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Brexit: a shock on the UK economy, a drag on the recovery in the Eurozone

The Brexit vote is an immense source of uncertainty: Uncertainty over the future of trade relations between the UK and the EU and therefore, potentially, on the future location of certain industries; political uncertainty (which prime minister? For which policy and which negotiating model?), and further uncertainty over the country's unity (possible referendum on independence in Scotland). One thing is sure - these uncertainties will not be resolved any time soon. Heads of State and the government were clear at the summit of 29-30 June: no negotiation - even informal - can begin until the British government invokes Article 50 (which ratifies the procedure for a country exiting the EU). In the best case, the uncertainty on this topic will continue until 16 September (the date of the next informal summit of the EU-27), one week after the Conservative party elects a leader to succeed David Cameron as prime minister.

This shock of uncertainty may send the British economy into recession. Since the UK will remain a full member of the EU for at least two more years, it isn't the trade channel that will affect the British economy. On the other hand, the total lack of visibility will push economic actors to postpone their purchasing plans or decisions. Thus, between now and the end of the year we are likely to see:

  • A downturn in business investment and a freeze on hiring. The primary determinant in business investment is anticipated demand (which will drop). Thus investment plans will be postponed, whenever possible. The same is true for hiring, which will, by all appearances, come to a halt.
  • A rise in household savings. Consumers, fearing for their jobs, tend to build up precautionary savings. The household savings rate, which has dropped significantly over the past few years (from 9% in 2012 to 4.2% in 2015), may surge back up (remind that it was at 9% on average between 1996 and 2011). Not to mention that inflation caused by the pound's depreciation will weigh on their purchasing power (households import a great deal of the goods they consume).
  • A depreciation in real estate. There is a housing bubble, especially in London. The decline in demand will drive prices down. The good news is that this will return the least-mortgaged households to solvency. But at the same time, it will generate a "negative wealth effect" that will weigh heavily on consumption.

However, there's no reason to become deeply pessimistic. The British economy has always been flexible and resilient against shocks. Moreover, a large part of the goods consumed are imported, so the impact on GDP should ultimately be less than the impact on domestic demand, especially since exports should benefit from the pound's depreciation (-12% vs. H2 2015, in trade-weighted terms). Finally, and above all, economic policy is going to get very accommodative: beyond the Bank of England (see analysis below), which will quickly lower its interest rates, there is also fiscal policy to consider. Once in place, the new PM will probably adopt an expansionist policy (tax cuts). Against this backdrop, we anticipate a short-lived recession (two quarters of contraction in GDP, Q3 and Q4 2016), then a rebound in growth as of H1 2017 (but at a slower pace than before the Brexit vote). That's why we are revising our growth forecast (annual averages) from 1.8% to 1.1% in 2016 and from 2.0% to 0.2% in 2017(+1.3% yoy, Q4 2017 vs. Q4 2016).

The recovery in the Eurozone will continue, but at a slower pace. The shock of uncertainty affects the UK most of all. Remember that the euro was (before the Brexit) enjoying good cyclical momentum, driven by domestic demand. From a fundamental standpoint, there is no reason to change the scenario. Indeed, at this stage, monetary and financial conditions remain highly accommodative. The current episode has nothing in common with the recession triggered by Lehman’s collapse, or with the one precipitated by the sovereign debt crisis (credit crunch). The economic impact on the Eurozone passes, primarily through trade exposure (goods and services), from the EU to the UK. Exports from the Eurozone to the UK are automatically going to fall due to the decline in domestic demand and the pound's depreciation. But the portion of exports to the UK is a mere 4% of the Eurozone’s GDP, which is not enough to derail the recovery. However, it would be unwise to consider that trade is the only transmission channel through which the Brexit can impact the economy. Business surveys are likely to deteriorate and domestic demand may slow. At the end of the day, we are revising our growth forecast down by 0.3 pp, from 1.5% to 1.2% in 2017. All things considered, the Brexit would trigger a slowdown in growth, but it should not challenge improvement on the jobs front.

Nonetheless, risks are very clearly tilted to the downside. The political crisis in the UK may cause a political crisis throughout Europe. Then the confidence shock would spread through the entire Eurozone: consumption and investment would slow down significantly, growth could fall below 1%, and unemployment could climb. A shock of this nature would increase deflationary pressure, force the ECB to adopt more monetary easing and governments to implement fiscal stimulus. The ball is in the camp of the Heads of State or Governments. Only they are capable (1) to avoid stalemate, (2) to maintain the EU’s cohesion and (3) to take initiatives to jumpstart the “European project”. It is possible but it clearly requires leadership.

 

 

2016-07-01-focus
BOROWSKI Didier , Head of Macroeconomic Research
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Brexit: a shock on the UK economy, a drag on the recovery in the Eurozone
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