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Monday, June 27, 2016

Brexit Has Left a Big Mess, but the City of London will be Fine.


By Roy C. Smith

For years successive UK governments have fought the EU to protect the freedom of the City’s financial markets. Now they won’t have to.
Yes, we know that the unexpected Brexit vote has thrown much into confusion, to be sorted out messily over an uncertain period of time, but the effects on the City after the smoke clears are likely to be more beneficial than not.
Indeed, the City has been around a lot longer than the EU, and its generally unregulated Euromarket, born in the 1960s, has evolved into the world’s largest capital market for global corporations, banks and governments, generating $4 trillion of new issues of debt and equity in 2015 as compared to less than $3 trillion in the USA.
Not much of this volume was British, of course; the markets have evolved to what and where they are because they have attracted others to use them. Over many generations, London, unlike any other European city, has learned to appreciate the value of low tax rates and a light regulatory touch that favors competitive free-market pricing of financial assets for issuers and investors from all over the world.
It has also accumulated a large financial talent pool with an accompanying infrastructure. London markets in securities, foreign exchange, commodities, and derivatives are hard wired into counterparts in New York, Toyko, Hong Kong and elsewhere to present a seamless, high-tech global trading environment in financial instruments of all kinds. These markets also serve as a hub for intra-European trading, where local European markets have benefitted by increasingly being integrated into the Euromarkets.
According to a recent McKinsey report, the global value of all outstanding securities in the world in 2015 was approximately $300 trillion, more than 3% of world GDP. The London-based markets account for a major chunk of this sum.
Since its beginning, the EU has been distrustful of the power of global financial markets, and since the 2008 crisis has attempted to impose significant limits on them. As the UK markets are the largest in Europe, they are the most affected by these ideas.
British governments have blocked or opted out of many of these efforts, but some still remain, in one form or another.
These include limits on bonuses paid to bankers, the European Banking Authority’s inclusion of British banks in its oversight and regulatory grasp, the applicability of a Financial Transaction Tax (which has been delayed, if not undone, with help from other EU member countries), and a proposal from the ECB to force clearing houses used by EU members to be located in continental Europe. Other such rules could be introduced in the future.
Being Out, of course, means not having to worry about these incursions any longer. But being Out also means the EU might enact other anti-market regulations that might require, as an extreme example, that EU issuers and investors only use EU regulated markets.  That would be a serious self-injuring mistake that likely would create ways around the rules, or encourage other member countries to object, but even so, British firms should still be able to participate in such transactions.  
That is because, as American firms have realized, under the Single Market Act, anyone can set up a subsidiary in the EU to do its business there with all EU membership benefits. Being outside the EU has not hurt US global capital market firms, which have a dominant share of the Euro market business. Though this may mean some legal reorganizing and shift of personnel to get passporting right, there is little reason for British firms to think they might not be able to adapt effective platforms to preserve their market shares.
In any case, it’s too early to worry. The UK has to serve official notice of its intention to withdraw, which may take several more months to do, and then there is a two-year negotiation period (which can be extended) during which competent officials try to reach a sensible agreement aligned with their own interests out of the public eye.
They will be negotiating just how Out Britain is to be. Out like Norway with special trading rights, or like Switzerland, which has bi-lateral trade deals with most EU countries. That kind of Out might not be so bad.
In the meantime, Britain is still In and will l be in for several more years.

Friday, June 24, 2016

The Brexit Shock



By Roy C. Smith

A year ago it was Greece that everyone thought might leave, or be tossed out of the European Union.  Grexit never happened, but today Brexit did through a 52-48 percent referendum vote (with an amazing 72% turnout) in which only Scotland and the London region supported remaining in the EU.

Pollsters said the sentiment had changed in recent weeks to favor remaining in the EU, and yesterday markets soared as investors treated themselves to an early victory celebration. But the polls were badly wrong. Markets collapsed on the news this morning.

Prime Minister David Cameron will resign sometime soon but no one knows who the next Conservative Party leader will be, as Cameron’s inner circle all supported remaining and are probably not eligible.  Boris Johnson, the maverick former Mayor of London, who broke with the Conservatives to support leaving, said the referendum provided Britain with a “glorious opportunity” to take control of its economy and its borders.

