Continent Cut Off! Return of the Belgian Dentist?

On the basis of what's publicly available, in the early hours of this morning in Brussels, something became unquestionably clear: France and Germany care more about taxing and regulating the City of London than preserving the European Union. Something else became clear: that Britain's political leaders consider avoiding such taxes and regulations as it expects to be advanced from Brussels as being more important than preserving its position in the European Union.

Therefore, unless things change, we must expect that the Eurozone-et-al will attempt to impose burdensome financial regulations and taxes on its financial sectors; and second, that Britain will reject these taxes and regulations, at virtually any cost. The divorce is coming, and it will be over money.

Expect things to become even more stupid, wasteful and vain. Once Eurozone-et-al's technocrats get a taste for financial repression, will they know how to stop? After all, they have governments and banks to refinance against a backdrop of near-zero nominal growth, and financial repression always delivers results in the short term, no matter what the longer-term conseqeuences. Which tools of financial repression will be off-limits? Limits on alternative investments? - already passed the European Parliament in October. Widening reserve ratios? - the attempt to pre-empt Basel III is already on its way. Withholding taxes popping up everywhere? Limits on deposit rates and bond yields?

Back on this side of the Channel, the response by the City to Britain being chased from the EU will be to toughen its act as Europe's offshore financial centre. Since almost by definition London's more lightly-taxes and lightly-regulated fee structure is likely to undercut those onshore burdened by the EU's taxes and regulations, it's an inevitable role. That being so, we have to at least ask whether the remaining members of the EU would also finally have to burden themselves with capital controls in order to break free of London's gravitational pull.

But would capital controls work anyway? Put it another way: what sort of economic, financial and regulatory circumstances would be conducive to the growth of what might be called a Euro-EuroMarket in London. Take a step back and recall the circumstances behind the birth of the Eurodollar and Euro-Deutschemark bond markets between the 1960s and 1980s.

The birth of the Eurodollar bond market relied on the collision between long-maturing financial imbalances and what were seen at the time as urgent political/financial imperatives. On the one side, the post-War period saw a build-up of dollars earned and held offshore, as a result of several factors:

• the accumulation of offshore dollar balances, encouraged by 'Regulation Q' – a cap dollar interest rates offered by US bank;
• the fear that dollar accounts held in the US might be frozen in response to balance of payments pressures;
• sizeable outward direct investment by US multinational companies; and
• a series of US current account deficits, which had the effect of internationalizing the dollar.

The automatic and logical response was that European holders of  dollars got used to buying dollar-bonds issued by European companies in New York.

And that's what was happening until urgent US political/financial imperatives drove the business offshore. Persistent balance of payment pressures (the flow which built the stock of overseas dollar liquidity), led to an attempt, in 1963, to stop foreigners raising dollar capital in New York. The means chosen was the Interest Equalization Tax, which was designed to raise by 1% the effective annual cost to foreigners of borrowing in the US. This was augmented by an attempt to years later to engineer a Voluntary Restraint Progam on FDI by US companies, by discouraging US banks fro making anything but short-term loans to international borrowers. By 1968, this had morphed into mandatory restrictions on FDI. Faced with these tax and regulatory pressures, the foreign US bond market simply moved to London, and the Eurodollar market was born.

The birth of the Euro-DM market was slightly different. With W Germany running persistent current account surpluses, Germany could at first afford to take a relatively relaxed view of foreigners raising money on their capital markets, since this capital outflow at least eased the upward pressure on the DM. However, there was the simple matter of tax, and when in 1964 W Germany introduced a withholding tax on German bonds, non-German investors discovered a real appetite for DM bonds raised, tax free, in London rather than Frankfurt. This was the famous tax-dodging 'Belgian dentist' at work, hoarding his bearer-bonds.

You'll notice that none of these circumstances lasted – indeed after the collapse of the Bretton Woods arrangements in 1972, the US restrictions withered away naturally. However, by that time, the Eurobond market was sufficiently established in London to perpetuate itself. Then came the 1980s, when the combination of falling bond yields and global financial liberalization did the rest.

It's strange to revisit this world of financial repression and imagine that Eurozone-et-al might be heading back there.

However, for London, two circumstances which bred the Euromarkets look to be settling into place. First, of course, the likelihood of Eurozone-et-al financial repression creating arbitrage opportunities; second, there is also a massive pool of offshore Euros available – and my guess is that offshore pool will balloon exponentially within hours of plans to tax onshore Euros being unveiled. And, of course, there are also urgent financial/political pressures now at work to bend Euro capital markets to the will of European governments. 

Third, for most of the last five years, the Eurozone has run modest current account deficits. The logic of German inspired endless austerity is for these deficits to be reversed, and sharply. For as long as this attempt lasts (and the Euro looks to have an immediate future), the corollary is that there will be no shortage of foreign issuers wishing/needing to issue Euro-Euro bonds. The more so if government-and-banking-system refinancing crowds out other onshore corporate issuers.

Finally, on a personal note: I firmly believe that London is invincible – it is the unexampled global city with so many diverse dimensions that it effortlessly reshapes itself for the eyes of every visitor. It has no equal today, having never been successfully copied or replicated. Personally, I also think it's dirty, expensive, difficult and dangerous, and when it's cornered it'll fight like the mongrel dog it is. What sort of idiots would pick a fight with it?