2 September 2019
Economics Brexit and the EU Eurozone
Implications of 'no deal' for the eurozone
The clear gap between the UK and EU negotiating positions means a 'no deal' Brexit is a real possibility
While we do not think a disorderly Brexit will cause a recession in the eurozone, nor even in Ireland…
…it would likely weigh on already lacklustre growth prospects
and could raise calls for the ECB to scale up QE
'No deal' a real possibility
UK Prime Minister Boris Johnson has pledged to leave the EU 31 October "do or die". As we outline in a box on page 4, we see little incentive for the EU to meet Mr Chris Hare Johnson's demand to remove the Northern Ireland 'backstop', meaning the prospect of Economist a deal still looks fragile. And, with limited time for the UK Parliament to block 'no deal', HSBC Bank plc [email protected] it is perhaps unsurprising that the bookmakers see a roughly 40% chance of it. +44 20 7991 2995
Fabio Balboni What would a potential 'no deal' look like? Senior Economist It is impossible to predict the precise arrangements that would be established HSBC Bank plc [email protected] between the UK and the EU under a potential 'no deal'. But on the whole, we follow +44 20 7992 0374 the 'disorderly no deal' assumptions outlined in our 'no deal' analysis of the UK Chantana Sam (Brexit Strategies: No deal for real? 27 June 2019). This includes immediate trade Economist HSBC France tariffs and trade disruption relating to border checks, but more benign transition [email protected] measures for (financial) services trade. +33 1 40 70 77 95 Rainer Sartoris, CFA Weaker growth, lower inflation, looser policy Economist HSBC Trinkaus & Burkhardt AG In this context, we construct a scenario for eurozone growth and inflation under 'no [email protected] +49 211 910 2470 deal'. Bearing in mind that eurozone exports to the UK are worth just over 3% of its Shanella Rajanayagam GDP, we consider spillovers from: (i) trade disruption (ii) a possible UK recession (iii) Trade Economist weaker UK demand due to a likely fall in the pound (iv) confidence effects (v) banking HSBC Bank plc [email protected] sector spillovers. Taken together, a 'no deal' Brexit would knock 0.3ppts off eurozone +44 20 3268 4118 growth in 2020. A small, slow-burn drag on trade and GDP might well persist beyond that. And inflation might be a touch softer, too.
As a central case, then, we assume a relatively mild impact of 'no deal' Brexit for the eurozone as a whole. But the impact could be bigger, particularly if financial conditions tighten. And in any case, we think 'no deal' might raise calls for the ECB to scale up its QE programme, versus our EUR30bn a month central case. There might be a fiscal response, but perhaps only limited to the most affected sectors. Meanwhile, as we outline in a box on page 15, a tussle over the 'Brexit divorce bill' lies ahead.
Finally, from page 16 onwards, we outline scenarios for the Big 4 eurozone countries and Ireland. While the likely impact on the Big 4 might be broadly similar to that on the eurozone as a whole, Ireland would likely see by far the biggest hit. But even there, strong fundamentals should help avoid a recession, in our view.
Disclosures & Disclaimer Issuer of report: HSBC Bank plc This report must be read with the disclosures and the analyst certifications in View HSBC Global Research at: the Disclosure appendix, and with the Disclaimer, which forms part of it. https://www.research.hsbc.com
Economics ● Eurozone 2 September 2019
'No deal' for real?
The clear gap between the UK and EU negotiating positions means 'no deal' Brexit is a material possibility
While we do not think a disorderly Brexit will cause a recession in the eurozone, nor even in Ireland…
…we do think it would lead the ECB to ramp-up stimulus, and might lead some countries to consider fiscal loosening
'No deal' has become more likely
Since Boris Johnson became the UK's Prime Minister in late July, the chances of a 'no deal' Brexit have risen. Mr Johnson has pledged to remove the UK from the EU on 31 October "do or die".
We are getting ready to come out on 31 October… do or die. Come what may. UK Prime Minister Boris Johnson, 25 June
The problem is, it is difficult to see how a deal can be agreed to by the EU, the UK government and the UK parliament by then. Mr Johnson has called for a complete removal of the Northern Ireland 'backstop' from the UK's Withdrawal Agreement. It is very unlikely that the EU would go far as that, in our view. Nor do we think it likely that the UK will devise alternative solutions (to the satisfaction of the EU) to supersede the backstop by late September, as suggested by German Chancellor Angela Merkel.1 We do think the EU could agree to tweaks to the Withdrawal Agreement which could bring a majority of UK MPs onside, but that is by no means guaranteed. Moreover, particularly following the government's announcement that it will prorogue (shut down) parliament between mid-September and 14 October, there are limited opportunities for MPs to block 'no deal' (see Brexit: Season finale? Ten questions and answers, 30 August).
The bookies are pointing to a Bearing this impasse in mind, it is perhaps unsurprising that the bookmakers' odds are pointing roughly 40% chance of 'no to a 40% chance of 'no deal' Brexit by the end of the year (Betfair, 29 August). deal' Brexit this year
______1 'Boris Johnson accepts Angela Merkel challenge to replace Irish backstop in 30 days', The Independent, 21 August
2 Economics ● Eurozone 2 September 2019
What would 'no deal' look like?
This June we published a report on the possible impact of 'no deal' Brexit on the UK (Brexit Strategies: No deal for real? 27 June 2019). It is impossible to say precisely what a potential 'no deal' would look like. Indeed, even after a 'no deal', the UK and the EU could soon come back to the negotiating table to hammer out a deal, thereby limiting economic fallout. But assuming that doesn't happen, we highlight some assumptions underlying the trading relationship in more details in Table 21 in the Appendix (page 24). We think key elements of potential 'no deal' Brexit would be as follows:
The EU immediately imposes WTO tariffs on imports from the UK: The EU's average non- preferential tariffs rates stand at 12% for agriculture and 4.2% for non-agriculture.
The UK immediately applies a 'temporary' tariff regime, first outlined in March 2019: This would leave most UK tariffs on industrial goods imports from the EU at zero. But the EU would face higher UK tariffs on imports of cars and certain agricultural goods compared to current arrangements.
Significant border disruption: In particular, this would involve the EU rapidly imposing customs and regulatory checks on imports from the UK at its ports. On the other hand, the UK appears to be signalling a more gradual imposition of checks.
Uncertainties around the Northern Irish border: We do not envisage border infrastructure being established, at least in the first instance. But without the establishment of some form of comprehensive border arrangement, some form of behind-the-border checks, alongside significant uncertainty, is likely, in our view. The UK will not impose any tariffs or new border checks temporarily on Northern Irish imports from the Republic of Ireland.
Limited shock to financial services: The UK authorities plan to give EU financial institutions continued 'passporting' rights to the UK for three years under 'no deal'.2 EU arrangements for UK firms are more piecemeal, though, which is a risk to EU27-based consumers of UK financial services.
Citizens' rights broadly intact: Even under 'no deal', we find it highly unlikely that the rights of EU citizens living in the UK, and vice versa, would be curtailed to the extent that would spark a big one-off migration. But over time, migration flows, particularly of unskilled workers, are likely to slow. There is a risk, though, that the adjustment might come more quickly, given reports of UK government plans to end free movement of EU citizens from 1 November. EU citizens already residing in the UK might face residency issues if they have not applied for 'settled' or 'pre-settled' status in the UK.3
Other forms of disruption: There are a range of other possible forms of disruption not covered above. For example, while an agreement has been signed to keep planes flying between the UK and the EU, many other agreements would likely be needed to prevent disruption in other areas, ranging from medicines, to fisheries, to data protection.
______2 'The temporary permissions regime for inbound passporting EEA firms and funds', fca.org.uk 3 'UK to end freedom of movement for EU citizens on day one of Brexit, under new government plan', The Independent, 18 August
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Box: Between a backstop and a hard place
The UK wants to remove the backstop… The chances of 'no deal' Brexit mostly reflect the state of play on the Northern Irish 'backstop', which forms part of the UK/EU Withdrawal Agreement. The backstop outlines that, after a post- Brexit 'status quo' transition period, if no alternative plans can guarantee a 'soft' border between Northern Ireland and the Republic of Ireland (RoI) (i) the whole of the UK needs to remain in the EU customs union (ii) Northern Ireland to remain in the EU's single market for goods trade.
Some Brexit supporters fear this risks tying the UK too closely to the EU. And crucially, as a pre- condition for endorsing a deal with the EU, UK PM Boris Johnson has called for the complete removal of the Northern Ireland backstop from the Withdrawal Agreement.
