Britain's vote to leave the European Union has engulfed the kingdom in a political, constitutional and economic storm. But it has also plunged Europe into uncharted waters. It may not be prepared for this challenging, uncertain course.
We’ve so far witnessed a striking lack of consensus among policy-makers. This is not only in regards to the way forward for the European Union, but also the negotiation stance to be adopted with the UK. A broad agreement will be needed to push decisions related to the UK through the European Council, and recent negotiations on the migrant crisis are a reminder of how cumbersome it can be to find agreement among all member states.
In light of this consensus vacuum, the European Central Bank (ECB) will be required to step in to steer the European ship. Though presently retaining a wait-and-see attitude, the ECB is closely monitoring both the economic outlook and financial markets, standing ready to intervene if necessary. Governing council member Ewald Nowotny has reassured markets that “it’s secured that neither English nor European banks will have liquidity shortages”.
We think the storm currently forecasted for Eurozone economic activity may turn out to be more of a chilly breeze. In our opinion, the impact of financial market volatility, rising uncertainty and potentially deteriorating sentiment may be moderate, leading us to cut our Eurozone 2016 GDP forecast from 1.6 per cent to 1.5 per cent and 2017 GDP forecast from 1.7 per cent to 1.3 per cent. The IMF’s latest forecast on Eurozone growth supports this view. Expanded ECB easing could push the trade-weighted euro down, which would help exports and provide a cushion against negative effects.
The UK’s trade relationship with the rest of Europe has been a key focal point of the referendum. During the UK’s “negotiating period”, the impact on trade will depend on the exchange rate. Even if UK growth is sluggish, the transmission via trade to economic growth in the Eurozone is not likely to reduce the annual economic growth rate by more than 0.1-0.2 per cent, if at all.
Further ahead, the forecast depends upon future trade arrangements between the UK and the EU. Given that exports to the UK make up just over 10 per cent of the total, we expect the long-term impact through trade to be negative but small. It could be offset by foreign direct investment, which is likely to be, to some extent, redirected from the UK to remaining EU member states.
A UK departure may force the Eurozone to accelerate its integration over the long term. This would improve growth, and ultimately prove the decisive factor in terms of the long-term growth impact. All in all, despite risks presented by the increased likelihood of further referendums, these effects could in fact lift the long-term potential growth rate from 1 per cent to 1.5 per cent.
Some commentators have suggested a British exit spells the end of the European project. We disagree. Instead, the UK’s vote could mark the tipping point in the EU’s evolution, prompting its further transformation into a monetary union. The Eurozone’s economic size will increase from 71 per cent to 82 per cent relative to the EU when the UK leaves. Furthermore, Eurozone member states would see their share within the European Council, the EU’s most powerful institution, soar to 76 per cent. This means non-Eurozone countries will by definition not be able to even come close to reaching the 35 per cent required to block a decision – and so any deal with the UK will primarily be aligned with the interests of the Eurozone.
Further integration, though, will likely have to wait at least until the German and French elections next year. The UK laid down its integration anchor early, sometimes hindering efforts for an “ever closer union”. Greater integration risks aggravating populist forces on the continent, which have already made their voices heard preceding and following the UK’s decision. Nevertheless, popular support for the euro is at near record highs, attesting to the cohesion of EU members that have adopted the single currency. Since EU support is correlated with economic growth, growth-enhancing structural reforms will be critical in the future.
And this is perhaps the crux of the matter. The UK’s departure will not sink the EU. Rather, it will present new obstacles to navigate and at the same time open up potential new routes. Eurozone members will be at the helm, and should the winds blow in the right direction, the EU ship could yet sail to sunnier climes over the long term.