To date, the response of the UK economy to the threat of Brexit has been quite benign. As this article is being written, there are gathering clouds in terms of consumer demand and industrial production, but thus far there has not been a pronounced aggregate effect.
One explanation is that the terms of Brexit are yet to be determined. Another is that there has been a compensatory change in the exchange rate that is offsetting the anticipated effects of Brexit. The imposition of trade barriers, the reintroduction of non-trade barriers outside of a single market, and the withdrawal from the customs union impose costs of cross-border activity. These can be offset by depreciation of the exchange rate. Indeed, since the balance of payments must balance, that is precisely what must happen in the presence of a floating rate, and it is what has happened since the referendum in the form of a 20% depreciation in sterling.
Of course, there is a risk that a depreciation in the exchange rate will not be reflected in a fall in the real exchange rate because of rising wages and inflation. In addition, the depreciation of the exchange rate has very real effects on citizens’ standards of living. To the extent that we consume internationally priced goods, we are all 20% worse off. But from the point of the view of the corporate sector, in aggregate, the price and non-price effects of Brexit can be compensated by price adjustments through the exchange rate.
This is a useful benchmark against which to evaluate Brexit, not least because it provides an explanation for the observation that not much has happened in the first year since the referendum. However, it masks the much more substantial impact that Brexit has on the composition, rather than the aggregate level of activity, and it is to this that we now turn.
- Who Bears the Brunt of Brexit?
Consider the impact of Brexit on the three factors of production – capital, labour, and land. We know from economic theory that the incidence of an exchange rate adjustment is borne most heavily by the least mobile factor of production. As the least mobile factor, land is most exposed to the depreciation in sterling and, to the extent that prices to date have remained quite static, land has devalued by 20% in foreign currency terms.
Capital is the most mobile factor and those financial assets that are not invested in domestic physical assets have appreciated by around 20% or more in domestic currency terms and remained approximately unchanged in foreign currency terms. An illustration of this is the way in which the Financial Times Stock Exchange 100 Index (the ‘FTSE 100 Index’) has moved almost exactly in inverse relation to the strength of sterling over the past year.
So those productive activities that are intensive in land have, in many cases, become more competitive, whereas those that are dependent on capital have become less competitive as the prospect of increased price and non-price trade barriers has not been offset by reductions in primary factor costs.
Regarding labour, in the absence of offsetting wage rises, labour costs have fallen in foreign currency terms and sectors that are intensive in labour inputs have benefited. However, that is only true of internationally immobile labour. Where firms are competing in international markets for labour, then their real wage costs have not declined.
So firms that are intensive in property and domestic labour have fared the best. Those that are intensive in capital and international pools of labour have fared the worst. To take two examples, the financial sector has fared worst where it is virtual and dependent on high skilled international labour, for example ‘fintech’, and best where it is branch based and dependent on domestic pools of labour, for example commercial banking. As a second example, higher education has fared well where it is not dependent on international academics and is intensive in the use of domestic property, but poorly where it employs a large pool of internationally mobile academics.
The purpose of this discussion is not so much to undertake an analysis of the winners and losers from Brexit, but to emphasize that there are marked cross-sectional variations in its impact on the corporate sector. This is before one considers the compounding effects of the geographical concentration of some activities in Europe and elsewhere, and the terms of agreements that might be negotiated within the EU and with the rest of the world.
In essence, what is happening is the reverse of the Dutch disease in the 1980s caused by the appreciation of sterling in response to the emergence of North Sea oil and gas. This had the effect of deindustrializing Britain and it was an important contributor to the explosion of the service sector, including financial services, in the UK. It would have been a mistake to stop the changes that occurred then and it would be a mistake to do so now. So it will be damaging to resist the changes that will occur in financial services and higher education to name the two mentioned before.
Just as we had to let much of industry go in the 1980s, so we will have to let some of our non-industry go in the 2010s and 2020s. Change is painful, but no change is terminal. What should be done is to plan for the changes, direct policy towards facilitating them and ameliorate their most serious social and personal consequences through, for example, well-structured programmes of education and training. There are serious market failures that arise during periods of transition that the public sector can help to alleviate.
- The role of corporate governance
It is not just the public sector that should help to reduce the costs of the required restructuring; so should the private sector. Change will require corporate governance arrangements capable of managing it. It is no coincidence that one of the first policy statements that Theresa May made as Prime Minister was to exhort a shift in the governance of UK companies – ironically just as we are exiting Europe, in a direction associated with Continental European corporate governance.
A much-debated issue is the extent to which UK corporate law is conducive to the promotion of different types of activities and restructuring of companies. In particular, there is a concern that its emphasis on shareholder interests in Section 172 of the 2006 Companies Act discourages firms from adopting different types of governance arrangements. For example, the presence of workers on company boards to which Theresa May referred in her discussion of corporate governance does not appear to sit comfortably alongside a requirement on directors of companies to act primarily in the interests of their shareholders.
However, the recent UK government consultation on corporate governance in the UK has brought out the fact that, at least in principle, it is possible for companies to take account of other parties and, indeed, according to Section 172, directors are supposed to have regard for the interests of other stakeholders and the long-term success of the company. In addition, the Act allows companies to have altruistic purposes that go beyond the benefit of their shareholders.
So, on the surface, the Companies Act looks quite flexible in allowing companies to adopt different governance structures, and it is suggested that some headway could be made by just requiring companies to report how they have discharged their duties under the Act, including those owed to their other stakeholder interests. In other words, the Companies Act appears to be enabling in allowing companies to adopt appropriate governance arrangements.
There are, though, two fundamental concerns with this interpretation of UK company law. The first is that, notwithstanding the flexibility it grants companies, in practice convention means that companies observe their primary duties to their shareholders and ignore their subsidiary responsibilities to other stakeholders. The second concern is that, irrespective of whether the Act is placing sufficient emphasis on stakeholder interests, it is not prioritizing what should be the driver of corporate governance – and that is the company’s purpose.
It is potentially erroneous to regard either shareholder or stakeholder interests as primary considerations as against both being derivative of corporate purpose. In other words, the structure of companies in terms of prioritizing the interests of different parties to the firm should be a product of the objective of the company and help in the delivery of it.
This is of particular significance when the nature and purpose of the company may need to undergo change in response to an external influence such as Brexit and alterations in the relative prices of the factors of production. The ability of companies to be able to respond to this by adjusting their purpose and their associated governance arrangements may be of critical significance in promoting a smooth transition to the new state of the economy.
The adoption of alternative model companies within the framework of the Companies Act might be one way in which this could be achieved. Companies could adopt public benefit, stakeholder participation, or privileged shareholder arrangements that allow them to specify a public benefit over and above their financial returns, their accountability to different stakeholder groups, and the privileging of certain classes of shareholders. By specifying these alternative arrangements, greater substance could be given to the flexibility that is in principle, but not currently, in practice associated with UK company law.
In summary, the marked changes in the composition of the UK economy that are in prospect as a consequence of Brexit will require company law and corporate governance systems that are sufficiently enabling and flexible to respond appropriately to the changing circumstances and needs of companies.
Colin Mayer is Peter Moores Professor of Management Studies at Said Business School, University of Oxford.
This post is part of the ‘Brexit Negotiations Series’, a series of posts based on contributions at the ‘Negotiating Brexit’ conference that took place in Oxford on 17 March 2017.
 For more extensive discussions of this see Big Innovation Centre, ‘The Purposeful Company Interim Report’ (London, 2016) and Colin Mayer, ‘Who’s Responsible for Irresponsible Business?’ (2017) 33 (2) Oxf Rev Econ Policy 157-175.