No to time limits or unilateral escape hatches or these kind of elaborate devices, glosses, codicils and so on which you could apply to the backstop… It needs to come out.
UK PM Boris Johnson, The Sun leadership debate, 15 July
…but Ireland has no political incentive to budge… But, as we outlined in Brexit: The Irish Perspective (7 February), the odds of Ireland agreeing to remove the backstop are slim. The backstop is popular there – a Sky poll last February found 79% of the Irish public think the government should hold firm on the backstop, even if it risks 'no deal' Brexit. Only 7% thought the government should prioritise avoiding 'no deal'.
We think PM Leo Varadkar's minority government could collapse if Ireland backtracked on the backstop. Granted, after 'no deal', Ireland would face the issue of what to do about the border because, in theory, goods checks would be required. Economic disruption would be likely, too. But the government remains firm – even the option of a time limit is something that would "not be acceptable", according to European Affairs Minister Helen McEntree (Irish Examiner, 27 August). And the prospect of the UK devising, and Ireland accepting, alternative solutions to the backstop by late September looks optimistic, in our view.
…nor does the rest of the EU… Of course, another route by which the backstop is tweaked, or removed from the Withdrawal Agreement, is by agreement from the rest of the EU, against Ireland's wishes. This is possible in theory, given that the agreement to a deal only needs qualified majority support.
But after sticking with Ireland on the backstop so far, a big shift from other member states is by no means a given. For one, the backstop is an EU-wide issue in that it guards against the risk of a porous border between the EU and a country outside the Customs Union and Single Market (the UK). Second, reneging on promises to one member state (Ireland) to accommodate a leaving member state (the UK) could be a significant risk to EU solidarity.
…and the UK Parliament can't necessarily block 'no deal' It might then be up to the UK Parliament either accepting only fairly minor substantive tweaks to the Withdrawal Agreement, or to prevent 'no deal'. But now the government has announced it will shut down Parliament from week beginning 9 September until 14 October, the time for MPs to try to block 'no deal' is limited. Unless MPs takes the 'nuclear' option of revoking Article 50 (unlikely, we think) they are instead set to try to legislate against 'no deal' and/or try to bring down the government in a vote of no confidence.
Ultimately, we think parliamentary pushback, and the threat of a vote of 'no confidence' in the government, can push the UK back towards a deal with the EU, or at least another delay to Brexit. But the UK government's harder line means 'no deal' risks have risen.
4 Economics ● Eurozone 2 September 2019
The economics of 'no deal': cars, cows and beyond
Exposing exposures… Based on the assumptions above, the next step is to work out the likely impact of a potential 'no deal' on the European economy.
The most obvious direct impact is through trade flows. So it first makes sense to get an idea of Exports to the UK are worth 4 around 3% of EU GDP the EU's trade exposures to the UK. Chart 1 shows that, according to official UK data, EU27 exports to the UK are worth just over 3% of EU GDP (2.5% goods, the remainder services). But that masks significant differences across countries – French and German exposures are somewhat smaller than the EU27 average, but other economies are much more heavily exposed. Irish exports to the UK are worth over 11% of its GDP.
1. EU27 exports to the UK make up around 3% of its GDP, but the shares vary by country % GDP Exports to UK (2016-2017 average) % GDP 12 12 10 10 8 8 6 6 4 4 2 2
0 0
Italy
Slovakia
Malta
Spain
Latvia
Ireland
Austria
Poland France
Cyprus
Croatia
Finland Greece
Estonia
Czech Rep Czech
Belgium
Sweden
Bulgaria
Portugal
Hungary
Slovenia
Romania
Denmark
Lithuania
Germany
Total EU27 Total Netherlands Luxembourg Services Goods Source: ONS, Refinitiv Datastream, HSBC calculations
…by country and sector Exposures to the UK also vary significantly at a sector level. The most exposed sectors are those which trade heavily with the UK, and those which would be subject to significant barriers under a potential 'no deal' – Chart 2 gives a sense of sectors to watch. For example, it shows that German car and part exports to the UK are worth 0.9% of its GDP, and that Irish agricultural exports are worth 1.7% of its GDP.
2. Sector exports to the UK of selected countries "Other" Machinery & Food/ Travel & Financial business Vehicles electrical Pharma Agriculture transport services services Germany 0.9 0.6 0.2 0.2 0.1 0.0 0.2 France 0.2 0.2 0.1 0.2 0.3 0.0 0.2 Italy 0.2 0.3 0.1 0.2 0.3 0.0 0.1 Spain 0.5 0.2 0.0 0.3 1.3 0.0 0.1 Netherlands 0.3 1.3 0.1 1.2 0.3 0.1 0.5 Belgium 2.2 0.6 0.9 0.7 0.4 0.0 0.2
Ireland 0.1 0.7 0.7 1.7 0.9 0.3 1.5 Source: ONS, Eurostat. "Vehicles" refers to all non-rail vehicle exports, which mostly comprises cars and car parts. NB: The width of each column equates to 2.5% of GDP. Note -- the export data are calculated using UK imports data provided by the Office for National Statistics.
______4 This is to ensure complete coverage and consistency across the data by EU country. It is worth noting, though that the UK data do not always match up one-for-one with the counterpart data of other EU countries. For example, the Irish statistics office estimates that Irish exports to the UK are worth just over 12% of its GDP. Full ONS data for 2018 will be published on 31 October.
5 Economics ● Eurozone 2 September 2019
Some sectors might get by fairly unscathed. For example, EU financial services would not face major immediate barriers to operating in the UK, especially given the UK's proposed three-year transition period (see page 3). Besides, financial services exports to the UK only make up a very small portion of EU GDP (Chart 2).
Cars and cows But other sectors might take a much bigger hit. As suggested in Chart 2, and as we describe on Cars and agri-business are sectors to watch… page 22-23, Irish agri-business faces clear risks. As does car production, where issues relate not only to final goods exports, but disruption to a supply chain which spans the UK and the EU27. On WTO terms, EU and UK tariffs on finished vehicles would range from 9.8% to 12.3%. Duties on production inputs would range a bit lower, but still represent a significant increase in costs (4.5% - 9.9%). In a no-deal the UK and EU would face World Trade Organization (WTO or non-preferential) tariffs when trading with each other. EU import tariffs on finished vehicles range from 9.8 to 12.3% on average while duties on vehicle parts are a bit lower (3.8% to 9.9% on average). In a no-deal, the EU would face similar tariffs on finished vehicles to the UK but will be able to export auto parts duty free. Trade friction in the form of non-tariff barriers (e.g. regulatory compliance and additional customs processes) could compound these tariff costs.
On the narrow issue of tariffs (certainly not the only likely trade barrier under 'no deal') there's good …but the vast majority of EU goods would not be subject news and bad news from an EU perspective. Chart 3 shows various countries' goods exports to the to UK tariffs UK, as a share of GDP, marking out those exports which would be subject to UK import tariffs (as opposed to zero tariffs currently). The bad news is perhaps most pronounced for Germany and Ireland – German car, and car part, exports to the UK, which would be subject to UK tariffs, amount to just over 0.5% of Germany’s GDP, while Irish agricultural exports subject to UK tariffs would be worth 0.8% of Ireland’s GDP. Regarding the latter, by far the biggest exposure is beef exports.
The good news on tariffs, however, is that, as Chart 3 shows, the overall share of goods exports that would be subject UK tariffs would actually be very low. Only 18% of EU goods exports would be subject to tariffs.
3. Only a small proportion of EU goods exports would be subject to the UK's 'no deal' tariff schedule % of GDP Goods exports to the UK % of GDP 7.0 7.0 6.0 6.0 5.0 5.0 4.0 4.0 3.0 3.0 2.0 2.0 1.0 1.0 0.0 0.0 EU28 Germany France Spain Italy Ireland Netherlands Cars and parts Agriculture/food Clothing/textiles Other tariffed Not subject to tariff
Subject to UK tariffs Source: UK government, Eurostat, HSBC calculations
Long-term versus short-term effects Bearing these exposures in mind, how big might the hit to the EU27, the eurozone and individual countries be? Here, we think it's helpful to distinguish between the long-term impact of more restrictive UK/EU trading arrangements, versus the short-to-medium term impact, where it's also worth considering economic damage from temporary disruption and a dent to market and business sentiment.
