BRITAIN OUTSIDE THE EU: FINANCING UK COMPANIES

In advance of the classroom workshop, Dr. Permjit Singh explores the latest developments on the UK’s planned exit from the EU and their impact on companies, as well as the potential challenges and opportunities available.

After a bitterly fought contest that stoked up fears of financial doom, higher taxes, and racism, the UK referendum on whether to stay or leave the EU was decided on 24 June, and the shock to the UK and global financial system was evident.

Sterling immediately depreciated to a record low, the value of the UK stock market plummeted and gold rose: all clear signals that investors were far from optimistic about the future of the UK economy.

The negative outlook was to a large degree due to an uncertain future for the UK created by the following factors:
— The potential for years of negotiation between the UK with the EU lying ahead, a possible EU backlash, and the fact that the UK would need to seek out new trading partners
— The question as to whether a second vote would be granted to remain in the EU
— Cameron stepping down leaving the country rudderless whilst a new leader was elected
— Whether MPs and the newly elected prime minister would follow through with the electorate’s decision (under the rules of the referendum they had no obligation to), a decision that could be put off until the end of the year or even into 2017
— Whether Scotland would hold a referendum favouring the EU over the UK
— Whether other EU countries would emulate the UK’s decision, triggering an EU break-up

However, within days of the vote UK markets bounced back strongly, especially UK equities – though the sterling exchange rate against the US dollar remained far below its pre-vote highs, a sign that markets did not believe it was ‘business as usual’ for the UK.

Forecasts for UK GDP have been cut drastically, prompting a rating agency to cut the UK’s credit rating.  A cut in interest rates was expected in July by Bank of England governor, Mark Carney, but he surprised markets by holding off
– probably until August.

Some foreign companies have already raised their UK retail prices to mitigate some of the dollar costs of their raw materials, and others are likely to
follow (1).

Carney has warned that the risks of Brexit are beginning to crystallise.  The need for monetary easing reflects the real possibility of a recession, imported inflation, on top of which the UK has to deal with its persistent and large trading deficit.  The risk of recession and a need for continued market liquidity also prompted Carney to ease bank capital requirements, giving banks more liquidity and financial slack.

The commercial property market experienced a run as investors sensed a collapse, prompting some large property funds to block early redemptions.  This market is likely to experience substantial near-term stress and, through contagion, might adversely affect related markets – it has already pulled down house builders’ shares and it might, with a shortage of bank funds, depress the residential market (2).

How can UK companies finance themselves during this uncertain economic outlook?

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Undoubtedly UK banks have been and will continue to be for some time ahead, negatively affected by Brexit.  Their market values have plummeted and in some cases trading in their shares has been suspended.  With falling equity comes weakened capital adequacy, leading to renewed central bank financial support and perhaps bailouts.   Banks’ weakened position will make it harder for them to continue to access markets and if they do it will only be at higher funding costs.  The government might again provide credit enhancement to keep banks’ funding costs down, but with the condition that the banks pass some of their funding on to the wider economy.

Companies will need to confirm with their core and principal banks what credit and currency facilities they still have, and be prepared for accepting inevitably onerous terms and conditions.

Higher costs, onerous terms and conditions, and less committed funding, are the likely outcomes of bank discussions, so companies must seek out financing alternatives, especially small-medium-sized enterprises (SMEs), given their heavy reliance on bank financing.

As SMEs clamour to take advantage of alternative sources of finance, rising funding costs, stricter terms and conditions, and reduced availability of alternative finance might act as a hindrance until new suppliers enter these markets and satisfy increasing demand.

Since some financing markets are asset-backed, companies will be compelled to review their assets and determine which may be used as security and which can be sold off for cash.

Complementing bank and alternative finance are wholesale debt markets, covering the entire maturity spectrum.

Importers and exporters have unique financing needs, and liquid and well-established markets exist to cater to eligible companies, often with the support of government agencies and banks.  As noted above, however, going forward, banks might not be as reliable at providing credit support for importers.

In conjunction with debt-based finance, companies will need to familiarise themselves with, and be ready to access, various sources of equity finance, or engage in joint ventures, mergers, or corporate restructuring.

Financing is only one part of the challenge a company must overcome to realise its commercial strategy.  Another key challenge is making sure a company does not collapse through inadequate financial risk management.  The collapse of sterling immediately following Brexit is just one example of how exposed companies can be to domestic and global financial markets.

Understanding internal and external methods of managing financial risks such as currency and interest rates, will enable companies to quantify their possible adverse impact and mitigate them to avoid financial distress, and insolvency.

Companies with adequate sources of funding and control over financial risks will be better-positioned to withstand the tremors likely to be felt as the post-Brexit financial landscape evolves.