The decision by the UK population to leave the European Union on 23 June 2016 was a momentous event for the UK and also for Europe. Three months after the vote, no clear decisions have been taken as to the future relationship. There remain a number of key questions that will need answering:
Will there be a “soft”, a “hard” or an intermediate Brexit? Even after the recent Conservative Party conference this remains unclear.
Will the UK remain part of the customs union and will companies be able to trade as part of the single market for both goods and services?
Will regulated financial services firms in the UK be allowed to sell their services in Europe without additional regulation?
How will immigration into the UK both from within and outside Europe be organised?
How will trading with non-EU countries change?
What will be the long run implications for UK growth and for Sterling?
Will there be a significant change in foreign direct investment into the UK?
Will Europe use the UK negotiations as a catalyst for change?
All these questions and uncertainties need to be considered by businesses and financial institutions as the environment changes.
We will summarise the current options and consider the implications of Brexit on the business community and how preparations can be commenced so that companies are in the best position to take advantage of the opportunities and to manage the uncertainties.
The Brexit Options
There has been much discussion since the June vote on the type of Brexit that will be negotiated. For the UK, the future relationship with the EU centres on several key issues, the access to the single market, intra-EU immigration, sovereignty and the judicial process. For the EU, the 4 Freedoms of Movement of goods, services, people and capital within the Customs Union are fundamental as is the project of closer integration for all its members. Negotiating an agreement will require significant flexibility from both parties. The three options at present are;
1. Hard Brexit
When the UK invokes Article 50 a two year process commences to leave the EU. Two agreements are to be negotiated, the withdrawal agreement and the trade agreement. The withdrawal agreement focuses on the requirements for the UK to leave the EU and the future relationship framework with the EU. The EU would like the UK to finalise this agreement before commencing discussions on a trade agreement. The UK’s preference is to negotiate the two in parallel.
Two years is a very short period to negotiate such complex agreements and the likelihood is unless an extension is agreed with all the member states of the EU, the UK would leave the EU without an agreed trading arrangement for goods and services. A transition period can also be considered before the formal exit from the EU. Trading for goods can continue as the UK is a member of the World Trade Organisation and the relevant tariffs would be applied.
Services, especially financial services is a more complex area as at present there is an agreement that a regulated UK firm can sell its services throughout Europe based on its UK regulation, the “passporting” rights. However, at the current time there is not the freedom to sell all financial services throughout the EU and any future agreement would need to take this into account. It would be detrimental to the whole of Europe if the UK’s role as Europe’s premier financial centre is compromised. There are alternatives following a Hard Brexit that may be considered or negotiated, including setting up a subsidiary and obtaining regulation in another EU country such as Ireland or Cyprus and then continuing to sell financial services within the EU. There will be solutions to every eventuality and businesses will need to take decisions once the political landscape becomes clearer.
Following withdrawal after two years, the UK’s sovereignty would be increased with a Hard Brexit. Controls on immigration could be re-imposed which would allow firms to hire talent globally rather than primarily from the EU. Bureaucracy and cost of hiring will have to be factored into the process.
The freedom of movement of capital is a global rather than a European issue and therefore the Brexit negotiations are unlikely to impact this freedom.
2. Soft Brexit
Retaining access to the single market for goods and services whilst agreeing an “emergency brake” on the number of immigrants entering the UK is the option most favoured by a significant proportion of the business community. However, the current positions of the EU and the UK differ on the freedom of movement of people within EU states. Any change to this important Freedom would require a unanimous vote of the 27 EU States and at present there is no clear agreement on this issue.
3. The Norway, Switzerland or Canada Models
Other countries outside the EU have varying arrangements regarding the sale of goods and services within the EU, the acceptance of freedom of movement of people, the contribution to the EU budget and importantly the acceptance of EU Regulations with limited or no ability to shape the legislation. The British Government will aim to negotiate a UK agreement which will be specific to its unique circumstances and will encompass elements of all the existing relationship models.
4. Alternative Relationships with the EU
a. Continental Partnership
The Brexit negotiations provide an opportunity for Europe to restructure. One option requires the EU to formally acknowledge that there is a two speed Europe. The partnership would provide a shallower relationship than full EU membership, but would be closer than a simple free trade agreement. For example there would be access to the single market, the ability to participate in the negotiation of relevant single market EU laws and the continued close cooperation on security and foreign policy. In return, there would be a continued contribution to the EU budget, exclusion from the free movement of labour and from further political integration. This continental partnership could be expanded to other countries within Europe that do not want to have full EU integration but require access to the single market.
b. Joining the European Banking Union
The City of London has a powerful voice within Europe and retaining passporting rights for UK based financial institutions is a key issue. One alternative to consider is for the UK to become a member of the European Banking Union without being a member of the EU. This will provide regulatory commitments, but importantly will allow passporting and if agreed, the free movement of banking labour across the EU. Regulatory and legal hurdles would need to be overcome. However there is a clear danger for both the UK and for Europe if there is no agreement: within 5-10 years significant financial business that is currently handled in the UK will migrate away from Europe to other financial centres including New York, Hong Kong and Singapore. This scenario will be to the detriment of the whole of the EU.
