Anjalika Bardalai, Cheif Economist, TheCityUK, speech to Guernsey Finance Funds Masterclass, 18 September 2019
Good evening everyone. First of all, a warm thank you to Guernsey Finance for the invitation to be here. TheCityUK and Guernsey Finance have a close working relationship so I’m very pleased to be able to take part in today’s event. Over the next 15 minutes or so I’d like to build on the insight the panel has given us by offering some context from the point of view of UK financial and related professional services - and hopefully, also, some food for thought.
As you can see, I want to talk about the global movement of services and capital. But what does this actually mean? Well, to start, I think we should remind ourselves of the importance of trade in the real economy. We talk a lot about financial services trade and investment, but sometimes it’s helpful to go back to basics to remind ourselves why these things matter. One of the main ideas I want to get across is that we would do better not to just look at trade in isolation, which is often the way it’s presented in media and policy discussions.
Here for example, you can see just what a prominent role trade plays in the global economy – you can see that as a percentage of global GDP, global trade is fully 60%. In its latest World Economic Outlook, the IMF cited ongoing global trade tensions as a major factor behind what it called “still sluggish global growth”
I also want to talk about the balance between goods and services trade since, after all, we are here today talking about financial and professional services. The IMF’s analysis actually introduces this theme quite well. They note:
Weak trade prospects—to an extent reflecting trade tensions—in turn create headwinds for investment. Business sentiment and surveys of purchasing managers for example point to a weak outlook for manufacturing and trade, with particularly pessimistic views on new orders. The silver lining remains the performance of the service sector, where sentiment has been relatively resilient.
The service sector is an extremely important part of the economy globally, and particularly in advanced economies. But it’s under-represented in trade data. Services account for around 75% of world GDP, but here you can see that they make up only around 20% of world trade.
Another way to look at it is here. On the left you see the huge difference between goods and services trade in value terms, and on the right you see that although services trade growth has generally been higher than growth in goods trade, merchandise trade is definitely still driving overall trade given that it’s growing pretty steadily, and from a much higher base.
Given the importance of trade in the overall economy, and the importance of services in the economy, what accounts for this big discrepancy between services’ weight in the economy and its weight in trade? One reason for the discrepancy is that there are significant barriers to trade in services. The existence of high barriers means that only a small proportion of services firms actually trade their services internationally.
Nevertheless, the UK has quite a special position in terms of services trade. The UK has the second-largest services trade surplus, and the second-highest level of services exports in the G7, after the US. Overall, UK exports of services accounted for around 7% of world services exports. Of course, financial and related professional services play a major role in that trade - but let me come back to that just a little later.
Another reason that services’ role in trade is so much smaller than its role in the economy overall actually has to do with measurement issues. There are 2 different ones that I want to touch on.
First, there’s the basic conceptual problem that services are harder to measure than goods. This is particular true of digital services, which make up a rapidly increasing share of the service sector overall. On top of that, services play an increasingly important role in global value chains, and being able to capture and accurately measure, for example, the services component of a manufactured product is still very much a work in progress.
Second, there’s the odd fact is that not all services “trade” is counted as trade. What do I mean by this? To explain this, I have to delve into a slightly technical matter known as the World Trade Organisation General Agreement on Trade in Services Modes of Supply. There’s a nice summary of this here, but basically the idea is that the WTO describes four different ways in which services can be traded. The most intuitive is probably Mode 1. For example, if someone in the US were to go online and buy an insurance policy from a UK-based provider, that would be measured as an insurance export from the UK to the US. Mode 2 is also pretty intuitive, but it generally doesn’t apply to financial services.
But Mode 3 is the tricky one at the heart of our discussion. The key point is that the way the WTO describes trade is broader than the way statistical authorities describe trade – none of the Mode 3 trade is ever included in trade data. There are good reasons for this – it’s not an oversight on the part of statistical agencies. But since I promised not to get too bogged down in technical detail, I’m not going to delve into those various reasons now.
But let me explain the practical impact of this, and why I think it’s worth discussing. We just did some work looking at new data published by the UK’s Office for National Statistics, which shows that of the £81bn of UK financial services exports recorded in 2018, 88% of it was classified as Mode 1. 12% of the total was classified as Mode 4. As I said, Mode 2 didn’t apply to financial services, and Mode 3 trade is excluded from the figures.
But imagine if we added £Xbn of UK financial services exports done by Mode 3 to that published £81bn exports figure I mentioned earlier. We did some analysis to try to estimate what that £Xbn would be and very roughly, we think the range could be something like £70-150bn. That would mean that UK financial services exports, instead of being £81bn, would be more than double that.
And you might think that the natural thing to do would be to add the figures together to get a “truer” picture of industry exports. But actually, that would be misleading, which is why I haven’t done it, and I’m just presenting the idea in general terms as a thought experiment. The reason is that some of the export revenue generated under Mode 3 is included in a country’s balance of payments, just as investment income rather than export revenue. So if we just added everything together, we would be double counting.
The point with all this is that I think the narrative focus on 'trade' and 'exports' is actually pretty misleading. Whenever services trade is discussed—which to begin with is much less often than we have discussions about trade in cars and food and textiles and so on—the familiar export-import framework of selling overseas and buying from overseas—is, understandably, what we use. But for many services, a lot of overseas business is transacted through overseas branches or subsidiaries, via this Mode 3 trade. And that is especially true of highly-regulated services like financial and related professional services. So, a broader focus on the overall balance of payments, including income and foreign direct investment, would be much better and more accurate than focusing in isolation on the trade component of the balance of payments.
