Feature of the Month – November 2017

THE ECONOMICS OF DIVORCE: THE POSSIBLE IMPACT OF BREXIT ON THE LEASING INDUSTRY

by Lindsay J. Town, IAA-Advisory Ltd

 Historically, the leasing industry accounts for over 30% of all capital expenditure in the UK and more than 25% of all such expenditure in the EU, so any changes that impact the UK and wider EU economies will inevitably have an impact on the industry’s performance and prospects.

Equally, the leasing industry does not act in isolation so any material changes to one national economy will inevitably have a knock-on effect to some degree in other countries. As this short piece is written in the latter quarter of 2017, the biggest problem with Brexit is that no one knows with any certainty what the final shape of the exit path will be, and nor do we know how long that path may be after the official date is reached.

For those not directly involved in the Brexit debate it is sometimes hard to appreciate the strength of opinions being expressed within the UK, and the absence of any clarity on the outcome.

The decision to invoke the now infamous “Article 50” can be seen as a decision born of political ideology and sentiment as much as, if not more than, economic or fiscal hard-headed cold calculation.  Added to the rationale for invoking the exit provision is the fact that it has never been done and was never seriously contemplated in the original drafting. So, the UK, and the rest of the EU, enter wholly uncharted waters and if nothing else the entire process has thrown into sharp focus the long-standing historic tensions within the whole construct of the EU as well as some very stark political and even emotional tensions within the UK.

The technical complication of unwinding the legislative framework that bound the UK into the EU is an incredibly complex task and that process alone has set another layer of tension within the UK, driven in part, and not surprisingly, by a degree political opportunism (across the whole political spectrum).

Meanwhile, the remaining 27 members of the EU must contemplate the loss of the UK’s contribution to the collective budget and a wholesale re-engineering of trading arrangements, including fiscal ones. Further afield, inward investors into the UK and those that have seen the UK as a suitable location for seating EU targeted activity have to contemplate their plans in terms of location and investment.

Whilst the specific outcome of Brexit may be unclear, it is certain that it will not be status quo when the dust settles. If one reads commentators in the popular press it is going to be a wonderful and positive future for the UK, or an unmitigated political and economic disaster, and of course they are all drawing on the same information or lack of it to come to their respective emphatic conclusions. The polishing of crystal balls and reading of runes has never been so active a pursuit!

The reality is that it will be some years before the full impact of Brexit is able to be truly analysed.  What is certain is that any of the several feasible scenarios will have a major impact on the UK and EU economy and probably on the wider global landscape. Awkwardly, it is hard to say without the benefit of several years of hindsight which will be positive, and which will be negative, though this has hardly stopped opinions being advanced.

In more cheerful terms, Brexit provides a veritable playground for pundits, forecasters, doom merchants and wild optimists alike.  Someone will inevitably say they were right all along, somewhat akin to the predictions of the financial crash of 2007 onwards, and any other major economic upheaval in modern times.

The problem with many of the forecasts is that they bring political tribalism to bear on what facts they can glean, extrapolating in a way that suits other agendas.  For the external observer, let alone anyone directly involved, it makes seeing clarity of direction a near impossible task. This lack of clarity is acceptable if one were merely a bystander, but for tens of millions of people and thousands of businesses around the globe, it is not a spectator sport.

What we do know without fear of dissent is that the process of Brexit has introduced that most lethal of all business conditions, uncertainty.  This uncertainty is compounding an already potentially difficult economic and fiscal picture where the continued use of “cheap” money and expanded money supply would be a big enough challenge alone.

Within this heady mix of circumstances, we must remember that the leasing industry relies for its success on continued investment in capital assets and a relatively stable credit environment for corporates together with sustainable consumer demand level. Any events that act negatively on business sentiment and consumer confidence or demand will impact our industry.

Looking at the leasing industry in isolation, we can consider the possible impact of Brexit under several different headings.  Before doing so, my caveat is that unlike the journalists and politicians, I do not claim to have a monopoly on being right, so I will try to cover both sides of the arguments: “Sunny Uplands and Green Pastures” or “Weeping and Wailing”.

