Eurozone: Life after Brexit Global Economic Outlook, Q3 2016

While the Eurozone’s economic recovery has continued and even gained momentum, the outlook is shaped by Brexit. Key among the questions now are how to structure the future relationship with the United Kingdom as well as how to manage political risks.

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While the economic recovery in the Eurozone has continued and even gained some momentum, the Eurozone’s outlook is shaped by the decision of the United Kingdom to leave the European Union. The first exit of an EU member (besides Greenland, then part of Denmark in the mid-1980s) poses a variety of questions for the European Union, in the political as well as economic spheres. Key among them are how to structure the future relationship with the United Kingdom as well as how to manage political risks in the European Union.

Some good news on the recovery

The Eurozone’s economic recovery gained some momentum in the first quarter. This was not necessarily expected: After the financial market turbulences in the beginning of the year and the various external risk factors, a weakening dynamic was more likely. Nevertheless, the growth rate of 0.6 percent in the first quarter was the strongest since Q1 2015.

External uncertainties did not scare the Eurozone’s consumers, who have continued to drive the recovery. Wages are growing, unemployment is slowly shrinking, and low energy prices do their part to encourage private consumption. At the same time, the net effect of external trade is negative, as imports have grown stronger than exports, even in the case of Germany, the Eurozone’s main exporter. The key reasons behind this are the waning tailwinds of a weak euro and weaker demand from emerging markets.

The arguably most important component for a self-sustaining recovery, corporate investments, has been the weak spot of the Eurozone’s recovery since it started in 2013. Overall, the level of capital investments in the Eurozone is still hardly higher than it was in 2010. But finally investments in the Eurozone show some signs of life: Overall investments have grown robustly, at 0.8 percent, for the second quarter in a row.

Interestingly, the stock markets in Germany and France dropped more than the UK market did on the day after the referendum. To some degree, this is because Brexit comes at a very unfavorable time for the European Union.

 

Whether these encouraging developments indicate higher growth dynamics is not clear. In any case, they have been overshadowed by the June-end decision of the UK electorate to leave the European Union. While the possibility of Brexit was widely seen as one of the key tail risks for Europe and the world economy and was widely discussed, the likelihood of its occurrence was seriously underestimated, not least in the financial markets.

How does Brexit affect European business?

At first glance, the main economic and political effects of leaving the European Union should fall on the United Kingdom, the second-biggest EU economy. However, this is only partly true. Interestingly, the stock markets in Germany and France dropped more than the UK market did on the day after the referendum. To some degree, this is because Brexit comes at a very unfavorable time for the European Union.

The European Union has a host of challenges to solve, ranging from migration policy to the stabilization of the Eurozone and pressure from the rise of anti-EU and populist parties. In addition, Brexit has happened just when the recovery gained some momentum.

While the immediate effects of Brexit play out in the financial markets, the effects on the real economy in the Eurozone will depend on Brexit’s impact on consumer and corporate confidence. Forecasts project the likely GDP losses in 2017 for the Eurozone to be 0.3 percent—not enormous, but sizable given the growth trend of around 1.5 percent. Given that there are no historical precedents, the effects will ultimately hinge upon the degree of political and financial market uncertainty surrounding Brexit in the coming months.

The political challenges for the European Union play out in two dimensions: the European Union’s position in upcoming UK exit negotiations, and the region’s future.

 

What kind of divorce?

The political challenges for the European Union play out in two dimensions: the European Union’s position in upcoming UK exit negotiations, and the region’s future. According to the EU treaties, the EU-UK negotiations are supposed to be concluded within two years, starting from the date the United Kingdom formally gives notice of its wish to leave the European Union. This period can be extended if both parties agree.

Given that the negotiations need to disentangle legal relations that have developed over 40 years and set up a new trade regime, it is doubtful that two years of negotiations will be enough. The EU-Canada negotiations over a free trade agreement just entered their seventh year. Some EU countries are likely to be more affected by a disruption of trade relations. On average, the export volume of EU countries to the United Kingdom is around 3 percent of their GDP, but this number is 6–11 percent for countries such as the Netherlands, Belgium, and Ireland (figure 1).

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Best and worst cases

In a best-case scenario, the divorce develops smoothly. Both sides realize that erecting trade barriers will lead to a lose-lose situation. From an economic standpoint, both sides are interested in a mutually beneficial outcome and minimal trade restrictions. However, the Brexit decision itself is evidence that economic considerations do not necessarily prevail. The European Union might be tempted to block agreement to deter secessionist movements in other EU countries or set other priorities than Brexit.

From an economic standpoint, both sides are interested in a mutually beneficial outcome and minimal trade restrictions. However, the Brexit decision itself is evidence that economic considerations do not necessarily prevail.

 

On the other hand, from the European Union’s perspective, a smooth divorce with a liberal trade regime inevitably requires the free movement of people. The models under discussion with no or limited disruption of trade relations (the United Kingdom as member of the European economic area, or a Swiss-style negotiated access to the Single Market) include open borders for employees. This might be hard to accept for a new British government that is committed to realizing the anti-immigration demands of the Brexit movement.

In this sense, a best-case scenario with minimal trade restrictions faces considerable hurdles on both sides and is far from automatic. A worst-case scenario, with disruption of trade relations and major economic damages in terms of lower trade volume and foregone economic growth, is equally possible. The expectations of which scenario will prevail is very likely to move financial markets and investment decisions during the coming years of negotiations.

What kind of future European Union?

The second (political) factor involves the future of the European Union itself. Given the emergence of populist parties in many European countries, Brexit has already led to calls for similar referenda elsewhere, as well as to fears that Brexit could be the beginning of a wider disintegration of the European Union.

A best-case scenario with minimal trade restrictions faces considerable hurdles on both sides and is far from automatic. A worst-case scenario, with disruption of trade relations and major economic damages in terms of lower trade volume and foregone economic growth, is equally possible.

 

Enterprises also recognize this risk. In a joint survey conducted by Deloitte Germany and the Confederation of German Industry shortly before the Brexit decision, two-thirds of the 215 polled German managers saw the risk of further exits in the aftermath of Brexit, and many fear political fragmentation of the European Union. Only a few see Brexit as a catalyst for deeper integration (figure 2).

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In this sense, Brexit creates a variety of political risks for the European Union, and an intense discussion about its goals and future governance structure will likely emerge. Quite a few scenarios are plausible. They range from deeper integration and the emergence of a more state-like European Union to the return to a free-trade area with more political powers at the member-state level. As always in uncertain times, more extreme scenarios are also imaginable.

From an economic perspective, the crucial factor is how open and market oriented the future European Union will be. Consequently, political decisions are likely to shape the Eurozone’s economic outlook to an unusually high degree.