Negotiations on future financial services regulation between the UK and EU is due at the end of March 2021, however, as the deadline approaches uncertainty remains. Under the new EU-UK Trade and Cooperation Agreement, the two parties aim to reach a Memorandum of Understanding (MOU) by the end of this month, setting out a framework for regulatory cooperation in financial services – the UK’s most valuable export sector with an annual value of around £60bn. In 2020/21, our study finds the sector to contribute £122bn to the UK total GVA and between £71bn and £76bn in taxes (about 10% of the total government tax receipts). While the UK Chancellor, Mr Sunak, sees the prospect as a second ‘Big Bang’ for the City of London, one of the biggest challenges for the sector is losing the EU ‘passporting’ rights.
So, what is ‘passporting’? It is an EU system offering financial services companies, which have been authorised in one EU Member State, the rights to operate and trade freely in another without the need to seek new authorisation. Removing this time-consuming and usually expensive procedure has been the foundation of the EU single market for financial services.
Under the new arrangement, from 1 January 2021 banks and financial services companies from both sides of the Channel have automatically lost their ‘passporting’ rights. What this means to the UK is that around 5,500 UK-authorised firms that have passported their authorisation into Europe are impacted according to the Financial Times. For capital markets, the first trading day after the end of Brexit transition arrangements saw €6bn (approx. £5.3bn) of EU share trading shifted to European platforms as EU banks and asset managers must now use EU platforms for euro share trading. So far, UK based asset management firms have moved more than £1 trillion in assets to Europe with Dublin, Luxembourg and Frankfurt being some of the most popular locations. The lucrative IPO market has also been disrupted, with some leaning toward EU-based listings in Frankfurt, Paris and Amsterdam. InPost’s plans for Dutch listing, valued at around €7-8bn (£6-7bn), is one of the latest examples of US-owned companies seeking a EU-based listing venue.
However, the UK’s long-standing role as the world leading financial centre is unlikely to fall overnight. On the contrary, the latest Global Financial Centres Index (GFCI) reveals that London has increased its rating by 24 points since March, only four points away from overtaking New York to regain its position as the top financial centre in the world. Our recent study shows that the UK IPO market remains Europe’s most active market amid Covid-19 and Brexit-related uncertainties. While European IPO proceeds in 2020 suffered a 10% drop compared to the previous year, the London market is likely to exceed its 2019 levels, with more than £5.5bn raised in 2020 and a further £1.3bn in just one month of 2021.
How about finance jobs? A Financial Times survey of 24 large banks and asset managers reveals that the initial warnings of a dramatic employment shift post-Brexit at the scale of tens of thousands is yet to happen. Instead, the majority of international banks and asset management companies have increased their UK headcount over the past five years, with nine of the world’s largest asset managers increasing their combined headcount by 35%.
Beyond ‘passporting’ and the MOU, the EU and the UK can ease cross-border trading by recognising each other's standards or regulatory regimes in certain areas of financial services - a practice known as equivalence. While the UK has granted the EU equivalence in 22 areas, the EU has only temporarily recognised UK clearing houses, so there is clearly more to be done here to improve mutual market access. Absence of such an arrangement would negatively impact both parties, resulting in a 0.3% loss in annual GVA for the EU27 and 1.3% loss for the UK by 2030 according to our study.
Going forward, while some friction in cross-border trading is expected, what lies ahead for financial services will depend on the willingness of both sides to cooperate for mutual shared interest. Regardless the City of London should remain a critical centre of global finance for many years to come.
As a second national lockdown gets underway, along with fears of a double dip recession, the debate around negative interest rates is likely to resurface. With Mr Sunak extending the furlough scheme until March next year, all eyes will now be on the Bank of England over the coming months to see how far monetary policy can stimulate the economy.
In its November Monetary Policy meeting, the Bank of England voted to hold interest rates at 0.1% and increased its bond buying programme by a further £150bn. To date, the Bank has increased its firepower by around £460 billion to fight the effects of the pandemic, significantly more than during the Global Financial Crisis. But the Bank left one key question unanswered - under what circumstances could negative interest rates be utilised?
The Bank of England has been reviewing the appropriateness of using negative interest rates as a policy tool since the start of the pandemic. Last month, it exchanged letters with all UK banks and building societies to ask about the operational challenges that may emerge with a zero or negative Bank rate. But in a recent speech, Dave Ramsden, the Bank’s Deputy Governor for Markets and Banking, made it clear that this exercise was just part of their ongoing assessment.
