www.financialdirector.co.uk September 2016
The Great British Brexit How Brexit has changed the landscape for business
INSIDE ● BREXIT ● PENSIONS ● WORKING CAPITAL
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Contents
EDITOR Richard Crump PRODUCTION EDITOR Simon Turner CONTRIBUTORS Hywel Ball, Nigel Chism, Christian Doherty, Nicholas Hallam, Anthony Harrington, Neil Johnson, David Kern, Simon Laffin, Keith Nuttall, The Secret FD, Sooraj Shah, Phil Thornton ILLUSTRATOR Bill McConkey EDITORIAL ENQUIRIES (020) 8080 9138
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SALES MANAGER Oli Henry (020) 8080 9133 ACCOUNT MANAGER Renaldo De Souza (020) 8080 9133 Georgia Riley (020) 8080 9128 EMAIL firstname.lastname@contentive.com HEAD OF EDITORIAL Kevin Reed CEO Louis Warner POSTAL ADDRESS Contentive, 1 Hammersmith Broadway, London REPRINTS For custom editorial reprints contact Wrights Reprints at (+1) 877 652 5295 (international toll free) financialdirector@wrightsreprints.co.uk PRINTERS Headley Brothers Ltd. Mailed by Headley Brothers Ltd. SUBSCRIPTIONS UK £68, Europe £88, RoW £118
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CURRENT AFFAIRS
6 Enter Mr Digital Does the new CDIO at HMRC mean it’s business as usual for the taxman’s digital strategy? 7 Power to the people? Theresa May’s bid to put employees on company boards raises questions about how big business should be governed
COLUMNS
10 Diamond FDs How can the finance function in a multi-faceted company deal with the pressure? 11 Secret FD As our Olympic heroes return, spare a thought for those FDs who work hard in the background
FEATURES
BREXIT SPECIAL 12 Strained relationship How will the shock Brexit
15 vote affect trade relations and supply chains? 14 Infrastructure impact The UK exiting the EU could have major implications for a raft of planned investments 15 How about VAT? We examine the effect Brexit will have on the tax rate 16 Financial statements Six ways companies’ bottom lines will be affected 17 Which laws remain? EU accounting and taxation legislation may no longer apply in the UK 18 Defined benefit pensions Trustees and FDs need to work out a post-Brexit strategy 20 Not me, guv Why struggling pension schemes are due to corporate greed and governance failures 22 CFO Agenda What did attendees learn from Alistair Darling and Sir Clive Woodward?
24 Working capital European companies are struggling to register sustainable improvements in working capital performance
Financial Director is published by Contentive © Contentive, 2016 Financial Director is available on the internet at www.financialdirector.co.uk ISSN no. 0961-2556 Average net circulation, 7,547 (December 2015-May 2016). Total net circulation for audit issue cover dated May 2016, 7,533 Financial Director is printed on paper from sustainable sources in Scandinavia/Germany
REGULARS
2 Briefing Accounting misstatement proves costly for two Connaught FDs 4 Movers Weir gets all its ducks in a row 26 The Rules: Audit reform Will the Brexit vote see new EU audit reforms maintained, repealed or replaced? 27 The Rules: Audit tendering Audit tendering is nothing new, but in the face of the new EU reforms, how will companies now approach it? 28 Macro Market anxieties are due to widespread perceptions that the central banks are running out of ammunition
September 2016 | financialdirector.co.uk | 1
BRIEFING FDs banned
ACCOUNTING ERROR
FRC bans former Connaught FDs over £4m misstatement Two former Connaught finance directors responsible for a £4m accounting misstatement at the collapsed social housing maintenance provider have been banned from the profession by the FRC. An investigation found that the conduct of FD Stephen Hill and David Wells, the deputy FD responsible for the company’s treasury management, “fell significantly short of the standards” to be expected from members of the profession. The duo were banned over their role in the £4m accounting misstatement of a short-term loan in Connaught’s interim financial statements for the six months ended February 2010. In addition, the loan was not disclosed to the audit committee or the auditors, PwC; neither was it disclosed as a related party transaction, as it should have been.
The former social housing maintenance provider collapsed in 2010 with debts of £220m. The £4m loan – made by the CEO of Connaught shortly before the 28 February halfyear end, and substantially repaid between 15 March and 29 April 2010 – was not accounted for as a loan, but as operating cash flow in Connaught’s interim financial statements. The interim statements, issued on 27 April 2010, were therefore “materially misleading” in that cash flows from operating activities were overstated by £4m and net cash generated from financing
activities was understated by £4m, the FRC said. “But for the loan, the group would have fallen somewhere between 6% and 11% short of their 70% cash conversion target,” the FRC ruled. “This ratio was one of a number of key measures used by analysts and one upon which investors rely – and a figure that was especially important to Connaught at the beginning of 2010.” The FRC’s independent tribunal accepted that neither Hill of Wells acted dishonestly. Hill admitted that his conduct was sufficiently reckless to have amounted to acting with a lack of integrity. He was banned from the ICAEW for five years and ordered to pay £133,387 in costs. Wells was banned for three years and ordered to pay £125,198 in costs.
Profit warnings by sector, Q2 2016
Source: EY
2 HMRC defeats £30m EY tax avoidance scheme used by Greene King HMRC has defeated a tax avoidance scheme used by a major brewery and marketed by EY, protecting about £30m in tax. The avoidance scheme, marketed by EY in 2003, to brewery Greene King and other large groups, involved loans between group companies. The aim was for one company in a group to get tax relief on interest paid to another group company without that other company paying tax on the income it received. HMRC initially defeated the scheme in the First-tier Tribunal in 2011, and in 2014 the Upper Tribunal upheld the decision.
Government considers company car tax changes The government is consulting on ultra-low emission vehicle (ULEV) bands in the company car tax system. The government announced as part of the 2016 Budget that it would consult on reform of the bands for ULEVs in the company car tax system to refocus incentives on the cleanest cars using the latest technologies into the next decade, a period during
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General financial
Real estate investment & services
Food & drug retailers
Industrial engineering
Healthcare equipment & services
Construction & materials
Oil equipment,services & distribution
Chemicals
Personal goods
Mobile telecoms
Banks
Software & computer services
Aerospace & defence
Technology hardware & equipment
Electronic & electrical equipment
Media
General retailers
Travel & leisure
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Support services
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1 Sports Direct launches independent board review Sports Direct, the embattled sports clothing retailer, has said that it will hire independent advisers to “evaluate” its board after criticism over its corporate governance. The retailer said that “an external evaluation of the board is planned for later this financial year”.
FOLLOW FINANCIAL DIRECTOR APPOINTMENTS twitter.com/fdappointments
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Metrics
£46 bn The combined deficit of UK pension funds run by FTSE 100 companies post-Brexit Source: LCP
£28 bn The working capital
opportunity of UK companies Source: PwC
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94%
Percentage of professionals who would elevate an employee into a new role without offering any additional remuneration in sales in the first half of August Source: Robert Half
in which it expects rapid significant changes in the way motor vehicles are powered. While views are welcomed on specific tax bands and rates, this consultation is principally seeking views on the general approach of how company car tax should be levied for ULEVs into the 2020s.
Bosses must focus on corporate culture Company bosses must pay more attention to instilling the right corporate culture in order to restore trust in the way businesses are run and deliver long-term sustainable growth, according to an FRC report. The report comes after the prime minister, Theresa May, called for an overhaul of boardroom governance, including plans to put employee representatives on company boards (see page 9).
What do you feel are the prospects for the UK economy in the coming 12 months? 1% 13%
45%
41%
Set to decline
Growth will be flat
We will see modest growth We will see strong growth
Source: ICAS
Recent scandals including Volkswagen’s emissions rigging, Tesco’s accounting irregularities and the Libor investigations damaged trust in big business and director behaviour and highlighted the need for greater attention to company culture at board level, the FRC said.
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The point fall in the latest quarterly Credit Managers’ Index (CMI), which showed confidence in manufacturing fell for the second consecutive quarter Source: CMI
4 Inflation nears twoyear high post-Brexit The UK inflation rate hit its highest level in almost two years in July, suggesting that the sharp fall in sterling following the UK referendum to leave the European Union is forcing prices up. Inflation was pushed up by a rise in fuel, alcohol and accommodation costs, the Office for National Statistics reported. It said the Consumer Prices Index rose by 0.6% in the year to July 2016, compared with a 0.5% rise a month earlier. September 2016 | financialdirector.co.uk | 3
MOVERS Fashion
Smith & Nephew finance chief bags Burberry role Medical technology group Smith & Nephew has announced the departure of CFO Julie Brown, with the former AstraZeneca finance chief set to join fashion business Burberry in early 2017. Brown will have responsibility for finance, investor relations, IT, global business services and business transformation. The appointment is one of a series of changes to the Burberry senior team and forms part of its business review that is targeting future growth opportunities in retail, product and digital enabled by changes to ways of working. Christopher Bailey becomes president and chief creative officer overseeing all elements of brand and design, working in partnership with new CEO Marco Gobbetti, who takes responsibility of all commercial, operational and financial elements of the business. Current Burberry CFO Carol Fairweather will leave the business to pursue new opportunities. Burberry says she will help to manage the transition following Brown’s arrival and will step down from the board by the end of January 2017 before leaving the company at the end of the financial year. Brown previously worked at ICI and AstraZeneca, where she served as vice
president group finance, VP corporate strategy and ultimately, as interim CFO. She has a proven track record of delivering multi-billion pound cost saving and restructuring programmes in commercial, operations and R&D. She is also a non-executive director and the audit committee chair of Roche Holding. Commenting on her departure from Smith & Nephew, Brown said: “I am immensely proud of my time at Smith & Nephew and what we have achieved together. We have made significant progress with group optimisation and the finance transformation and delivered significant shareholder value. “I look forward to joining the board of Burberry and pursuing a new opportunity in my career.”
NorthEdge strengthens team with CFO appointment 1
NorthEdge Capital has appointed Prem Mohan Raj to chief financial officer as the firm continues to invest in its team and target more deals across the North. Prem joins NorthEdge – which manages £525m of private equity funds aimed at lower mid-market buy-out and development capital transactions – with more than 12 years of private equity experience. He joins from Livingbridge, where he worked in senior financial management positions, latterly as CFO, across a range of its funds, including its limited partnerships, Venture Capital Trusts and AIM quoted investments. Prior to that, he was CFO at real estate private equity firm Brockton Capital, having started his private equity career at Coller Capital. As CFO at NorthEdge, Prem will manage all aspects of the firm’s finances and the firm’s growing catalogue of portfolio companies. He will be responsible for driving NorthEdge’s financial strategy, delivering strong financial control to allow the firm to accelerate its growth plans. Dan Wright, chief operating officer at NorthEdge, said: “Prem has demonstrated an outstanding aptitude for financial management throughout his extensive career in private equity. He offers the operational and strategic excellence required to be a real asset to NorthEdge as we seek to continue our momentum and expand our portfolio.”
