Dangers of Following the Path to an Offshore Britain

Published by the Financial Times on The Exchange

June 22, 2016

Infamously 20 years ago, in assessing whether Britain should join the euro, one of the five tests was whether it would be good for the City of London. What seems good for the City, however, is not necessarily good for the United Kingdom as a whole, as has been demonstrated over the past 10 years. An Out vote would be likely to drive this divergence to extremes. In response to the inevitable post-Brexit recession, and with its antiregulation ideology, the new government may well go down the path of trying to be a financial center by becoming more and more an offshore center. For both Britain and the world, this would erode financial stability and create only a false recovery at best at home.

Offshoring Britain via doubling-down on the City would be a disaster for the United Kingdom.

The advocates of Leave claim that, no longer fettered by EU regulations, the City would be free to compete harder, and more able to reach out to China to become the offshore renminbi retrading center. They tell me they would love the United Kingdom to become like Singapore or Switzerland. Leaving aside the fact that the next prime minister would not be Lee Kuan Yew, if you're a country of 60 million people, not all of whom can be employed in financial services, you really do not want to take that route. Even Singapore has found financial services a double-edged sword: lots of volatility, real estate bubbles, and upward pressure on the currency hurting the rest of the economy.

In any case, such offshoring would not succeed. The City would lose its entrée as the beachhead for investment and commercial banking in Europe—roughly 30 percent of its total business volume. The European Central Bank would try to force clearing houses to move their euro-denominated operations to the euro area. In March 2015, the European Court of Justice (ECJ) ruled that such an attempt was illegal, because it was unfair to the United Kingdom as a member of the single market. Now, the ECJ would no longer have reason to rule that way.

The real danger, however, comes from the already unhealthy overweighting of financial services. A doubling down would increase the risks and distortions to the economy. That the United Kingdom has historically been good at financial services does not mean it is something that can grow infinitely. Then, with a banking system headquartered on your territory with balance sheets in multiples of GDP, if it blows up, it costs you.

In the face of a post-Brexit recession, a new government would scramble to be seen to act in retaining or creating jobs. Given the blow to trade and corporate investment, and ongoing uncertainty, it would be near impossible to do anything quick in the real economy; fiscal stimulus would be ruled out with a fallen currency and rising interest rates.

The administration would resort desperately to regulatory arbitrage. It would pull the cord on the most obvious parachute in reach: a race to the bottom by financial regulators and supervisors, hoping to attract or keep financial services. An awful lot of British territories and companies already promote regulatory arbitrage and tax evasion. If the United Kingdom were outside the European Union, why not bring it home to be done directly in London, rather than through Jersey or the Cayman Islands?

At times the United Kingdom has become a more dominant financial center by getting it right on deregulation, such as the original euro-dollar markets in the 1970s. The United States was massively overregulated while the United Kingdom was innovative. But that led to capital market volatility with flows in and out of the City, of regulatory arbitrage. A post-Brexit government would be desperate to be the world's banker and go all out for market share. That is a very real threat to global financial stability. It would go beyond having AIG financial products blowing up markets and billionaires from a lot of nasty places putting their money in UK real estate. It would further unbalance the British economy and reinforce the United Kingdom's increasingly pariah status after exiting the European Union.

Now, the European Union, the United States, and the Financial Stability Board may well wisely say: "We don't want to be part of this race to the bottom. We're going to reduce our London exposure." That may not be a terrible outcome for the world—although the United Kingdom would still be creating a huge hole in the financial safety net—but it would not be good for Britain, having bet so much on this path.

Regime changes are not neutral. Constitutions reflect the interests of those dominant at the time. The people in power after a Leave vote would want to be seen to shore up the City and the economy in the face of the recession they had caused—especially given an ideology that says deregulation is the avenue to prosperity. Offshoring Britain via doubling-down on the City, however, would be a disaster for the United Kingdom.