How should companies respond to Brexit?
This short review indicates the level of uncertainty that continues to surround the post-Brexit situation. Even when Article 50 is invoked, there will be a minimum of two years before the UK exits the EU and potentially many years before the trading agreements are finalised. Transition arrangements are also being discussed and may lengthen the process of disengagement from the EU, although may provide a longer period of certainty.
An agreement will be reached eventually. It will not satisfy all parties, but it will be workable.
The key approach for UK based companies and financial institutions is to continue developing their businesses. Scenario planning and impact assessment analysis on a business given the above options for the UK is important and Boards of Directors of small, medium and large companies need to be asking the relevant questions and carrying out the necessary analysis. These include:
1. Identification of the key business uncertainties:
a. Tariffs
Leaving the Single Market may result in tariffs for UK goods entering the EU. This could amount to between 1% and 10% of the value of the product. VAT will also need to be added and can be reclaimed. Extra bureaucracy is inevitable. For a business, the key considerations will surround product pricing. With a significant European market, acquiring a European presence will be beneficial.
b. Currency Implications
Sterling has fallen around 10% against both the Euro and the US Dollar since the Brexit vote. This can assist exporters as products will be cheaper for international purchasers. However, if there is significant import content with the product, these imports will raise the price of the final product that will be exported. The company will then have to decide whether to alter the price or the product margin, based on the competitive environment. Currency hedging is also possible, but normally for relatively short periods. An overseas subsidiary that is Euro or Dollar based will generate local currency costs and will act as a natural hedge.
c. Employee Hiring
The free movement of labour within the EU has been of great importance particularly for fast growing companies requiring manpower. Also the City, with its focus on international financial services has been a major attraction for European employees. The imposition of visa requirements on European nationals will increase the bureaucracy of the hiring process. Reciprocal arrangements will be negotiated for UK nationals wishing to work in Europe. On the other hand, it will also broaden the market for talent allowing non-EU labour with improved access to the UK.
d. Re-Location
Relocating all or part of a business to mainland Europe can be considered in order to simplify the trading process. This will depend on the amount of European business that is carried out. Different legal and regulatory requirements will need to be taken into account including labour and taxation laws in individual countries. Europe is not homogeneous and therefore careful consideration of the markets to enter is key.
e. Additional or Reduced Regulation
Clearly if the UK leaves the single market with no formal agreement with the EU then selling goods and services will lead to extra bureaucracy. In the financial sector it may be necessary to obtain additional regulation in addition to the FCA in order to sell financial services within Europe. As discussed previously, a deal will be struck, but contingencies need to be considered.
2. Understand the different scenarios in key markets particularly if there is a long period of uncertainty:
a. Within the UK
How will UK business be affected if there is a slowdown in growth and less foreign direct investment from overseas? Conversely, a more open UK market with lower regulation and taxation may lead to increased investment from foreign companies. In either scenario the competitive environment must be considered and international expansion into alternative markets reviewed.
b. Within the EU
How to maintain and increase trading in EU markets with the increased bureaucracy and regulation. More staff may need to be hired and also overseas offices or alliances formed.
c. Opportunities outside of the EU.
New trading relationships with Asia, the US, Latin America as well as the EU can be considered. Trading will be fundamental to the UK. The opportunity to forge relationships outside of the restrictions of the EU trading bloc can present exciting growth opportunities for companies.
3. Determine how to succeed under each of the scenarios and consider the strategic option:
a. Flexibility, to adapt to the new market opportunities and threats.
b. Expansion via Internal growth.
c. Reducing headcount in certain markets.
d. Acquisition.
e. Divestiture.
f. Joint venture.
g. Strategic alliance.
4. Review every quarter the scenarios to ensure that the company will be responsive to the changing situation.
The following flow chart summarises some of the key strategic and financial options:
Strategic Options
Conclusion
In periods of uncertainty preparation is critical. Throughout the extended Brexit negotiations there will be continuous rumours and speculation and this will have an effect on the financial markets. It is therefore important for companies to consider their strategic options carefully so that they can react to both the opportunities and the uncertainties as a result of the Brexit vote. The UK has for centuries been a trading nation. We will continue to grow and to adapt to the new environment. The City of London is very powerful in Europe and globally. An agreement that meets the business requirements for both goods and services will be reached eventually. It will not be a deal that will satisfy all parties, but the UK will make it work and will continue to grow and prosper.
These are the personal views of David Dwek, Managing Director of DC Dwek Corporate Finance Limited
DC Dwek Corporate Finance 