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In the long term, headwinds to European growth are likely to come pretty much entirely from trade barriers. The likely extent of these is difficult to assess, given that it's unclear what form 'steady state' arrangements would take, let alone their impact on the balance of imports and exports between the EU and the UK.
However, most empirical studies of the long-run impact of trading on WTO terms point, unsurprisingly, to a material reduction in the overall volume of UK-EU trade, relative to a scenario where the UK remains in the EU. In economic theory and practice, there is a well- established link between economic openness and long-run performance in productivity and, therefore, GDP.5
Chart 4 shows some estimated long-run effects of a potential 'no deal' Brexit on various EU Studies of the long-term 'no deal' impact suggest a slow- economies. They come from two studies (few EU-wide studies have been published), which burn drag on trade and GDP tend to use 'gravity' models to work out the link between trading arrangements, trade flows and GDP. We think two things are worth pointing out from these studies. First, the relative sizes of the GDP (or productivity) impacts are broadly consistent with export exposures – aside from the UK, Ireland tends to see the biggest hit, followed by the Netherlands. Interestingly, one of the studies, from the European Parliament, actually estimates a bigger hit to Ireland than the UK, given a particularly large assumed impact on agri-business. Second, aside from Ireland, the average estimated effects are small (less than 0.5% of GDP for France and Germany). Perhaps this isn't entirely surprising either – after all, an export exposure to the UK worth 3% of GDP is material, but not game-changing.
4. Big long-run effects on the UK and Ireland, but limited elsewhere % impact on productivity EU 27: Economic costs of a hard Brexit % impact on GDP
0.0 N/A N/A N/A N/A N/A N/A N/A N/A N/A N/A N/A N/A N/A N/A N/A N/A N/A 0.0 -0.5 -0.5 -1.0 -1.0 -1.5 -1.5 -2.0 -2.0 -2.5 -2.5 -3.0 -3.0
-3.5 -3.5
Italy
Malta
Spain
Latvia
Ireland
Austria France
Poland
Cyprus
Greece Finland
Estonia
Sweden Belgium
Bulgaria
Portugal
Slovakia Hungary
Slovenia
Romania
Lithuania Denmark
Germany
Netherlands
Luxembourg
Czech Republic Czech United Kingdom United Impact on productivity (Bertelsmann Stiftung), LHS Impact on GDP (European Parliament), RHS Source: European Parliament, Bertelsmann Stiftung, HSBC
But while these studies do capture the long-run impact of trade barriers, they do not capture the impact of near-term disruption which we think would likely follow a 'no deal' Brexit.
In the short-to-medium term, we see five additional effects that would be likely to be relevant We consider five immediate headwinds from 'no deal' under a potential 'no deal'. These are (i) the immediate impact of trade disruption on net trade Brexit (ii) the impact of a possible UK recession (iii) the impact of weaker UK demand resulting from a likely fall in the pound (iv) confidence effects (v) financial sector spillover effects.
From the point of view of our forecast horizon (to the end of 2020) and monetary policy, these effects are the most significant ones. Granted, the long-run impact of trade barriers could be significant, particularly for certain sectors. But these are slow-burn headwinds affecting the supply side of the economy, which the ECB can do little to influence. So for the bulk of this report, we focus our attention on the short-to-medium-term effects.
______5 The BoE's November 2018 "EU withdrawal scenarios and monetary and financial stability" report provides a comprehensive summary
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The impact of 'no deal' on our eurozone forecast
This section traces through the possible impact of the five short-to-medium-term effects of a potential 'no deal' Brexit on the European economy over our forecast horizon, with a particular focus on the eurozone.
i) Trade disruption The direction of the near-term impact of trade barriers on eurozone GDP is not obvious. EU We assume a GDP-neutral impact from trade barriers, exports to, and imports from, the UK are likely to fall. Regarding the balance between the two, we which affect exports, imports think trade barriers have a larger negative impact on EU imports from the UK than exports to the and business costs UK. That is because we think the EU will likely impose more onerous trade barriers than the UK, and more quickly. All else equal, that would have a positive impact on eurozone net trade and, therefore, GDP. But on the other hand, the likely upward pressure on costs running through European supply chains, as per the car production mentioned above, might dent production.
Overall, given a likely fall in EU imports from the UK, we assume a GDP-neutral impact on the eurozone from trade barriers, despite all the likely disruption. But clearly there are significant uncertainties around this assumption.
ii) A UK recession Next, there's the issue of more general weakness in UK demand resulting from 'no deal'. Through a combination of trade disruption, economic uncertainty and a real income squeeze from a weaker pound, we estimate that a 'no deal' Brexit would send the UK into recession, with a peak-to-trough GDP fall of 1.5% (Table 5) (for more details, see Brexit Strategies: No deal for real? 27 June). Given that impact, we would expect to see UK GDP falling by 1.3% in 2020, versus our base-case forecast for a 1.1% expansion. Relative to this baseline, our 'no deal' scenario would see the level of UK GDP around 3% weaker than it would have been by the end of 2020.
5. We think a potential 'no deal' Brexit would send to the UK into a mild recession Change peak-to-trough, unless ‘No deal’ Brexit otherwise stated 1990s Global financial crisis (Indicative HSBC view) Number of quarters of negative growth 5 (Q3 1990 - Q3 1991) 5 (Q2 2008 - Q2 2009) 3 (Q4 2019 - Q2 2020) GDP -2.0% -6.0% -1.5% Unemployment rate +3.7ppts to 10.6% +3.2ppts to 8.2% +0.8ppts to 4.6% Bank Rate -975bps from 14.88% to 5.13%* -525bps from 5.75% to 0.5% -65bps to 0.1% QE (GBPbn) - 200 65 Source: ONS, BoE, HSBC forecasts Note: Changes in indicators may begin before and last beyond the technical period of recession * At the time of the 1990s recession, the UK was a member of ERM2, which kept UK rates artificially high, and the easing cycle which followed included the UK's exit from that mechanism, which increased its freedom to reduce borrowing costs
'No deal'-related weakness in To work out the impact of this on the eurozone, we assume the 3% hit to UK GDP, relative to baseline, UK demand might knock is matched one-for-one with a hit to UK import demand. This would imply a 3% hit to eurozone exports 0.1% off eurozone GDP… to the UK, relative to our baseline assumption. Because eurozone exports to the UK are worth 3% of eurozone GDP, that would equate to a hit to eurozone GDP of 0.1%, relative to baseline.
But of course, the impact would be bigger for those economies with closer trade ties to the UK. For example, because Irish exports to the UK are worth almost 10% of its GDP, weaker UK demand would knock 0.3% off Irish GDP, relative to baseline.
iii) A weaker pound FX effects are likely to play a role too. Our FX strategists think that in a 'no deal' scenario, GBP- USD would tumble to 1.10 and EUR-GBP would rise to around parity. This appreciation in EUR- GBP, which amounts a little over 10% from current levels (EUR-GBP stands at 0.90 at the time of writing), would likely add a further drag on eurozone exports.
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Our estimates suggest that a 1% euro appreciation should reduce the level of eurozone exports …and a weaker pound might knock another 0.1-0.2% off by around 0.5% (Will the strong euro hurt? Implications for eurozone exports and growth, 13 eurozone GDP September 2017). Assuming that estimate holds for exports to the UK, then a 10% appreciation in EUR-GBP would take almost 5% off eurozone exports to the UK. That would knock 0.1-0.2% off eurozone GDP, relative to our central case.
As a cross-check on the likely impact of weaker UK demand and a fall in sterling, we can take a look at the experience since 2016. Chart 6 shows that eurozone exports to the UK have virtually flat-lined since 2016, relative to solid growth in exports to other trading partners. We think relatively soft UK growth and the post-referendum sterling depreciation drove this weakness, and, of course, these headwinds to eurozone exports would likely intensify under 'no deal' Brexit.
6. Eurozone exports to the UK have been weak since 2016, consistent with sluggish UK demand and the weaker pound
% Yr Eurozone export growth by country/region (values, 3mma) % Yr 25 25 20 20 15 15 10 10 5 5 0 0 -5 -5 -10 -10 -15 -15 14 15 16 17 18 19
Intra-EMU US UK Asia Latin America
Source: Refinitiv Datastream, Eurostat, HSBC
(iv) Sentiment effects 'No deal' Brexit would also be likely to have an impact on eurozone confidence and domestic demand, business investment in particular. It's entirely plausible to think that a car producer based in the eurozone would postpone investment, given uncertainty relating to trade with the UK and cross-border supply chains. Looking across the eurozone economy as a whole, how large and widespread might the impact on sentiment be?
