Thursday 23 March 2017

Brexit: what should Irish businesses now expect?

After last week's referendum shock, Irish industry figures give their take on the short-term future for small business, banking and the macroeconomy

Michael Gove and Boris Johnson on the campaign trail. Photo: Andrew Parsons/Getty
Michael Gove and Boris Johnson on the campaign trail. Photo: Andrew Parsons/Getty
a teary David Cameron announces he will step down before October. Photo: Stefan Wermuth/Reuters

Gavin McLoughlin and Justin Doyle

Brace yourself for the return of the dreaded U-word: uncertainty. It's a state of things that's Kryptonite for the economy as businesses are faced with tricky decisions about whether or not to proceed with projects.

Though the legal position regarding trade is unchanged from prior to the vote, will Irish exports to Britain be more expensive due to a weak pound and the potential for tariffs as the UK negotiates on single-market access?

Here's how the experts think Irish businesses should act, and how banking and the macroeconomy will perform:

SMALL BUSINESS

Patricia Callan
Director, Small Firms Association

'The difficulty is that small businesses tend to be price-takers in this marketplace so they don't have a great degree of control. So those companies that have been in a position to hedge may have some exchange rate protection, for other people it's very much a 'wait and see' - it'll be on the basis that they have to prepare if there's a sustained devaluation in Sterling or unpredictability in the markets.

"In terms of entering into new contracts you really need to assess that and whether you can cope with that level of exchange rate volatility

"Despite the reassurances of the ECB and the Bank of England we have to wait and see how it's all going to settle down. We're hopeful obviously that it will settle, but I think people should be pricing in, and looking to do that, even at a small company level where they don't have the sort of tools that larger companies have in terms of hedging.

"In terms of price-setting, the best thing to do would be that you would price and ask for payment in euros, so that you're guaranteed regardless of what happens, that you don't have a fluctuation.

"But equally, you're going to have to keep an eye on your competitors.

"In terms of the tourist sector, we're heading into summer and we know our biggest market is the UK, so it's about looking at the value message in that sector and trying to sell that to UK tourists - that even if their Sterling is worth less, we have valuable product offerings and that they will have a great time here and it won't be too expensive for them.

"We know that because flights are very cheap, that even if people had them pre-booked they might still decide to just not come if the exchange rate got too bad.

"Then, going forward, for companies that are planning on entering the UK market, they are going to have to look carefully. For the immediate future we know that nothing will change over two years, very likely it will be longer than that."

Philip O'Sullivan
Chief economist, Investec Ireland

'The UK is the destination for more than 40pc of exports from Irish indigenous companies, so the decision to leave and the big fall in the value of Sterling is a very big headwind for a lot of businesses here.

"We think that the euro-Sterling exchange rate will remain volatile for an extended period. Following Prime Minister Cameron's resignation you're going to see a different kind of uncertainty around who is going to lead the negotiations, who's going to be the next Prime Minister. And after that you're going to have two years of negotiations with the European Union. So you're going to look at a lot of volatility.

"From an Irish SMEs perspective - and the phones have been hopping here in Investec, we've one of the biggest treasury offerings of any banks in Ireland - the phones were basically ringing non-stop from people saying, 'What are we supposed to do?'

"What we've been saying for quite a long time is that Irish companies need to think about strategies as to how they can protect themselves.

"Every company will have a different requirement, and should be looking for advice from the likes of the banks, the professional services firms and accountants.

"Some of them just source stuff in the UK, some of them export to the UK - but all their costs are in euros, so you're going to need to have strategies in place to protect against the volatility, which is a function of the uncertainty that we see.

"This is a level of volatility that we really haven't seen since the global financial crisis, and a backdrop like that really makes it necessary that Irish companies look to take steps to protect themselves.

"Typically the type of products that we would offer would be foreign exchange hedging, to make sure that if you know you're going to be receiving a certain amount in Sterling at a certain point, you can lock in an exchange rate.

"You can put in other things to protect yourself, so that if the rates start moving towards a certain level you can have things kick in that offer you a bit of protection there. On the commodities side, we and other treasury providers can offer protection so that if people need to buy a load of steel for example, which is quoted in dollars, they can lock in whatever price they have in mind.

