The impact of Brexit on the economies of selected Euro area member states

By Stefan Griller, Florian Huber, Michael Pfarrhofer and Sonja Puntscher Riekmann

Salzburg Centre of European Union Studies (SCEUS)

12 March 2019

In this blog post, we look at the international spillover effects of a Brexit shock to the economies of the UK and selected Euro area member states, in particular Austria, Gemrany, France, Spain and Italy. Our method is based on a large-scale dynamic macroeconomic model that is estimated using cutting edge Bayesian techniques and allows for analyzing how a Brexit shock impacts the model economy. The Brexit-uncertainty shock is constructed using the magnitude of prediction errors when forecasting economic variables as an indicator of uncertainty. We scale this quantity to quantitatively reflect scenarios of a hard and a soft Brexit as calculated by the Bank of England (BoE).

 

Macroeconomic reactions to a Brexit shock

Figure 1 shows the dynamic responses of year-on-year growth in industrial production for the UK and selected euro area countries to the Brexit uncertainty shock over a time horizon of 20 months. The estimated parameters suggest a moderate decrease in industrial production growth of approximately 1.3 percentage points over the horizon considered. The plots depict the median response alongside uncertainty surrounding the scenarios (green-shaded).

Industrial production in the United Kingdom and in all selected continental European countries declines, with significant differences in the magnitude and dynamics of the responses. This result is consistent with the fact that increasing uncertainty related to Brexit leads to a decline in private consumption and investment. The estimated effect appears to be permanent and suggests persistent negative effects of Brexit uncertainty on the economic performance of the countries studied. The effect on Austria is substantial. This can be explained by the degree of openness of the Austrian economy and the strong dependence on the Southeastern European (CESEE) neighboring states. The CESEE countries, which are not explicitly analyzed here, also react with a slump in economic activity due to the generally higher volatility of their macroeconomic fundamentals, which has a negative impact on the demand for Austrian goods. 

Brexit Shock Figure 1

Figure 1: Dynamic responses of growth in industrial production to a Brexit-shock (in percentage points).
Expected inflation dynamics for the UK and the euro area countries following the Brexit shock are highly relevant for policy makers in the Bank of England and the European Central Bank, who typically intend to offset possible negative outcomes of the Brexit by enacting expansionary monetary policies. Figure 2 suggests that disinflationary pressures emerge in the UK and across Europe (except for Austria and France) of around 0.1 percentage points year-on-year. This decline in prices can be attributed to companies lowering prices in face of decreasing demand.

Brexit Shock Figure 2

Figure 2: Dynamic responses of inflation to a Brexit-shock (in percentage points).
If short-term interest rates, the conventional modern monetary policy instrument, are close to zero – a ubiquitous phenomenon in the aftermath of the Global Financial Crisis and the subsequent European Debt Crisis – central banks need to adopt unconventional monetary policy measures. These measures target long-term interest rates. To adequately capture such unconventional policies, Figure 3 depicts the responses of 10-year government bond yields. Responses for the UK, Austria, Germany, and France are negative for the impulse response horizon considered (with decreases of approximately 0.1 percentage points), confirming our view that both the ECB and the BoE engage in unconventional monetary policy by buying long-term securities. For Spain and Italy, however, effects are negligible and insignificant. Besides central banks targeting long-term yields, this may reflect increased demand for comparatively safe assets such as German treasuries.

Brexit Shock Figure 3

Figure 3: Dynamic responses of long-term interest rates to a Brexit-shock (in percentage points).
Equity price responses, captured through the dynamic reactions of the largest stock market indices across countries, are shown in Figure 4. With the exception of Austrian and German stock markets that exhibit insignificant reactions, equity prices in the UK and the remaining countries decline over the forecast horizon considered (with magnitudes ranging from minus four to minus two percent). This drop in the stock market provides a further rationale on why output declines, namely that the decline in asset prices culminates with a decrease in the value of collaterals used to borrow money. This, in turn, depresses investment and consumption activities.

Brexit Shock Figure 4

Figure 4: Dynamic responses of stock markets to a Brexit-shock (in percent – 0.01 reflects 1%).
Figure 5 presents the responses of real effective exchange rates across countries. The responses of the continental European countries are very similar, reflecting them being tied together by the euro. Specifically, the euro appears to slightly appreciate vis-á-vis its main trading partners in real terms across the economies under consideration (approximately by around 0.2 percent). By contrast, the British pound depreciates sharply on impact of the uncertainty shock (by roughly 1.3 percent), indicating lower levels of confidence in the British economy after the Brexit and money flowing into relatively safe havens such as Germany or Switzerland. Changes in international exchange rate dynamics are crucial for private and public debt, especially considering the high debt levels across most developed countries.