This is very difficult to answer, of course. One crumb of comfort comes from the short-lived and, EU sentiment held up in 2016… in some cases, very small, pick-up in European economic uncertainty measures after the UK's vote to leave the EU in 2016 (Chart 7). In particular, markets remained fairly unmoved, credit conditions remained benign and sentiment held up, providing a bulwark against Brexit fears.
7. Brexit-related uncertainty has not been associated with market stress
SD from average since 2001 Measures of uncertainty SD from average since 2001 5 5 9/11 Collapse of Eurozone debt 4 Lehman crisis intensifies 4 Brothers 3 3 Iraq invasion Mario Draghi: 2 'Whatever it 2 takes' 1 1
0 0
-1 UK votes to -1 -2 leave EU -2 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16 17 18 19 Euro Stoxx implied volatility Itraxx cross-over CDS index Policy uncertainty index Source: Refinitiv Datastream, policyuncertinty.com
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Eurozone business sentiment looks less assured now, though. In particular, German business …but it looks less secure now confidence has fallen sharply of late, according to the ifo survey (Chart 8). Of course, it is extremely difficult to identify a Brexit effect here – broader global growth concerns have likely been the main issue. But the ifo has anecdotally reported 'hard Brexit' concerns as a possible headwind. It is also notable that in Ireland, consumer confidence appeared to wobble around March this year, the originally scheduled Brexit date (Chart 9).
It could be argued then, that just as we might have already seen a significant drag on UK growth as a result of Brexit-related uncertainty (Forecasting Brexit: What we've learnt about the Brexit effect on the UK, 22 January), there might have been a headwind to growth elsewhere in Europe, too.
8. German surveys have weakened, but it's 9. …whereas Irish consumer confidence hard to tell if there's been a Brexit effect… has shown Brexit jitters
Index German ifo Index Standard devs. Consumer confidence Standard devs. 110 110 from average from average 2 2 105 105 100 100 1 1 95 95 0 0 90 90 85 85 -1 -1 80 80 -2 -2 75 75 05 06 07 08 09 10 11 12 13 14 15 16 17 18 19 -3 -3 Business Climate Current Situation 12 13 14 15 16 17 18 19 Expectations Ireland Eurozone UK Source: Refinitv Datastream, HSBC Source: Refinitv Datastream, HSBC
In the event of 'no deal', we think it's fair to assume at least some sort of sentiment effect. We assume a 0.2% hit to GDP from confidence effects, with Quantifying the impact is extremely difficult. But we can draw on an ECB study suggesting that around the hit in 2020 as the eurozone debt crisis intensified in late 2011, higher economic uncertainty might have knocked around 0.3% off eurozone GDP (of course, many other growth headwinds, not least higher borrowing costs, emerged at that time).6 A 'no deal' Brexit might have almost as big an impact. Tentatively, we would assume a 0.2% hit to eurozone GDP from economic uncertainty. In addition, we think around half that (around 0.1ppt) would come through in 2020.
(v) Financial sector spillovers Importantly, we have not assumed that a 'no deal' Brexit would have a material impact on We expect no worsening in eurozone credit conditions, eurozone credit conditions. But if banks and sovereigns do begin to face funding stresses resulting but there are risks from exposures to the UK, that could have a large impact. This could come about in two ways. First, European financial institutions might face stresses as consumers of UK financial services, which might face restrictions under 'no deal'. Second, EU banks' exposures to the UK (Chart 10) might become a cause for concern (perhaps for Spain and Ireland in particular). They might increase banks' borrowing costs and weigh on lending to the real economy.
______6 We have backed this out of from an ECB study which suggests that a one standard deviation in its economic uncertainty index would be consistent with a 0.3% hit to GDP. And the indicator rose by roughly that amount in last-2011 (see ECB Economic Bulletin 2016, Issue 8).
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10. Spanish banks have the largest exposures to the UK. As a share of GDP, Ireland has the second largest EURbn Total claims on an ultimate risk basis % of GDP 400 40 350 35 300 30 250 25 200 20 150 15 100 10 50 5
0 0
Italy
Spain
Ireland
Austria France
Finland Greece
Sweden Belgium
Portugal
Germany Netherlands Euro % of GDP Source: Bank for International Settlements, HSBC calculations
Summarising the impact
Overall, a mild central case… Taken together, our 'no deal' scenario for the eurozone is actually fairly mild. Table 11 'No deal' would reduce our eurozone 2020 growth summarises our estimate of the impact on 2020 GDP growth, which we think adds up to a hit of forecast by around 0.3ppts around 0.3ppts for the eurozone (our current 2020 growth forecast stands at 1.1%). But the impact varies by country, with a much bigger prospective hit to Ireland, albeit against a significantly stronger baseline forecast (see page 24 for more details).
11. GDP forecast impact of 'no deal' Brexit Impact on 2020 growth Current 2020 growth forecast Eurozone -0.3 1.1 o/w trade disruption 0.0 o/w a UK recession -0.1 o/w FX effects -0.1 o/w sentiment -0.1 Germany -0.3 1.1 France -0.2 1.0 Italy -0.1 0.5 Spain -0.2 1.9 Ireland -1.2 3.4 Source: HSBC
…but with the risk of a bigger impact Of course, there's a risk that the impact on the EU could turn out to be much bigger than our Confidence or financial market effects might turn out central scenario. First, we have assumed a GDP-neutral impact from trade barriers over the to be larger medium term, given our view that eurozone imports from the UK might fall by more than exports to the UK. But if eurozone import demand holds up, net trade could weigh more heavily on eurozone GDP. Second, sentiment effects, which are extremely difficult to quantify, might turn out to be larger than we assume. For example, the drop in German sentiment in recent months (Chart 9), which is often blamed on global tensions, looks large relative to the likely direct impact of US-China trade barriers. In other words, 'fear itself' could be a much more powerful headwind than the direct impact of Brexit-related disruption.
11 Economics ● Eurozone 2 September 2019
What about inflation? The economic fallout from a possible 'no deal' Brexit might also have an impact on eurozone inflation, which is ultimately what matters for the ECB. However, as a baseline assumption for what might happen under 'no deal', we think the impact might actually be fairly limited, albeit slightly disinflationary. There are three channels to consider here.
First, the impact of trade tariffs and other barriers is likely to put upward pressure on firms' costs and, ultimately, consumer prices. But from an economy-wide perspective, we think the impact might be fairly small. The impact of likely tariffs on imports from the UK – an average of 4.2% for industrial goods, 12.0% agricultural goods on WTO terms – should be small because goods imports from the UK only make up around 2.5% of GDP. For example, a 10% rise in the price of imports from the UK would raise the 'price' of eurozone GDP by 0.25%, which is small in the grand scheme of things. We think the likely impact on inflation is unlikely to exceed +0.1ppt.
Second, the rise in EUR-GBP would likely weigh on the consumer price of goods imported from the UK. According to the Bank for International Settlements, sterling has a 10% weight in the euro's trade weighted index. So a 12% appreciation in EUR-GBP would raise the trade-weighted euro by a little over 1%. According to ECB estimates, this would reduce the level of eurozone CPI by 0.25% over three years.7 That would mean a peak inflation impact of -0.1ppt.
Third, weaker aggregate demand (a 0.3ppt hit to 2020 GDP growth) would also be disinflationary. Taken in isolation, we think this would subtract around 0.1ppt from 2020 inflation. This assumes that, at least over the medium term, the hit to demand exceeds the hit to supply, leading to a slight widening in the output.
Taken together then, we think the disinflationary effects of the stronger euro and weaker We think 2020 eurozone inflation would be a touch demand would more than offset the inflationary impact on trade barriers. Specifically, we think a lower under 'no deal' 'no deal' Brexit would see 2020 eurozone inflation around 0.1ppt weaker than otherwise. That would bring our 2020 inflation forecast down from 1.5% to 1.4%.
Policy implications
More action from the ECB? Worries over the possibility of a 'no deal' Brexit appear to already be featuring in the ECB's policy discussions – ECB President Mario Draghi alluded to the issue at the July press conference.
The possibility of a hard Brexit certainly is another factor to take into account ECB President Mario Draghi, 25 July Press Conference
Because we have argued that, under a reasonable central assumption, a 'no deal' Brexit would weigh on eurozone growth, and also be mildly disinflationary, there is reason to become more dovish on monetary policy. What's more, there might also be a case for the ECB to respond on an 'insurance' basis, in case the impact of 'no deal' Brexit turns out to be particularly large.