Firstly, let us consider the demand side.  It is being suggested by some studies that a degree of capital investment has been deferred or scaled back until the final shape of Brexit is seen.  This is intuitively sensible, not just for the UK economy but also in terms of capital expenditure from inward investors where they have a choice of EU location and anywhere in the EU where the business feels that its output could be impacted by Brexit.

Once the Brexit outcome is understood then investment decisions return to a more stable footing, bar any other material changes in the economic/political landscape. In the UK, a favourable outcome to Brexit could release a degree of pent up demand leading to increased business.  Elsewhere in the EU and for inward investors, clarity will allow capital plans to be put back in train and so some demand pick up would be expected.

If Brexit leads to a less favourable outcome for the UK, such as a return to WTO trade rules and hard capital borders with the remaining 27 then the UK capital expenditure picture looks far softer in the near term until businesses adjust to the “new normal”.

Within the remaining 27 EU countries there could well be a pick-up in leasing demand as new and existing inward investors may select countries other than the UK for their “gateway to Europe” and existing EU businesses pick up internal market demand where the UK is no longer able to compete effectively due to changes in areas such as tariffs.

It is unlikely that even in a “negative” Brexit that change will happen overnight and so it is unlikely that there will be dramatic instant changes in the demand for leasing either in the UK or in the remaining EU.  However, what the whole process will highlight is the interconnectedness of markets, manufacturing and supply chains that have become used to an increased globalisation and have the ability, in time, to reallocate location and capital.

Turning secondly to credit quality and risk generally.  Looking at Brexit in isolation, I do not see that a favourable Brexit will mean much for credit quality generally. A Brexit outcome that puts the UK materially “outside the fence” of the EU may however add to risk within the UK business world.  This adverse impact will come from demand constraints as prices for goods and services exported to the EU face different tariffs and potentially goods and services exported elsewhere compete on different tariff levels.  This impact may be exacerbated by a change in input prices for UK manufacturers where new tariff rules and trading arrangements make the cost of goods and services less competitive.

The issues in terms of risk may also be impacted if labour cost and availability alter negatively, both in skilled roles and in areas such as seasonal or unskilled roles, all of which have a strong need for a comparatively free flow of labour within the EU (and wider of course).

Looking wider at risk issues, there may be some impact in terms of residual values on assets financed.  One immediate result of the decision to follow the Brexit route was a drop in the value of Sterling.  Assets financed in Sterling but traded internationally in other currencies therefore are impacted.

Once Brexit happens, the various scenario possibilities may impact the net value of leased assets which are traded within the EU, for example should there be tariff changes or similar that are applied to the sale of assets internationally. As always, there will be a mix of winners and losers in such a scenario, but all should look carefully at whatever new rules emerge.

To put the international trade arguments into context by a quick analysis of trade data is unfortunately not feasible as data is compiled and reported on varying bases. There is also the added factor that a considerable amount of international trade deriving from and to the UK is around financial services.

Based on UK government data sets (August 2017 1) in 2016, UK exports to the EU were 44% of all UK exports and UK imports from the EU were 53% of all imports.  More interestingly, the UK had an overall trade deficit of £71bn with the EU, comprising a deficit of £96bn in goods and a surplus of £24bn in services.

Outside the UK, the impact of Brexit in terms of credit and risk for the leasing industry is likely to be modest in any scenario.  There may be some areas of concern where entities have high trading dependencies on the UK should the exit rules make their outputs less competitive, but in general the impact may be of a somewhat lower order than in the UK alone.

Thirdly let us look at market competition and here we see some interesting, if remotely likely, possibilities.  Whilst UK lessors are less active in the wider EU, several EU-based lessors are very active in the UK market.  If an extremely negative Brexit occurs, then it is not impossible to see non-UK financial institutions having a serious debate about the scale of their UK activity.  Whilst I find it hard to envisage a hostile capital or fiscal regulatory regime being implemented, such an event could ultimately allow UK domestic leasing companies to pick up additional business, albeit a larger share of a potentially smaller pie.

