course, included in the Single Euro Payments Area (SEPA). Inclusion in SEPA is not conditional on membership of the EU: non-EU states such as Switzerland, Norway and Monaco are, indeed, part of the scheme. But until the point at which the political leaders of the UK and the EU come together and iron out the details of the UK’s new relationship with Europe, there would be some uncertainty around the UK’s continuing participation in the scheme. A matter of this sort would, most probably, need to be addressed in a trade deal. In the absence of such a deal, some industry sources have even speculated payments sent from the UK to the EU might be subject to deductions from the beneficiary bank.
“As in other situations of uncertainty, money may cost more and it may become more difficult to borrow on good terms on a long-term basis.”
“The SEPA uncertainty is one of the ways this could impact clients,” a source inside the transaction banking industry told Treasury Today. “It could be bad news for companies who have centralised accounts in London for the purpose of pooling liquidity. We have been receiving quite a lot of questions from corporates with liquidity pooling structures based in London.”
Cash pooling is far from the only financial service that could face disruption were Brexit to lead some UK-headquartered banks into structural reviews of their businesses. The loss of passporting rights, which permit banks access to European Economic Area (EEA) markets from London, could push some banks to move selected areas of their business to an EU financial centre like Frankfurt or Paris. The statement from HSBC’s CEO Stuart Gulliver earlier this year indicating that the lender plans to move 1,000 of its investment bankers to Paris if the UK withdraws from the EU could be taken as a sign of what is to come should the UK vote to leave.
Not every bank will be impacted in this way though; only those UK regulated entities, like HSBC, that use the UK to passport into Europe. A US headquartered bank with a footprint in Europe, for instance, could in addition to relying on the EU passport also have US branches operating in Europe that are negotiated locally in each particular country.
Treasurers will therefore need to understand what a Brexit means for their banking partners and that some banks will be more affected than others. Those with one of the large UK banks might find that, operating from the UK, the bank can no longer offer services into the European market. The bank may need to move part of their business into Europe to keep servicing the markets locally.
The loss of passporting rights could be an equally significant issue for money market funds too. In the event of a Brexit, asset managers could find that their ability to sell funds across Europe from the UK is hampered. At the present time, the right to do this is guaranteed under the EU’s Undertaking for Collective Investments in Transferrable Securities (UCITS) Directive. But there is a very real possibility that the EU will seek to change these arrangements if the UK leaves the EU. If that were to happen some funds would have to either withdraw from marketing on the continent or re-domicile their assets. This too could become an issue for treasurers of European companies using UK domiciled sterling MMFs post-Brexit.
Looking across the spectrum of treasury activities that could be affected by the UK exiting the EU – from banking and money funds to financing – there appears to be one major recurring theme: uncertainty. Perhaps this is the reason why so many corporate treasurers and CFOs have indicated that, as the referendum approaches, they have yet to make contingency plans.
Despite all the grave predictions made by commentators on both sides of the debate, the truth of the matter is that nothing actually fundamental changes on the morning of 24th June even if the UK votes in favour of leaving the EU. The much talked about two-year countdown clock that is Article 50 of the Lisbon Treaty will not even begin ticking until the UK Prime Minister David Cameron goes to the EC to convey his government’s desire to exit. In the absence of any immediate impact, it is quite understandable that treasurers feel reluctant to begin planning for a new world that will only become clear as the post-Brexit negotiations progress.
Predictions of an economic meltdown – as some in the ‘Remain Camp’ have indulged in – may be overstating the ramifications of the vote somewhat. But the potential market volatility most economists expect to follow, together with all the political uncertainties, should be more than enough to give Europe’s treasurers jitters as the big day approaches.