How Would U.K. Firms Cope Under Sanctions?

Includes: BAESF, LYG
by: Learn Bonds

Lloyds Banking Group PLC (NYSE:LYG) and BAE Systems PLC (OTCPK:BAESF) are examples of firms that operate in the UK, and are listed on the FTSE 100. Lloyds Banking Group provides banking and financial services throughout the UK and overseas. BAE Systems is a defense & aerospace company. Both of these firms, and several others, would be affected by the economic sanctions being imposed on the UK. Economic sanctions are often employed by governments to state their disapproval over a particular state or reigning government. Economic sanctions often cripple the economy of the targeted country by isolating them from international trade through the use of a trade embargo.

A trade embargo effectively forces the country to run a closed economy (provided that every country adopts and enforces the embargo). Countries that are currently under international economic sanctions include North Korea and Syria. Countries that have been sanctioned economically in recent years have had a relatively undeveloped economy and a weak currency.

​The UK's economy is currently the fifth largest in the world, and the Great British pound is the fourth most valuable/strongest currency in the world. In this article, we examine how the UK economy would be affected by international economic sanctions, and what the UK government could do to keep the economy functioning and to control the situation. For the purpose of this article, we will assume that a trade embargo is imposed on the UK economy, in all sectors (not specific to just one sector, e.g. armaments.) Therefore, many PLCs operating in a wide range of sectors could potentially be hit hard, particularly firms that export a lot, such as Lloyds Banking Group or BAE Systems.

The UK's Current Economy

In order for us to estimate (with any degree of accuracy) how the UK economy would cope under economic sanctions, we must first analyze the currency UK economy and understand what it is comprised of. Services account for nearly 80% of the UK GDP as of 2014, and the Services sector also accounts for nearly 80% of UK employment. The UK also exports many of these services abroad, particular Financial Services. Firms like Lloyds Banking Group are heavy exporters of their services. Many UK-based firms that operate in the Services sector (typically based in London's financial district) export their services abroad. Worth 9% of UK exports, cars are the most exported good by the UK. Other widely exported goods include petroleum products, packaged medicaments, armaments, gold, hard liquor, mechanical parts and computers.

In recent years, the UK has run a trade deficit, importing more than it exports (in terms of money value.) In 2013, the UK imported around $630 billion (approximately £415 billion) worth of goods, making it the 6th largest importer in the world. Imported goods include mineral products such as granite or petroleum jelly, cars, wine and gold.

Implications of the Sanctions for the UK Economy

International economic sanctions would effectively isolate the UK from world trade, forcing it to rely on its own means to produce the necessary goods and services for the economy to function and to satisfy the needs and wants of citizens. The sanctions would drastically reduce the supply of goods available for UK consumers and UK businesses (capital goods). Demand for the products and services provided by UK businesses will also decrease, as UK businesses will have much less exposure to their respective target markets. The extent to which demand will be decreased by is unclear, as the increase in demand from domestic consumers may counteract the decrease in demand from abroad. The UK has a relatively deindustrialized economy, but it is certainly capable of being able to produce many of the required products. Investment is necessary to achieve this, and the UK may have to be particularly innovative when producing a good which requires a particular natural resource (e.g. copper) that is not abundant in the UK. Alternatives may have to be produced and used if the production of a certain good is not possible.

In 2014, the UK was a net importer of crude oil and petroleum products. However, if crude oil & crude oil products were allocated carefully in the UK, then the current crude oil production capabilities may be sufficient. In the long term, the UK government could invest heavily in renewable energy in order to cut down on the consumption of crude oil. Generating electricity from other means (nuclear power, solar power and wind power) would drastically reduce the amount of crude oil that the UK economy would need to function. Improvements in technology may allow the UK to optimize crude oil extraction, further reducing the need to import crude oil, as the UK's own reserves will be utilized.

Many British firms, such as BAE Systems or Jaguar Land Rover, are heavily reliant on exports for sales. In 2013, exports accounted for around 85% of Jaguar Land Rover's sales revenue. Other UK-based car manufacturers are also dependent on exports for a large proportion of their car sales. BAE Systems is one of the largest weapons manufacturers in the world, and they export a lot of their products abroad. Lloyds Banking Group will also see a reduction in demand for its services, as it exports a lot of them to clients abroad.

International economic sanctions will inevitably have a negative impact on many UK businesses. However, some UK businesses may benefit from the sanctions, as they may experience much lower levels of competition. Over the past few decades, UK businesses have lost sales as a result of globalization. They were unable to compete with foreign businesses, often based in developing countries, where the minimum wage is lower or non-existent. This lowered the average cost of production per unit for foreign businesses and allowed them to sell their goods at a lower price than UK firms. Furthermore, the strong GBP made it even cheaper for UK consumers to purchase goods from abroad. As a result, UK firms were simply unable to compete on price with foreign firms operating within their market.

The effect of economic sanctions on the London Stock Exchange should also be considered. Foreign institutional investors (e.g., pension funds, sovereign wealth funds or hedge funds) may be prevented from trading UK-based companies which are floating on the LSE (PLCs). It is impossible to judge exactly what implications this could have, but it may lower volatility on these shares and could lead to a shortage of capital for UK-based PLCs. Foreign residents or institutional investors may not be able to trade shares in firms listed on the London Stock Exchange. Therefore, firms like Lloyds Banking Group may not be able to raise as much capital via the sale of shares.

Implications of the Sanctions for Other Economies

The UK is one of the major players in international trade, importing large quantities of goods from a range of countries. Therefore, many foreign businesses profit by exporting to the UK. Even though these economic sanctions are aimed at hindering the UK economy, they would arguably do more damage to other economies, as the UK has consistently run a trade deficit. Perhaps the only way that very serious damage could be done to the UK economy is if there were a shortage of a particular good or raw material, which the UK could not produce or extract.

Essentially, many foreign businesses and economies would see demand for their goods shrink, as UK firms and consumers could no longer purchase their goods. As a result, foreign businesses may see a decline in sales revenue, and ultimately, in profit. The UK has always been a lucrative export destination for foreign businesses. The strong Great British pound means UK firms and consumers may be willing to pay more than other export destinations (with weaker currencies), yielding greater profit for producers.

Potential UK Government Policies To Prevent Economic Decline

The UK government may have to facilitate investment in certain sectors to ensure that UK businesses can fill the gaps (produce products that were previously imported from abroad.) This will ensure that demand for certain products by UK firms and consumers will be met, and economic growth won't be limited.

The UK may have to revert to having large state-owned firms providing public services. For example, the energy sector may be nationalized. Another less extreme option is more regulation. This will allow the UK economy to maintain a certain level of output for each good or service, preventing shortages.

It should be noted that the sanctions could make the UK economy immune to any international economic crisis, as the UK would effectively have a closed economy. Therefore, another subprime mortgage crisis in the US would not have an adverse effect on the UK economy. Operating a closed economy would essentially make the economy immune/indifferent to events external to the UK.

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