When examining the potential fallout from the two greatest risks facing European markets, a no-deal exit from the European Union and possible Italian contagion, the impact on EU supply chains and cross-border banking exposures is especially important to consider.
Arguably the most comprehensive study of EU supply chains was published more than a year ago by a group of economic geographers led by Raquel Ortega-Argilés and Philip McCann, professors at the universities of Birmingham and Sheffield, respectively. The study looks at world input-out tables, which make use of intermediate inputs into production process from around the world. This is helpful when assessing the potential impact of a no-deal Brexit at a detailed regional level across the EU28, but does not totally address the issue of embedded services in the manufacturing process.
The UK Trade Policy Observatory puts the embedded domestic services in UK exports of manufactured goods at more than £70bn annually. This compares to around £340bn of total UK exports of goods in 2017, and is equivalent to all UK exports of financial services and insurance. These embedded services include research and development costs and intellectual capital. In many cases, they have a much higher value added than the actual physical manufacturer of the product.
Despite this, little attention has been paid to the issue of these ‘Mode 5’ services exports. This matters a great deal to the debate around the possibility of a hard border between Northern Ireland, part of the UK, and the Republic of Ireland, an EU member. Maintaining free movement of both goods and services (embedded or otherwise) after Brexit will be essential to preserving the all-Ireland economy. This is complicated by the UK government Chequers proposal, which makes scant mention of services.
The EU regions that would be most impacted by a no-deal Brexit are richer and have lower unemployment rates. These include southern Germany and the Netherlands. Such regions stand in contrast to Italy and Spain, which are less exposed to the UK through supply chains.
Spain is exposed to the UK through its banks, which Bank for International Settlements data last put at around 30% of Spanish GDP. This is a markedly high figure and makes Spain very much an outlier. As a general rule, those countries most at risk from a no-deal Brexit through supply chains also have banks that are more exposed to the UK. This is especially evident in the case of Ireland, but is true to a lesser extent for Germany and the Netherlands. Italy, Portugal, Austria and Finland have little exposure to the UK on both counts.
The Spanish banking sector may be much more exposed to the UK, but when thinking about possible contagion from Italy, the French banking sector is the outlier. The BIS last put French bank exposure to Italy at around 11% of GDP, skewed towards loans. The equivalent figures for Spain in the first quarter of 2018 was around 5% of GDP, skewed towards Italian government bond holdings. Portuguese bank exposure to Italy was around 3.5% of GDP, Germany’s not much more than 2% of GDP, and the UK’s around 1%.
When it came to the Greek debt crisis, one of the reasons the EU kicked the can down the road was the exposure of French and German banks to the country. Several years into the European economic recovery, banks are in a much heathier state, but the exposure of French banks to Italy today is much higher than their exposure to Greece in 2009. At its peak, the French banking sector’s exposure to Greece was more than $75bn. The equivalent figure for their exposure to Italy in the first quarter was almost $320bn, with another $50bn of credit commitments and $20bn of guarantees extended.
David Owen is Managing Director and Chief European Economist of Jefferies.