The Council of Financial Regulators (CFR) has issued a report to Government on the potential impact of Brexit on the Australian economy. It takes into account developments up to and including Tuesday 5 July. They conclude that the outcome of the vote on 23 June represented an appreciable negative shock, but the impact on domestic and international financial systems and markets was well-contained and orderly. On the evidence to date, they say it suggests that the domestic and international financial reform agenda adopted following the financial crisis is on the right track.
The CFR is comprised of the Reserve Bank of Australia (RBA); the Australian Prudential Regulation Authority (APRA); the Australian Securities and Investments Commission (ASIC); and the Treasury. The report is informed by CFR agencies’ close consultation with their respective counterparts in the UK, Europe and other jurisdictions.
It is uncertain how the UK’s exit will proceed and what the associated impacts on the stability of the rest of the EU will be. This will be a source of continuing uncertainty and market volatility for some time, against the backdrop of an already fragile global economy. Significant shocks could also come from other sources. While the Australian financial system has weathered the immediate reaction to the vote well, the event underscores the importance of pressing ahead with further reforms to enhance our system’s resilience.
The short-run negative effect on economic activity in Australia, through channels such as reduced trade, lower commodity prices and financial linkages, is expected to be very limited for several reasons. The effect on global activity is expected to be small, Australian trade is oriented more towards Asia than Europe, and Australian banks have limited direct exposure to the UK and Europe and are well-placed to handle disruptions to funding markets.
The medium- to longer-term implications for the UK and Europe, and the global economy more broadly, will depend on the degree and persistence of uncertainty, and the length and outcome of negotiations on exit. In the UK, business investment growth was already weak prior to Brexit and is likely to weaken further, at least until the nature of any future trade agreement with the EU, by far the UK’s largest export market, is known. Some firms may also choose to relocate from the UK to EU countries if their businesses depend on access to the single market. Concerns over job security and negative wealth effects will be a drag on household spending. Prior to Brexit, the IMF indicated that should Britain vote to leave the EU, GDP in the EU could be lower by up to 0.5 percentage points and GDP in the rest of the world could be up to 0.2 percentage points lower by 2018.2 There is a significant degree of uncertainty around the estimated economic impact of Brexit. The IMF forecast a wide variation in output losses across individual economies, reflecting differing trade and financial exposures to the UK, as well as the policy space to respond to negative spill-overs.
Beyond the central forecasts, the Brexit result has arguably added to global tail risks, particularly through heightened risk in Europe. The result could potentially strengthen exit momentum within euro area countries, which if successful would be considerably more disruptive given the common currency. Ongoing banking sector fragility also remains a potential trigger for political discord and financial instability. European banks have been grappling with weak profitability and a high stock of non-performing loans for many years, which has been reflected in low share price valuations. Market movements reflect increased apprehension about banks in a number of European countries post Brexit, most notably Italy, where the Italian Government has been denied permission by the EU to inject capital into its banking system. The newly established European bank resolution framework, which favours bail-in of private creditors and substantially precludes government support, is largely untested.
Overall, tail risk considerations aside, the implications of Brexit for the Australian economy are not likely to be significant, but will depend upon the nature and length of the transition to new arrangements. Australia has proved resilient during past periods of financial market volatility and remains well placed to manage the economic and financial market response from the UK referendum outcome. Additionally, Australia has a relatively small direct trade exposure to both the UK (2.8 per cent of goods and services exports) and the rest of the EU (4.6 per cent of goods and services exports). However, Australia’s major trading partners have larger exposures to these markets. For example, the EU (including the UK) accounts for 15.6 per cent of China’s goods exports and 18.2 per cent of the US’s goods exports. A sharp slowdown in the EU economies with spill-overs into other major economies would place downward pressure on the demand for Australia’s exports.
The Australian economy may also be affected if the UK transition out of the EU is not orderly and uncertainty remains heightened for a significant period. This poses some downside risk to the domestic outlook, with negative wealth and confidence effects having the potential to affect household consumption and business investment.
The strengthening of the banking system’s capital position over recent years to meet the new ‘Basel III’ requirements represents a material increase in the banking sector’s ability to withstand a significant deterioration in asset quality. The Financial System Inquiry highlighted the importance of ensuring the soundness of the financial system. The Government endorsed its recommendation that capital standards be set such that bank capital ratios are ‘unquestionably strong’. While Australian banks are well-capitalised, a further increase in capital ratios is likely to be required over the coming years to satisfy the ‘unquestionably strong’ benchmark. The Government has also endorsed the implementation by APRA, over
time and in line with emerging international practice, a framework for loss absorbing and recapitalisation capacity.APRA is also introducing further reforms to strengthen the resilience of the banking system. Of particular note, on 1 January 2018, APRA will implement the Basel III Net Stable Funding Ratio (NSFR) to discourage banks from being overly reliant on less stable sources of funding. The NSFR will be part of APRA’s prudential liquidity rules and will complement the Liquidity Coverage Ratio – introduced on 1 January 2015 – that requires banks to hold sufficient ‘high quality liquid assets’ to withstand a 30-day period of stress. APRA is currently consulting with the industry on the design of the NSFR and intends to finalise proposals by the end of 2016.
Consistent with the Government’s response to the FSI, further work is needed to clarify and strengthen regulators’ powers in the event a prudentially regulated financial entity or financial market infrastructure faces distress. A recent peer review by the Financial Stability Board identified some gaps and deficiencies in the Australian resolution framework and work is progressing on this as a matter of priority.
More broadly, such episodes of significant shocks and market volatility reinforce the value of Australia’s financial (and economic) policy frameworks. The separation of responsibility for prudential regulation and market conduct regulation (between APRA and ASIC), the operation of independent monetary policy and a floating exchange rate continue to serve us well.