Laird CFO steps up to chief executive The chief financial officer of technology company Laird will take over as CEO when current boss David Lockwood leaves to join aerospace and defence business Cobham. Tony Quinlan, who joined Laird as CFO in July 2015, will take over on 5 September. Richard Harris, the current group financial controller, will assume Quinlan’s previous responsibilities as leader of the finance function on an interim basis, while Laird looks for a permanent successor. Laird said Quinlan has played a key part in the strategic direction of the group and has demonstrated strong leadership. Chairman Martin Read said Quinlan “has been very impressive since joining us and we believe he has the leadership skills and track record to take the business forward”. Lockwood joins Cobham after it recently recruited David Mellors as its new chief financial officer from rival engineering group QinetiQ. 4 | financialdirector.co.uk | September 2016
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Ubisense Group appoints Gingell as new CFO 2
Tim Gingell has taken over the role of chief financial officer at AIM-listed Ubisense Group. Gingell has worked at the company since February 2015, as interim CFO and company secretary since July 2015. He has over 25 years of commercial and financial experience across the software, wireless and telecoms industries, having qualified as a chartered accountant with Deloitte in London. Gingell holds a beneficial interest in 40,000 ordinary shares in the company, which represents approximately 0.1% of the company’s issued share capital.
G4S recruits new CFO from Petrofac 3
Security company G4S has named Tim Weller as its new chief financial officer, recruiting him from oilfield services business Petrofac. Weller, who has been a non-executive director of G4S since 2013, replaces Himanshu Raja as CFO, who steps down on 1 October. Weller will step down from the G4S audit committee with immediate effect. Weller was a partner at KPMG before gaining CFO positions at Innogy, RWE
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Thames Water, United Utilities Group and Cable and Wireless Worldwide. Ashley Almanza, G4S’s chief executive officer, said: “Tim is a highly accomplished executive with extensive commercial and financial experience in global businesses. “His experience and skill will be invaluable in leading our global finance team and supporting our broader transformation programme. It is greatly to our advantage that Tim arrives with an already deep understanding of G4S and our well established transformation programme.”
Ex-BA finance chief checks in at Aviva 4
One of the UK’s most experienced finance professionals is to join the board of Aviva. Keith Williams, the previous CFO, CEO and executive chairman of British Airways, will join the consumer financial services business as a non-executive. Williams began his career as an auditor at Arthur Andersen before working at Reckitt, Coleman, Apple and Boots. He also held major roles at BA/Iberia business International Consolidated Airlines Group. He will serve on Aviva’s audit, governance and nomination committees. “Keith helped transform British
Airways into a customer-focused organisation and his experience with technology companies helped BA embrace the internet revolution early in its development,” said Aviva chairman Sir Adrian Montague. “He will be a strong asset to the board and I very much look forward to working with him.” Williams won the 2010 Blue Chip FD of the Year at the Accountancy Age Awards.
Weir CFO lined up for top role in succession plan 5
A succession plan of FD-to-CEO has been maintained at FTSE 250 engineering group Weir, with Jon Stanton set to take the company’s reins. Current Weir chief executive Keith Cochrane is to step down in September after ten years on its board – where he first served as Weir’s group FD. Stanton took over from Cochrane in the finance role, and has worked closely with him on the strategic and operational aspects of the business – alongside his financial duties. Chairman Charles Berry said: “Jon has a strong track record both during his time at Weir and in his previous career and has developed a deep understanding of Weir’s culture, operations and markets. The board is confident that Jon will be highly successful as he leads the business forward.” September 2016 | financialdirector.co.uk | 5
CURRENT AFFAIRS HMRC CDIO quits
Mr Digital to provide a steady hand on the taxman’s tiller Sooraj Shah questions what a change in leadership will mean for the disentanglement of the Aspire contract and for HMRC’s digital strategy When Mark Dearnley revealed he would be leaving HMRC as chief digital and information officer (CDIO) next month, it came as a shock to anyone who had been following the organisation’s digital development. After all, Dearnley is leading the tax authority’s move away from the £800m-ayear Aspire contract, which is the largest single ICT contract in all of government. It is for this reason that MPs on the Public Accounts Committee (PAC) emphasised in its recent report on the Aspire contract the need for effective leadership. “HMRC now plans to take crucial decisions in 2018 on the long-term IT model it will operate from 2020,” the report said. “We remain concerned that HMRC may struggle to integrate different services from different providers. As we have seen from elsewhere in government, one of the main factors that determines the success of complex programmes such as this is the quality and stability of their leadership.” The committee had heard that HMRC was in negotiations with Dearnley about his contract which ends in September this year, with MP Richard Bacon stating that the department should ensure it kept him. HMRC chief executive Jon Thompson replied: “We all share the same aspiration.” But that aspiration didn’t lead to Dearnley staying, and just one week later, he revealed that he would be moving to the private sector. Mr Digital While this looks from the outset to be a damaging blow to the department’s ‘making tax digital’ strategy, Georgina O’Toole, an analyst at TechMarketView, 6 | financialdirector.co.uk | September 2016
believes it will not mean any change at all, and that HMRC will continue to work towards a digital tax system. “My understanding is that, in the interim, Mike Potter, who has been HMRC’s head of digital, will take Dearnley’s role,” she said. “While he may be a different type of operator, the fact that he is ‘Mr Digital’ – as one supplier described him to me – bodes well for the commitment to the strategy.” Although MPs may have wanted a leader to continue with the job they’re doing, O’Toole suggests that Dearnley may have thought of the organisation’s tasks in phases, and may have felt that he had achieved everything he had set out to achieve in the current ‘phase’ and that the next phase is better suited to someone with different skills. It must be noted that the committee did conclude that HMRC “is making progress in replacing the Aspire contract” – although that should of course be the minimum requirement. HMRC meanwhile, has said that it trusts the executive leadership team it has, and the external parties that it is using to ensure the programme will be a success.
A super-complex digital programme HMRC has to deal with a huge amount of complexity, involving staff changes and IT architecture changes, in addition to other legal, commercial and technical issues. The first task for Potter in the interim, or indeed Dearnley’s replacement in the long-term, will be to improve the quality of service it is providing taxpayers, which has been deteriorating because HMRC released too many staff too soon. The new digital leader will also have to figure out how to ensure customers use online methods of contact such as a digital tax account; HMRC has stated that this is the key risk it faces in personal tax services. As the PAC advised, HMRC also has to ensure that its plans to further digitise its services are sustainable (particularly in regards to the 34% reduction it expects to see in its personal tax department by 2020-21). Whoever does take over from Dearnley will have to give regular updates to the committee on HMRC’s progress, in what is still an extremely daunting task ahead. The digital tax account programme is an exemplar for other government departments, and therefore its importance cannot be understated. “Government can’t afford the digital tax account programme to fail. It is, arguably, the highest profile and most complex digital programme in the public sector today,” said O’Toole. “It needs to succeed otherwise other departments will use it as an excuse not to pursue their own more complex digital transformations. That wouldn’t be good for the public sector, suppliers or the taxpayer.”
Accountability CURRENT AFFAIRS
Will it be power to the people under May’s boardroom plan? The new prime minister wants to put employee and consumer representatives on company boards, but will it work? Richard Crump reports Theresa May began her campaign speech as home secretary, cracking down on big business and the privileged few, and ended it as prime minister. The decision by Andrea Leadsom to fall on her sword and bow out of the Conservative leadership race has given May’s comments about overhauling boardroom governance in the UK added potency. Launching her leadership campaign, the soon-to-be prime minister announced a policy to put employee and consumer representatives on company boards. Such a pledge would not sound out of place in a Labour leadership campaign. The plans are indeed radical, but have some precedent in Germany where companies such as Siemens operate an advisory board that consists of 50% of employee representatives. Under the German model – which is very different to the UK – there are two boards. The management board is comprised of company executives held accountable by a supervisory board made up of independent directors and employee representatives. Indeed, putting workers’ representatives on boards will give staff a greater sense of ownership but, for example, it could also distort how management approaches employee pay – with workers having conflicting priorities. Taking the example forward, boards must consider the best interests of the business across jurisdictions. If it is in the company’s best interests to move jobs to China, an employee representative in the UK would need to support job cuts among their own colleagues, which would place them in an unmanageable position.
The plans are not dissimilar from the model suggested by John Kotter, the emeritus professor at Harvard Business School. Kotter’s prescription, suggested in 2013, is that companies need two systems operating side by side – one for management and operations, and a second for formulating strategy. The idea behind the dual system is to reintroduce some of the conditions present when a business is in development mode, with a relatively flat structure in which everyone is happy to do anything and ideas come from all quarters. Binding shareholder votes May also wants to see annual shareholder votes on corporate pay packages binding, instead of advisory. This would go further than the measures introduced by former Liberal Democrat business secretary Vince Cable, which forced companies to hold a binding vote on prospective pay policy at least once every three years, and an annual advisory vote on the annual report on remuneration. A series of shareholder revolts against high pay earlier this year, including BP, Anglo American and Smith & Nephew, demonstrates that Cable’s measures have failed to curb excesses in executive pay. But government should be wary of further
intervention in the relationship between companies and shareholders and the pay awards of a few hundred senior executives. This particular issue should not be used as an excuse to complicate corporate governance engagement between companies and shareholders. Indeed, the recent BP remuneration awards to its executive directors were in line with a policy already approved by shareholders. The proposals raise some interesting questions about how big business should be governed. But as the German model demonstrates, at companies such as Volkswagen, employee representatives at board level are not always able to prevent failings of governance and instances of mutual back scratching.
September 2016 | financialdirector.co.uk | 7
VIDEO SPECIALS
The Next Generation of Finance with Oracle & IntelÂŽ
In conjunction with Oracle and Intel, Financial Director presents a series of videos on the next generation of finance. Click on the images to watch each video
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THE DIGITISATION DRIVER
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THE DATA HUNT
In the first of a series of Q&A videos on the Next Generation of Finance with Oracle and IntelÂŽ, Financial Director speaks with Oracle vice president finance (EMEA) Enzo Tolino about the digitisation of business and its implications for the finance function. In the second video, The Data Hunt, Tolino talks about how businesses can align key performance indicators with their value drivers.
