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15 March 2019

Sharon Donnery: The departure of the UK from the EU - implications for the Irish economy and financial system

The Deputy Governor of the Central Bank of Ireland discussed some of the contingency planning by public authorities in light of the forthcoming departure of the UK from the EU. Donnery also highlighted some of the channels through which a no-deal outcome would affect the Irish economy.

[...]Broadly speaking our work on the UK leaving the EU has focused on four key areas. These are ensuring that:

  1. Risks to the Irish economy and consumers are understood;
  2. Regulated firms prepare appropriately for all scenarios;
  3. Where necessary, the required policy and legal adjustments are prepared to counteract the cliff-edge risks of a hard exit to the delivery of vital financial services; and
  4. We perform our gatekeeper role in a robust and efficient manner for new firms seeking authorisations or existing firms revising business plans.

To meet these objectives, we established a Task Force in 2016. More recently a Steering Committee was set up to oversee the final stages of the Central Bank's preparations for cliff-edge risk mitigation. In line with our commitment to transparency, the reports of the Task Force are regularly published in redacted format.

We have made every effort to ensure that the financial system has the necessary level of resilience to avoid financial stability risks in the event of a no-deal scenario. Our preparations have involved a significant amount of engagement with financial firms and this has focused on ensuring that all necessary steps have been taken to mitigate the risks to their customers and businesses from the UK's exit, with a particular focus on a disorderly scenario.

The scale and complexity of the Irish financial system has already changed considerably as a result of the UK leaving the EU. Work dealing with the authorisation or extension of business for over 100 firms has required the Central Bank to substantially increase our workforce as well as prioritising and reallocating our existing resources to ensure that we took decisions in an effective, efficient, predictable and timely fashion.

The Central Bank does not view the authorisation process through a solely domestic lens - we are cognisant that the standards we hold firms to are relevant for the entire EU27 single market in financial services. Cooperation with the SSM and the ESAs has therefore been crucial to ensure a level playing field and avoid regulatory arbitrage or a race to the bottom.

Broadly speaking, while we continually assess the risks and challenges posed by the UK's departure to the overall financial system in Ireland, we have not provided a blueprint for firms to follow when considering their own particular risks. Firms are responsible for their own plans to mitigate risks to their businesses and customers. We have stressed this point clearly and consistently through our supervisory work and in our public communications. In the cases when firms have not made plans - we have made our concerns known. Additionally, there are some areas where the Bank, with other public authorities, have had to intervene to put in place measures to mitigate specific financial stability concerns.

Contingency planning

One area which has been of particular importance is the effect a no-deal scenario would have on the use of a UK-based central securities depository (CSD) by the Irish market.

Securities settlement is a central component of the financial system.

For those unfamiliar with market infrastructure issues, in simple terms, when shares in a stock or other securities - like government or corporate bonds - are bought and sold, they are settled at a central securities depository or CSD. Securities settlement systems provide the institutional and technical infrastructure that allows trading to happen.

Today paper certificates are rarely used - since so-called dematerialisation - the settlement system has operated on a real-time basis. The Irish market however is unique in the area of securities settlement due to the fact that it has no domestic infrastructure and utilises a number of settlement systems located across Europe.

Furthermore, due to the level of integration of the UK and Irish financial markets, Ireland has for many years used a UK based CSD, to settle equity trades and Exchange Traded Funds (ETFs) through its CREST electronic platform.

Multi-currency settlement (euro/dollar/sterling) is also an important feature of the Irish market.

However, due to the UK leaving the EU, the current arrangements are not sustainable.

To mitigate against potential market disruptions, the Central Bank has engaged extensively with European counterparts including the ECB, the European Commission, ESMA, and the Bank of England while also working with domestic stakeholders including the Department of Finance, the National Treasury Management Agency and the relevant regulated firms.

Thankfully, this immediate cliff edge risk has been largely mitigated with the European Commission's decision to grant temporary equivalence to the UK's legal and supervisory arrangements for CSDs until 29 March 2021. The Central Bank will continue to liaise with the relevant stakeholders to ensure a long-term solution is implemented on time.

