Opening statement - Gabriel Fagan, Chief Economist, at the Seanad Committee on Brexit

04 May 2017 Speech


Chairman, Committee members,

I welcome the opportunity to appear before you today to discuss the implications for the Irish economy of hard and soft Brexit scenarios. I am joined by Mary-Elizabeth McMunn, Head of the Supervisory Risk Division, and Mark Cassidy, Head of the Financial Stability Division, who is also chair of the Bank’s internal Brexit Task Force. This task force was initiated approximately one year in advance of the UK referendum, indicating our proactive approach in preparing for potential Brexit-related issues. The task force comprises representatives from divisions across the Bank, and provides comprehensive assessments of Brexit-related matters to the Central Bank Commission.

Brexit will have significant implications for trading arrangements between the UK and the EU with effects also for labour markets, investment patterns and capital flows. The impact will depend on the terms of the UK’s exit, in particular the timing and nature of the final trade deal. In addition, the impact will also depend on the nature of the transitional arrangement, if any. Ireland stands out as the EU economy likely to be most affected. This reflects the size and the nature of our economic and financial linkages with the UK, including our shared land border. In my opening remarks I shall set out the assessment of the Central Bank regarding the channels through which our economy is likely to be most affected, with reference to both challenges and opportunities, as well as some important policy issues for national authorities, including the Central Bank.

Ireland’s reliance upon UK markets for our international trade has reduced considerably over the past forty years but still remains significant. Before Ireland’s accession to the EU in 1973, the UK accounted for over 50 per cent of Irish trade. This has fallen to under 14 per cent for goods exports and under 20 per cent for services exports. In terms of imports, almost 26 per cent of goods imports but only 8 per cent of services imports are from the UK. Nevertheless, Ireland is still more reliant on UK export markets than any other EU country. Certain sectors of the economy rely more upon UK markets than others. These include traditional manufacturing sectors, agri-food, materials manufacturing and tourism. These sectors are often quite labour intensive and it is notable also that a large number of small and medium-sized enterprises (SMEs) are engaged with UK markets either through trade or tourism.

The overall impact of Brexit on the Irish economy and financial system remains subject to considerable uncertainty, depending in large part upon the nature of new trading arrangements to be agreed between the UK and EU, including possible transition arrangements, and also the capacity of our economy to adjust. From communications issued by the current UK government, we know that the UK will not seek continued single market membership, or a ‘soft’ Brexit, as red lines for the UK are control of immigration and ending the jurisdiction of the European Court of Justice in Britain. It will instead seek an ambitious free trade agreement with the EU, perhaps some form of customs agreement, and also some form of transitional arrangement or ‘phased process of implementation’. Under this scenario, an agreement would be based on tariff-free trade in goods (but not services). Over time, some regulatory divergence between the UK and EU may emerge which could lead to an increase in non-tariff barriers. This seems to plot a middle course between a soft and hard Brexit, although until the negotiations are finalised, a hard Brexit cannot be ruled out.

Under a hard Brexit scenario, the UK would leave the EU without a trade agreement and would instead exercise its rights under the Most Favoured Nation (MFN) clause of the World Trade Organisation (WTO). Under this most damaging scenario, goods trade would be subject to tariff and non-tariff barriers, which would vary across sectors, leading to more significant negative effects on trade. Under this scenario, our estimates suggest that after 10 years, GDP would be lower by 3 per cent and the number of people employed would be 40,000 fewer (compared to a benchmark no-Brexit scenario). This estimate is in line with those of the ESRI and the Department of Finance. These aggregate figures mask the fact that certain sectors and indeed regions of the economy would be disproportionately affected and some small and medium enterprises are likely to be among the hardest hit by Brexit.

A hard Brexit may also require sudden regulatory and financial adjustments, since UK financial firms would lose passporting rights associated with EU membership. This is likely to be accompanied by a period of heightened uncertainty in the financial services sector. The importance of a transitional period to mitigate potentially disruptive cliff effects in the workings of the financial system must be recognised.

Our analysis is that the overall economic effects for Ireland in both the short term and longer term will be negative. The effects will be much worse if no free trade agreement can be reached. In the short term, before new arrangements come into effect, which is not likely to be until at least 2019, the main effects may come through the exchange rate channel and uncertainty. The value of sterling has generally traded in the range of 10 to 15 per cent weaker against the euro since the time of the Brexit referendum in June 2016. This makes Irish exports to the UK more expensive. There is some tentative evidence already of this exchange rate effect in the economic data. For a number of important food and beverage sectors, the value of exports declined last year even though volumes increased. This may be some indication of exchange rate fluctuations having an effect on export values. Irish imports will also be affected by Brexit. In the near-term, the weaker value of sterling has put downward pressure on import prices, which is beneficial for consumers and producers who use UK imports in the production process, but can leave Irish producers who are competing in the same markets at a competitive disadvantage.