The Bank is right to be cautious. Negative rates create problems - in particular for the banking sector - which need to be weighed against their ability to stimulate the economy. The objective of negative interest rates, as with conventional cuts in interest rates, is to stimulate demand in the economy; spending now is more attractive than saving. But compared with conventional interest rate cuts, two key questions need to be assessed.
Will negative interest rates actually be effective in stimulating the economy? Negative rates would see commercial banks charged to hold balances at the central bank, instead of receiving interest. To recoup this cost, banks could in theory pass this cost onto savers. In reality, banks will be reluctant to do this; disincentivising saving deposits would reduce the funds available for bank activity. Indeed, the experience of negative rates in other countries has seen banks choose to increase bank fees and charges instead. This means the pass-through and stimulating effect will be much weaker compared to a normal rate cut.
To what extent will negative interest rates create challenges for the banking sector? With banks unlikely to pass on charges for holding balances at the central bank, they will see a squeeze in their profit margin. And with banks already facing credit losses from the economic fallout of COVID-19, undermining profitability further could lead to problems with their ability to support the economy. And back to the first question - squeezed profits constrains lending capacity, which is counterproductive to stimulating spending and business activity.
The effectiveness of such a policy also depends on country-specific macroeconomic circumstances, structural features and financial systems. Indeed, the experience of negative interest rates around the world has been mixed. In Japan, negative interest rates have failed to stimulate an economy where ageing populations continue to save. In Sweden, the combination of five years of negative interest and a housing shortage led to a housing price bubble. In the Eurozone, the evidence is mixed; it suggests that overall negative rates have been effective at stimulating the economy and raising inflation, although the impact on the banking sector has varied by country.
Negative rates can be designed in various ways to try and limit the pressure it causes for banks - for example, tiering of reserves, whereby only some of the reserve balances they hold at the central bank are charged negative rates. As part of their ongoing review, the Bank will need to assess the risks and how they could be mitigated very carefully, before introducing any such policy.
There is considerable evidence that house prices tend to be higher around good state schools. In our recently released report, we have added to this evidence base by updating and extending research published by the government in 2017. In line with this research, we have estimated the additional cost of living near to one of England’s highest performing state schools (i.e. in the top 10% based on attainment data).
We refer to this additional cost as the ‘house price premium’ and find that, in 2017/18, this averaged around £27,000 (7%) for primary schools and around £25,000 for secondary schools across England.
We also found that this premium varies significantly between regions. The largest percentage house price premium for primary schools is 12% in Yorkshire and the Humber, equal to about £27,000. The secondary school house price premium varies more between regions, with a premium of £47,000 (19%) in the West Midlands, for example, while we estimate there is no premium in the East of England.
Figure 1: % house price premia by region (2018)
The high cost of living close to, and so potentially within the prime catchment area of, a high performing school has potentially serious adverse implications for social mobility. In particular, children of poorer families may be locked out of the best education, which negatively impacts on their later career prospects and life opportunities. Research by The Sutton Trust suggests that improving social mobility could benefit individuals, businesses, and the economy. As such, reducing the house price barriers to the best schools could be critical to improving equality of access to education and opportunity, unlocking improvements to productivity and in turn economic growth.
What should be done?
Both business and government can take action to help to unlock these benefits, but some policies are likely to take longer to achieve than others. In the shorter term, policy options could include:
In the longer term, housing policy could be used to reduce the size of the house price premium, while businesses could invest in new programmes for school leavers. Actions and policies could include:
The house price premium is a potentially significant barrier to social mobility, but the actions and policy outlined above could help to level the playing field. Through central and local government and businesses working together, these policies and actions have the potential to generate large benefits including: more people achieving their potential, businesses benefiting from greater diversity of staff from a range of socio-economic backgrounds and better matching of staff to roles. These then have the potential to benefit the economy through improved productivity, equality, and in the long run, living standards.
In the latest edition of UK Economic Outlook we released our latest projections for house prices in the period to 2025. In our main scenario, we expect the house price-to-earnings ratio to remain close to its all-time high, at around 8.5. This means that it will not become any easier for workers to get onto the housing ladder, as house prices are likely to rise at a similar rate to wages.