The CSD issue outlined above is not the only area where financial regulatory authorities have had to take steps to mitigate against cliff edge risks. Work from the Prudential Regulation and Financial Conduct pillars in the Central Bank has highlighted some remaining risks of consumer detriment and corresponding mitigating measures. For example, the Central Bank has worked with the Department of Finance to support the drafting of legislation to protect customers of insurance products in the event of a no-deal scenario.

The recently published Brexit Omnibus Bill includes amendments to allow for a temporary run-off regime, which will allow certain UK/Gibraltar insurers and brokers to continue to service existing insurance contracts with Irish policyholders. This is necessary to protect consumers in the event of a hard exit.

Authorities have also taken steps with respect to Investment Funds. Some issues that have arisen include the loss of passporting for UK Fund Management Companies acting for Irish Funds and the loss of the ability for Irish funds to delegate their portfolio management to UK investment managers.

As with the other issues we have faced, the Central Bank has engaged intensively with other relevant stakeholders to mitigate these problems and cooperation with our European partners has been essential.

ESMA recently agreed Memoranda of Understanding with the Financial Conduct Authority (FCA) of the UK which allows activities, such as fund manager outsourcing and delegation, to continue to be carried out by UK based entities on behalf of counterparties based in the European Economic Area (EEA).

Cooperation with UK authorities has also been important with the FCA implementing a temporary permissions regime that allows EEA-based firms currently passporting into the UK to continue regulated business within the scope of their current permissions in the UK in the event of a no deal Brexit.

The Irish economy and the UK leaving the EU

Moving to macroeconomic aspects of the UK's departure from the EU, much has been said regarding the particular vulnerability of the Irish economy and I think it is true that Ireland will be the country most affected, outside of the UK.

Since the referendum in June 2016, the impact on Ireland of uncertainty related to the UK's exit appears to have been small.  Instead, the main impact thus far has been through the depreciation of sterling against the euro, which has been about 12 per cent. 

Despite the depreciation, Irish exports to the UK have generally held up well - until recently at least.  However, the weaker sterling exchange rate has put downward pressure on import prices and as a result overall consumer price inflation over the past three years.

More recently, we have seen some deterioration in business and consumer sentiment as the exit date has come closer, and the possibility of a no-deal scenario has come into greater focus.

The UK, however, has not yet left the EU. [...]

The Irish economy remains extremely open and has grown strongly over the past five years as evidenced by annual average growth of over 4 per cent in underlying domestic demand.17 This measure abstracts from the measurement issues around GDP in Ireland and gives a more accurate indication of real activity. The labour market also gives evidence of robust growth with employment now above its pre-crisis peak.

The economy is focused on services and high value added manufacturing. Strong pharmaceuticals boosted overall export growth significantly in 2018 with one product, vaccines, accounting for 36 per cent of total merchandise exports on average in the ten months to October 2018.

MNCs continue to play an important role in the Irish economy today and are estimated to account for 22 per cent of total employment.

The public finances in Ireland have improved markedly since the crisis although the debt-to-GNI* ratio remains elevated and above 100 per cent. GNI* is an alternative measure of national income that more accurately reflects the size of the economy compared to GDP and thus gives a more informative picture of debt sustainability.

The reason I have outlined this assessment of the Irish economy is that all these elements factor into our thinking on the effects of the UK leaving the EU.

From a historic perspective, the Irish economy is now far more diversified than in the past when the UK was by far the most important market for Irish exports and when these exports were highly focused on agricultural products.

However, this reduction in exposure does not mean that the risks from the UK leaving the EU are not serious. The UK is still a hugely important market for certain sectors and regions in Ireland as well as being Ireland's nearest neighbour.

The closeness of the Anglo-Irish relationship is evident in the data.

Research from the Economic and Social Research Institute, for example, has highlighted the contrast between Irish-owned and foreign-owned exporting firms in Ireland. Their findings show that Irish-owned firms are less diversified then their foreign-owned counterparts, both in terms of products and markets. They also highlight that around 40 per cent of exports from Irish-owned firms are sent to the UK, with food exports particularly important.