Brexit Shock Figure 5

Figure 5: Dynamic responses of real effective exchange rates to a Brexit-shock (in percent – 0.01 reflects 1%).

Analyzing the effects of a soft and hard Brexit

The effects discussed above refer to a soft Brexit scenario with moderate effects on output growth for the UK of roughly negative 1.3 percentage points at the peak, assuming the UK and EU to remain in some kind of economic partnership.

To provide a grasp of what to expect in the case of a hard Brexit, that is, a disruptive or disorderly no-deal Brexit, we use the conservative estimates by the Bank of England (2018) and rescale our responses accordingly. This results in a peak output response for the UK of approximately negative 7.5 percentage points on a year-to-year basis.

 

Table 1: Peak responses for a soft and hard Brexit.

Infl.

 

Soft Brexit

 

Hard Brexit

 

IP

Infl.

IR

Stocks

XR

 

IP

IR

Stocks

XR

GB

-1,305

-0.081

-0,081

-1,336

-1,301

 

-7,556

-0,467

-0,466

-7,732

-7,533

AT

-0,656

-0,021

-0,100

-1,512

0,260

 

-4,494

-0,124

-0,580

-8,755

1,502

DE

-0,725

0,016

-0,047

-3,339

0,367

 

-4,196

0,095

-0,274

-19,332

2,126

FR

-1,006

-0,071

-0,056

-0,849

0,169

 

-5,827

-0,412

-0,326

-4,916

0,981

ES

-0,794

-0,102

0,016

-3,392

0,167

 

-4,599

-0,591

0,091

-19,637

0,970

IT

-1,027

0,035

-0,069

-5,356

0,277

 

>

-5,944

0,201

-0,397

-31,008

1,604

 

Notes: industrial production (IP, in percentage points), inflation (Infl., in percentage points), ten-year government bond rates (IR, in percentage points), equity prices (stocks, in percent – 1 refers to 1%), real effective exchange rates (XR, in percent – in percent – 1 refers to 1%).

 

Table 1 contains the results for the soft and hard Brexit scenario. It is worth noting the pronounced macroeconomic reactions across countries, with a decline of industrial production in Austria of approximately 4.5 and in the case of Germany, of 4.2 percentage points. The impact on inflation is much stronger than for the soft Brexit, with responses in France (-0.41 percentage points) and Spain (-0.59 percentage points) being the largest. Long-term interest rates and equity prices also show pronounced declines, with substantial effects for Italian stock markets. This finding, however, is driven by the current discussion about public debt and strong international linkages of Italian banks. The British pound depreciates against its main trading partners by approximately 7.5 percent.

It follows from this discussion, that the adverse scenario of a hard Brexit yields major disruptions in financial markets and macroeconomic fundamentals in the Euro area and the UK.

 

Conclusions

This post provided some evidence of the international economic consequences of a Brexit induced uncertainty shock. In line with established findings, such a shock depresses hiring and investment in the UK, thereby affecting productivity growth and real activity. Interestingly, however, pronounced negative effects are also evident in the remaining euro area countries. Challenges for top level policy makers will include offsetting the negative output effects, while battling disinflationary pressures. Disruptions also occur in terms of financial markets, where the Brexit shock depresses equity prices in the UK and the continental European countries. International currency relationships shift as well, with the British pound depreciating against the US dollar, and an appreciation of the selected euro area countries in real terms.

 

References:

BAKER SR, BLOOM N, AND DAVIS SJ (2016), “Measuring economic policy uncertainty,” The Quarterly Journal of Economics 131(4), 1593–1636.

BANK OF ENGLAND (2018), “EU withdrawal scenarios and monetary and financial stability: A response to the House of Commons Treasury Committee”.

BLOOM N, CHEN S, AND MIZEN P (2018), “Rising Brexit uncertainty has reduced investment and employment”.

BORN B, MÜLLER G, SCHULARICK M, AND SEDLÁCEK P (2018), “£350 million a week: The output cost of the Brexit vote”.

CARRIERO A, CLARK TE, AND MARCELLINO M (2018), “Measuring uncertainty and its impact on the economy,” Review of Economics and Statistics 100(5), 799–815.

FERNÁNDEZ-VILLAVERDE J, GUERRÓN-QUINTANA P, KUESTER K, AND RUBIO-RAMÍREZ J (2015), “Fiscal volatility shocks and economic activity,” American Economic Review 105(11), 3352–84.