Over the longer term, slower growth in UK consumption and investment, if it materialises, and in particular, any new barriers to trade including tariffs, will also weigh on some Irish firms. In the event of a hard Brexit, the trade impact on different EU countries will depend on (1) the share of total exports and imports accounted for by the UK, (2) the size of tariffs imposed on exports, which differs very significantly across sectors, and (3) the sensitivity of exports to price changes, which also varies across sectors. A detailed EU-wide sectoral analysis undertaken by ESRI researchers shows that Ireland is the economy most affected by Brexit due to the fact that we have the highest share of our exports going to the UK and also that the tariff rate on our exports to the UK would be almost double the EU average due to the very high rates on agricultural and food products under WTO rules.[1] Their analysis shows that under a hard Brexit, and taking into consideration all these factors, Irish exports to the UK might fall by around 30 per cent, which would be equivalent to an overall reduction in our exports of over 4 per cent.

The imposition of tariff or non-tariff costs would not only reduce trade volumes but also increase import prices, which would likely be passed onto consumers.

From a financial stability perspective, we are monitoring the impact that Brexit will have on the Irish banking system. Weaker UK and Irish growth will negatively affect those banks which have significant UK exposures. The weaker sterling exchange rate will reduce the value of profits and assets that are denominated in sterling. Other financial sector firms may also be affected, either positively or negatively, depending upon their business models and the extent of their UK business. Since before the referendum the Central Bank has been engaging with firms from across the financial sector to ensure that they are fully accounting for risks that may arise from the Brexit process.

The risks and uncertainties in relation to Brexit underline the importance of stability-oriented policies, notably in the area of public finances and financial system stability. Also, the challenges in areas of trade and investment underline the importance of maintaining competitiveness and ensuring that Ireland remains a flexible, adaptable economy that is supportive of enterprise and innovation. The risks from Brexit can be mitigated by further expansion of our trade links with other EU and non-EU countries, particularly for the indigenous sectors that are currently more reliant on UK markets.

Brexit will also present new opportunities for the Irish economy. Most notable in this regard are potentially stronger inward foreign direct investment as a result of both a relocation of existing UK-based FDI to Ireland and new FDI flows locating to Ireland instead of to the UK. It is too early yet to see any evidence of such flows, but they could create new employment opportunities and add to growth in the economy, while at the same time potentially creating challenges and opportunities, including for the property sector. Already Irish commercial property agents have noted increased office accommodation enquiries from British companies. In addition to the availability of office space, sufficient housing and adequate infrastructure will be required to accommodate any additional investments in Ireland, including notably in the international financial services sector.

In the financial sector, new business lines and new firms bring new opportunities, new challenges and new risks. In addressing these, it’s important to note at the outset that the Central Bank does not have a mandate to promote the development of financial services in Ireland. Rather, our mandate is to safeguard stability and protect consumers. In assessing any application, we are guided by that mandate such that each application is assessed to understand the business, its risks and how they are managed and mitigated. This is critically important for the stability of the sector as a whole, for ensuring that financial firms are soundly financed and soundly run, and for ensuring that consumers of financial services are appropriately protected.

Since the referendum, as firms weigh their options for a post-Brexit world, the Central Bank has received a large number of Brexit-related authorisation enquiries from across all sectors, including banks, insurance companies, investment firms and payment institutions. They have been considering a variety of factors relevant to their business, and wish to understand our approach to authorisation and ongoing supervision, e.g., substance, risk management, governance structures, etc.

Overall, the level of Brexit-related activity and developments is in line with what we expected to see following the referendum decision. In the coming weeks and months, as firms make decisions, we expect to see a meaningful increase in applications for authorisation or for extension of existing business. As Governor Lane has already said, we deal with enquiries in an open, engaged and constructive manner, and are committed to providing transparency, consistency and predictability in our regulatory decisions.

To deal with the increased level of activity, we have increased, or are in the process of increasing, our authorisation teams across all sectors. Since Ireland is already home to a large-scale international financial services centre, we have considerable experience in dealing with such authorisations.

Our regulatory approach is in line with sound practices being agreed across Europe; our responsibility is to ensure that firms authorised to operate from Ireland demonstrate compliance with EU requirements. To this end, we seek to ensure that an entity will be substantively run from Ireland and that the set-up permits effective supervision, with local management accountable for decision making. The Central Bank has consistently said it is not sustainable to entertain proposals that fall short of these basic requirements.

We are actively engaged in the work of the European Supervisory Authorities (ESAs)[2] and with our colleagues within the ECB/ Single Supervisory Mechanism (SSM). It is worth noting in this regard that the SSM has recently issued important guidelines for banks looking to relocate their business within the euro area which set out the ECB’s supervisory expectations in a number of areas, including internal governance, risk management and outsourcing. The ESAs are also advancing their work on these issues in respect of other entities such as securities firms and insurance companies.

Regardless of where a firm relocates, firms should expect that there will be rigorous assessment of the applicable EU regulatory standards and intrusive ongoing supervision of their activities.

In concluding, the Central Bank of Ireland will continue to monitor Brexit developments in this area and, via its Brexit Task Force, will coordinate expert analysis from across its supervisory and economics functions to ensure an integrated and comprehensive understanding of economic, financial and regulatory risks.