Will Brexit reconfigure international banking

Investment banks will be hurt by a lower risk taking appetite, shut windows for IPO/merger deals and lower trading volumes. Asset managers will be hit by a vast exodus of retail investors, who had already yanked $40 billion from European stock exchanges in the longest period of outflows since the autumn of 2008 UK fund managers will find it difficult to use their London platforms to sell equities and funds in continental Europe. As sterling plunges, European banks with UK exposure as varied as Banco Santander and Bank of Ireland lost 20 – 30% amid shock results of referendum. After all, global financial markets lost $2 trillion in a single day on 24th June after the verdict on the referendum. The epic volumes in foreign exchange trading are a testament to the raw fear and uncertainty that now grips financial markets. Yet the potential for a 2008 crisis, a run on a major bank or hedge fund followed by global contagion, cannot be dismissed even by the most bullish of bankers.

International banks face a legal minefield. Many banks will no longer be able to sell “passported” funds from London into the money markets of the European Union countries. This will benefit Frankfurt, Amsterdam, Dublin and Paris at the expense of London. Jamie Dimon of J.P. Morgan has said the bank could relocate 4000 out of its 16000 staff from London. Volatility and risk premia in financial markets will continue to rise. The political, trade and legal wrangling between Berlin, Paris, Westminister, Edinburgh and Brussels has barely even begun.

A recession in the UK (until Scotland secedes) will be catastrophic for international bank profits. The Bank of England will be forced to respond to a growth slump with a £100 billion gilt purchase program. This could cause sterling to fall to 1.25 or even lower. The Tories are divided even as they seek a new leader, who will have to deal with a bitter and polarized House of Commons. This is not exactly positive for international bank regulation, ring fencing and capital adequacy rules. The City will no longer be able to freely employ, say, French derivatives experts or German bond salesmen or even trade Euro denominated instruments. Banks, insurers, brokers, fund managers will downsize staff in London. The real tragedy of Brexit is that the decision to Leave was made for reasons unrelated to economic logic. Now both the UK economy and the EU must pay a bitter price for David Cameron’s epic failed gamble.

The geopolitical shock waves of Brexit will change the course of British, European and, yes, world history. Scotland’s Chief Minister wants a referendum since it is more important for the Scots to remain in Europe than in the UK. The six counties of Ulster could well seek to reunite with the Irish Republic and resurrect the ugly ghosts of the Troubles. It could make more sense for Belfast to stay in Europe then stay in the UK even though a dear Anglo-Irish grandee friend from Chase’s grandfather, a lord of the Ascendency defended Trinity College in Dublin Town in April 1916. The Unionists will go to war, as they did for the last hundred tragic years to preserve their umbilical cord to Westminster. The dark side of Europe’s lurch to the far right will be magnified now that the National Front’s Marine Le Pen has called for a French referendum, positioning herself for the 2017 Presidential election. Spain and Italy could turn their backs on the EU in elections this autumn. Germany has become isolated in the EU and Angela Merkel, Mutti Europe, is threatened by the rise of her own AFD fascist. The EU’s military and economic clout on the global stage will irrevocably shrink with Brexit.

A Europe in recession and divided by deep political rifts becomes vulnerable to Putin’s Kremlin as Russia exploits the spoils of its military aggression in Ukraine. Erdogan’s autocratic rule in Turkey will continue unchecked. Britain will lose some of its influence in the US, Europe, Gulf and Asia. These macro trends will drastically reconfigure UK and international banking.

Milton Friedman once said, “Only a crisis, actual or perceived – produces real change”. This is very true in an Indian context. The Indian economy, one of Morgan Stanley’s “fragile five” in 2013, mired in a balance of payment crises with a rupee in free fall, now boasts 7.6% GDP growth and a slight current account surplus.  Ever since the end of India’s License Raj era in 1991, foreign investors have pinpointed India’s growth performance as accidental and not structural. This is no longer true. India’s growth momentum is domestic and secular, not dependent on bullish global market cycles alone.

Emerging markets have been facing difficult times especially with the rising dollar and collapse in commodities. Uncertainties from the Chinese economy have increased with manufacturing burdened by overcapacity albeit cushioned by a strong consumer. From Latin America to the Middle East, productivity gains can only be achieved through improving business environment and infrastructure led growth to diversify away from the vagaries of commodity markets.

The distinctly visible direction of global politics has triggered a new era of de-globalisation and closed economic policies. Emerging economies in this era cannot export their way to prosperity. They have to rely on domestic markets which would focus on services led growth diverging away from manufacturing where automation will reduce jobs.

India’s top down story could stand out as a key differentiating factor in a world starving for domestic demand led growth uncorrelated to cyclical commodities. The government along with the central bank is addressing some key structural problems which make economy more resilient and low risk even at the cost of short term pain like rural stress and a delayed recovery in private investment. Few areas which stand out:

Crushing crony capitalism: For most of India’s independent history, crony capitalists have cornered key resources in large sectors of the economy. Modi led government which made tall promises during election rhetoric has been addressing this issue through transparent, policy oriented approach and even draconian legislation. Corruption in India is now a more bottom up problem than a top down problem.

Focus on financial stability: Indian policymakers have been complacent with high growth often at the cost of high inflation and financial stability. Since 2013, with relentless focus and help from commodity crash, the sticky consumer price inflation has come down from 10% to below 6% which coupled with lower fiscal deficit has allowed the interest rates to fall 150 bps. A relatively stable currency attracts investments.

