In this explainer, we look at the international effects of Brexit to the economies of the UK and selected euro area member states: Austria, Germany, France, Spain and Italy. Our analysis is based on a large-scale dynamic macroeconomic model that allows us to estimate the impact of Brexit on a modelled version of these economies, based on a ‘hard’ or a ‘soft’ Brexit.
Macroeconomic reactions to Brexit
Figure 1 shows the dynamic responses of year-on-year growth in industrial production for the UK and selected euro area countries to uncertainty arising from Brexit over a time horizon of 20 months.
The model suggests a moderate decrease in industrial production growth of approximately 1.3 percent 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, explained by the degree of openness of the Austrian economy and the strong dependence on the neighbouring states in south-east Europe.
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 Brexit are highly relevant for policy makers in the Bank of England (BoE) and the European Central Bank (ECB), who may well respond by enacting expansionary monetary policies. Figure 2 suggests that disinflationary pressures of around 0.1 percent emerge in the UK and across Europe (except for Austria and France) .This fall in inflation can be attributed to companies lowering prices in the face of decreasing demand.
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 financial crisis and the subsequent European debt crisis – central banks need to adopt unconventional monetary policy measures which 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 time horizon considered (with decreases of approximately 0.1 percent).
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 the 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 in a decrease in the value of collateral used to borrow money. This, in turn, depresses investment and consumption activities.
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 their 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 pound depreciates sharply (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.
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 minus 1.3 percent at worst, 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 outcome) we use the conservative estimates by the Bank of England. This results in a drop in output for the UK of approximately minus 7.5 percent on a year-to-year basis.
Table 1: Responses for a soft and hard Brexit
[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 percent, and in Germany 4.2 percent. The impact on inflation is much stronger than under a soft Brexit, with responses in France (-0.41 percent) and Spain (-0.59 percent ) 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 pound depreciates against its main trading partners by approximately 7.5 percent.
It follows from this discussion that a hard Brexit scenario yields major disruptions in financial markets and macroeconomic fundamentals in the euro area and the UK.
This post provided some evidence of the international economic consequences of the uncertainty arising from Brexit. 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 policy makers will include offsetting the negative output effects, while battling disinflationary pressures. Disruptions also occur in 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 pound depreciating against the dollar, and an appreciation of the selected euro area countries in real terms.