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THE DATA FRAMEWORK
4 MODERNISING THE FINANCE FUNCTION
In the third of the series, The Data Framework, Tolino discusses the rigour needed in terms of data collection and analysis. And in the final part, Modernising the Finance Function, he talks about how digitisation has changed the traditional finance function. 8 | financialdirector.co.uk | September 2016
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GUEST COLUMN Nigel Chism
READ ALL OF OUR COLUMNISTS financialdirector.co.uk/opinion
A multi-faceted FD How can the finance function in a business with a broad variety of projects cope with the pressure placed on it?
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ompanies whose operations span a number of sectors and a broad variety of projects put immense demands on FDs and their supporting finance teams. How might they address some of the challenges that they face? Arrange appropriate funding For any FD in a multi-faceted business, ensuring adequate funding is a major challenge. Projects in different sectors, with varying timescales and a variety of funding sources require careful handling. While selffunded projects offer a degree of flexibility, invariably commercial development projects can result in additional and sometimes unexpected costs and so it’s important to have made provision for this or to have the flexibility in the funding to cover any such eventualities. PFI-type projects are largely funded by banks, typically with senior debt, though in some cases an element of subordinated debt will be included. Banks typically have very strict requirements and these also vary enormously from bank to bank. A further difficulty is that there are a limited number of banks that lend to such projects, where the timescale of the contracts can be up to 35 years. Standard areas include drawdown arrangements, repayment formulas, covenants, representations and default provisions. These can all vary from project to project too so it’s very challenging when you have a number of such projects running at the same time. Take a balanced approach to budgeting When it comes to planning a budget, working across sectors requires quite different approaches. Our commercial projects offer flexibility because the budget is based around how much we decide we want to spend, rather than having a budget stipulated to us. But such projects still have to be carefully budgeted for to ensure they come in on time and on cost.
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With PFI projects, which require far longer-term planning, over several decades, budgets must be accurate given the length of the contracts, the lack of flexibility to change terms and the need to meet a set schedule of payments. So there must be a tight focus on areas such as liquidity ratios to ensure that the contract requirements can be met. Fine-tune key to financial modelling Given the need to put a very accurate budget together at the start of a PFI-style project, having finely tuned financial models is key. Core inputs on costs, repayment conditions, fee schedules and all the other key input factors for the model must be carefully thought through as the long-term nature of such projects means there is little scope to vary terms once the project has started. Having within the finance team individuals who have financial modelling as a core strength is an important consideration. Managing cash flow is critical Cash flow is a critical issue both for the business as a whole and for the shorter-term commercial projects and longer-term PFI-style projects we undertake. Clearly the longerterm PFI projects require the most detailed cash flow management as there are contracted amounts that we must be paid each month, and it’s important to build reserves into any projects to withstand risk. ■
Nigel Chism is finance director of the UK arm of Japaneseowned global construction and property development company Kajima
READ ALL OF OUR COLUMNISTS financialdirector.co.uk/opinion
THE SECRET FD
Still running for gold Spare a thought for all the hard-working FDs that work hard to make Britain great
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o one can fail to be impressed by the success of Team GB at the Rio Olympics with their haul of 67 medals. No one gives much credit, though, to the Team GB of FDs working to sustain all those organisations in the non-profit sector in the face of its Olympic size challenges. The charity sector is overcrowded by a plethora of organisations of all sizes; many are poorly run, competing for scarce funds, and it is not sustainable. Many charities are characterised with issues that must give their FDs nightmares. The sector has suffered massive cuts in government funding after years of underinvestment, it is plagued by a duplication of services coupled with excessive competition for funding, and is constantly in the media for its latest sins. In addition, it has not yet worked out when and how Brexit will catch it out. The charity FD must unlearn many of the Generally Accepted Accounting Principles (GAAP) and financial norms. ‘Profit’ is a dirty word, ‘surplus’ may be used as a term but is actively discouraged as an outcome. ‘Income’ is the term used for ‘revenue’, initiatives to develop commercial income are referred to as ‘going on the dark side’, cashflow forecasts and balance sheets are as rare as Moroccan gold medals. Essential financial control is seen merely as an annoying overhead, finance staff recruitment is discouraged by the organisations, and impeded by the low salary levels on offer. Although a small number of UK charities are very successful and extremely well run, many others are suffering medium-term financial stress, and this is a sector-wide systemic issue. However, the usual response is for each charity to invent its own version of the dreaded ‘change programme’. These can become hilariously complex, bogged down by the sector norm of excess governance, and are typically underfunded and poorly staffed. They tend to be focused internally, achieving cost efficiencies, and developing fundraising and commercial income streams. However, very few charities possess the necessary commercial skills to
exploit their brands and to compete effectively with anyone at all, and most charities preserve their costly pet projects. Significantly, these organisations are each acting in splendid isolation from each other. They need to work together. Joint bidding for commissioned services; prime contractor/ sub-contractor arrangements can be negotiated so national markets can be accessed more efficiently. Arrangements can be made to merge back-office services, and small charities that compete in local areas can be mopped up by acquisition. The FD can take a lead in this. Mergers and acquisitions are very different here than in the private sector. There are no shareholders nor equity capital, but the multiplicity of stakeholders each with their own agendas and obvious limitations makes any deal almost impossible to negotiate. The challenge for the charity FD is to ensure the organisation is focused on financial imperatives, turning its managers into budget holders who accept financial responsibility, challenging the economic viability of all its projects, helping to develop income streams, and taking more of a private-sector FD stance. Sadly, even achieving gold medal success is only a small victory for the charity FD as it does little more than to ‘buy time’ because the solution to the financial stress lies in addressing the inefficiency across the wider sector. It may take too long to catch up with the winning teams from the private sector. ■
Last month the SFD was in Singapore which is such a model of efficiency that even the rain was reliably on time … between 4pm and 5pm every single day
September 2016 | financialdirector.co.uk | 11
FEATURE Brexit special
Forever friends? Christian Doherty looks at the impact Brexit will have on trade relationships and supply chains
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eeping up with the latest surveys of business confidence post-Brexit is a fool’s errand: every day brings a fresh set of barometer readings from across the economy, many of which seem to contradict the last. While the more hyperbolic ‘apocalypse now’ scenario painted in the immediate aftermath of the vote appears to have evaporated, there is no doubt many firms remain unclear on what comes next. For what it’s worth, various bodies – from the CBI and BCC to sector groups – have come out with their wishlist of Brexit measures. Top of most lists was simple: retaining the benefits and ease of UK-EU trade that businesses gain from the Single Market, while assuaging political concerns that the big Brexiteer ambition – curtailing
unfettered immigration – is delivered to the satisfaction of the 52%. Achieving that, of course, won’t be easy. For now, the experts are largely prescribing similar medicine: avoid knee-jerk reactions, review scenario plans, consider new opportunities, form crossfunctional teams and open dialogue with suppliers, customers and other partners. Lisa Callinan, research director at Gartner, says that many companies have put major investments on hold until trade agreements are known, as they face up to the need to formulate plans for a postBrexit future. “Of course there’s no doubt that the financial and services industry makes up over 80% of UK GDP, so it is likely to have a very strong lobbying influence,”
she says. “And the industry will strongly favour retaining access to free market and financial passporting rights along with free movement of people.” Whatever the plan, she says, FDs will need to consider a range of factors: • Border controls: Potential increase in admin and costs for customs clearance activities as well as delays in the physical movement of goods. • Network design: Little change for companies that already have centralised hub and spoke distribution located on mainland Europe. • Capability development and resourcing: Begin thinking about how customs clearance processes will be managed as part of scenario planning. • Evaluate the potential impact on human resources and access to talent as part of scenario planning. Eliot Wells, FD at MLM, a £30m turnover multi-disciplinary engineering and construction consultancy, says that, so far, reaction has been mixed. “We had seen a slow down in decision-making in the build-
Japan’s business Brexit demands Japan’s government has warned that Brexit could result in the country’s firms moving their European head offices out of the UK. Request to the UK and EU 1. Maintenance of the current tariff rates and customs clearance procedures 2. Introduction of provisions for cumulative rules of origin 3. Maintenance of the access to workers who are nationals of the UK or the EU 4. Maintenance of the freedom of establishment and the provision of financial services, including the “single passport” system 5. Maintenance of the freedom of crossborder investment and the provision of services as well as the free movement of capital, including that between associated companies 6. Maintenance of the current level of
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information protection and the free transfer of data 7. Unified protection of intellectual property rights 8. Maintenance of harmonisation of the regulations and standards between the UK and the EU (including the maintenance of established frameworks of mutual recognition and equivalence) 9. Securing the UK’s function as a clearing centre for the euro and the location within the UK of EU agencies such as the European Medicines Agency 10. Maintenance of the UK’s access to the EU budget for research and development and participation in the Japan-EU joint research project Requests to the UK 11. Liberalisation of trade in goods without the burdens of customs duties and procedures
12. Maintenance of access to workers with the necessary skills 13. Maintenance of basic policies regarding the entry of foreign capital 14. Implementation of measures to promote investment 15. Maintenance of the current levels of information protection and the free transfer of data in case the UK establishes its own legislation distinct from the EU’s 16. Ensuring the consistency of regulations and standards between the UK and the EU 17. Ensuring that the EU’s research and development budget applies to research institutions in the UK Requests to the EU 18. Provision of transitional arrangements for the single passporting system
Trade deals – the five possibilities in a nutshell 1. EEA + EFTA UK could join both and enjoy full access to the single market, provided it accepts EU regulations and standards. Example: Norway, Iceland Sticking point: free movement of labour, if not people, is an intrinsic part of EEA
up three months prior to the vote in any case,” he says, admitting that he, like many others, had not anticipated the Leave result. “Post-Brexit, some jobs have gone on hold and some have deliberately been slowed down by clients/investors. The level of new opportunities has been strong though – at the moment we don’t know if that is due to our extra marketing efforts pre/post-Brexit or the market in general.” A few simple steps That uncertainty is reflected across the UK, but Rick Cudworth, who heads up Deloitte’s Brexit Centre, says FDs can begin to assuage some of that by taking a few simple steps. “We recommend using a WTO scenario for impact analysis and planning purposes,” he says. “This reflects the most potential business change if there is a ‘hard landing’ and will help FDs understand the key issues and when you may need to make decisions. On this basis, the key questions businesses should be asking are: • What would I need to do to either maintain a right of access to the market, or maintain profitable access to the market? This should include looking at key investment decisions that maybe looming. • If I need to make changes, at what points will I need to take key decisions and how sensitive are these to other scenarios? • What information will I need to help make the best informed decisions at the time?”