Financial inclusion: Considerable progress has been made in the last two years with over 220 million new bank accounts covering over 90% of unbanked families. This would further help reduce the $40 billion subsidy bill through direct benefit transfers. With Indian corporate reeling under a balance sheet recession, the retail credit is clocking growth of over 18% which emphasises the consumption recovery.

Lowering the cost of capital: India despite having a high savings rate is burdened by a high cost of capital as over 50% of India’s household savings are in locked in land or gold. The orderly real estate correction and measures to curb gold demand has meant more savings into the financial system. This means India’s cost of debt capital is coming down structurally.

Note that Indian capital markets reflect these new macro realities while Dalal Street falls on global risk aversion, these declines are a buying opportunity. Its implied volatility has fallen dramatically over last two years as it attracts more sticky long term investors. At 16 times earnings, India is not cheap but its valuation is anchored by the tail wind of earnings recovery and structural reform.

In 2015, India attracted $63 billion in green-field FDI, a global record that beat even the US & China. India is unquestionably the world’s most attractive consumption driven growth story with macro-economic stability. As a parliamentary democracy with a demographic dividend of 1.2 billion people and an entrepreneurial tradition that preceded the East India Company by centuries, India is on a roll on the global economic stage. Brexit trauma only reinforces the Indian story since it precludes a traumatic rise in US dollar interest rates and places a premium on secular growth story. This is India’s new tryst with economic destiny.

President Muhammadu Buhari’s decision to devalue the Nigeria is a dramatic policy U turn after ten months of denying that he had any such intention. Buhari insisted that devaluation was a symbol of national weakness and that it would only boost inflation since Nigeria imports even “toothpicks”! Unfortunately, macroeconomics is rarely the forte of military rulers, as then General Buhari proved in his disastrous first stint in power in the 1980’s, seizing power in a coup in 1983 and losing it in a countercoup two years later led by General Ibrahimu Babangida, who I met on a trip to Lagos in 1991. A Nigerian naira devaluation was inevitable since the peg rate was 198 while the black market rate was as high as 370 to the dollar. In emerging markets, the black market exchange rate reflects supply and demand, the official rate only Presidential fantasies.

Four macro forces made a Nigerian naira devaluation inevitable in June 2016. One, oil prices (on which Nigeria depends for 90% of its foreign exchange earnings and 70% of government revenue) had fallen from $148 Brent in July 2008 to a mere $46 now. Two, Nigeria’s oil production had slumped from 2.1 million barrels a day to a mere 800,000 now, due to an escalation in militant sabotage after President Buhari cut the “amnesty” (bribes) deal agreed by the Goodluck Jonathan regime. The sudden, draconian fall in oil prices and output hemorrhaged Nigerian foreign exchange reserves and made devaluation a one way speculative bet, despite Buhari’s repeated denials. Shorting the Nigerian country index fund in New York (symbol NGE) was unquestionably the rational strategy to position for this event – the index dropped 10% after the day the Central Bank of Nigeria announced that the naira would be set “entirely by market forces”. This meant a 30% devaluation of the naira.

Three, the auditor general of Nigeria reported $16 billion in petrodollar revenues vanished from Nigeria in 2016. Even by the standards of elite kleptocracy in Africa, this was a huge sum in the twilight of the Goodluck Jonathan era. Nigeria was literally robbed blind by its outgoing PDP government, led by the lucky guy in a black fedora hit from the Niger Delta!

Four, the IMF had long insisted that Nigeria devalue the naira and raise petrol prices in exchange for an emergency loan. No coincidence that petrol prices soared 80% at the pump as soon as Central Bank threw in the towel on the naira peg. If Buhari must accept the king’s (IMF) shilling, Nigeria must do the IMF’s bidding – and this is exactly what happened with the naira devaluation. The “Washington consensus” is alive and well in Africa’s largest economy!

Buhari’s punitive, selective anti-corruption program is mainly directed at the opposition PDP, the party of Goodluck Jonathan. In a country where law enforcement often moonlights as extortion rackets, Buhari amplified capital flight from Nigeria even as oil prices and oil output collapsed, a triple whammy for Abuja’s hard currency reserves. The decision to impose a VAT (another classic IMF “structural adjustment” thingy) in the midst of a deep recession might make economic common sense to the officers in Victoria Island’s Dudomi barracks but make no sense to me, a lifelong student of credit cycles and emerging markets. It is pity that President Buhari undermined the independence of the central bank by repeatedly contradicting Governor Godwin Emefiele in public and pledging not to “kill the naira” by a devaluation that every intelligent foreign investor knew was inevitable. All Buhari created was a chronic shortage of foreign exchange that gave speculators a one way bet on naira forwards and enabled insiders to make a killing in the currency black market.

Now Nigeria faces recession in 2017, a possible rift between the Hausa Fulani north and Christian animist south widens while Boko Haram terrorizes the northeastern states and MEND secessionists hold the Niger Delta hostage. Nigeria’s history is steeped in blood, with successive military coups, civil wars, ethnic revolts, assassinations (Lagos airport is named after a murdered military President) and the horror of the Biafra civil war. Africa’s financial superpower, a nation of 187 million people, cannot degenerate into a basket state. The nation that gave the world Wole Soyinka, Chinua Achebe and Femi is nation of effervescent, beautiful men and women with the gift of laughter. Buhari’s naira peg was from a bygone era. Russia, Angola, Kazakhstan and Mexico have all devalued their petrocurrencies – and Niger joins the clean float club.

The new exchange rate regime means inflation, now 15.6%, will probably surge to 20% unless the central bank squeezes the money supply. This means the Nigerian naira falls to 400 against the US dollar in the next four month. Brexit is the UK’s Biafra and means King Dollar runs anole again.