With that caveat, let me turn to look at financial services exports as a key indicator of the highly international orientation of the UK-based industry. Here you can see that the UK has the world’s largest trade surplus in financial services, which we can interpret as a measure of its competitiveness.
Unfortunately the ONS doesn’t provide data about UK financial services exports to Guernsey. But total services exports plus imports with Guernsey were worth £5.3bn last year – roughly the same amount of total services trade as with Singapore.
But let’s look at that financial services trade surplus in a little more detail. You can see the geographical breakdown here. Overall, the US is the biggest single contributor to the UK’s financial services trade surplus. You can see that financial services exports are highly concentrated – the US plus just four other countries together account for more than half of the industry’s exports. And since three of those other countries are France, Germany and the Netherlands, the EU as a whole accounts for almost half the surplus.
With everything going on there was no way I could avoid Brexit in these remarks! I’m afraid I have no more idea than any of you as to what might happen on the political front in the weeks and months ahead. But what I can say is that we, TheCityUK, feel strongly that the future relationship between the UK and the EU is vital to ensuring the continued strength and economic contribution of the UK-based financial and related professional services industry.
And what should this future relationship look like? Well, first and foremost it means avoiding a No-Deal Brexit next month or indeed at any point thereafter, because No Deal would be the worst outcome for our ecosystem of businesses, not least because it means there would be no transition period. Another priority is a bespoke future relationship that delivers the best possible mutual market access.
This critical need to resolve the UK’s future trading relationship with the EU post-Brexit will impact the shape of the UK’s regulatory regime, including the regime for market access for third-country firms. So this is an important issue for the UK-EU relationship. But it’s actually more than just that. The macro issue of the UK-EU relationship, and the micro issue of the regulatory architecture that will govern that regime, are both part of the much broader question around how the UK remains competitive in the longer term as an international financial and related professional services hub.
One of the ways in which we’ve addressed that very question about competitiveness is with research published in 2017 that we refer to as our ‘Vision’ report because it basically tries to describe what the industry should look like in the future – taking account of Brexit, but also taking account of a whole range of other challenges like shifts in global economic power, and geopolitical and policy risks.
The report sets out this vision, and includes 35 specific policy recommendations to help achieve it. This image is a graphical summary of the Vision. And you can see that one crucial theme that runs right through it is regulation. This is because strong and agile regulation is one of the key competitive advantages that the UK has as an international financial centre.
Overall, we believe that the UK regulatory system is, and will remain, largely fit for purpose. But there is certainly an opportunity to build on the existing system post-Brexit in order to maintain and enhance the UK’s position as an international financial centre.
UK regulators and policymakers must continue to lead the development of an open and compatible global financial system. So this is not at all about pushing a de-regulation agenda; this is about providing global best practice, and promoting consistent regulatory standards and approaches. The UK’s regulatory regime must remain internationally attractive. And what will make it internationally attractive? The UK needs a regime that is accessible, flexible, responsive, proportionate and rigorous, and which underpins confidence in the integrity, fairness and transparency of UK financial markets. Existing regulations should be regularly assessed to identify and address any unintended consequences.
In fact, I think this issue of unintended consequences is so critical - because it has system-wide and indeed economy-wide effects – that we are currently working on new research, which we are producing jointly with Pension Insurance Corporation, on the nature of risk and the consequences for the financial system and the economy as a whole of regulation-induced de-risking. So if that particular aspect is of interest, do watch this space. We’ll be publishing the report in November, but I can give you a little preview – one of the themes that is emerging from that work is that risk is not inherently a bad thing; financial stability has to be based on free-market principles and market liquidity, which in turn involve a degree of risk-taking. Because without that, the financial sector is constrained in its ability to help promote positive economic outcomes.
I could spend a long time talking about the concept of economic competitiveness but I’m sure we’re all keen to enjoy the drinks that Dominic has kindly arranged. So let me wrap up my remarks by coming back to my original theme: the global movement of services and capital, and the link to financial services.
In short, trade in services is under-measured and under-appreciated. It’s an increasingly important part of the global economy, but because of cultural norms and conventions about the way we talk about trade, we leave out an important part of the story when it comes to services trade—namely, the investment side. So I would argue that if we really want to have a more informed and accurate debate about capital flows, we need to start talking about trade and investment in the round.
For financial services, investment is a particularly important part of the equation not only because of investment income, which the WTO would classify as part of trade, but also because it is one of the biggest sectors in terms of attracting FDI inflows. Guernsey actually features quite prominently in this regard – although we don’t have industry-specific FDI figures, we know that total FDI from Guernsey to the UK was £7.7bn in 2017. That’s on the basis of the immediate position of the investment source; the figure for the ultimate position was lower, at £6.5bn, which indicates that Guernsey acts as a conduit for investment to the UK from other countries as well.
From the UK perspective, financial services is a highly competitive industry, and the large trade surplus it generates every year is evidence of this. But the UK’s overall competitiveness as an international financial centre depends on more than this strong performance. Qualitative factors like the strength of its regulatory architecture are equally important.
The UK and indeed the whole world is faced with an incredibly challenging environment at the moment. We have a confluence of strategic geopolitical tests; domestic political upheavals all over the world; structural global economic shifts; and massive policy challenges like increasing automation and the impact of climate change. But I have no doubt that the combination of better insight, robust policy debates, and an ability to build on existing hard and soft sources of competitive advantage will see us through.
 IMF, World Economic Outlook, July 2019, available at: https://www.imf.org/en/Publications/WEO/Issues/2019/07/18/WEOupdateJuly2019