But there’s no doubt that whatever concessions the UK’s negotiators manage to secure, structurally the UK will face challenges. The country is not in the ideal geographical position to be an attractive proposition for centralising inventory for Pan-European supply, for instance. In addition, the result will almost certainly mean added logistics complexity as companies spend months disentangling supply chains, with many perhaps opting instead for EU-specific supply chains alongside separate ones for non-EU countries. Alongside that there is also the question of duties for UK-manufactured and EU-manufactured goods, and how these duties will be applied. For Wells, the focus is now on the medium to long term. “As the FD of a growing profitable business, I need to ensure the mix of operational and strategic decisions of the business to ensure the best outcome for stakeholders in the short medium and long term,” he says. “One area we are keeping a close eye on is Ireland. We currently have a small office in Dublin and may look to expand there to maximise our EU presence and enhance the possible relationships with some of the large multinationals that have offices there.” Cudworth agrees that no options should be off the table. “The key now is to have looked at this in a robust and measured way so that you have a clear plan where needed and are able to communicate this to relevant stakeholders,” he says. “This
2. Customs Union Goods travel tariff-free between UK and EU. Example: Turkey Sticking point: Many areas of the economy – notably financial services – unlikely to be covered 3. Bilateral accords + EFTA UK agrees trade deals for each sector, free of many EU regulations currently in place Example: Switzerland Sticking point: Not full access to single market 4. FTA One deal to rule them all, with a single comprehensive treaty covering all areas of UK-EU trade Example: Mexico-EU currently share this arrangement Sticking point: Any access to single market likely offset by close political ties – and movement of people – remaining in place 5. WTO The default option – no need for negotiations as UK and EU revert to basic WTO rules Example: China Sticking point: UK leverage is decreased by acting solo
will in turn increase confidence and enable decisions to be taken at the right time. “Simply saying ‘I’ll wait and see’ isn’t the best answer.” ■ September 2016 | financialdirector.co.uk | 13
FEATURE Brexit special
Building projects up in the air
T
he unexpected vote to leave the European Union has cast a shadow over the outlook for Britain’s infrastructure industry, just as it was recovering from the economic shocks of the global financial crisis and eurozone debt debacle, and looked set to embark on a series of projects that would reverse decades of under-investment. In March the National Infrastructure Plan (NIP) set out £483bn of investment in more than 600 infrastructure projects and programmes in all sectors and spread across the UK. The vision includes the “big ticket” items such as High Speed 2 from London to the north, Crossrail 2 in the capital, the Thames Tideway tunnel, and the new runway for the Southeast. On top of that is the £18bn Hinkley Point C nuclear power station. Immediate impact The impact of Brexit was visible immediately after the vote: the decision on siting a runway at Heathrow or Gatwick that had been scheduled for July was delayed until at least October. However, Brexit will have more longer-term impacts because of increased uncertainty as the UK and the EU agree new trading relationships. A survey of infrastructure investors in the UK by S&P Global Ratings found 71% believed Brexit would halt investment for two years or more after the vote. One key concern was that the negative impact on economic growth in the UK would make investors less keen to commit to the long-term funding needed for infrastructure projects. Julia Prescott, chief strategy officer at Meridian, a private equity firm specialising in infrastructure assets, points out the NIP assumed half the funding for projects would come from private finance. 14 | financialdirector.co.uk | Month 2013
“There are fairly significant concerns that global investors will not be as enthused by investing in the UK as they were before,” she says. “The movements of sterling [since the vote] is clearly indicative of the sorts of risks those investors will face.” Prescott says it is important to start a dialogue with UK institutional investors about taking up some of the slack if overseas investors pull back. “There hasn’t been sufficient engagement to get them involved at an early enough stage,” she says. Skilled workers A key element of that funding mix is money from the EU. The UK receives £1.8bn a year of structural grants from Brussels. UK projects also benefit from loans from the European Investment Bank, which is owned by EU member states and which funds major infrastructure projects. Last year, the EIB invested €7.8bn in the UK. Another worry is access to skilled labour from other EU countries who make up between 20% and 30% of the UK construction workforce. Tony Meggs, chief executive of the Infrastructure and Projects Authority, which published the NIP, says the culture has changed in the wake of the vote.
“One of the biggest risks is that these extraordinarily skilled and hard-working people will be put off by the climate and tone that has appeared in some parts of the country,” he told the City & Financials Annual UK Infrastructure Policy Summit a fortnight after the vote. Projects in the pipeline will require 400,000 workers, according to the Institution of Chartered Engineers. Its president, Sir John Armitt, warns a lack of skilled workers could cause delays. “They could certainly become more expensive,” he says. “We want to see certainty around these issues as soon as possible. Free movement of people is very important. There will be gaps in the future of infrastructure without very close relationships with Europe.” According to Sir Merrick Cockell, chairman of the Municipal Bonds Agency, which issues bonds to finance local authority projects, investment is needed urgently to address shortfalls in infrastructure that may have contributed to the Leave vote. “Infrastructure investment – or the lack of it in the constituencies in which they live – has proved to be of a great concern to the UK electorate,” he says. “It is not surprising that many of the constituencies where the Leave vote was most popular are also the communities most in need of investment who feel they have been missed over the years.” He cites two council leaders from Cumbria who intervened in a conference on HS2 to say their voters wanted “any speed rail”. “They didn’t feel they’d had a fair share,” he says. “It is more important than ever that investment in infrastructure is maintained but it is vital that we create the capacity to meet the country’s infrastructure needs that may be different from when we were part of the EU.” ■
Photo: Hugh Llewelyn/Flickr
The impact of Brexit on the infrastructure industry was immediately visible. Phil Thornton examines the impacts on investment and what it means for business
VAT’s your lot Nicholas Hallam looks at how an exit from the EU could affect the UK VAT rate
I
n late 2013 – that prehistoric era when Brexit was largely considered the unachievable fantasy of a few political obsessives – I wrote and asked Daniel Hannan, Conservative MEP and long-term campaigner against the UK’s membership of the EU, what he thought about the prospects for the European Commission’s then dream for EU VAT harmonisation: the Single European VAT Return (now mothballed). In a thoughtful and skeptical response, Hannan mentioned something I did not know: that VAT was treated as part of the EC’s ‘own resources’. As a matter of European law, a proportion of the VAT take from all member states goes directly to Brussels. He further commented: “The commission clings hungrily to VAT as, first, its one sure source of independent income and, second, the only successful example so far of the tax harmonisation that it now wants to extend across the board.” To Hannan, the EU’s VAT policy was a typical instance of the relentless undemocratic grab by European institutions at controls and resources that were rightly the property of sovereign nation states. And he had an obvious point: how many voters were even aware that tax was being collected from them in this manner? Nevertheless, at the time, and even reflecting on it later, it seemed relatively abstruse; and, like other jurisprudential and technical-fiscal based objections to the EU raised in the runup to the referendum, unlikely to have a major impact on the UK public’s consciousness. Hardly anyone would know the detail of the VAT issue; and, as far as the broader principles were concerned, did the population of the UK really care about the mechanical displacement of the English common law by the rationalist idealogues of the EC? Surely it did not. Project Fear would win, because it always did. In the (perhaps now
discredited) piece of received wisdom: “It’s the economy, stupid.” The Leave campaign narrative was that it was only because of EU that we need to have VAT on fuel at all; it was yet another arbitrary, costly, debilitating encumbrance. This may be true today; the EU does indeed demand a minimum 5% VAT charge on energy as a condition of membership. But, as the journalist Tom Goodenough detailed in a piece on the controversy, the reason why the UK has any VAT on energy at all is that a Conservative chancellor, Norman Lamont, decided in 1994 to unilaterally abandon (under no pressure from Brussels) the UK’s zero rate on fuel. Indeed, Lamont attempted to bring in VAT on fuel at the then standard rate of 17.5%. An 8% reduced rate was actually adopted and it was Gordon Brown that eventually reduced it to the current 5%. Nevertheless, Hannan, now famous for being one of the leaders of the UK’s biggest political upset since Churchill’s defeat in 1945, is not willing to accept the analysis of the vanquished Remainers. In a Spectator piece last week, he attacked the presumption that Leave voters were motivated by anger and prejudice. Against the various theories offered
by pundits, we have one massive data set. On polling day, Lord Ashcroft’s field workers asked 12,369 people why they had just voted as they had. The answer was unequivocal. By far the biggest motivation for Leave voters was ‘the principle that decisions about the UK should be taken in the UK’, with 49% support. Control of immigration was a distant second on 33%. His remarks gave me pause; not least because I saw them on the same day a colleague alerted me to the existence of The French VAT System and Revenue Efficiency, an ‘economic brief ’ released by the European Commission in July. The brief is essentially a long, polite scolding for France, the country’s particularly offensive misdemeanor being persisting with reduced VAT rates in sensitive sectors, such as the restaurant trade. No doubt the authors mean well; they always do. It appears to be simply incomprehensible to them that cultural differences (this is France they are talking about, the home of cuisine itself ) should stand in the way of uniform tax efficiency. But the timing is astonishing, as is the general deafness to the surrounding political context, and the lack of transparency about beneficiaries of the proposed reforms: at no point, for example, is it mentioned that VAT contributes to the Commission’s ‘own resources’. Indeed, the brief ’s most revealing and blackly humorous line is in the legal notice that serves as an introduction: “This paper exists in English only.” Having left the EU, the UK will no longer have any say in the indirect tax policy of its largest trading partner. Depending on the economic weather, that may become a source of regret; it will certainly increase complexity for outward bound British firms. But, if the EC cannot adapt itself to the actualities of the remaining member states, it cannot be long before the UK has company on its journey outside the EU. ■ Nicholas Hallam is chief executive of VAT consultancy Accordancee
September 2016 | financialdirector.co.uk | 15
FEATURE Brexit special
The bottom line Six ways Brexit will impact firms’ financial statements
F
ollowing the referendum vote for the UK to leave the EU and the consequential uncertainties in the political and economic environment, the FRC has highlighted the things directors should consider when preparing their forthcoming half-yearly and annual financial reports.