Research from the Central Bank has also shown that the UK is the most significant market for agri-food exports and increases in tariff or non-tariff barriers have the potential to significantly reduce trade. And while primary agriculture accounts for a small share of overall national output, the broader agri-food sector (including food processing) makes a sizeable output and employment contribution, particularly when assessed on a regional basis. Some 50 per cent of Irish beef exports go to the UK. Research has estimated that in a hard Brexit scenario, agriculture products would attract some of the highest tariffs. Teagasc estimates suggest the tariff on fresh boneless beef, which accounts for two-thirds of the value of beef exports to the UK, would be 69 per cent.

Further research from the Central Bank focusing on the specific effects of non-tariff barriers estimates a 9.6 per cent decline in trade flows between the UK and Ireland with the largest effects on fresh foods exports, as well as on manufacturing materials and machinery and transport.26

The most recent analysis from the Central Bank assessing the effects of a disorderly exit underscores the potential challenges that the Irish economy would face, particularly in the short term. Modelling work suggests that a disorderly departure could reduce the growth rate of the Irish economy by up to four percentage points in the first year.27

The effects of a disorderly exit would be felt through several channels.

- There would be heightened stress in financial markets and a potentially large depreciation of sterling.

- The deterioration in economic conditions and a more adverse outlook would cause firms to delay or cancel investment plans.

 - Consumer spending would also be negatively affected, reflecting concerns over future job losses and income prospects.

 - At least for an initial period, it is likely that there would be disruption at ports and airports if infrastructure is unable to cope with the new arrangements.

Given the deep supply chain linkages between Ireland and the UK, reflected in the reliance on the UK for imports of intermediate goods used in production by Irish firms, and also given the scale of food and consumer goods imports from the UK, there would be implications for firms through disruption to their production processes and for households through the price and availability of consumer goods.

 - Exports would fall due to an immediate and large reduction in demand from the UK and the fall in sterling, with some sectors being further affected by any imposition of tariffs and non-tariff barriers.

 - Those sectors - as I discussed - which are more reliant on trade with the UK or which are more vulnerable to the imposition of tariff and non-tariff barriers, such as agriculture, food and smaller scale manufacturing, are likely to be more adversely affected. These effects are also likely to be focused on rural areas and, in particular, the border regions.

So, there are a variety of ways that the departure of the UK can adversely affect the Irish economy and contribute to a material slowdown in growth.

However, it is important to note that in this scenario, our modelling work still suggests that there would be growth in output this year and next.

Quantifying the impact of a disorderly UK exit through these channels is extremely uncertain but the insight to be taken from this result is that some of the structural elements of the Irish economy also have a role to play as the process moves forward. Structural factors include the diversified nature of production in many sectors. While some sectors are heavily reliant on the UK as an export market, for others, the UK is an important market but nonetheless not the only one.

The current status of the public finances are also relevant. There is scope to run a counter-cyclical fiscal deficit through the operation of automatic stabilisers on tax revenues and transfer payments in the event of a severe downturn. Moreover, there is some scope for temporary investment to support trade routes after the UK's departure and temporarily help hard-hit sectors adjust to new realities.

Of course, while the UK leaving the EU is the most clear current downside risk to the Irish economy, there are others including the weakening of the European and global economic outlook. The openness of the Irish economy is again a key factor here as some of the sectors that may be able to weather a slowdown related to the departure of the UK by relying on a variety of other markets may not have as much space to operate if a global slowdown also persists. Aside from external risks, the cyclical upswing in Ireland also gives rise to concerns about the economy's position in the business cycle and the potential for overheating.

To summarise, the Irish economy is currently in a good place but this outlook is subject to an unusually high degree of uncertainty given the lack of clarity around the withdrawal terms of the UK exit process. Also, we at the Central Bank find ourselves in the interesting position of considering a potential slowdown from external events on one hand while also worrying about potential overheating from a domestic perspective. [...]

Full remarks

© BIS - Bank for International Settlements

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