"It's like an insurance product. It does cost companies, as all insurance products do, but at the same time the potential costs if you get caught offside if there's a big move in the currency or commodity markets could be an awful lot more."

BANKING

Stephen Hall
Equity analyst, Cantor Fitzgerald Ireland

'It's obviously a very negative development from our point of view. Unfortunately, there aren't a lot of positives to take for the Irish banking sector.

"Bank of Ireland will be the most heavily impacted as much of its loan book is denominated within the UK, so that has a big translation effect on the euro-denominated balance sheet. As Sterling weakens, that has a negative effect and it also impacts any profits which originate in the UK. It is a massive development in terms of their operating business model.

"Going forward, Permanent TSB is looking to dispose of €3.8bn of a capital home loans (CHL) UK book. Now that the UK has voted to leave the EU, it's going to have a lot of difficulty in selling that portfolio.

"It is a performing loan book so it all depends on the level of a haircut it is willing to give to a buyer on that book.

"Looking at AIB, I feel that this could potentially delay the float of the Government's holding. I guess a lot of it depends on sentiment in the market, but at the moment it's quite weak towards the financial sector. They have some exposure to the UK, but not as big as Bank of Ireland's.

"In terms of whether we're looking at a fresh banking crisis, it's too early to tell. The banks are quite well capitalised, they have protection in place, the CET1 ratios (a measure of banks' stock of capital versus its risk-weighted assets) are quite healthy for all three banks, particularly AIB and Permanent TSB."

Eamonn Hughes
Equity analyst, Goodbody, in an investor note

'The shock No vote has various negative consequences for the banks in Ireland. The most obvious read-through is on Sterling-related exposure. The UK accounts for around 25pc of profit at Bank of Ireland, and 15pc at AIB, so every 10pc Sterling-euro move would knock around 2.5pc from BoI's earnings and 1.5pc from AIB. PTSB is modestly loss-making on its UK book, so the impact is minimal.

"However, the UK Treasury analysis of the impact of a No vote highlighted negative GDP impacts... as such, there would likely be a material slowdown in mortgage lending activity and a rise in impairments for BoI's retail business and activity in AIB's SME franchise, depressing earnings further than just the foreign exchange move.

"Discussion of possible Bank of England rate cuts may also have net interest margin consequences in due course.

"Over at PTSB, its non-core UK loans account for around 13pc of its loan book, but the book is loss-making, so any foreign exchange move is actually marginally positive. However, turmoil in the UK may see the sale of those assets (which we have in 2017) delayed further."

MACROECONOMICS

Justin Doyle
Treasury, Investec Ireland

After this week's shock Leave result, we feel it is premature to be making new market predictions. Indeed, trying to identify the right questions is a big enough challenge for now.

It is clear that volatility will not be confined to domestic markets as investors begin to fear an anti-establishment domino effect outside the United Kingdom.

In particular, the most obvious question mark is over how the EU evolves from a Brexit - and what the specific implications are for the euro area.

Markets have reacted sharply and negatively to the news - calling it a bloodbath is no exaggeration. Having touched off £0.76 directly after the polls closed on Thursday night at 10pm, the benchmark EUR/GBP rallied over an eye-watering 9pc to trade just over £0.83 before European markets opened on Friday morning.

This was taking place against a background of a global sell-off in risk assets. Within the currency space, the euro is struggling against the USD (tipping $1.09 on Friday, from over $1.14 on Thursday). It was the biggest one-day move in Sterling's history - and it all happened in less than six extremely illiquid hours.

Safe-haven currencies such as the Swiss Franc and the Yen made major gains as well.

In terms of stocks, Asia is in deep red territory - the Nikkei, for example, lost just under 8pc on Friday. FTSE futures were at one stage over 500 points down. In terms of core government bond markets, 10-year Treasury yields were 30bps lower at 1.43pc during Friday. Gold tipped $1,339 - up from $1,270 on Thursday.

And who will be in charge of the UK? Although 84 'Vote Leave' Conservative MPs wrote Prime Minister David Cameron a letter of support on Thursday night, Cameron announced his plan to step down as PM before the Conservative party conference in October. Boris Johnson is now the bookies' firm favourite to succeed Cameron.