The converse is possibly less of an issue as few UK domiciled lessors are massively active in the EU, although there are still considerable volumes at risk for several.  In a more favourable Brexit scenario it is unlikely that we will see any material shift in competitive dynamics.

There is a debate on the provision of financial services generally post Brexit and the concept of “passporting” the right to provide financial services within the EU would seem to be far from settled.  For the leasing industry such debates are, at least currently, less direct.  However, the potential for changed financial regulation could alter the market dynamics for lessors who are bank owned and active in the UK.

Equally, lessors who are genuine “pan European” such as some of the captive lessors and pan-European bank-owned lessors may face some challenge in adapting to the new “27 + UK” model. However, the true captive lessors who follow their parent will of course continue to do so irrespective of what type of Brexit transpires even though some of the impacts may require careful re-engineering of parts of their activity models.

It is unlikely in the extreme that all the dice will fall in favour of just the UK or just the EU. There have been commentators speculating that the EU wants to “punish” the UK for looking to leave, if only to make it clear to the remaining 27 countries that departing is not a viable option, thus preserving the EU model.  Whilst this view seems overly Machiavellian, there is certainly no incentive for the EU to allow the UK to have a better position outside the EU than if it was inside it.

However, as is the case generally, the problem is a two-edged sword as we have seen that trade flows both ways.  To cut off the UK with draconian exit terms and impenetrable trade tariffs would not just hurt the UK. It should be remembered that we are in a negotiation with no clear rules of engagement to follow – so as in any negotiation, it is not to be expected that all the details will be laid out in clear terms for everyone to see.

The reality is that the final terms of Brexit will be a compromise, an obvious comment perhaps but worth repeating as there will in any compromise be some who feel betrayed, and will make considerable noise, just as much as some who will feel that they have achieved whatever goals they envisaged, and will be equally noisy.

Whatever route is finally adopted, what Brexit has done is throw into stark relief the inherent political divisions within the European Union and without doubt within the UK.  The ramifications of the political debates may well rumble on for longer than the economic issues.

The Brexit debates will continue for some time to come before clarity is finally achieved, and probably even longer before it is all finally implemented. In the meantime, the leasing industry both in the UK and the wider EU will adapt to the “new normal”, irrespective of the type of Brexit that takes place, something that the industry has proved perfectly capable of doing through change of all types.

About the author:

Lindsay has over 40 years’ asset finance experience having been involved in sectors ranging from high-value international to point-of-sale small-ticket and consumer. He has dealt with most asset types, ranging from aerospace and marine through to IT and auto.  Lindsay has worked both in the UK and US, having held senior roles in various organisations including Barclays, Lloyds and PricewaterhouseCoopers. Prior his current role, he led one of the largest UK asset finance businesses at HBOS.  He is now Chairman and Chief Executive of IAA-Advisory, focusing on supporting the development of the industry through a range of services from strategic and M&A work to funding and capital markets options. Lindsay was previously a board member of the Finance and Leasing Association and is a Fellow of the Chartered Institute of Bankers in Scotland.

Note:

1. House of Commons Library Briefing Paper 7851, August 17, 2017.

The views and opinions expressed in this article are personal to the author alone and do not necessarily represent the view of IAA-Advisory.

 

Author:

2016-1111 - AII-Advisory pics at the Board Meeting

 

 

 

 

 

Lindsay J. Town

Chairman & Chief Executive

IAA-Advisory Ltd

Tel: +44 7801 239223

Email: lindsaytown@iaa-advisory.com

Website: www.iaa-advisory.com

 

To view previous Feature of the Month articles, please click below:

Brexit and equipment leasing

New lease accounting standard

The new era of lease accounting

Intermodal container leasing

Aircraft leasing in Germany

Commercial Aircraft leasing

 IFRS 16 Leases: Taking a risk-based, practical approach