Donald Trump, visiting one of his golf courses in the UK at the time, agreed with Johnson said Britain had done the right thing.

Former Labour Party Prime Minister Tony Blair, who strongly supported remaining, said he though people believed the referendum offered an opportunity for a “protest vote,” when in fact it was instead a very important “decision vote.”  Referendums can be dangerous when voters get things confused.

Nicola Sturgeon, head of the Scottish Nationalist Party that lost a referendum vote in 2014 on leaving the UK, said a new Scottish vote would now be necessary.  The Scot Nats are the third largest political party in the UK.

Right wing politicians in several European countries claimed that referendum votes in their countries would likely follow the British example, causing elected leaders to worry about further defection among the (now) 27 remaining EU members. 

But out is out. Britain will now have to begin a two-year negotiation with the EU, under the never tested Article 50 for an orderly withdrawal. They will argue over future tariffs and market access. The EU doesn’t want to make it too easy, for fear others will follow the UK out the door, but they don’t want to make it too hard either because they still want the British economy linked to theirs.  But to do this the UK has to field a team of true-believing negotiators, and that may require another general election.

The economic argument for Brexit was that cut free of its obligations to the EU (social and economic policies more left than the UK would prefer), the UK could make its own laws and shape its own destiny and be better off.  But, leaving means that UK’s exports to the EU (44% of total exports) would be subject to tariffs and therefore more costly, and new investment in the country (especially by foreign companies) would likely fall off with diminished access to European markets.  A weaker pound (it fell 7.3% on the news) would balance some of this stuff, but whether Britain actually ends up better off will depend on how effectively it can change its own laws to boost its economy as the leavers expect it to do.

This will not be easy. Low growth and fears about job losses have driven economic policy in the UK, the EU and the US (the UK growth rate has averaged 2%, and unemployment 6.5% since 2010, but unemployment is now 5%). Many economists forecast a 3-4% recession as a result of the vote.

Or, as David Brady, a Stanford political scientist has said “no party, country or leader has discovered the path to achieve economic growth while mitigating the ills that go with it. “ It is a difficult time for tough-love market economics that threaten to make things worse in order for them to get better over the longer term.

There is also a lot of uncertainty over how the vote will affect the City of London, the longstanding financial center of the EU. There may be some job shifts to other European cities, but the talent and infrastructure of the London markets is likely to survive, and perhaps be made more competitive by its ability to escape the many EU rules it dislikes.

The politics of the thing, however, ultimately may be the more important issue for Britain. Leaving essentially is a repudiation of its old neighborhood, which clumsily or not has forged a historically unprecedented economic confederation of nations to provide economic prosperity and political security for a region of the world that had little of it for the first 50 years of the 20th Century. Confederations are at best unwieldy and fragile alliances, but the EU, now with a pre-Brexit population of 507 million is the world’s largest economic marketplace (GDP of $18.5 trillion). The UK is Europe’s second largest economy (GDP of $2.9 trillion) and the second largest country by population (64 million).

For the EU to survive it has to strengthen itself as it grows and this requires the skillful attention of national political leaders from the largest countries. The UK has been an important dissenter (along with a few other countries that looked to the UK for leadership on certain issues) that has brought a market-oriented viewpoint to a group that definitely needed, but resisted it.

Now this voice will be absent, Britain’s influential role in Europe will be lost, and Great Britain may slip back to being Little England.     