So what might the ECB actually do under 'no deal'? As it stands, our central ECB forecast is for a Under 'no deal', we think the ECB might increase the pace 20bps cut in the deposit rate in September, to -0.60%, and a re-start of net asset purchases in of QE asset purchases January, at a purchase rate of EUR30bn per month, lasting for one year (ECB: Determined to act, 26 July). We think that, if our central case comes true, the ECB could increase the monthly annual purchase pace above that.
______7 ECB Working Paper no. 243, July 2003
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Given our relatively benign 'no deal' scenario, we do not think the ECB would draw on more radical forms of monetary policy ammunition. But of course, if downside risks materialise, the central bank might need to look at an unappetising menu of additional easing options (Table 12).
12. If 'no deal' fallout ramps up, the ECB might need to look at its unappetising menu Measure Feasibility Effectiveness Talk/forward guidance High Low Rate cuts High Low A tiered rate system Medium Low Cut 10bps step up in the TLTRO programme High Medium Extend QE under current rules Low Low Extend QE by changing some parameters (ie. issue limit) High Medium Yield curve control Zero N/A Operation twist Low Low Buy other assets (eg equities) Medium Low Helicopter money Low Medium Outright Monetary Transactions Low High FX intervention Low Medium Raise the inflation target High Low
Source: ECB, HSBC.
Limited fiscal measures What about fiscal policy? Again, we would not expect any hugely radical changes here, at least at a eurozone level. For example, while recent headwinds from trade wars and broader global demand weakness have seen some calls for looser fiscal policy, including in Germany, we are sceptical about the prospects of a major policy shift (see Fiscal fantasy: Germany might ease policy, but not by much, 22 August 2019). Indeed, while we expect a slight eurozone fiscal expansion this year, we expect it to be dwarfed by that of the US (Chart 13).
13. If 'no deal' fallout ramps up, the ECB might need to look at its unappetising menu % GDP Fiscal Deficits % GDP 0 0
-1 -1
-2 -2
-3 -3
-4 -4
-5 -5
-6 -6 2015 2016 2017 2018 2019 2020 Eurozone Jun 19 Forecasts Eurozone Oct 17 Forecasts US Jun 19 Forecasts US Oct 17 Forecasts Source: HSBC forecasts
We do not think a possible 'no deal' Brexit shock worth a few tenths of a per cent of GDP would Even Ireland is steering away from discretionary stimulus change many minds around the EU. Indeed, even the Irish government has shied away from under 'no deal' the prospect of large-scale stimulus measures to offset the shock. The Irish Finance Minister, Paschal Donohoe has suggested that, in order to prevent the budget deficit widening too much,
13 Economics ● Eurozone 2 September 2019
plans for tax cuts would be delayed under no deal. Instead, measures would be restricted to relying on 'automatic stabilisers' and support for the most affected sectors.8
[We] would allow for the automatic stabiliser to provide counter cyclical support… and temporary, targeted support for the sectors most affected by Brexit
Irish Finance Minister Paschal Donohoe, 25 June press conference
Finally from a fiscal perspective, another issue to bear in mind would be the prospect of a tussle with the UK about its payment of the 'Brexit divorce bill'. We discuss this issue in the box on page 15.
Conclusion
With the odds of a potential 'no deal' Brexit currently at around 40% (if the bookmakers are to be believed) Europe faces a high risk of material economic disruption this November and beyond. But despite the likely disruption from 'no deal', which we think would likely send the UK into recession, we would not generally expect a game-changing economic impact on the economies of the rest of the EU. Given strong underlying fundamentals, we think that even the most affected economy, Ireland, would avoid recession.
However, there is a risk that our 'no deal' scenario for the EU turns out to be too sanguine, particularly if spillovers through confidence, markets and the banking sector turn out to be larger than we would assume as a central case. And, of course, some countries (Ireland) and sectors (cars and agriculture) are likely to be more affected than others. So, from the point of view of monetary, fiscal and supply-side policies, a 'no deal' Brexit could pose some major challenges for the EU.
______8 'Minister indicates tax cuts will be delayed in a no-deal Brexit, Irish Times, 25 June
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Box: Who picks up the 'divorce bill'?
A GBP33bn tab… The UK has agreed to a Brexit 'divorce bill' currently estimated to be worth GBP32.8bn (EUR36.3bn).9 This payment includes UK contributions to the EU budget up to 2020 (under the multiannual budget period 2014-2020) and other spending which the UK has already committed to, ranging from investment projects to covering staff pensions (Chart 14).
14. The UK government is threatening to withhold payments to the EU Budget € billion Assumed annual path of EU financial settlement payments € billion 12 12 10 10 8 8 6 6 4 4 2 2 0 0 -2 -2 2019 2024 2029 2034 2039 2044 2049 2054 2059 2064 Other net liabilities Net RAL contributions Net MFF contributions Total net payments
Source: OBR. RAL = Reste à Liquider (funds that have been committed in EU budgets, but not yet spent), MFF = multiannual financial framework (ie the EU 7-year budget)
…which might be withheld under 'no deal' UK PM Boris Johnson has said that the UK should withhold the 'divorce bill' until a path towards a Brexit deal can be found (Sunday Times, 9 June). Presumably, the UK government might try to withhold the payment in the event of 'no deal'. The legalities have been subject to debate – the EU would probably sue the UK, perhaps at the International Court in The Hague, to try to claim these financial commitments.10 Beyond the legalities, the EU would almost certainly, in our view, rule out any trade deal with the UK until the payment is settled. Given that, we think the UK is ultimately unlikely to withhold the payment, but it is a risk to the EU's budget plans.
Other countries need to take up the slack If the UK does end up avoiding the 'divorce bill', other member states might face the choice between paring back their commitments, or meeting those payments themselves. We calculate that, if member states meet these commitments according to their existing proportional contributions to the EU budget, each country would need to fork out around 0.2% of its GDP. For Germany, the highest contributor, that would equate to a payment of roughly EUR12bn. However, as shown in Chart 14, the payments can be spread over several years.
Deal or no deal, the EU will need to work out how to deal with the absence of UK contributions to the next multiannual budget period, running from 2021-2027. The annual budget gap would equate to around EUR12bn (7% of the annual budget), which we think might be covered through a combination of higher contributions from richer member states, and lower receipts for poorer member states (EU budget challenges: Who picks up the "Brexit Bill"?, 11 April 2017).
______9 The 'divorce bill' has often been quoted to be worth GBP39bn. But this is a previous estimate based on the assumption that the UK would have left the EU on 29 March 2019. Now the UK is scheduled to leave on 31 October, the UK needs to pay six months' worth more of membership payments, which are subtracted from the 'divorce bill'. 10 Channel 4 FactCheck: Can we avoid paying the GBP39 billion Brexit divorce bill? 9 January 2019
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Germany
Brexit fears might already be affecting German exports
A UK recession and trade barriers might be a material drag, particularly on car exports…
…which could knock 0.3ppts off 2020e growth and might see greater calls for fiscal stimulus
Rainer Sartoris, CFA Already feeling a Brexit effect Economist The preparations for a disorderly Brexit have already led to high volatility in German exports HSBC Trinkaus & Burkhardt AG [email protected] during the spring. In the run-up to the original Brexit deadline at the end of March, significant +49 211 910 2470 stockpiling in the UK appeared to drive a strong increase in exports from Germany to the UK,
boosting Q1 net exports and ultimately economic growth. British companies reduced their inventories in the second quarter, which could have had negative effect on the German economy, which saw GDP contract by 0.1% q-o-q in Q2.
