Eurozone: Dealing with Brexit Global Economic Outlook, Q4 2016

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The direct economic effects of Brexit have so far been relatively muted, thanks to central banks’ decisions. But this does not imply there will be no serious long-term consequences, as risks stemming from a potential disruption of trade relations have not disappeared.

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Four months after the decision of the United Kingdom’s electorate to leave the European Union, the fog around what Brexit exactly means for the Eurozone and the European Union has not disappeared. The direct economic effects have been limited so far, as financial markets, helped by central banks’ decisions, remained relatively calm. Politics has been more affected than economics, as European leaders try to figure out how they can react and what sort of strategy they should adopt in the upcoming negotiations with the United Kingdom.

While these political decisions will have substantial repercussions on the European economy, especially regarding the future form of the European Union and the future relationship with the United Kingdom, it is much too early to argue that Brexit will have limited effects in the long run as well. While the shock to the financial markets has not happened, the effects on the real economy are likely to materialize in a less spectacular, yet very palpable way.

While these political decisions will have substantial repercussions on the European economy, especially regarding the future form of the European Union and the future relationship with the United Kingdom, it is much too early to argue that Brexit will have limited effects in the long run as well.

The immediate reactions to Brexit

It was widely feared that the biggest immediate effect of Brexit would play out on the financial markets, sending shock waves through the global financial system. Given the problems in the Eurozone’s banking system, this would have affected the Eurozone in a very big way. However, the shock to the financial markets failed to materialize. After a brief period of volatile financial markets, European stock prices rebounded, and the Euro Stoxx 50 reached its pre-referendum value in late July.

The relative calm is partly due to central bank reactions and liquidity, which reassured investors. Second, the effects of Brexit are hard to assess for financial market participants, as they will be completely dependent on the future model of EU-UK economic, trade, and investment relations. Until the negotiations begin and the probabilities of which future model is likely to emerge are known, it is hard to price Brexit into valuations. This will change once relevant information flows and probabilities can be attached to the possible outcomes.

The Eurozone’s GDP grew 0.3 percent in the second quarter, after 0.5 percent in the first, suggesting that the recovery had continued until the Brexit referendum. After the referendum, economic sentiment went down, but not in a big way (figure 1). Sentiment surveys proved resilient immediately after the referendum; they fell slightly in August, but improved in September, mainly driven by a rebound in the manufacturing sector.1 Thus growth in the Eurozone can be expected in the coming quarter.

Figure 1. EU economic sentiment decreased slightly

The updated macroeconomic predictions for growth in the Eurozone in 2017 were lowered because of Brexit uncertainty; increased uncertainty about its impact on future consumer and industry confidence will have, according to the International Monetary Fund and the Organization for Economic Cooperation and Development, a slightly negative impact on economic growth in 2017.2 However, one decidedly negative effect can be expected regarding investments. Investments in Eurozone were recovering before Brexit, a development that fueled hope for a self-sustaining recovery. Given the uncertainties surrounding Brexit, it is unlikely that the positive investment trend will continue, so the recovery might continue to be based mainly on private consumption.

Getting ready for the negotiations

That an immediate crisis after the referendum could be avoided does not imply that there are no serious long-term consequences of Brexit. In the real economy, the risks stemming from a potential disruption of trade relations have not disappeared. The long-term consequences will depend on the outcome of the EU-UK negotiations that are likely to start at some point in 2017.

Meanwhile, European institutions have started to get ready for the negotiations. The European Commission and the European Parliament have appointed their lead negotiators. The European Parliament is involved because it has a vote on the final withdrawal agreement. It can agree with or reject the final outcome, but cannot change it. The commission will be heavily involved in the negotiations, but will depend on mandates from the member states’ governments. Generally, the withdrawal agreement has to be decided by the qualified majority of member states, that is, by 72 percent of the member states representing at least 65 percent of the population.

Widely diverging political positions

Among the governments of the EU-27, no coherent strategy has emerged on how to approach the Brexit negotiations. Broadly, there are at least three different positions:3

  • The deeper integration camp: European institutions as well as some of the southern member states tend to see Brexit as an opportunity to deepen European integration. This implies a speedy Brexit and negotiation goals that stress the deterrent effect on other member states.
  • The security camp: Other member states, especially those in Eastern Europe, stress the security aspect of Brexit; they fear a weakening of Atlantic security ties and favor strong ties with the United Kingdom.
  • The market camp: Central European states tend to worry about a disruption of trade ties and support a liberal trading regime with the United Kingdom, but want to avoid “cherry-picking” and a watering down of the four freedoms of the Single Market (free movement of people, capital, goods, and services).

The negotiation position of the European Union will have to consider these competing interests, which increases the likelihood of complex negotiations linking several political issues areas.

Free movement of people a key issue

Nevertheless, one crucial issue in the negotiations is predictable, namely immigration and the free movement of people. Currently, the positions of the United Kingdom and the European Union seem incompatible. For the European Union, free movement of people is a nonnegotiable part of the Single Market, while controlling immigration was the key objective of the Brexit camp. In this sense, the United Kingdom’s access to the Single Market and the future economic relationship will largely depend on a compromise on immigration.

An important factor in this context will be public opinion on the free movement of people in the European Union, especially considering the elections in France and Germany in 2017.

An important factor in this context will be public opinion on the free movement of people in the European Union, especially considering the elections in France and Germany in 2017. Currently, attitudes toward a compromise with the United Kingdom on the free movement of people are quite negative. According to survey research by YouGov, almost a quarter of respondents in France and Germany reject a free-trade deal with the United Kingdom in general, and almost half of them think that there should only be a trade deal if EU citizens can live and work in the United Kingdom (figure 2). Only around 10.0 percent would favor a trade deal without free movement of people.4

Figure 2. Public attitudes in the United Kingdom, Germany, and France regarding a free-trade deal

Think tank proposals seek to reconcile the positions of the United Kingdom and the European Union. They suggest that the United Kingdom could continue to participate in the mobility of goods, services, and capital, while labor mobility would be confined to temporary labor mobility and not to the free movement of people in general. This arrangement would be linked in terms of political governance with a close and structured intergovernmental relationship between the European Union and the United Kingdom.5 Whether proposals along these lines will have a chance to create room for a compromise remains to be seen. Without progress on the immigration issue, an economically favorable outcome of the negotiations seems unlikely.

In any case, the Brexit negotiations will shape the European Union’s agenda in the years to come and will bind considerable administrative capacity and resources. From an economic point of view, not to disrupt the deep economic relationships between the United Kingdom and the European Union that has developed over the last four decades should be a key goal.