1
BUSINESS MODEL The FRC encourages clear disclosure of a company’s business model as part of the strategic report, including a description of the main markets in which the company operates and its value chain. The disclosure should be sufficient to enable readers to make an assessment of the company’s exposure arising from the outcome of the referendum.
2
PRINCIPAL RISKS AND UNCERTAINTIES Directors must consider the nature and extent of risks and uncertainties arising from the result of the referendum and the impact on the future performance and position of the business. These may also have an impact on reported amounts which could lead to further consequences such as an effect on debt covenants. Those which the board judges to be principal risks and uncertainties must be disclosed and explained in the company’s interim management or strategic report. The outcome of the referendum may give rise to general macro-economic risks or uncertainties that affect all companies as well as those risks that are specific to a particular company or industry sector. Care should be taken to avoid ‘boilerplate’ disclosures. Company specific disclosures are more informative and useful to investors; for example, the impact of trade agreements for companies with a high level of exports to Europe. The FRC attaches great importance
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to clear and concise reporting, and any risks and uncertainties that are disclosed should enable the reader to understand how those risks and uncertainties are relevant given the specific facts and circumstances of the company. We would also expect boards to provide an explanation of any steps that they are taking to manage or mitigate those risks. As part of the assessment of principal risks and uncertainties, boards should consider whether the referendum vote gives rise to solvency, liquidity or other risks that may threaten the long-term viability of the business; and any implications for the viability statement in the annual report.
3
MARKET VOLATILITY The volatility in the markets following the referendum result may have an impact on balance sheet values at 30 June 2016 or at subsequent reporting dates. For example, financial instruments measured at fair value and discount rates used in measuring pension and other liabilities may be affected by changes in foreign exchange rates, interest rates or market prices. Cash flows included in future forecasts may need to be reevaluated. In respect of foreign exchange risk, the board may wish to consider the potential gains or losses arising from transactions in foreign currencies; for example, the impact on future earnings as a consequence of the decline in the value of sterling for non-UK sales. The FRC encourages directors to consider whether assets may be impaired and/or disclosures made consistent with the requirements of IAS 36 Impairment of Assets, IAS 39 Financial Instruments: Recognition and Measurement and IFRS 7 Financial Instruments: Disclosures. They may need to consider the continued recognition
of deferred tax assets. Attention should also be given to the nature and extent of sensitivity disclosures required by IAS 1 Presentation of Financial Statements that support estimates in the annual financial statements where due to volatility, in the short term, ranges may be wider. Boards should also consider the disclosure of events after the reporting period that have not been adjusted in the financial statements. Examples of such events include abnormally large changes in asset prices or foreign exchange rates.
4
GOING CONCERN BASIS OF ACCOUNTING As part of the preparation of the financial statements, directors must consider whether the going concern basis of accounting is appropriate and whether disclosures of material uncertainties are needed, particularly where there is a material risk of breach of covenants. Further guidance on the application of the going concern basis of accounting is included in the FRC’s Guidance on Risk Management, Internal Control and Related Financial and Business Reporting and the FRC’s Guidance on the Going Concern Basis of Accounting and Reporting on Solvency and Liquidity Risks.
5
TRUE AND FAIR There is an overarching requirement for annual financial statements and half-yearly reports of listed issuers to give a true and fair view. We encourage directors to consider whether additional disclosures are necessary to ensure that this requirement is met.
6
HALF-YEARLY FINANCIAL REPORTS There is a general requirement that the interim management report of listed companies must include disclosure of important events that have occurred during the first six months of the financial year, and an indication of their impact on the interim financial statements. ■
Keeping on the books EU accounting and taxation legislation may not apply in the UK as the PM declares ‘Brexit means Brexit’
W
ith new UK prime minister Theresa May apparently determined to fulfil the wishes of the Brexit referendum result backing the UK leaving the European Union, which EU accounting and taxation laws will ultimately remain on the British statute? The PM has made it clear she recognises that a key force behind the ‘leave’ vote was a dislike of unrestricted EU immigration into the UK, and should she satisfy that demand, the prospect of the UK becoming a nonEU member of the European Economic Area (EEA) will become most unlikely. Non-EU EEA states such as Norway and Iceland have to accept EU immigration (with some recourse to emergency controls in cases of social unrest) in return for admission to the EU single market for industrial goods and services, which of course includes accountancy. No such admission to the EU single market for services exists for Switzerland, which retains strong links with the EU, but which is also mulling EU immigration controls. So single market laws laying down rules on accounting, bookkeeping and company formation may not apply in the UK – assuming it will quit the EU – which could well happen within 2019 under the EU’s Article 50 schedule for departing member states. Of course, with more than 23,000 EU laws currently in force, there is every chance that the UK will not immediately change how European accounting and tax legislation applies in Britain once it formally leaves the bloc. But from that point onwards, it will be able to amend or unpick such legislation, without being hauled before the European Court of Justice (ECJ). So
accountants will need to keep a close eye on UK legislation and watch carefully for how it might conflict with EU laws, especially when serving corporate clients working in or selling into remaining EU member states. There may well be additional compliance demands. Accounting law As it stands, there is a comprehensive slew of EU accounting and company law legislation impacting on how accountants work that may come up for review. This includes directive 2013/34/ EU on annual financial statements, consolidated financial statements and related reports; directive 2009/101/ EC on the disclosure of company documents and company obligations; directive 2012/30/EU on forming public limited liability companies, maintaining and altering their capital; directive 89/666/EEC on disclosure requirements for foreign branches of companies; directive 2011/35/EU on mergers between public limited liability companies; and much more. The same applies to the critically important EU international accounting standards regulation (1606/2002/EC) and the related law on consolidated
standards and interpretations (1126/2008/EC). That said, given UK support for international financial reporting standards (IFRS), it is hard to imagine Britain EU taxation legislation departing from the IFRS gospel preached across Europe. Tax law EU taxation legislation would most certainly be reviewed, however. It would cease to apply automatically even if the UK joined the EEA, and tax law is where Britain might be most inclined to contrast itself from the EU, seeking competitive advantages with its former partners. EU VAT directives insisting that standard VAT rates must be at least 15% and reduced rates be at least 5% would no longer be in force. Legislation on harmonising excise duties would most certainly be under review. The EU’s proposed gold plating OECD model within the proposed directive on BEPS (base erosion and profit shifting) may not be introduced for UK registered companies. And the EU’s proposed law mandating financial transaction taxes would almost certainly never apply in Britain. Employment law Another key impact of a Brexit could be on employment law and especially the ability of accountants to move jobs and practices within the EU’s 27 remaining member states, should the UK leave. At present, under the EU’s professional qualifications directive (2005/36/EC), EU accountants wanting to work in different member states have to undergo top-up training, to learn skills required specifically by their destination country. But they do not have knowledge retested when it is required both in their home and new country’s accounting qualifications. If the UK leaves the EU, such wholesale recognition would be gone, and UK accountants may have to pass more examinations to practice in a sunnier country to the south, or a wealthier country, such as Germany. ■ September 2016 | financialdirector.co.uk | 17
FEATURE Brexit: pensions
Getting the heebie DBs
Anthony Harrington examines the actions trustees and sponsors of defined benefit pension schemes should take in response to Brexit
O
n 4 August the governor of the Bank of England, Mark Carney, cut the bank’s base rate to 0.25% and launched a massive stimulus package to counter what he said were clear signs that the Brexit vote was already having a negative impact on the UK economy. Irrespective of how one feels about the respective merits of being in or out of the European Union, Brexit looks, over both the short and the medium term, to be bad news for UK defined benefit pension schemes. For a start, there are two obvious negatives that are likely to increase DB scheme deficits for the next year or two at least. First, as the Bank of England demonstrated in spades with its rate cut, the low interest rate environment looks set to persist for a long while yet. Second, markets hate uncertainty and the one sure and certain fact about Brexit is that it is going to take at least two years and possibly longer for the terms of the exit to become clear. So we are in for a protracted period of low base rates and heightened uncertainty and market volatility. What should trustees and scheme sponsors do? The question then is what should trustees and scheme sponsors do in response to Brexit? Mark Jones, a director in Deloitte’s pensions advisory services practice, says that the best advice for both is to work together to plan a middle road between the two extremes of doing nothing and leaping into a hugely defensive investment strategy. “What is needed is a measured action plan,” he says. However, it will be a ‘measured action plan’ set against an unfavourable economic backdrop. There is no doubt that depressed gilt yields – a
18 | financialdirector.co.uk | September 2016
£900bn £820bn
UK defined benefit pension scheme deficit before Brexit UK defined benefit pension scheme deficit after Brexit
natural result of the low base rate regime around the world – magnify deficits by reducing the discount rate on scheme liabilities. At the same time, substantial uncertainty in the markets is likely to depress asset values (though at the time of writing markets were at or near alltime highs). As a result, schemes could be looking at a double whammy of elevated liabilities and depressed asset values. This is not a happy position for scheme sponsors, some of whom could soon be facing calls for additional chunks of funding to help shore up their DB schemes. Post-Brexit investment strategy Jones argues that it is important for trustees and finance directors to look beyond the scary headlines. They need to look specifically at how their particular scheme is being impacted. “Schemes that have been quite heavily de-risked already have probably not seen a significant decrease in their deficit
since Brexit,” he notes. Raj Mody, partner and head of pensions at PwC agrees. “The fundamental point here is that despite all the headlines, Brexit has not yet happened and it has not yet been defined. So you need to take stock and not over-react,” he cautions. Interestingly, Mody argues that the furore around Brexit provides yet another reason for trustees and sponsors to move away from the practice of valuing their scheme liabilities by reference to gilt yields. “If you are planning to have all your scheme assets in gilts as your end game for the scheme, or if you are planning a buyout, then sure, the discount rate is relevant,” he says. “But if you are planning to run your scheme off your own books, then I would really question its relevance. You need to work out what measure is right for your scheme.” Portfolio of assets The key point here is that IAS 19 prescribes the discount rate that schemes need to use, but the cash financing deficit that finance directors need to agree with their scheme trustees is not prescribed. This should be the measure of the deficit that is strategically right for that particular scheme’s overall investment strategy. In those circumstances, Brexit notwithstanding, it could make more sense to construct a liability-matched portfolio of assets that may well have a cashflow basis, with the cash coming from a variety of asset classes. What is certain is that both sides, trustees and finance directors, need to sit down with their advisors and work out a carefully thought through strategy to deal with the new dynamic imposed by Brexit. ■
The five pension ailments being felt by FDs today. And how to treat them. If Defined Benefit (DB) pension schemes were likened to the human
cannot quantify their risks are in danger of facing
lifespan, they are entering their middle-age. For most, the features of youth are gone – contribution holidays, equity-laden investment
unexpected challenges.
