Here we answer common questions about the implications of Brexit for the Eurozone and the United Kingdom (UK).
Part 1: The Implications of Brexit for the Eurozone
Q: What is your economic outlook for the Eurozone absent the UK?
A: I think we need a few more weeks to assess the impact. It will depend on the political and financial contagion from the UK. In a first response, many analysts lowered their growth projections for the Eurozone and estimated a 0.3%-0.5% reduction in the annual growth rate of gross domestic product (GDP), but I think this estimate is either too modest or too exaggerated. It would be modest if there is meaningful contagion of economic fallout in the UK, which would bring us to a scenario similar to what happened in 2011 (Exhibit 1). On the other hand, we may be experiencing just another market correction, which had little impact on European growth dynamics over the past year. The point is that it’s premature to make any growth projections, and we shouldn’t jump to conclusions.
The initial market reaction has not been disruptive, and markets recovered last week. The credit spreads of peripheral European countries are range-bound, while interest rates are at historical lows and help debt sustainability. Credit default swap (CDS) spreads were initially higher, but they do not indicate a big jump in perceived default risk. The equity market sell-off doesn’t appear to differ from a typical market correction. Overall, the market shock sustained by Brexit so far doesn’t look worse than the one of August 2015 or February 2016. It also doesn’t seem as if the market is questioning the sustainability of the currency union for now. Let’s hope it remains so.
Yet there is no guarantee that the market’s response to Brexit will remain relatively muted as it has been so far. When we experience market shocks in response to an unforeseen event like Brexit, volatility and risk aversion tend to spike and remain elevated for a while until the actual implications of the event become clearer. We thus need a bit more time to be able to offer more confident estimates about the near-term effect of Brexit.
If the current shock doesn’t prove to be persistent, the impact of Brexit on the European economy may be marginal and can be offset by monetary and fiscal policies. If, however, it proves to be persistent, and if there is political contagion to the Eurozone (in the form of other countries pursuing departure from the European Union (EU)), I am afraid that the current revisions to the GDP growth forecast would prove too optimistic, and we may see a Eurozone recession such as witnessed in 2011-2012. There would also be a more significant impact on the world economy.
Q: What could be Brexit’s political implications for other EU memberships?
A: This would be the key impact of Brexit, and whether there would be political contagion to the Eurozone or not. I don’t think anybody knows the answer just yet. But in the near term, a Brexit-style referendum is not on the agenda in any EU country. Current governments in Europe are pro-EU and, after the Brexit experience, would not easily submit sensitive issues to a public vote; the bar would be much higher. Political developments down the road can change this, of course, but that would take at least a year, and possibly more.
“Euro-skeptic” movements are on the rise in some countries but in most cases they haven’t been advanced enough to win majorities or lead at this stage. In Spain, for example, despite what polls were suggesting, the anti-establishment Podemos Alliance remained as the third party, and establishment parties raised or maintained their popularity and positions. That was good news in a sensitive environment.
There are two important elections in the Spring of 2017 in France and the Netherlands that can raise political risks. In France, the Front National party under the leadership of Marine Le Pen advocates a referendum on France’s membership in the EU. While Front National had some success in past elections, the two-stage electoral system in France typically leads to parties uniting around a centrist candidate in the second stage.
In the Netherlands, there are elections by March 15, 2017, and the populist PVV party is gaining in the polls and pushing for a referendum on exiting the EU. But current polling reflects popular support of around 35% for PVV, which doesn’t provide enough votes to gain a majority. In fact, PVV’s leader called for a referendum after the UK’s decision but only 14 out of 150 members of the Netherlands parliament supported the motion. This is a risk factor to follow in the next year.
Italy is the country to watch for the remainder of the year. The closest political risk in Europe is Italy’s referendum on constitutional reform. If passed, it will be great news for reform prospects in Italy. If not, Prime Minister Renzi said he would resign, which would create a political vacuum.
Part 2: The Implications of Brexit for the UK
Q: What are the short-term implications of Brexit on the UK’s economy?
A: In the short run, the UK faces a recession risk. The results led to a significant rise in political uncertainty. The prime minister resigned, the leader of the opposition is challenged by his parliament group, and leaders of the Brexit movement left the stage. The position of Scotland in the UK is again in question. On the economic front, there is uncertainty about trade, capital and labor flows. The list goes on, but in such an environment of elevated uncertainty, it’s likely that companies will delay investment decisions and households will postpone major expenditures. There is not much room for fiscal policy in the UK to offset this highly probable decline in domestic private demand. The Bank of England’s policies can only ease the pain but are unlikely to be able to reverse Brexit’s consequences altogether. Weaker currency may help boost exports on the margin, but the UK is not an export powerhouse to begin with; in fact, it has a large and growing current-account deficit. In sum, we expect the UK to face a difficult adjustment period in the near future.
Q: Could the UK’s economy stabilize and eventually grow following the aftershocks that would result from leaving the EU?
A: Certainly. In the long run, just like any country, I expect the UK economy to stabilize and resume growth. However, I expect long-term economic output to be lower in the wake of Brexit because of poorer trading and financial arrangements than the ones the UK had in place as an EU member, and risks to attracting global talent—all of which will likely reduce investment and lead to lower productivity growth.
Q: Could Brexit affect London’s stature as a global financial center?
A: I believe London will likely keep its status as a financial center, but Brexit will not be costless.
London is a financial center in a key European time zone between the Americas and Far East, only matched by New York. Its geographic advantage is here to stay. It is also an agglomeration that brings together financial firms, skilled people, infrastructure, a favorable and competent regulatory framework, and legal and tax systems that all support and reinforce each other. London is, by western standards, a very agreeable city in which to live that offers plenty in the way of career opportunities, education, culture and leisure. No other city in Europe can match such an agglomeration of skill and services, and it is advantageous for a firm or individual to be part of its hub.
But Brexit could exact a toll. Other EU members will surely promote their own financial centers in the absence of the UK at the table. They can create incentives for firms to move some functions elsewhere in the EU. For example, French President Francois Hollande already said that the city of London would no longer be able to clear euro-dominated trades.
The key here is the so called “financial passport,” an agreement that any firm in an EU member state can provide financial services to customers anywhere in the EU. It is not clear if the UK will keep the financial passport in exit negotiations, but even if it does, such a passport would not be earned for free. In the absence of the financial passport, firms may have to relocate at least certain functions elsewhere in the EU, or open subsidiaries to gain EU access. As the Eurozone takes steps toward a systemic union for banking and capital markets, it will have no reason to listen to the concerns of London, which in the past managed to win “opt-outs” in negotiations.
What’s more, the status of EU citizens living in the UK who provide London with professional talent is also unclear. There’s a possibility that nothing would change on this front, as we expect London to continue to make an effort to attract global talent, but given the central role of immigration in this referendum, clarity would be needed regarding the status of the EU and other citizens.
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These views represent the opinions of OppenheimerFunds, Inc. and are not intended as investment advice or to predict or depict the performance of any investment. These views are as of the publication date, and are subject to change based on subsequent developments.