Hamish McRae: Could foreigners and regulators spoil the City's invisible exports triumph?

Markets go up, markets go down but the City seems to go on delivering the bacon for UK plc.

Markets go up, markets go down but the City seems to go on delivering the bacon for UK plc.

The new invisible export figures for 2003 are just out and it seems that last year was another record, with net exports of financial services inching up to £17.26bn. The climb has been pretty steady over the past decade and in money terms is now nearly three times the level of 1993 (see first graph). Intriguingly, earnings rose by more in 2001 and 2002, which you would imagine were bad years for the City - both bonuses and jobs were down, whereas last year both were rising again.

Out of that £17bn, insurance was the largest contributor at £6.4bn, with securities dealers producing £3.3bn and banks £3.0bn. The other really big earner was fund management, which produced a net £1.2bn, nearly double the level of the peak year for equities, 1999.

It should be a bit of a relief that export earnings carried on rising through bad times as well as good because we do very much need this surplus to cover the big deficit in trade in goods. The second graph shows how financial services and business services taken together produce a surplus of more than £30bn, while there is a deficit of more than £50bn in trade in goods, ex oil. You can see too, the lever that these earnings give the City in its discussions with the government. No government is ever going to put at risk this sort of money.

There aren't yet any comparable international figures for 2003, but the 2002 ones are out and they, plus the run of figures back to 1995, are shown in the next graph. The UK increasingly dominates world trade in financial services, with a surplus way ahead of Switzerland and Germany. The US, slightly surprisingly, has a small net deficit in this business.

I suspect there are two main reasons for this. One is that most US financial institutions increasingly run their international business out of London rather than New York. The other is that the US insurance industry has done increasingly badly since the late 1990s and had a deficit of more than $12 billion in 2002. (German insurance did well in 2002, which is why the German surplus jumped upwards.)

The final chart shows how important trade with the US is, though if you add up all the EU countries the surplus is almost as big. Again, you can see the way the UK has outpaced the rest of the world since 1996.

So that is the good news. Is there any bad?

If there is, it is not yet evident in the figures. The steady growth of the surplus on business services is also very helpful. Things like legal services and management consultancy, which are not technically part of the financial services industry, are now starting to rival banking and securities dealing. For example, the lawyers now generate a surplus of £1.5bn a year and the management consultants are almost as big net earners.

This leads to a further thought. It is quite easy to understand that companies want cross-border legal agreements to be under British law - would you really want to have disputes settled in New York or Paris? - but in the last couple of years the earnings of the management consultants have risen even faster. Do we have a comparative advantage in management?

If the surplus has gone up, that is a market signal that we must do. What I think we have to realise is that this is not necessarily a function of the genius of British at management. Rather it is the ability of London to attract the sort of bright young Europeans and Americans than drive this business forward. So this rise is associated with the London effect - the way it has outpaced other European cities - rather than UK effect.

There is a broader point here. What we have to realise that the reason UK financial services have done so well is largely because the City has provided a marketplace for global talent. Of course some of that talent is British, particularly in dealing and in fund management. But a lot is not, and retaining that talent is enormously important. This is partly a question of salaries, which are at global rates rather than UK ones, and it is partly a question of tax.

That is one of the three main concerns going forward. Gordon Brown has fought off EU plans to tax wholesale interest payments, which would swiftly send the business to Switzerland but he has also talked on several occasions about the tax status of non-residents and is under some pressure to crank more revenue out of them.

The second concern is financial service regulation. There is widespread concern in the industry at the plonking and I am afraid plain stupid approach that the FSA is increasingly taking. This is increasing costs of doing domestic business and pushing some offshore, typically to Dublin or Gibraltar.

The genius of the Bank of England, when it was running regulation, was its light touch. Indeed, this did not always work to the advantage of the Bank because it got the blame for things that were very difficult to control, such as the Bank for Commerce and Credit International. But it was the basis on which the 1960s revival of the City's international business was built, the basis on which that £17bn surplus was generated. The FSA initially carried through the Bank culture, but as the split has widened, people without that sensitive culture have been recruited and the performance has deteriorated. And some business has already walked.

Finally, there must be a concern about the extent to which foreign institutions own the City. They have been and will in all probability continue to be exemplary corporate citizens, give or take the odd discrimination case. But it would be unwise to underrate the jealousy felt in Continental Europe about the success of London vis-à-vis Frankfurt and Paris. The fact that Continental institutions make so much of their profit here makes that worse, not better. When a UK company tries to get into France, as Egg did, it gets squeezed out. It was silly for a British company to try to run a business in France, sure, but it should be a sign that if Continental banks could repatriate business they would do so.

So the UK needs to handle its relationship with Europe carefully. That does not mean euro entry. In fact it is almost certainly an advantage from the City's point of view to be out, not in. That the Treasury should have concluded the opposite shows how little it knew about the City's history. The over-riding lesson of the post-war City is that it does best when it deals in other countries' currencies, exploiting its offshore position. But it does mean that the people handling our relationship with both Europe and the US need to be sensitive to trading relationships with these two blocs.

But that is in the future. Meanwhile it is a relief that financial earnings have gone on climbing through the once-in-a-generation bear market.