strategies, and double-digit interest rates. The majority of schemes have still not reached old age, though, when they hope to enjoy manageable risks – or to have transferred these to the care of a third party. Financial directors with responsibility for DB schemes therefore have to manage this tricky ‘mid-life’ transition – often typified by a desire to reduce risk while not increasing cost. The concept of a regular ‘health-check’ will be familiar to many readers (who like the schemes that they are responsible for, may well be in this transitional period!). Such a health-check might identify and precipitate actions to maintain or improve the well-being of the individual - eating more healthily, exercising more, or quitting smoking. We believe a useful parallel can be drawn with pension schemes from our experience with finance professionals, we have identified five common ailments faced by schemes, as well as possible treatments: 1. Increasing cash contributions Many sponsors still measure the burden of their scheme as the amount of money tied up in it, often at the request of the trustees. Symptoms of this ailment include increases or volatility in contributions, which in turn can limit the sponsor’s ability to invest elsewhere or pay dividends. We only expect these symptoms to worsen in the short term, as the current market environment causes deficits to balloon for many schemes. Possible treatments: • Take independent corporate actuarial valuation advice • Consider alternative financing arrangements • Review your scheme design to ensure it is still appropriate 2. Operational inefficiency Ongoing running costs are also an issue for many, concerned by inefficiency in scheme design or governance, trustees’ ability to make timely decisions when meetings may be infrequent, or the lack of a long-term strategic business plan. Possible treatments: • Explore alternative operating models to reduce running costs – for instance, delegation of routine or compliance matters • Support trustees to elevate their position to a more strategic role • Take Aon’s Governance Challenge - a quick self-assessment enabling schemes to measure their operational effectiveness 3. Risk exposure Many sponsors are concerned about the level of risks in their scheme, and how this can be monitored and optimised - these may be financial, demographic, legislative or reputational. Schemes that
Possible treatments: • Introduce effective risk monitoring. Aon’s Risk Analyzer is a tool used by over 600 schemes to measure their funding position and to track a range of related metrics • Stress-test your scheme to get an accurate picture of your risk tolerance • Explore the liability management and risk transfer exercises available 4. Accounting problems The disclosure of pension scheme information often makes corporate accounting very important. Any volatility in P&L or balance sheet can have negative implications for share price, dividends or reward policies. Conversely, it may also lead to the risk of balance sheet asset restrictions. Possible treatments: • Take accounting advice from a firm which is familiar with current market practices and can review your approach and benchmark against your peers • Use a daily tracking tool – like Risk Analyzer – to forecast results, including the impact of changing assumptions or taking any planned actions • Look at alternative financing, like escrow or a Pensions Stability Buffer, to reduce the risk of trapped surplus 5. Sub-optimal investment strategy Although investment responsibility ultimately sits with trustees, many sponsors could be more proactive in agreeing an optimal strategy. If you have concerns about the efficiency of your scheme’s strategy, you could benefit from becoming more actively involved. Possible treatments: • Ask an investment advisor to carry out an independent scheme review • Ensure all stakeholders’ views are understood, and that the scheme’s strategy reflects these views • Explore the potential of full or partial delegation (fiduciary management) to speed up and add expertise to the investment decision-making process If you recognise any of these symptoms (or are keen to avoid them in the future), hopefully the suggested treatments have given you some actions to consider. For more information, why not take advantage of Aon’s free DB health-check service, which will give you a greater understanding of your scheme’s ailments and how you might address them. You can take the health-check here. Matthew Arends is a Partner at Aon Hewitt.
FEATURE Pensions
Shifting the blame The cut to interest rates and the denouncing of business for running pension deficits are two sides of the same newly minted coin, writes Flybe chairman Simon Laffin
S
o the Bank of England has cut interest rates again, to 0.25%, as “the outlook for growth in the short to medium term has weakened markedly”. It is also pumping £70bn new money into the financial sector, that is ‘monetary easing’ or ‘printing money’. Meanwhile, the government is denouncing businesses for running deficits on their pension schemes. These two events, apparently unconnected, are very much two sides of the same newly minted coin. The last two governments, led by the Conservatives, have presided over a weak economy recovering from the financial crisis, arguing that the prime economic problem has been the budget deficit, necessitating cuts to government expenditure. They have left it to the Bank of England to boost the economy, by lowering interest rates and printing money. But monetary easing has had only limited impact. If people or businesses are worried about the future, and indeed the impact of government expenditure cuts, they won’t necessarily spend more, whatever the cost of debt. As the economy therefore grew more slowly than forecast, and consequently tax revenues languished, the budget deficit remained stubbornly high. Meanwhile the Bank of England has had to cut interest rates even further and pump even more money into the economy. The logic is to end up at zero interest rates, perhaps not so far away now. Dogma, not economics Even the Bank of England has now admitted that its monetary expansion is having limited effect. Explaining the recent fall in growth estimates, it admits: “Much of this reflects a downward 20 | financialdirector.co.uk | September 2016
revision to potential supply that monetary policy cannot offset.” Recent governments have refused to use their fiscal armoury to boost the economy, because of the supposed need to reduce the fiscal deficit. “You cannot spend beyond your means,” they still say. That is dogma, not economics. Of course you can – by borrowing. If you use that spend to boost the economy, the increased growth and jobs will provide the tax revenue to pay back that debt. How different is this really to printing an extra £70bn new money? Actually, it is a lot different. If the government boosted the economy by increasing infrastructure spend or increased NHS funding, there would be an immediate boost to jobs and investment. With 10-year gilts now at 0.6%, it wouldn’t take much of a return on infrastructure investment to deliver a positive project benefit, even aside from the general economic boost. Increased NHS funding would deliver significant social benefits, as well as reducing sickness. On the other hand, low interest
rates have reduced mortgage costs and so pushed up house prices. High house prices may make the middle class feel good, but do nothing for the economy. In fact, their main result is to transfer wealth from younger, firsttime buyers and renters to their parents and grandparents. This stealth wealth redistribution is no different to raising taxes on the young and the less well off, and then giving tax breaks to the middle class, except that the government then describes the resulting reduction in home ownership as a crisis, which it blames on house builders and buy-to-let landlords. The other big losers are company pension schemes. Longer life expectancy and recent poor investment returns have increased pension deficits. But so have low interest rates. Not only do they reduce expected returns on pension investments but, in a double whammy, they also reduce the discount rate on pension liabilities. Has the government admitted its role in the pensions crisis? No, it has condemned companies struggling to pay ever-higher contributions to largely closed legacy schemes. Governments prefer monetary expansion over fiscal stimulus, partly because it enables them to blame others for the consequences. Printing money and reducing interest rates are down to the independent Bank of England. Fiscal deficits are the fault of the dim and distant Labour administration. The housing crisis is due to land-banking house builders, greedy landlords and banks not lending. Struggling pension schemes are due to corporate greed and governance failures. ■ Simon Laffin’s views are his own and not those of Flybe
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FEATURE CFO Agenda
It’s good to talk Financial Director hosted the second CFO Agenda in June. Here’s what we learnt from a day of keynote speeches and panel debates
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INCREASED AND REGULAR COMMUNICATION CAN HELP IMPROVE MANAGEMENT OF CHANGE David Tilston, former chief financial officer of Innovia Group shared practical examples of managing change throughout his career. He said that one of the key takeaways from his time at WS Atkins was the importance of increased and regular communication between the divisional FDs in starting to break down barriers. The sharing of knowledge helped to solve problems in other divisions to the benefit of the whole company.
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BREXITEERS AREN’T AGREED ON THE RELATIONSHIP THEY WANT WITH THE EU Speaking as part of a panel discussion looking at the consequences of Brexit, Professor Vernon Bogdanor, research professor at the Institute of Contemporary British History, King’s College, London said: “The difficulty is the Brexiteers aren’t agreed on the relationship they want with the EU.”
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GOOD LONG-TERM CORPORATE GOVERNANCE WILL BE VITAL, FOLLOWING THE RESULT OF THE UK’S EU REFERENDUM In his keynote speech, former chancellor Alistair Darling noted: “I think you are going to need some good corporate governance over the next few years. This is a time when if problems are going to start re-emerging it’s going to be when the economy slows down. And that’s why the best leadership that boards can demonstrate is ensure their own organisations are properly run and they are alive to the issues to which they may become exposed.” The importance of corporate governance was backed by David Styles, director of corporate governance at the Financial Reporting Council, a panellist for the Corporate culture – an abstract concept for CFOs debate, who said: “Good governance underpins good culture at an organisation.”
22 | financialdirector.co.uk | September 2016
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THINK FOR YOURSELF – AND YOUR COMPANY In times of uncertainty, particularly prevalent with the outcome of the EU referendum, it can often fall to the CFO to help to maintain focus. CFOs can be in a position to help the ship steer forwards if they can continue to help their board understand how to navigate their market. Remaining focused and aware of external and internal risks as a CFO was reinforced by Alistair Darling, who said: “It’s terribly important that every organisation – especially when you’re under stress and strain – is alive to the risks; the one thing that will add to the general fear that everything’s not right will be when we start seeing failures in banks across Europe or companies.”
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TCUP: THINKING CORRECTLY UNDER PRESSURE Rugby World Cup-winning coach Sir Clive Woodward’s leadership philosophy is instilled in the acronym TCUP, or ‘Thinking Correctly Under Pressure’. Sir Clive claims that is it the job of a leader to constantly put their teams under pressure. He also said that contingency planning is key to success. As a team, working through every eventuality together reduces the possibility of facing an unknown or unexpected outcome. This forward planning means that the team are quickly able to think through a problem, as they have already considered all possible outcomes.
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CULTURE MUST DRIVE FROM THE TOP Gilly Lord, head of regulatory affair at PwC, said: “It’s important that an organisation’s leaders are seen to embrace the same values that underpin the company’s culture, but that also needs to be embraced by middle management.” Speaking to Financial Director later, Lord expanded on this view: “A good way to tackle tone in the middle is to identify a network of informal leaders who can spread your culture and values much more effectively than a CEO’s voicemail. These informal leaders are people of differing seniorities, usually without an official leadership or management role but who, through their charisma and behaviours, can influence numerous people around them.”
