FX Hedging Demand Hits Fever-Pitch Ahead of EU referendum
Are Brexit fears causing capital to flee out of Britain?
The economic debate on the UK’s future in Europe hit a new low last night when Sky News cited recent Bank of England figures as being evidence that capital is fleeing the UK ahead of the EU referendum.
Sky’s Ed Conway reported that “£65bn either left the UK or was converted into other currencies in March and April – the fastest rate since the financial crisis in early 2009.”
Further: “In the six months to the end of April, some £77bn left the sterling system. That compares to a fall of just £2bn in the six months to the end of October 2015.”
Politicians were quick to jump on the report with George Osborne saying this capital flight was a “taste of things to come” and William Hague saying the report was a danger to the economy.
But, Capital is Not Fleeing the UK
It is easy to understand why those urging a vote to Remain in the UK would interpret the data as being indicative of a capital flight; the promise of economic chaos on a Leave vote has been the mainstay of the Remain campaign, of which Hague and Osborne are figureheads.
The only problem is, this is not really capital flight at all, and it is important that correct assessments are made.
It turns out that the Bank of England’s data actually reflects a spike in hedging demand by corporations and SMEs, all eager to ensure their exposure to a potential Brexit is minimised.
Hedging is essentially the use of currency contracts to insure against any adverse moves in the future – a guaranteed rate is purchased now and can be exercised at a later date, regardless of where the currency actually trades at the point of delivery.
“More importantly, other equally obscure BoE data from the same release sheds light on what is really going on. In tables showing the activities of British banks outside normal deposit-taking and lending, in March there was a £60bn fall in sterling liabilities and a £42bn rise in foreign currency liabilities,” says Chris Giles of the Financial Times.
This hedging demand for sterling is well documented and will certainly be the reason for the eye-opening figures.
A survey conducted by East & Partners shows an average of 83.4 percent of top UK corporates their exposure hedged, while an average of 32.1 percent of exposure is hedged by SMEs.
In preparation for these potential currency fluctuations during June following a Leave vote, over half (53.4 percent) of all companies have hedged against FX exposures, including over a fifth (21.6 percent) of SMEs.
This hedging exposure goes some way in explaining the turmoil on the futures markets, where this hedging activity takes place.
If we look at the options market we can see activity has hit levels last seen during the financial crisis. Look at GBP/USD v EUR/USD Implied Volatility levels:
The same measure for EUR/GBP is also at its highest level in seven years, with volatility in both pairs likely to remain very high until after the referendum.
“In an attempt to avoid any adverse moves in the Pound in the event of a Brexit, businesses in the UK have continued to hedge their Sterling exposure in the lead-up to the referendum on 23 June,” says Enrique Diaz-Alvarez at Ebury Partners.
The FT’s Giles also points out that the Bank of England’s data shows there was no overall drop in deposits in UK banks in March, but a £10bn rise.
All this activity makes for an incredibly interesting time for the British pound – if sterling is trading at a premium to where it should, owing to fears of Brexit, then there could be a rapid recovery following the referendum.
All these hedging bets must ultimately be unwound at some point after all.
But, for corporations the risk of a Leave vote is simply too high to not insure against.