Given that the cost of housing is likely to remain prohibitively high for many groups, we conducted some new research into the affordability of the rental sector. The proportion of 25-34 year olds who rented privately in 2017/18 stood at 46%, compared with just 20% two decades earlier. This increase is likely to reflect the greater difficulties in buying a house. However, rapid house price inflation has not just affected young people. Over the past 20 years the proportion of those renting privately has risen for all demographic groups, while the proportion owning a house with a mortgage has fallen for every group. This means that affordability in the rental sector is a concern for more people than ever.
To determine whether rental prices were affordable for UK workers, we assumed that rent should cost no more than 30% of gross annual income, a benchmark that has been widely adopted by previous studies. On a nationwide basis, an employee would need an annual salary of £23,800 for the median private rent to remain at or below this affordability threshold. However, the median annual wage stands a little below this, at £23,400, suggesting that there are likely to be issues in the sector.
Both wages and private rents vary enormously across the UK. Our study compared incomes and rents for hundreds of different occupations in 11 different regions. We found that four regions - London, the South East, the East and the South West - had average rents above 30% of the median regional income in 2018. In London, the average rent was as high as 42%. These four regions pulled the national average over the 30% threshold. At the other end of the scale, the average rent in the North East was just 25% of the median regional wage.
We paid particular attention to key workers when we looked at rental affordability by profession. We define key workers as public-sector employees essential to the smooth running of society, such as teachers, nurses, firefighters and police officers. The affordability of rents for these professions showed a similar trend to regional averages. London and the South East were particularly prohibitive for key workers; primary and nursery teachers, nurses and prison officers in the most expensive areas of the country face affordability ratios above 30%. For prison officers in London the ratio was 45%, meaning that they could be paying almost half of their income in rent.
The difficulties of finding affordable rented accommodation could have broader societal effects. They may result in shortages of workers in particular professions, if employees are faced with either very expensive rent or a long commute. They could also prevent potential employees from taking up job opportunities in more productive areas of the country, which in turn could limit social mobility and productivity growth. A steady rise in the proportion of properties used for multiple occupancy in London over the past 25 years suggests that some workers have made a different choice. Faced with a need to work but unable to buy a house or pay high rent, workers are trading down the quality of their accommodation and are sharing properties.
These trends are not irreversible. The government could intervene to increase the supply of properties by relaxing planning laws and committing funds to affordable housing in its forthcoming spending review. It could also take inspiration from policies adopted elsewhere, such as rent controls or regulations on short-term letting platforms. Where appropriate, there could be a role for large employers too, by relocating roles to more affordable areas or negotiating better rates with letting agents on behalf of their employees. A mix of these policies and commitments could result in benefits to the economy through improved social mobility and higher productivity growth, as well as greater wellbeing among affected workers.
Ever since the burgeoning of international trade in the post-war era, economists have sought to understand the fundamental factors that drive it.
One surprising finding was that trade is largely determined by the same two features that govern the physical world - mass and distance - as captured in an equation that mirrors Newton’s universal law of gravitation. This gives rise to the so-called ‘gravity model’ of trade1.
The model predicts that bigger economies which are closer together will trade more with each other. That’s particularly intuitive for trade in goods: the greater the distance goods need to travel, the higher the trade cost, which in turn reduces trade flows.
However, for services, like accounting and finance, which do not have to be physically transported, one might argue that their intangible nature makes them less susceptible to the forces of economic gravity. So, given the growing importance of services in global trade flows, do the lessons of the gravity model still hold true?
Our latest research suggests that they do. Using a new experimental dataset from the ONS on UK services and exports, and controlling for a number of factors2, we find that distance matters as much for services as it does for goods.
Doubling the distance between the UK and a trading partner is associated with a 41% decrease in the value of services exports. The effect on goods is only slightly stronger. Doubling the distance would decrease the value of goods exports by 44%.
So what might these findings tell us about the UK’s approach to negotiating future trade relationships?
Services exports: A great British success story
The UK is the world’s second largest exporter of services after the US. From tourism and transport, to financial, business, creative and cultural offerings, the UK’s services exports combine to generate a trade surplus equivalent to 7% of GDP3.
Many of these services, as our gravity models would predict, head to both closer and larger economies like the US and the EU, as the map below shows.
How the world map would look if the size of each country’s land area were scaled to the size of UK services exports to these countries
It’s clear, therefore, that focusing on services as part of the post-Brexit trade negotiations with the EU and other geographically proximate (and larger) economies would play to the UK’s strengths.