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FRAGMENTATION OF GLOBAL TAX RULES COULD RESULT IN HIGHER COSTS OF DOING BUSINESS Events such as Brexit and the fragmentation of global tax rules “is bad for everybody” and could result in higher costs of doing business and increased risks of cross border of investments and global trade. Speaking to an audience of business leaders at the CFO Agenda, Simon Henry, chief financial officer of Shell, acknowledged that the level of public trust in business has been low since 2008 and “hasn’t really recovered since”. Henry said improved tax transparency is “one of the few ways of improving trust” but warned that efforts would be hampered by the fragmentation of global efforts to implement policies such as the OECD’s Base Erosion and Profit Shifting (BEPS) project.
September 2016 | financialdirector.co.uk | 23
FEATURE Working capital
Go with the flow
European companies are struggling to register sustainable improvements in working capital performance, writes Neil Johnson
O
ver the past nine years an average of only 12% of firms covered in REL’s annual working capital surveys achieved three years of consecutive gains. This despite another improvement in 2015 in the cash conversion cycle (CCC), a measure that expresses the length of time it takes for a company to convert revenue into cash. In 2015, CCC improved 1.7%, maintaining a trend in place since the global financial crisis. Performance drivers were improvements in receivables and payables processes. Still, the opportunity in working capital across Europe amounts to a significant €981bn-€305bn in receivables, €328bn in inventory and €348bn in payables. Working capital in Europe is a rather muddled picture. Revenues are on the up – 2% in 2015 and 19.8% over five years – and so too is the debt companies are carrying and the amount of cash they have on hand. Cash on hand rose 3% to €23.3bn in 2015, while debt has increased 40% since 2008, fuelled by low interest rates. Yet, contrarily, companies are not hoarding cash, with both CAPEX and dividends up since 2008 – 9% and 25% respectively. Rising debt levels alongside growing economic and political uncertainty make for uncomfortable bedfellows. Working capital opportunity
FY 2015
Total A/R opportunity €305bn Total inventory opportunity €328bn Total A/P opportunity €348bn Total working capital opportunity €981bn % of gross working capital 35.8% % of revenue 13.1%
24 | financialdirector.co.uk | September 2016
European executives need to take a look at the considerable opportunity in their working capital, in particular seeking improvements in inventory efficiencies, says Gerhard Urbasch, senior director at REL Consultancy. “It seems that investment into IT and greater supply chain efficiency over the last ten years has not paid off at all in terms of greater inventory efficiency, substituting inventory through information and better processes,” he says. “What happened to the promise from the lean revolution?” Meanwhile, a performance split in cash conversion efficiency is opening
up between the traditional economic powerhouses of Germany, the UK, Ireland and Northern Europe and countries such as Belgium, Spain, Portugal and even Greece. “Much of the variation between countries can be explained by different sector mixes as well as payment cultures,” says Urbasch. “There is, however, also an element of truly differing performances and attention to working capital and cash management that can be seen when comparing apples with apples. Southern European countries seem to have put most effort into ‘tightening the belt’ postrecession, while the UK, for example, has
remained fairly flat and is in the minority of countries that actually deteriorated performance.”
REL 1000 WORKING CAPITAL PERFORMANCE
The question of Brexit Despite poor performance in certain REL metrics, a PwC review over ten years to 2015 was more positive, revealing a working capital opportunity of £28bn for 450 UK businesses. Meanwhile, after two years of positive performance, working capital fell year-on-year in 2015 by £14bn to £110bn. The UK’s performance outpaced those of global counterparts with less time spent on waiting for invoices to be paid and paying bills 16% lower than the global average – UK 36.6 days, global 43.4 days. But with the UK an even smaller minority, having voted to leave the EU, what now for its working capital performance? Learn lessons from the gains made post-financial crisis, says Daniel Windaus, working capital partner at PwC. “Cash trapped in working capital has risen in the years since, indicating
Net working capital
€860
42
41.6
41
€800
40
38.9
€770
39.1
€740
38.7
39
38.2
€710
CCC
€830
41.1
38 37
€680
36
FY ‘10
FY ‘11
FY ‘12
FY ‘13
Net working capital
that companies should revisit the improvements they made then to release more of this cheap cash source,” he says. Urbasch is a little sharper in his assessment of the situation: “UK corporates have been taken by surprise by the outcome of the referendum and they seem not to be prepared to deal with the risks that lie ahead. The UK companies in our working capital survey have more than doubled their debt from €200bn in
FY ‘14
FY ‘15
CCC
2005 to almost €500bn in 2015, leaving them with fewer options and flexibility in the face of increasing risk. “EU-wide, about one-third of corporate debt may be reduced by realising the roughly €1tn working capital improvement opportunity. With the clouds from Brexit, UK companies will not leave this money on the table and will work on improving their levels of working capital.” ■
How to ensure good cash flow post-Brexit 1. Be flexible From both sides of the Brexit debate, we have been consistently told to remain positive post-referendum. This is due to the UK’s ability to adapt and be flexible in the face of difficulty. This isn’t just talking about the macro economy as a whole, but also the resilience of individual businesses. Flexibility requires problems to be recognised and addressed quickly. Solid reporting and analysis capabilities can help you to identify issues sooner rather than later, allowing you to adjust processes, invest in new tools or amend policies as required. 2. Have a plan Having a clear picture is also vital; advice that resonates from governments and banks through to the private sector – enterprise to small business.
What makes a good plan? It should fit the business’ need, be realistic and specific, defining responsibilities for implementation. In addition, a plan should motivate the team and include plenty of follow-up analysis so that adjustments can be made. 3. Use the right tools For credit management teams, effective and function-rich software can make a huge difference in how quickly payments are received. Software must automate processes and create full audit trails to create a more efficient, intelligent and successful team. Credit managers benefit from powerful analysis tools, and the insight it provides can simplify complicated accounts. 4. Boost communication Strong communication, both inside the organisation and with customers, is
always important, whether there’s a Brexit focus or not. Take steps to ensure your systems and processes allow an efficient flow of information and assist with building transparency – that way you can avoid surprises and ensure everyone knows what’s expected. Looking forward, there will be plenty of challenges to deal with, as the results of the referendum continue to take effect. There will be political changes, negotiations with Europe and new laws. But whatever happens, businesses that are able to maintain control of their cash flow will survive where others may falter as post-Brexit Britain looms large on the horizon. Michael Facey is head of marketing and product management at software solutions and services company OnGuard
September 2016 | financialdirector.co.uk | 25
THE RULES EU audit reforms
Navigating non-audit services With the EU audit reforms finally signed off, Hywel Ball asks whether the Brexit vote will see these long-awaited rules maintained, repealed or replaced
A
fter six years of debate, consultation and drafting, the EU audit reforms are finally here. The rules apply to companies incorporated in an EU member state with equity or debt listed on an EU regulated market. Banks and insurance firms are also impacted, whether listed or not. But the question many are now asking is whether these reforms are here to stay. Audit reforms are now enshrined in UK legislation. This also underpins the Financial Reporting Council’s (FRC) implementation of the changes. Brexit, when it comes, is not expected until the autumn of 2018 at the earliest, and noone knows whether any of these recent changes will be maintained, repealed or replaced. Even if the latter option is taken, the complexity and interconnectedness of the legislation with other laws, and the government resource required to replace them with something different, means that any changes may be a long time coming. It’s also worth bearing mind that if the UK ends up in the European Economic Area, this would in itself oblige the UK to retain the reforms. So whatever changes you have made or plan to make, in terms of audit and non-audit service provision, they should remain unaltered, at least for the time being. Procurement strategy One of the most important plans companies should be putting in place now, if they have not already done so, is a strategy for the procurement of professional services. I say this for three reasons. First, if companies are affected by the reforms in the UK, they will have to switch auditor at least once every 20 years. Companies that appointed 26 | financialdirector.co.uk | September 2016
whereas other member states make use of the reprieve on caps (for instance, the cap only applies to non-audit services provided for three consecutive years) for UK entities the cap applies regardless. Also, audit committees in the UK which may have pre-approved permitted nonaudit services in advance (for example, in clusters or categories) no longer have that option, unless the individual service relates to a matter which is “clearly trivial”.
an auditor several years ago also face a requirement to switch sooner than others. Second, the wider range of nonaudit services which an auditor can no longer provide to its audit clients means those clients will have to think more strategically about where they can source those non-audit services in the future. Third, the services an auditor can still provide will be restricted. A 70% cap applies to the fees for these services, based on a rolling three-year average group audit fee. So it’s not just a question of how many non-audit services can be used from the auditor. It is equally important to consider how much of each permitted service can be used. International procurement strategies It’s also worth bearing in mind that, unlike some of the other EU member states, the UK (or the FRC to be precise) has taken things a step further. Group entities incorporated in the UK have to develop and implement truly international procurement strategies. This is because the UK’s prohibitions on certain non-audit services and the cap apply to audit firms and their networks worldwide. So these services used by a group are caught up in these restrictions, and
Audit committee oversight If you happen to chair or sit on an audit committee, these developments should be front and centre of your agenda. Audit committees have a duty to oversee the independence of the auditor. They also have a responsibility to develop and communicate a policy on non-audit services, which includes the steps that will be taken to ensure the cap is adhered to by the audit firm and its network. Key to this of course is knowing which non-audit services are permitted and which ones are not. The FRC has published the EU’s list of prohibited non-audit services and also introduced the derogation on offer from the EU, allowing certain tax and valuation services to be provided subject to the approval of the audit committee. It will take time and effort to become familiar with these changes. But the one thing we can be certain of from the off is that it is better to plan for professional services procurement now rather than later. A good place to start is to establish an accurate inventory of all the non-audit services your group uses from its auditor and prospective auditors worldwide. Companies should then establish which of these services will be needed in the future, and from whom would the group prefer to receive them. Answers on a postcard… ■
Love me tender Audit tendering has turned from good practice to legal practice under EU audit reforms
T
he EU reforms require audit tenders to be “competitive”. This change, like others introduced in the EU audit reforms, is implemented via amendments to the UK Companies Act 2006. The tendering requirements can be summarised as follows. The audit committee must first undertake an audit firm selection procedure. This requires the committee to identify its first and second choice candidates for appointment, with explanations for each one. The committee also has to give written assurances that their recommendation is free from influence by a third party, and that no contractual arrangements have been introduced to limit the selection procedure. Once the committee has agreed on its choices, it has to make its recommendation to the board of directors. The board in turn is required to propose an auditor or auditors for appointment. This must include the recommendation made by the audit committee or, if the directors’ proposal departs from the preference of the committee, the reasons for not following that recommendation. Companies should also be mindful that the tender process does not in any way preclude the participation of smaller firms. Notice should also be taken
that tender documents “shall contain transparent and non-discriminatory selection criteria that shall be used by the audited entity to evaluate the proposals made by statutory auditors”. Qualifying tender Apart from outlining how the tender will be undertaken, the law states when it should be undertaken. The reason for this is twofold. First, the UK government took up an option in the EU reforms for companies to extend their audit tenures from ten years to a maximum of 20, on the proviso that a ‘competitive tender’ takes place on or before the tenth year of tenure. Companies have the flexibility to decide when that tender should take effect (for instance, the tender process can be for any accounting year up to and including the year following the end of the ten-year maximum). Second, the EU reforms come with a set of transition rules, stating when companies caught by the legislation have to switch their auditor for the first time in the new regime. If the external auditor was appointed between 17 June 1994 and 16 June 2003, the PIE needs to appoint a new auditor for financial years beginning on or after 17 June 2023 at the latest. If
the PIE appointed its external auditor before 17 June 1994, it needs to appoint a new auditor for financial years beginning on/after 17 June 2020 at the latest. It should be noted that there are no transitional provisions if the external auditor was first appointed on or after 17 June 2003. For example, if the auditor was appointed between 17 June 2003 and 16 June 2006, the PIE is required to re-tender the audit for financial years beginning on or after 17 June 2016. If the auditor was appointed later (eg. for 31 December year-end 2009) the audit would have to be re-tendered 10 years hence (eg. in 2019). Tender ahoy Before these new laws were enacted, an order was issued from the Competition and Markets Authority in 2014, requiring UK incorporated FTSE companies to announce the date of their upcoming tenders. This requirement still stands and is now also reflected in the UK Corporate Governance Code 2016, and the FRC’s Revised Guidance on Audit Committees 2016. These disclosures should be helpful for companies and audit firms alike, who need to keep a broad perspective on the rate of tenders over a given period of time so they can plan ahead accordingly. Similarly, investors will be interested to know if there are any issues or concerns behind a change in the timing of a tender, and those interested in this may also wish to engage with the company as it undertakes the tender process. ■ Hywel Ball is EY managing partner of assurance, UK & Ireland
WHO IN YOUR BUSINESS HAS MOST INFLUENCE OVER YOUR CHOICE OF AUDITOR?
