Brexit and the Global Economy: Spillovers Mainly on Europe
The Brexit vote will first and foremost have negative consequences for the UK economy, which is likely to see its expansion slow significantly. We expect some spillovers into other economies due to trade, confidence and financial contagion effects.
The decision of the UK to leave the EU will, first and foremost, affect the UK economy itself. Uncertainty about access to foreign markets, and the ability to hire people from abroad, will likely lead to a decline in investment. Employment growth could also come to a halt, which in turn might drag down consumer sentiment and spending. This might result in a technical recession, i.e., two quarters of negative growth, but, for 2017 as a whole, we do not think that the British economy will shrink.
Looking at past cyclical downturns, the reactions of investment spending are typically more immediate and pronounced than those of private consumption. This pattern is likely going to be repeated, but probably in a less pronounced manner than in the case of global recessions. However, UK domestic demand will likely slow down, in our view, and even contract for a few quarters. The longer-term impact on the UK is highly dependent on future economic relations with the EU, but will most likely be negative as well, with potentially reduced trade access and labor market mobility weighing on investment, productivity and income.
As regards the impact of Brexit on other major economies, we examine three main potential channels: 1) trade, 2) confidence, and 3) financial contagion.
The UK is the world's fifth largest importer, absorbing roughly 4 percent of world trade, and it is running a trade deficit which amounted to 7 percent of GDP last year.
As a consequence of Brexit and the weaker GBP, we would expect overall UK import volumes to stagnate in the second half of the year, and to decline around 2 percent year-on-year in 2017. The corresponding value of exports to the UK would probably drop even more, as most exporters would have to make price concessions due to the weaker GBP. This was also the case in the 2008–2009 recession. UK import volumes fell 15 percent, but the top ten trading partners suffered export declines to the UK ranging from 14 percent (China) to 31 percent (Spain) in local currency terms.
While the magnitude of the declines would be less in the upcoming downturn, we would assume the country pattern would be similar to the last recession. Therefore, the "Brexit drag" on China and the USA is likely to turn out to be negligible. Both countries' exports appear less vulnerable to a downturn in the UK and a weak GBP. In addition, exports to the UK only represent 0.5 percent and 0.3 percent of their GDP, respectively.
In Europe, Ireland and Norway both have a significant trade exposure to the UK. However, Ireland mainly exports relatively inelastic pharmaceutical, food and agriculture products to the UK, and its nominal exports were thus among the less affected in the last recession. Norway's mineral fuel exports are probably even more shielded from demand and currency effects; the steep decline in the last recession mainly reflected the drop in commodity prices. All other European trading partners are likely to suffer more, and we would not be surprised to see export declines reaching the 5-10 percent range in countries such as Spain, Italy and France next year, though uncertainty surrounding such estimates is considerable. Even then, however, the direct negative effects on GDP of the European trading partners is likely to remain mild, and would probably fall within the 0.1–0.3 percentage points range, in our view.
A second and potentially very powerful channel of contagion is via consumer and business confidence. Indeed, uncertainty over the longer-term prospects of the European Union are likely to increase with Brexit, although we think the view that Brexit marks the beginning of a disintegration of the EU is highly exaggerated. Conversely, it seems rather unrealistic to believe that the Brexit shock will lead to enhanced cohesion among the 27 remaining states. On balance, business sentiment and thus investment could be dampened due to this political development. Consumer sentiment might then also suffer in response to weaker corporate spending.
Nevertheless, the question remains by how much policy uncertainty will effectively rise outside the UK as a result of the Brexit vote, and how strongly that will affect economic sentiment. It seems unlikely to us that countries outside Europe would be much affected. But even within Europe, policy uncertainty has only a limited effect on economic sentiment.
A third channel by which the Brexit vote could impact the European economy, in particular, is via financial contagion. The Brexit vote has raised concerns that financial conditions might worsen in the European periphery. So far, the verdict in this regard is not clear: On the one hand, yield spreads of Italian and Spanish government bonds over those of Germany are back to pre-Brexit vote levels, after initially widening to some extent. In our view, this indicates that the markets believe in the ECB's determination and ability to prevent a renewed sovereign debt crisis in the Eurozone.
At the same time, refinancing conditions of many European banks have worsened sharply since the Brexit vote, with prices of their stocks and bonds dropping sharply. Concerns about a weakening economic outlook, as well as lower yields and a flatter yield curve, which constrain the banks' ability to generate revenues and thus weigh on profitability, were the likely causes. This has especially increased the market's focus on Italian banks which carry large amounts of non-performing loans on their books, in a situation in which the rules of the newly launched European Banking Union severely limit the ability of governments to provide support to banks.
Such stresses are likely to further restrain the lending activity of banks in Italy, and possibly elsewhere. At the same time, leverage in the banking system has, in our view, been reduced sufficiently to prevent a renewed financial crisis in the Eurozone. Overall, however, tighter financial conditions are likely to continue to imply sub-par investment and growth in the Eurozone periphery, as has been the case in past years.
Global Brexit Fallout Likely to Be Contained
To summarize, we think that the Brexit vote mainly has negative consequences for the UK economy, whereas spillovers – primarily via trade, confidence and financial conditions – are likely to be contained elsewhere. Nevertheless, recent developments regarding the European banking sector are a cause for concern, and need to be closely monitored going forward.
Even if the impact of each channel in isolation might not be particularly large, the sum might still represent a non-negligible drag on the European economy, in particular. We have therefore maintained our 2016 growth forecasts at current levels, in spite of the more positive data prints before the Brexit vote, but have slightly downgraded our 2017 forecasts. More negative scenarios would come into play over the longer term if political fragmentation risks increase in the EU more severely, contrary to our assumption.