We take the view, though, that a general election is not on the cards, as the Conservatives remain in a majority and, in any case, the Fixed-Term Parliament Act makes it more difficult for a poll to take place in Britain before 2020.

From the perspective of the economic outlook, one vital piece of the jigsaw will be how the British and the EU authorities negotiate the UK's exit and its post-exit arrangements, especially trade.

As we have written a number of times, EU law stipulates that a departing country must invoke Article 50 of the Lisbon Treaty, which sets aside a two-year negotiating period.

It is unrealistic to suppose a trade deal with the EU can be struck within this time-frame (let alone a further 50-plus deals with third-party countries that would cease on an EU exit). How the various parties handle this is a critical part of UK trade prospects and with it the outlook for investment - both in terms of inflows coming in from overseas, and from domestic firms.

The Bank of England (BoE) has moved firmly into crisis management mode, gathering its market experts and discussing what policy action it should follow.

In a statement designed to soothe market jitters directly after Cameron's resignation, BoE Governor Mark Carney said that the BoE and the Treasury have made extensive contingency plans to get through a period of post-vote volatility.

He also stressed that UK banks have been tested to withstand bigger shocks than this as part of the BoE's stress tests.

In terms of concrete measures, Carney announced that the Bank of England stands ready to provide £250bn funds to serve as a liquidity backstop, and that the bank will not hesitate to take additional measures where required.

The implications for medium-term policy (eg, monetary policy) are to be considered over the coming weeks.

Global central banks will likely be discussing the prospect of co-ordinated action, while we would expect the UK Monetary Policy Committee to be considering what steps it needs to take to calm market volatility and deal with financial pressure points.

We would expect all supportive policy tools to be on the table for the UK. First and foremost, we would expect the bank to respond to liquidity pressures as it did in 2008/09. We expect the bank to announce international swap lines in collaboration with other major central banks.

We also suspect the bank will seek to address some of the hits to the UK economy, and our expectation is that its concern over the UK demand shock will dominate in its core policy response (that is, we do not expect a move up in rates to seek to tackle any inflation implications of the weaker pound, or to shore up the pound itself).

We consider that a cut in the 0.50pc bank rate is likely, while the bank may also decide it is necessary to enhance the Quantitative Easing programme, which is currently held at a total of £375bn, while the response might also include considering the option of credit easing in collaboration with the UK Treasury.

Internationally, we expect a statement from the G7 at some point, seeking to reassure markets. We may even see co-ordinated central bank easing in response.

Without doubt, this development is negative for the Irish economy. With a sixth of total Irish exports (and more than 40pc of exports from indigenous firms) going to its nearest neighbour, Ireland was a far from disinterested observer of this process.

Our house view was that, in the event of a Leave win, Sterling could fall to £0.83 - and it briefly broke through that level amidst the panic early on Friday morning. We see further downside to £0.85 over the rest of the year.

This is a real headwind for Irish exporters and we note that the ESRI's Hermes Model had previously forecast a possible adverse hit to Irish GDP relative to baseline in the range of 0.5pc-1.6pc over two years in the event of a Brexit, due to a combination of a weak pound and wider spill-over effects in the global economic environment.

It is difficult to forecast the longer-term impact on the Irish economy from a Brexit, as this is highly contingent on the trade arrangements struck between the UK and the rump EU - but for what it's worth, the range of estimates suggest that Irish per-capita GDP could be between 0.8pc and 2.7pc lower by 2030 than would have been the case under a Remain outcome.

Negotiations on trade and other issues will take a minimum of two years once the British government invokes Article 50 of the Lisbon Treaty, so we are likely to be entering an extended period of uncertainty. It is also unclear at this juncture as to who will lead the UK's negotiations with the rest of the EU.

A further complication is the issue of Scotland, where leading SNP figures have signalled that Brexit could see demands for another independence poll in the near future.

Our base case for the Irish economy had always incorporated a Remain win. Now, we are likely to downgrade our GDP growth forecasts (+5.0pc in 2016 and +4.0pc in 2017), although we will wait until after fully digesting the market reaction to the news and for the release of Q1 national accounts data for Ireland in July before updating our est­imates.

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