86%
98%
32% 5%
19%
31%
4%
31% 8%
23%
Audit committee
37%
Chair of audit committee
Chairman
9%
6%
22% 5%
9%
£
17%
42% 18%
37%
31%
7% 10%
13%
Board
CFO Most influence
Second most influence
CEO Third most influence
September 2016 | financialdirector.co.uk | 27
MACRO Time to reload
Global central banks need to sharpen their monetary tools In spite of the markets’ buoyancy, the foremost anxieties are due to widespread perceptions that the central banks are running out of ammunition Equity prices have touched recently new highs in the US and Europe, but the mood of the financial markets DAVID KERN remains cautious and apprehensive. On the positive side, global fears over the UK’s Brexit vote have eased. In spite of worries that the UK economy is slowing, growth in other major economies is mostly unaffected by Brexit. Even in the UK, the current gloomy mood is unjustified. The main change so far has been a sharp fall in the value of sterling against all major currencies. But, though a weaker currency has drawbacks, it can also help the economy at a time when significant adjustments will have to be made, particularly if Brexit produces major changes in the structure of UK trade flows. The main global concerns are unrelated to Brexit. In spite of the markets’ buoyancy, the foremost anxieties are due to widespread perceptions that the central banks are running out of ammunition, and are no longer able to support their respective economies with the tools currently at their disposal. Ineffective tools In recent decades central banks have played a pivotal role in economic policy. Since 2008, the role of monetary policy has become particularly crucial, because ballooning public sector debt and deficits made it very difficult for governments to use discretionary fiscal measures in any effort to boost economic activity. However, the main monetary tools are proving increasingly ineffective. Indeed, some of the more extreme 28 | financialdirector.co.uk | September 2016
techniques (for instance, negative interest rates), are potentially counter productive. Since negative interest rates weaken banks, they risk more than offsetting any stimulus resulting from monetary easing, and the net effect on growth could be negative. Even if interest rates remain in positive territory, there is growing evidence that at levels near to zero, cutting rates and increasing QE will have at best negligible effects on economic activity. If it becomes clear that central banks are becoming almost impotent, the markets’ unease will worsen, and will heighten risks of sizeable stock market corrections. The longer term implications of this situation are unpleasant and potentially ominous. Markets and governments may have to accept that pessimistic scenarios such as secular stagnation are now the ‘new normal’. If true, the unpalatable implication is that we may be facing prolonged periods of low growth, which could threaten living standards over time. In the near term, such a gloomy view will be resisted.
The likelihood is that the central banks will intensify further their strategy of monetary easing, even though there must be serious doubts if doing more of the same will succeed. The Bank of England has announced a new major expansionary package in recent weeks, and the markets expect both the European Central Bank and the Bank of Japan to take further stimulatory measures in the next few months. Even in the US, where the Fed has signalled the possibility of considering modest tightening, policy makers are unsure over how to proceed, and are unlikely to take any new initiative in the near future. Apocalypse not yet Since the 23 June referendum there has been considerable pessimism over UK prospects, and many commentators have expressed widespread concerns that the Brexit vote would push the economy into recession. Even during the campaign, many thought that the slowdown in activity has started in the second quarter,
as those supporting ‘leave’ appeared to gain ground. So far, these fears have proved exaggerated, and have not been supported by the facts. Official figures show that, far from losing ground, UK GDP growth actually accelerated in the April-June quarter. More surprisingly, post-vote data for July has been much stronger than expected, with surging retail sales, which increased by 1.5% compared with June. UK consumer confidence remained strong after the referendum. Although purchasing managers (PMI) surveys point to weaker business confidence, the unexpected July fall in the number of those claiming unemployment benefits shows that the UK labour market remained strong after the Brexit vote. The resilient July retail sales reinforce hopes that buoyant consumer spending and improving exports would offset any negative effects of the Brexit vote on UK growth. Though UK GDP growth could slow to 0.8% in 2017, a recession is on balance unlikely. However, the Bank of England’s MPC reacted forcefully to fears of decline, by announcing early in August a multi-pronged package. This entailed a cut in Bank Rate to a new low
of 0.25%, relaunching and expanding the QE (asset-purchase) programme, and providing cheap funds to the commercial banks in order to encourage lending. But the more recent positive figures suggest that the MPC has acted prematurely and may have ‘jumped the gun’. The decision to pre-empt risks by using a ‘sledgehammer to crack a nut’ is understandable. However, if the MPC inadvertently reinforced the impression that the economic situation is worse than it really is, it risks damaging confidence and worsening threats to growth. It now seems likely that the MPC would cut rates further before the end of the year. But there is a strong case of waiting until we have better evidence about the true state of the economy. Cutting rates and adding to QE unnecessarily is potentially harmful and should be avoided. Eurozone decelerates Eurozone GDP growth slowed markedly in the second quarter of 2016, to 0.3%, down from 0.6% growth in the first quarter. Official figures show that the eurozone economy was decelerating even before the UK’s vote to leave the EU in late June.
Official interest rates – forecast for next 24 months Actual Forecast (end-quarter) 21.08.16 30.09.16 31.12.16 30.06.17 31.12.17 30.06.18 US Fed funds rate 0.25-0.50% 0.25-0.50% 0.50-0.75% 1.00-1.25% 1.50-1.75% 1.75-2.00% ECB refi rate 0.00% 0.00% 0.00% 0.00% 0.25% 0.50% Japan overnight rate 0.00% -0.25% -0.25% 0.00% 0.25% 0.50% China 1-yr lending rate 4.35% 4.10% 4.10% 4.10% 4.35% 4.60% UK bank rate 0.25% 0.05% 0.05% 0.25% 0.75% 1.50% Actual figures from official sources. Forecasts from David Kern, Kern Consulting GDP growth – major economies % change on previous year
Actual Estimate Forecast 2014 2015 2016 2017 2018 US 2.4% 2.4% 1.6% 2.0% 2.3% Japan -0.1% 0.4% 0.5% 0.7% 1.0% Eurozone 0.8% 1.5% 1.5% 1.2% 1.5% Germany 1.6% 1.5% 1.5% 1.3% 1.6% France 0.2% 1.1% 1.4% 1.2% 1.4% UK 2.9% 2.3% 1.5% 0.8% 1.9% China 7.4% 6.9% 6.5% 6.2% 6.2% India 7.3% 7.3% 7.4% 7.4% 7.3% Brazil 0.1% -3.8% -3.5% 0.9% 1.2% Russia 0.6% -3.8% -0.8% 1.4% 1.5% World 3.4% 3.0% 2.9% 3.2% 3.4% Actual figures from official sources. Forecasts from David Kern, Kern Consulting
Regional confidence was also hit by a number of terror attacks in July. Germany’s GDP expanded by 0.4% in the second quarter, but France and Italy didn’t grow at all, and the overall picture was dismal. At its 21 July meeting, the European Central Bank kept policy on hold, and expressed confidence that the eurozone’s modest recovery would continue in spite of the UK’s Brexit vote. But the full minutes of the meeting, published in August, revealed deeper concerns over the outlook. There are acute worries that the poor health of many banks could still derail the region’s recovery. Although eurozone inflation rose to 0.2% in July, and GDP growth prospects are adequate (at 1.5% in 2016 and 1.2% in 2017) there is a realistic chance that the European Central Bank will take additional measures in the next few months. The US economy remains the “star performer” among the developed economies. Although by historical standards the record is mediocre, the labour market showed renewed robustness in recent months. After a weak patch in May, the US economy created 292,000 jobs in June and 255,000 jobs in July, while the unemployment rate remained steady at 4.9%. There are still many challenges: US GDP is forecast to grow only 1.6% in 2016, with weak business investment. But the US economic data is sufficiently strong to keep alive the option of a rise in official rates before the end of 2016. Recently published minutes of the Fed’s July meeting, and comments by senior officials, show that policymakers are split about the timing of the next move. A September move cannot be ruled out; but given the uncertainties the Fed will probably be reluctant to tighten before the US November elections. On balance, it seems more likely that the Fed will only raise interest rates at its December 2016 meeting. David Kern of Kern Consulting was Chief Economist at the British Chambers of Commerce between 2002 and 2016. He was Group Chief Economist at NatWest between 1983 and 2000
September 2016 | financialdirector.co.uk | 29
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