- The Bank of England's recent article warns that the next financial shock could come from events overseas
- The size of the UK's foreign asset holdings leaves its banks directly exposed to financial and macroeconomic developments abroad
Brexit has happened, more than two-thirds of UK citizens have been double vaccinated and, with any luck, inflation will normalise when supply issues are fixed and energy prices stabilise.
So, where might the next shock come from? A recent Bank of England article, ‘No country is an island: how foreign shocks affect UK macro-financial stability’, suggests it is likely to come from matters overseas.
While it may seem an obvious point, the paper spells out how vulnerable the UK is to external shocks. In fact, it is more so than most other countries because it is more connected to the global economy. Total trade – the sum of imports and exports – is equivalent to over 63 per cent of UK gross domestic product (GDP) compared with a global average of 56 per cent and just 27.5 per cent in the US, according to the Bank of England.
However, it’s the UK’s foreign assets and liabilities that make it stand out – over five times larger than UK GDP and far bigger than any other major nation. In other words, foreign countries own more assets in the UK, as a percentage of UK GDP, than in any other major economy. And the UK owns relatively more abroad than anywhere else too.
This openness brings many benefits. Trade boosts economic growth by fostering competition, exploiting economies of scale and encouraging innovation transfer across borders. Similarly, cross-border capital flows can facilitate risk-sharing and diversification and help allocate resources efficiently, the report says. This should make the economy less vulnerable to shocks at home.
But it also makes the economy sensitive to other events, as highlighted by the global financial crisis and the pandemic, with UK banks particularly vulnerable.
“The global financial shock plays a more important role than the global real shock for UK financial conditions and UK GDP. This underscores the importance of foreign financial developments in particular for UK financial markets and the overall economy,” the report says. The UK's banks have the highest cross-border exposure of any global banking hub: according to report, UK-based banks’ foreign claims are around 60 per cent larger than US banks and 20 per cent larger than French banks, which have the second-highest foreign claims.
"These foreign-asset holdings leave UK banks directly exposed to financial and macroeconomic developments abroad. In the event of a downturn overseas, UK-based financial institutions, which have extended loans abroad, would likely face losses on their cross-border exposures," the report says.
In the report, using sophisticated modelling techniques, several Bank of England staffers estimate how global developments affected UK GDP from 1997 to 2019. The model separates the effects of global ‘real’ shocks, arising from changes in supply and demand, and global ‘financial’ shocks, relating to changes in risk attitudes and reactions to news, which then affect GDP through financial channels.
The Bank of England's model found that a global real shock that generates a 1 per cent fall in global GDP, after one year, leads on average to a fall in UK GDP of around 0.6 per cent. A global financial shock that generates a 1 per cent fall in global GDP will also lead to a 1 per cent fall in UK GDP, on average, according to the report.
Looking ahead, the bank’s point is that monitoring developments abroad is as important as monitoring developments at home. Its results also highlight that escalating foreign credit-to-GDP growth has significant negative effects on the most severe possible outcomes for UK GDP.
The takeaway from the report is not that we should look to cut trade in goods, services and financial assets, but that understanding sensitivity to global events is something investors should bear in mind. The FTSE 100 is particularly sensitive to the global economy as the companies included derive on average around 70 per cent of their earnings from overseas, according to FactSet data. A weak domestic economy, therefore, if it leads to a fall in a value of the pound, typically boosts the FTSE 100 as it is cheaper for overseas customers to buy sterling-denominated products.
Interestingly, the report doesn’t mention what effect Brexit might have had on UK financial stability. Perhaps it’s too early to say. The Office for National Statistics reported earlier this year that total trade in goods with EU countries decreased by 23 per cent if you compare the first three months of this year with those of 2018. However, it’s hard to disentangle lockdown effects from these figures.