Christian Fuertjes Analyst 15. Exports to the UK are stagnating 16. Germany’s car exports appeared to HSBC Trinkaus & Burkhardt AG suffer from poor UK demand [email protected] +49 211 910 7051 EURbn Germany: Exports (3MMA) EURbn Millions German car exports vs UK new car 000s 11 11 registrations 2.75 230
10 10 2.50 Billions
9 9 Millions 2.25 210 Thousands 8 8 2.00 1.75 190 7 7 1.50 6 6 1.25 170 5 5 1.00 0.75 150 4 4 09 10 11 12 13 14 15 16 17 18 19 2013 2014 2015 2016 2017 2018 2019 UK Passeneger Car registrations (RHS, m.a. 1 yr) US UK China France German car exports to UK (LHS, m.a. 1 year) Source: Macrobond, HSBC Source: Macrobond, HSBC
Apart from this short-term volatility, German exports to the UK peaked in 2015 and since then Brexit has driven export volatility, but UK car demand weakened considerably (bar recent inventory-related volatility), making the UK a clear looks structurally weak too underperformer relative to other export markets (Chart 15). While one might suspect that Brexit uncertainties, which led to weak investment activity in the UK, might be the main culprit, there is little evidence for that in the data. In fact, exports of machinery and equipment goods have expanded every year since 2010 and at a healthy pace even after the referendum. Instead, the reason for the decline in export volume is almost completely due to a plunge in car demand (Chart 16). While Brexit-related adjustments of international supply chains may have played a role here11, the drop in exports seems mainly driven by lower car sales in the UK in general. Hence, the German export weakness in recent years seems more related to structural factors than to Brexit-specific reasons.
______11 This is supported by recent studies like e.g. Busch (2019) IW-Report 1/18.
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'No deal' would disrupt exports A UK recession would likely weigh on exports but FX That said, a 'no deal' Brexit recession in the UK would certainly disrupt German exports. As we effects might be small pointed out in Germany motors on: Stronger euro won't slow the German juggernaut, 31 August 2017, German export demand is not very sensitive to exchange rate changes, but more to underlying foreign demand. This is particularly true with respect to the UK. Based on a linear dynamic regression model we estimate that a 1ppt decrease in British GDP would reduce total German exports by roughly 3ppts.12 Thus, an expected drop of 1.5 % in UK GDP following 'no deal' would cut exports by roughly EUR4bn over the year. On the other hand, the econometric model also suggests that additional negative effects due to the expected sterling depreciation would be very limited, as the corresponding coefficient for the exchange rate is statistically insignificant.13
Nevertheless, the expected drop in export demand still pushes down German GDP growth by Weaker exports could drag 14 0.1-0.2ppts off German roughly 0.3ppts, which is broadly in line with, if not at the upper end of, other studies. GDP… As with the eurozone as a whole, there is a risk that these forecasts will prove too optimistic if, in the event of a disorderly Brexit, there is disruption to capital markets and a clouding of corporate sentiment. Hence, the a potential 'no deal' Brexit might increase the strain on the already weakened German economy and could therefore reinforce calls for additional fiscal stimulus.
Such demands for more expansive fiscal policy in Germany have been continuing for some time …which might see a (modest) fiscal response now. In the event of a disorderly Brexit, those calls might get louder. In terms of a possible response, the German government could, among other things, change depreciation rules to stimulate investment. Moreover, additional subsidies for temporary labour contracts as well as higher public investment spending could be on the table. But for the time being at least, we consider the prospect of a major easing package to be the stuff of fiscal fantasy (Fiscal fantasy: Germany might ease policy, but not by much, 22 August 2019). And, in any case, all potential fiscal easing measures are subject to the continuity of the grand coalition, which seems to be anything but certain given the increasingly strained relationship between the coalition parties.
______12 Our estimation is based on the following regression model with monthly data: dlog(export)t = c + dlog(GDP)t + log(er)t + dlog(export)t + dlog(export)t-n + εt , where dependent variable “export” is nominal German exports to the UK, “GDP” is UK GDP and “er” is EUR/GPB nominal exchange rate, “c” is constant and ε an error term, while “dlog” stand for first difference of the logarithms. We also included 4 lags of the dependent variable (n= 1, 2, 3 and 12 months) to control for autocorrelation in the residuals and improving the overall fit of the model. While we found the coefficient of dlog(GDP) to be strongly significant in our specification, dlog(er) is insignificant according to our t-tests using (HAC) robust standard errors. 13 Interestingly, this is not the case for e.g. France, when applied to a similar model, where we detect a significant negative effect on exports in case of a sterling depreciation. 14 Felbermayr et al. (2017) estimate drag on GDP between 0.18% and 0.24%, depending on the precise form of Brexit.
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France
Port and transport disruption under a potential 'no deal' Brexit might be significant but can be mitigated
France's exports to the UK are services-heavy, which might see a more limited impact…
…but non-tariff barriers might be material and we predict a 0.2ppt drag on 2020e GDP growth
Chantana Sam Initial repercussions for trade and transport Economist Without any mitigating measures, a potential ‘no deal’ Brexit would hurt the French economy via HSBC France [email protected] several channels. Given the geographical proximity between France and the UK, the first +33 1 40 70 77 95 repercussions of a chaotic exit would be felt on customs and transports. However, French
authorities have already taken several steps to limit the potential disruptions on both sectors. Indeed, in January, the French Parliament empowered the government to act through ordinances (a quicker procedure than a full legislative act of the Parliament) in a scenario of hard Brexit.
Several ordinances were passed before the end of March (the initial planned date of the Brexit). They would in particular facilitate the quick establishment (via easing administrative constraints) of required infrastructures to implement customs and regulatory controls at the French border (specifically, at ports). Regarding transport, they would allow British firms to continue to temporarily operate road transportation in France and ensure the continuity of Eurotunnel services. Rail transport via the Eurostar would also be maintained. Other temporary arrangements would likely apply to financial services and citizens' rights. However, it’s worth highlighting that these measures would not be automatic and could be modified or cancelled if the British government didn’t adopt reciprocal measures.
At the macroeconomic level, the establishment of trade barriers (both tariffs and non-tariffs) The UK is France's sixth- biggest export market would have a non-trivial impact on French GDP. Indeed, France is the UK's sixth-biggest export market for goods (6.8% of French goods exports in 2018) and its second-biggest export market for services (10.4% of French services exports in 2018). Sector-wise, agricultural products would be the most impacted among goods as the UK is the third-biggest market for France in that sector (with 15% of exports in 2018). Regarding services, financial services and insurance is the most exposed sector (18% of exports).
The French national statistics institute (INSEE) estimated last March that the rise in tariff barriers in a scenario of ‘hard Brexit’ would reduce French GDP by 0.6% in the long run (as opposed to the impact on 2020 growth which we focus on), against 0.3% in a more benign scenario of ‘soft Brexit’.15 This estimate takes into account the direct impact of tariffs on French exports, but also the indirect impact on French output linked to the use of French components in the exports of other EU countries to the UK.
______15 See "Assessing the impact of Brexit on the economic activity of the UK's closest partners: the trade channel", March 2019
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This 0.6% impact on French GDP is smaller than INSEE's estimate of the long-run GDP effects on Ireland (-4.1%), Belgium (-1.1%), Netherlands (-1.0%) or Germany (-0.9%). The relatively modest impact on France can explained by the importance of services in French exports to UK (43% in 2018 – Charts 17 and 18), as services exports should be less impacted by higher tariff barriers.
17. Services represent a large part of 18. ... especially relatively to other EU French exports to the UK... countries
EUR (bn) France: Exports to UK % EU: Part of services in exports to UK (2018) 18 50 45 16 40 14 35 12 30 10 25 20 8 15 6 10 4 5 2 0 0 08 09 10 11 12 13 14 15 16 17 18 19 Goods Services
Source: Eurostat, HSBC Source: Eurostat, HSBC
That said, services exports would be more vulnerable to a rise in non-tariff barriers. According to INSEE, the additional negative impact of these barriers on French GDP would amount to 0.3% in a scenario of soft Brexit and 1.1% in a scenario of hard Brexit. All in all, French GDP would be 1.6% weaker in the long run than otherwise in the event of a ‘no deal ‘Brexit.
A 0.2ppt drag on 2020 growth The ultimate long-run impact on French GDP is very difficult to predict. But the INSEE estimate of a slightly smaller impact on France than the eurozone average seems right to us – we estimate a 0.2ppt drag on 2020.
To come to that estimate, it is worth noting that, on average between 2016 and 2018, French UK demand weakness and confidence effect are likely exports to the UK were worth 15.7% of total French exports. If UK GDP takes a 3% hit, relative headwinds to French growth to baseline, as a result of 'no deal', we think the resulting hit to French exports to the UK may damage French GDP by 0.1ppt. Layering on an effect on confidence, we arrive at a 0.2ppt hit to 2020e growth. In particular, because France is a major importer of UK goods and services, a ‘no deal’ Brexit could push inflation via a rise in tariffs, which would hurt French consumption. This effect on imported inflation is difficult to estimate given the importance of supply chains between France and the UK (which may amplify the impact of tariffs on final consumer prices).