Monday, June 13, 2016

Fifty Years of Extraordinary Change


By Roy C. Smith
Last week I attended the 50th reunion of my class at Harvard Business School. There were 650 who graduated, 120 have died, and of the rest, 340 (including many wives) attended the reunion. There were only six women in our class. 
We were told that in 1966 about 6,000 MBA degrees were awarded in the US (almost none anywhere else) – now it’s about 200,000 in the US and a large number abroad. Most of the core courses of our day are still taught, but there are fewer of them and more electives.
We were trained to be managers of large manufacturing corporations (“masters of business administrator”), but by the time of our 25th reunion, half the class identified themselves in a survey as being self-employed, working in small businesses or members of partnerships. Big business was not for them after all. 
Many of us were attracted to finance, which as an industry, probably changed more than any other during our 50 years.  Just as we were settling into our new careers (at an average starting salary of $11,000), the 1970s struck – the Dow Jones was the same in 1979 as it was in 1969, but the intervening years were plagued by inflation averaging nearly 8%. In 1971, the gold standard was abandoned; in 1973, the first oil crisis occurred; and in 1975 Wall Street was paralyzed by the forced introduction of negotiated commission rates. In 1979, the Volcker interest rate “shock” was engineered by the Fed to kill inflation  -- through this action led to the deep recession of 1981 and the S&L and Banking Crises of the 1980s.
So, for the first fifteen years or so, financial careers might have seemed pretty bleak, but out of all the difficulties of the 1970s came, a wave of innovations and a relaxation of competitive rigidities that enabled many financial firms to grow and prosper. Securitization, LBOs, junk bonds and derivatives were invented; new SEC rules such as shelf-registration allowed bankers to bid for business normally tied to “exclusive” relationships with other bankers.  The Eurobond market opened up and globalization of capital sources and investment opportunities abounded, especially in “emerging market” countries that previously had been considered as below the standards required to use capital markets.  
The world changed too. In 1979 Deng Xiaoping began China’s economic transformation; Margaret Thatcher brought “privatization” (of government owned businesses) and free-market policies to the UK. The EU was formed and the euro introduced, the Berlin Wall fell and the USSR voted itself out of business. First Japan, then China developed into Asian superpowers.
It wasn’t all easy – there were periodic financial crises along the way, but market economics prevailed and before we knew it, half the world’s population had bloodlessly changed their economic systems from ones oriented to socialist principles to capitalistic ones. And, the period from 1950 to the present became the longest uninterrupted time of peace and prosperity in Europe, North America, Russia, and China in modern history.
By 2016, global financial market capitalization was $300 trillion (over 3% of world GDP) and capable of generating market forces beyond the capability of any government to contain. In 1966, global market capitalization was well less than $1 trillion. In 2016, daily trading in foreign exchange was $5.3 trillion; in 1966 it was lass than $25 billion. In 2016 world trade was 33% of world GDP; in 1966 it was about 2%.
The daily volume of trading on the NY Stock Exchange was about 2 billion shares in 2016, up from 9 million in 1966; commissions had been reduced from about 1% of trade value to only 2-3 cents per share, but the NYSE’s share of trading in listed stocks fell to less than 20% as new technologies and trading platforms were introduced. 
Today, the cost of capital is largely determined by capital market activity; it is lower and more users have access to it than at any time in world history. Powerful economic linkages, and the extraordinary acceptance of markets (as judged by their use) despite some continuing political objections, leads us to believe that the system of market economics by which the world governs itself is here to stay.   
The firm I joined in 1966, Goldman Sachs, then had about 20 partners, with capital of about $20 million, and employed about 500 people. Fifty years later, Goldman’s public market capitalization is $62 billion and it employs 34,000. Still, the market value of the firm is about 3000 times greater than in 1966 but its headcount is only 85 times greater, which demonstrates the importance of computer and other technologies to all financial firms.
In 1966, Goldman Sachs had no foreign offices at all; today it has 61, 33 of which are in emerging market countries.
Despite all this growth in the industry, the fifteen largest US commercial and investment banks of 1966 have essentially disappeared – all but one (Goldman Sachs) have been acquired by other firms or failed, though some of the more prominent names have been retained. Today these thirty firms are boiled down into five – JP Morgan Chase, Bank of America, Citigroup, Goldman Sachs and Morgan Stanley, all buy Goldman the survivors of many large mergers that erased all traces of the cultures of the original firms.
The same thing happened in the City of London – for the same reasons. Globalization, deregulation and technology pushed all of the clearing banks, merchant banks, jobbers and brokers into mergers that consolidated the industry into just a few hands.
All in all, the world of global economics and financial services has been transformed far beyond anything we might have imagined in 1966. We are back into a bleak period, like the 1970s, with lots of reorganization and restructuring to come, but what the next fifty years in economics and finance is probably just has unpredictable as it was fifty years ago.