A one-size-fits-all approach doesn’t work
A deeper analysis of individual sectors shows that the influence of distance on trade can vary significantly depending on the type of service provided. Sectors that tend to be sold as part of - or embedded in - goods, such as construction and repair services, are weighed down by gravity. At the other end of the spectrum, the UK’s cultural exports, such as music and performing arts, fashion, films and TV, are examples of services exports that have strong global appeal, not just in geographically proximate markets.
Perhaps even more surprising is how trade in sectors like financial and professional services - which conventional wisdom might suggest would defy the forces of gravity as they are often delivered digitally and remotely - appear to be inhibited over greater distances.
This suggests that networks, close collaboration and relationship building - all of which are hampered over longer distances - can be crucial when it comes to demand for these services. The UK’s time zone between the East and West has helped it secure its position as a global financial services hub. Its proximity to Europe, and the fact that it’s a member of the EU Single Market, has also helped it to serve as the primary gateway to European markets for leading US and Asian financial institutions.
A one-size-fits-all approach to trade negotiations, where the same sector emphasis is applied in negotiations with different countries and regions, is therefore unlikely to work.
So while much of the Brexit debate so far has focused on securing the seamless flow of goods between the UK and the EU, the next stage of negotiations with the EU must focus on services.
Understanding which services ‘travel well’ and which do not, will serve the UK well as it steps up its efforts to deepen trade links with other countries beyond the EU, whatever the outcome of Brexit.
Read more of our research here. For more Brexit insights, go to pwc.co.uk/brexit.
1 Tinbergen, J., Shaping the World Economy, Twentieth Century Fund, New York, 1962.
2 Such as if the trade partner was part of the EU or if a trade agreement is in place, and if English is an official language.
3 IMF, Direction of Trade Statistics.
One of the striking features of the performance of the UK economy since the financial crisis has been the contrast between strong jobs growth and insipid productivity growth, as the chart below illustrates.
In some ways this has been a good thing, because unemployment never ballooned to the levels of over 3 million seen after the early 1980s and early 1990s recessions. It’s now down to only around 4%, the lowest level since the mid-1970s. The UK employment rate is at record highs of over 75%, driven in particular by a rise in the number of women working.
But there are limits to how much further employment rates can rise and, in the long run, you can’t raise living standards on a sustained basis without higher productivity growth.
Recent OECD research shows that a key reason why productivity growth has been relatively weak over the past decade, both in the UK and other developed countries, is that those economies have become increasingly focused on services, where productivity growth tends to be lower than in manufacturing. In the UK, services now account for around 85% of employment, up from only around 55% in 1960. Manufacturing employment fell from around 35% of total jobs to less than 10% over the same period.
The OECD analysis, in common with our own past research on productivity, highlights the slowdown in productivity after the 2008-9 crisis in sectors like financial services. But it also points to three more fundamental factors that drag down productivity growth in services, as summarised in this table:
Let’s take a closer look at each of these three factors in turn, and the way in which new technologies can potentially help to overcome these barriers to service sector productivity growth.
1. Lack of competitive pressure – the spur from digital platforms
In general, it is easier to standardise goods than services, leading to the emergence of highly competitive mass markets in goods that can spread globally and deliver economies of scale that help to drive up manufacturing productivity.
By contrast, services generally need to be tailored more to particular customer circumstances and often have to be delivered in person rather than remotely. Therefore, competition tends to be local rather than global. There are exceptions, such as financial services, but otherwise this applies to a broad range of service activities from shops and restaurants to hairdressers and personal trainers.
Economists relate this in part to informational asymmetries between buyers and sellers that make it harder to assess quality and build up trust quickly for many services transactions. This can lead to high switching costs for customers who prefer suppliers with whom they have built up long-term relationships. This tends to reduce competitive pressure and, as a result, the incentive for suppliers to make productivity gains.
Digital platforms, by making services more transparent and providing rating systems to assess quality and build trust, can help to overcome these barriers. We have seen this, for example, with Amazon in retailing, TripAdvisor for travel and Airbnb for accommodation.
If service providers wish to survive in the long run, this added competitive pressure and customer scrutiny should spur them to boost productivity. However, these effects will take time to come through as it requires investment in deploying and perfecting these new technologies.
2. Lack of scale and low capital intensity – the spur from AI and robotics
Relative to the large scale capital investments needed in traditional industrial sectors, like manufacturing, mining and utilities, many services industries tend to be ‘capital-lite’, growing primarily by taking on more people rather than facilities, machinery and other assets. This pattern has been very evident in the UK economy over the past decade where strong jobs growth has been focused in service sectors like retail and wholesale, and hotels and restaurants.
