Its Monetary Policy Committee meets on Thursday—for the first time since the Brexit voteby George Magnus / July 11, 2016 / Leave a comment
Read more: The FTSE indices will respond to Brexit in good time
The fastmoving events of domestic politics are currently driving what goes on in the UK markets. However the Bank of England’s Monetary Policy Committee has been assessing the state of the economy in the wake of the EU referendum, and will announce at noon on Thursday what it has decided to do (if it does decide to do something) with monetary policy. Financial markets are fairly convinced that the MPC will vote to cut interest rates by 25 basis points to 0.25 per cent, the first reduction since 2009. So the BoE will make news on Thursday, but there are other important things going on worldwide which will affect the UK one way or another.
In Japan, Prime Minister Shinzo Abe has just secured a sufficient majority in elections to the upper house of the Diet (parliament) to advance proposals for constitutional reform, including a probable change to the pacifist provisions of the constitution that have been in situ since 1947. This comes as the United Nations tribunal, which has been considering the maritime rights of countries claiming strategic reefs and atolls in the South China Sea, is expected to report on Tuesday. It has no enforcement powers, but China’s reaction will be important as it has refused to participate and has challenged the tribunal’s authority. The sharper its rhetoric, the greater the risk that tensions between China, several of its Asian neighbours and the US will escalate.
Closer to home, the instability of the Italian banking system continues to cause concern. It is estimated that the banks, whose share prices have plummeted, need about €30-40bn of new capital. At the end of July, the European Banking Authority’s latest bank stress tests will be published, and these are widely expected to corroborate this view. The “crisis” has already caused a rift between Rome and Brussels as to how the capital should be raised, and from whom—government or creditors. European banking union rules assert it should be the latter. However, a lot of small Italian savers would lose money just three months before an important national referendum over constitutional changes, while the Renzi government seems behind in polls and faces a major challenge from the anti-EU Five Star Movement. If push comes to shove, the government may well put its own interests first, and let small savers off the hook. Whatever happens, the eurozone certainly cannot afford a banking-political crisis in Italy, which, given the vote for Brexit, would very likely risk existential contagion.
These things will form a part of the backdrop to the MPC’s deliberations, but more likely it will focus on more immediate local economic issues. Even though the macroeconomic consequences of the referendum decision won’t be widely known until September—maybe later—the Bank of England will have its own intelligence from its Agents’ Report, a monthly review of what the Bank’s staff think is going on in different regions of the UK. Other than this, it will just have anecdotal evidence in the public domain, including, for example, the closure of several large commercial property funds in the face of significant redemption requests, reminiscent of what happened in 2007-08.
This is not to suggest that the economy is as exposed to property as it was then—nor that the banking system is as leveraged. But the Bank’s Financial Policy Committee’s is under no illusion that risks in the economy are starting to emerge, and to this effect, it recently lowered the so-called “counter-cyclical capital buffer” from 0.5 per cent of UK exposures to zero until June 2017. This will free up £5.7 billion of capital, and allow banks to boost lending by £150 billion, in the event there should be demand for loans, which is a moot point.
Commercial real estate might seem a bit remote for most UK citizens, but it can be a leading indicator of wider property sector problems, including lower mortgage demand, weaker house prices and the risk that buy-to-let investors go to ground. There are also anecdotal reports about a significant fall in consumer confidence, retail sales and job advertising. Clearly, if these are confirmed by larger data reports this summer and autumn, the knock-on effects on jobs, unemployment, and income and spending flows will be significant.
Another big focus for the Monetary and Financial Policy Committees will be close scrutiny of the UK’s balance of payments deficit that has soared to seven per cent of GDP, in spite of the protracted decline in Sterling since July 2014. The UK hasn’t had a “crisis” partly because the exchange rate is free to float, and partly because there have, by definition, been adequate inflows of short-term capital, portfolio and direct investment capital. But these flows may now be both riskier—because of their short-term and volatile nature—and less secure—because the UK’s economic and political outlook has become unpredictable.
Sterling has already fallen just over ten per cent and the decline is far from over. Some say that this was bound to happen because it was previously overvalued. This is a dangerously simplistic view. The trade deficit in the UK, while not great news, has been relatively stable for some years at about 2.25-2.75 per cent of GDP. There is no evidence that we have had an exchange rate competitiveness problem. Rather, the deterioration has happened in what we call net income flows—the receipts of interest, profits and dividends from abroad (less payments to foreigners). This balance has swung from a surplus of three per cent of GDP to a deficit of about three per cent, and is predominantly structural, rather than cyclical or exchange rate-affected.
The fall in Sterling will help to reduce the balance of payments deficit a bit, but we should not assume it will be a saviour. What it reflects is both a material change in the UK’s capacity to generate overseas earnings, for example in mining, commodities and finance, and a loss of confidence.
No one expects the Bank’s likely 0.25 per cent cut in interest rates to be more than symbolic, or effective from a macro standpoint. Next up, the Bank might consider re-activating Quantative Easing, which has been on hold since November 2012 with outstanding purchases of government bonds of £375 billion. The Bank might at some stage decide to buy more gilts and other assets, such as corporate bonds. Again, seasoned professionals are dubious as to whether even this would have a pronounced effect on demand, and it certainly couldn’t affect the investment, trade and immigration drags that now hang over the economy. On the other hand, if the Government were to act in the Autumn Statement or sooner to recalibrate economic policy and boost the economy fiscally, the Bank’s actions might gain a traction that otherwise would have been difficult. With UK politics delivering almost daily surprises, watch this space.