Conversely, possible mitigating factors like the potential reorganisation of supply chains or diversion of trade flows (with potential benefits for French exporters) have also been ignored by INSEE. Finally, the fact that the UK is intending to set its import tariffs to zero except for certain goods like agri-business and cars would also ease the potential shock for the French economy. However, even in such a scenario, the negative impact of non-tariff barriers would still be significant.
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Italy
Of the Big 4, Italy is the least exposed to the UK and we predict a 0.1ppt hit to 2020e GDP growth in the event of a ‘no deal’ Brexit…
…but the automobile and machinery sectors could take a hit…
…and Italy could be affected by contagion in the financial markets
Relatively small exposures, but financial contagion could hurt
Fabio Balboni The least exposed on trade, but it could still hurt Senior Economist Of the Big 4 eurozone countries, Italy is the least exposed in terms of goods and services HSBC Bank plc [email protected] exports to the UK. About 5% of Italy's goods exports go to the UK, amounting to EUR23bn last +44 20 7992 0374 year, about 1.3% of GDP, well below the EU27 average. Italy's services exports to the UK are
relatively small, about EUR9bn (0.5% of GDP) last year, of which EUR3.5bn related to tourism.
Among goods, cars are most exposed (7.5% of all cars exports from Italy go the UK, EUR2.6bn
last year, around 0.15% of GDP) and machinery and mechanical appliances (EUR3.8bn, 0.2% of GDP). Some sectors are smaller but could be affected disproportionally by Brexit: Italy exports over 12% of its beverages, spirits and vinegar to the UK (but only EUR1bn in total, 0.05% of GDP), over 9% of furniture items, and almost 9% of apparel articles. Italy's food exports are actually more limited than one might think, totalling about 0.1% of GDP in total, and are concentrated in the area of processed vegetable rather than fresh ones. Some of these products would be exempt from tariffs based on the new UK tariff schedule.
Overall, the impact of a 'no deal' Brexit, taking into account the imposition of possible tariffs and slowing UK demand, could shave 0.1ppts off Italy's GDP growth in 2020e.
Contagion risk In the immediate aftermath of the UK Brexit referendum in June 2016, the spread of 10Y Italian sovereign bond yield over Bunds shot up by some 20bps. By November, it had increased by even more, about 60bps, even if that was also linked to increased political instability risk surrounding the Constitutional referendum which eventually led to the resignation of PM Renzi.
Given Italy's high debt, the spread is crucial for Italy's borrowing costs: a 100bps upward shift in If 'no deal' triggers a jump in borrowing costs, the fallout yields across the curve increases Italy's interest payments by 0.2% of GDP the following year, might be significant cumulating over time. So a possible spread widening following a potential 'no deal' Brexit could reduce even further the fiscal space available to the cash-strapped government, which is already facing difficult negotiations with Brussels on the 2020 budget, to support growth.
A higher spread could also affect the banks, which own about 20% of Italy's sovereign bonds, putting upward pressure on lending rates for Italian households and firms, as argued recently by the Bank of Italy, leading to a possible tightening of financial conditions. Higher market volatility could also hurt consumer and investor confidence. So financial markets could prove to be a more powerful contagion channel from a 'no deal' Brexit than Italy's direct exposures to the UK.
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Spain
Spain is most exposed to the UK in terms of tourism…
…and also cars, aircrafts, and agricultural goods
We estimate a total hit to GDP growth of about 0.2ppts next year in the event of a ‘no deal’ Brexit
Some sector exposures, tourism could suffer most
Fabio Balboni Major trade exposures in some sectors Senior Economist Spain's goods exports to the UK were about EUR20bn in 2018, accounting for about 1.7% of HSBC Bank plc [email protected] Spain's GDP, less than the EU's average. But some sectors could be heavily affected. Spain +44 20 7992 0374 exports almost EUR5bn of vehicles to the UK, 12% of all its car exports, accounting for 0.5% of
GDP. So the impact of possible tariffs and trade restrictions on this sector could be sizeable. Based on our estimates, a possible 10% tariff on vehicles could reduce Spanish car exports to the UK by up to 20%, taking 0.1% off Spanish GDP. Another smaller sector which could be heavily affected is aircrafts, with 15% of exports going to the UK, worth about 0.1% of GDP.
Other sectors are smaller but are also heavily exposed to the UK: edible fruits (12.5% going to the UK, worth 0.1% of GDP) and vegetables (15.5% go to the UK, also worth 0.1% of GDP). Given its labour intensity, Spanish agriculture is a key contributor to employment. OECD data suggest that around 450,000 jobs in Spain are linked to UK demand (about 2.5% of total). Some of these jobs could be at risk. However, the UK's proposed new tariff schedule excludes most of the fruit and vegetables which Spain exports in large volumes to the UK. One however should also account for the impact of slowing UK demand after a potential 'no deal' Brexit.
Where have my Brits gone? Spain is more heavily exposed to the UK in terms of services. Spain exported around EUR18bn A weaker pound could hit tourism of services to the UK (around 1.5% of GDP) last year, the second largest exporting country after the US. More than a third of that is related to tourism. About a fifth of Spain’s tourist arrivals are from the UK, and the inflow of UK tourists (-1.3% y-o-y in June, on a 12mma, compared to +1.6% overall) has been slower than the overall inflow since H2 2016, just after the referendum, while before it tended to do better. A 'no deal' Brexit could make it more expensive for UK tourists to go to Spain, particularly given our expectations of a further depreciation of the pound. Furthermore, there are about one million UK citizens who live part time in Spain. They might also be affected by a ‘no deal’ Brexit, particularly in terms of access to key health services.
FDI at risk Spain is also heavily exposed in terms of its stock of Foreign Direct Investment (FDI) in the UK, particularly in the banking and telecommunication sector. A marked slowdown in the UK economy as a result of a 'no deal' Brexit, or changing regulations following the UK's departure from the EU, could therefore affect the income flows from these investments in the UK.
Overall, we estimate the drag on Spain's GDP growth from a potential 'no deal' Brexit would be about 0.2ppt in 2020.
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Ireland
Outside the UK, Ireland would be most affected by 'no deal' Brexit and fears have emerged in consumer surveys and in markets
Agri-business faces the biggest hit and we estimate a 1.2ppt hit to 2020e GDP growth in the event of a ‘no deal’ Brexit…
…but given strong growth fundamentals, we believe a recession can be avoided
Chris Hare The most exposed economy Economist Outside the UK, Ireland is the most exposed to a possible 'no deal' Brexit. Irish exports to the HSBC Bank plc [email protected] UK are worth around 10% of its GDP. While Ireland exports much more to the EU27 and the US +44 20 7991 2995 (each over 20% of GDP), that is still a significant exposure. And, of course, Ireland has a land border with the UK, which is 499km long, with around 275 road crossings and with over 100
million border crossings taking place every year (see Brexit: The Irish Perspective: Between a
backstop and a hard place, 7 February).
Given these exposures, it is perhaps unsurprising that Ireland is already seeing some impact from Brexit jitters. As shown in Chart 9, Irish consumer confidence wobbled around the time of the original last-March Brexit deadline. The Irish bond market has not been entirely immune either. Chart 19 shows that the Irish 10-year bond yield spread above French yields, which we think is a useful 'Brexit fear gauge' has spiked recently, as it did around the time of the UK referendum in 2016, and alongside recent declines in sterling since Boris Johnson became Prime Minister.