As our research has shown, however, the next decade or two will bring increasing capability to automate cognitive and routine manual tasks in service sectors like retail, finance and transport, through the adoption of new technologies driven by AI, including robots, virtual assistants and driverless vehicles.
This should boost productivity in these sectors, the benefits of which will flow through to the wider economy through lower prices, new varieties of goods and services, and increased investment. Overall, we estimate that the net impact on UK jobs should be broadly neutral in the long run, though there could be considerable disruption and need for reskilling in the transition to this new technological future.
3. Limited international trade – the spur from digital communications
International trade, by allowing specialisation and knowledge transfer, has been a key driver of productivity improvements in industrial sectors for the past 250 years. But, as mentioned above, some services are inherently local due to the need to be delivered in person. I am not going to travel from the UK to China just to get a cheaper haircut or a better foot massage. At least for the moment, many such services also require the ‘human touch’ and associated social skills, which are not easy to automate (although even that could change in the long run, as recent developments in ‘human-friendly’ robots illustrate).
There are, however, some services with significant unrealised potential for increased international trade, especially as digital communications become ever cheaper and more reliable. Video conferencing, for example, can facilitate many international business services transactions but, at least in my experience, the technology has not always been 100% reliable in the past. But that is changing and new advances in areas like AI-driven instantaneous translation could add further to the potential to overcome barriers to services trade linked to physical distance and language. This, in turn, could boost productivity in sectors like professional and business services.
The challenge ahead – unlocking the potential of new technologies
We have seen that there is considerable unlocked potential to use new digital technologies to spur service sector productivity growth in the UK and beyond. But how can this potential be realised?
Governments have a role to play in supporting early stage research in technologies like AI and in the development of relevant skills. They can also take the lead in employing digital technologies in the public sector.
But, ultimately, it will come down to individual businesses to deploy these technologies across the economy. As with any new technology this will involve risks, but there are also big prizes to be won for successful early adopters.
In our latest UK Economic Outlook report we take a detailed look at the performance of UK regions over the past five decades.
We find that London has consistently outperformed other UK regions for most of the past three decades in terms of economic growth, but this has not always been the case. London had relatively slower output (GVA[1]) growth in the 1970s and early 1980s as people moved out of the capital to other parts of Southern England.
This only began to reverse with the financial deregulation of the mid-1980s, which boosted London’s position as a global financial and business services centre and acted as a global magnet for talent that has boosted London’s population and GVA growth to well above the UK average since the 1990s (see Figure 1 below).
Figure 1: London has grown consistently faster than other UK regions since the 1990s
At the same time, a sharp decline in manufacturing activity hit traditional industrial regions in the North, West Midlands and Wales relatively hard, particularly in the 1980s. Since the 1990s, however, there has been less of a general North-South growth divide outside London. Relative growth rankings of different regions outside the capital have varied across decades without a clear, consistent pattern.
All regions have also seen a boost to total GVA growth from increased net immigration since the early 2000s, but this has also been reflected in a general decline in real GVA per capita growth across UK regions relative to the average rates seen in earlier decades.
Will London’s dominance continue?
More recently, there are some signs from the latest housing and labour market data that London’s relative performance may have been less strong in 2018 and we expect this to continue in 2019-20, with London growing at only a slightly faster rate than the UK average in those years (see Figure 2).
Figure 2: Projected regional economic growth assuming an orderly Brexit (% pa)
It remains to be seen if this is a short-term cyclical phenomenon or the start of a longer-term trend. The case for the former is that London retains advantages as a global financial centre that no other UK region can match, and it also remains a leading European hub for fast-growing digital sectors.
On the other hand, London’s growth could be held back by problems related to transport congestion and lack of affordable housing, as highlighted in our latest Good Growth for Cities report. While Brexit will affect all parts of the UK, London could be particularly exposed if it reduces its attractions as a destination for global talent in key sectors like finance and digital.
More generally, regional growth should not be seen as a zero sum game where strong London growth has to be at the expense of other regions losing out. Looking beyond Brexit, the challenge for policymakers will be to invest in infrastructure, innovation and skills across the regions, harnessing the benefits of London’s success for the good of the country as a whole.
[1] GVA refers to Gross Value Added, which is the closest regional equivalent to GDP at national level.