19. The elevated Irish bond-OAT spread 20. …consistent with the risk of a hefty hit suggests market concerns over Brexit… to GDP (Ireland spreads and GDP sheet)
Level Brexit 'fear' gauges ppts % ESRI estimate of GDP impact (vs 'remain') % 1.60 0.6 UK votes Boris Johnson 0 0 0.5 to leave EU becomes UK PM 1.50 0.4 -1 -1 0.3 -2 -2 1.40 0.2 0.1 -3 -3 1.30 0.0 -4 -4 1.20 -0.1 -0.2 -5 -5 1.10 -0.3 -6 -6 Jan-16 Jan-17 Jan-18 Jan-19 After 2 years After 5 years After 10 years GBP-USD (LHS) Ireland-France 10Y bond spread (RHS) Disorderly no deal No deal Source: Refinitiv Datastream, HSBC Source: *Economic and Social Research Institute, Department of Finance, Refinitiv Datastream, HSBC
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How big might the impact be? Ireland, therefore, seems most vulnerable to headwinds relating to trade, weakness in UK A big hit to GDP and, in particular, to agribusiness… demand, a fall in the pound, economic sentiment and, possibly, credit conditions. Various studies have attempted to estimate the likely GDP impact of these headwinds on Ireland. One study, which has been flagged by the Department of Finance, accounts for short and long-term disruption. It points to a potential long-run GDP impact of around 5% (Chart 20) from a 'no deal' Brexit, which is broadly in the middle of reputable studies.16
At a sector level, agri-business is the one to watch. There are three reasons for this. First, agricultural exports to the UK are significant – they are worth around 1.7% of GDP (Chart 2). Second, some of those agricultural exports are subject to high and complex tariffs. In particular, beef exports to the UK, which are worth 0.3% of GDP, would likely be subject to tariffs of 6.8%, plus EUR160.1 to EUR160.5/100kg. And third, there are significant cross-border supply chains in this sector – in many instances, livestock cross the Irish land border several times for slaughter, processing and sale and there would likely be tariff and border checks at each crossing, although the UK government has committed to temporarily refraining from imposing tariffs and new border checks on Northern Ireland imports from the Republic of Ireland.
Importantly through, underlying growth fundamentals remain strong in Ireland. Domestic …but we think an outright recession would be avoided demand remains solid and unemployment is falling. Our central forecast for 2020 growth stands at a punchy 3.4%. Our assumption is that a 'no deal' Brexit would knock around 1.2ppts off that. But that would keep growth above recessionary territory.
Still a key player in negotiations Of course, the Brexit saga would not be over after a 'no deal' Brexit. For one, uncertainty around the border is likely to persist – infrastructure required for customs and regulatory checks is seen by many, including the Irish government, as anathema to the Northern Ireland peace process.
In July, the Irish government released a report pointing out that 'checks and controls' would be needed for imports from the UK, including Northern Ireland.17 But the report shied away from providing specifics. We think it's reasonable to assume that no infrastructure will be set up at the border itself, at least in the first instance. But, over time, unless the UK and the EU manage to cobble together some sort of fresh 'backstop' arrangement, the border issue is likely to be fraught with risks surrounding illicit trade and, potentially, security.
In fact, an agreement on the border might well turn out to be a pre-condition for the UK and the EU putting together any kind of trade deal following 'no deal' Brexit. So, just as has been the case over the past three years, Ireland is likely to be a key player in Brexit-related negotiations.
______16 The report was published by the Economic and Social Research Institute (ESRI) on 26 March and the Department of Finance lists the research on its website. An overview of other studies contained in that report suggest a long-run GDP effect ranging between 2.3% and 7%. 17 Government of Ireland Contingency Action Plan Update, July 2019
23 Economics ● Eurozone 2 September 2019
Appendix: Table 21: UK and EU27 ‘no deal’ measures by key trade policy areas Trade policy area UK EU27 Tariffs UK's ‘no deal’ tariff regime will apply: 87% of UK goods imports will be eligible to enter Imports from the UK will be subject to EU27 non-preferential tariff rates: average tariff rate of duty-free. 12.0% for agriculture and 4.2% for non-agriculture. Customs processes UK’s Transitional Simplified Procedures (TSP) will apply. Imports from the UK will be subject to EU27 third-country rules such as border checks and other UK to temporarily waive border checks on most agri-food imports from the EU27 customs requirements. Farming and fishing UK will no longer be part of the Common Agriculture Policy and Common Fisheries Policy. No change to current arrangements. Agri-food trade regulations UK will follow EU food safety and animal health regulations for at least nine months in a Imports from the UK will be subject to EU27 third-country rules. ‘no deal’. Food imports of animal origin from the UK will have to enter through EU27 Border Inspection UK would no longer have access to TRACES (the EU’s import system for notifying trade in Posts and will be subject to third-country checks. animal products). A new UK system will replace this: Import of products, animals, food and feed system (IPAFFS). Industrial goods trade UK bodies that assess conformity of industrial products with EU standards prior to export will no No change to current arrangements. Imports from the UK will be subject to EU27 third-country regulations longer be recognised by the EU27. rules. Northern Ireland border UK will not apply tariffs or new border controls on Northern Irish imports from Ireland. No unilateral measures have been announced to-date, although the EU insists there should be no hard border. Financial services UK will transfer EU financial services law into the UK statute book. Imports from the UK will be subject to EU27 third-country rules, incl. loss of passporting. UK will enact temporary regimes for EEA financial services firms operating in the UK. EU27 will put in place a limited number of contingency measures to safeguard financial stability UK financial services firms will lose passporting rights in the EU27. (eg access to UK central clearing counterparties). Existing trade agreements UK needs to sign trade continuity agreements with existing FTA partners or risk falling out of All existing trade agreements will continue to apply to the EU27. But cumulation of rules of origin these deals. with the UK may still need to be agreed. Cumulation of rules of origin with the EU27 has been agreed for those deals signed already. Tariff preferences for UK will continue to apply non-reciprocal tariff preferences to around 75 developing and least No change to current arrangements. Existing preferences will continue to apply. developing countries developed countries. WTO commitments Goods: UK submitted its goods schedule for certification, which largely replicates current EU Goods: EU is modifying its tariff rate quota volumes to reflect the UK’s departure. It is currently obligations. The UK is currently engaged in negotiations with selected WTO members to engaged in negotiations with selected WTO members to determine precise volumes, but will determine its share of existing EU28 WTO tariff rate quota volumes. apply its proposed apportionments if negotiations are not concluded by exit day. Services: UK submitted its services schedule to WTO members for certification. It mostly replicates current EU obligations. Government Procurement Agreement (GPA): UK authorised to become a party to the GPA in its own right. Road haulage EU27 hauliers will continue to be able to move goods in the UK as they do now. EU27 will apply current (preferential) arrangements to UK road haulage operators until 31 December 2019. Extra permits will be needed thereafter. VAT and excise UK will introduce postponed accounting for import VAT for businesses for goods Imports from the UK will attract VAT. over GBP135. Excise goods imports from the UK will have to be released from customs formalities before these Duty suspension for excise goods from the EU27 will no longer apply. Excise duty will be can move under duty suspension within the EU. charged upon importation unless placed in excise or customs suspension. Movement of excise goods to the UK may need an electronic administrative document.
Note: This table contains a non-exhaustive list of key areas that may impact UK-EU27 trade in a ‘no deal’. These measures reflect the initial situation under a ‘no deal’ and are subject to possible modification over time. Sources: WTO EU tariff profile (2017 rates); Reuters, “UK to follow EU food and agriculture rules for 9 months in '‘no deal’' Brexit – Telegraph”, 1 March 2019; European Parliament legislative train schedule for apportionment of the EU’s WTO tariff rate quotas; House of Commons Briefing Paper on EU preparations for a ‘no deal’ Brexit, 30 May 2019; UK Government’s temporary tariff regime for ‘no deal’, 13 March 2019; WTO news item on UK set to become a party to the Government Procurement Agreement in its own right, 27 February 2019; UK House of Commons Briefing Paper on UK progress in rolling over EU trade agreements, 26 April 2019; Various UK Government ‘no deal’ guidance: Avoiding a hard border in Northern Ireland, Road haulage, Existing trade agreements; Importing animals, animal products and high-risk food; Placing manufactured goods on the EU internal market; Banking, insurance and other financial services; Customs, VAT and Excise regulations; VAT for businesses; EU Commission ‘no deal’ guidance on Customs and indirect taxation.
24 Economics ● Eurozone 2 September 2019
Disclosure appendix
Analyst Certification The following analyst(s), economist(s), or strategist(s) who is(are) primarily responsible for this report, including any analyst(s) whose name(s) appear(s) as author of an individual section or sections of the report and any analyst(s) named as the covering analyst(s) of a subsidiary company in a sum-of-the-parts valuation certifies(y) that the opinion(s) on the subject security(ies) or issuer(s), any views or forecasts expressed in the section(s) of which such individual(s) is(are) named as author(s), and any other views or forecasts expressed herein, including any views expressed on the back page of the research report, accurately reflect their personal view(s) and that no part of their compensation was, is or will be directly or indirectly related to the specific recommendation(s) or views contained in this research report: Chris Hare, Fabio Balboni, Chantana Sam, Rainer Sartoris, CFA and Shanella Rajanayagam
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25 Economics ● Eurozone 2 September 2019
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