Brexit Means Draghi’s ECB Seen as Euro-Area Rescuer Again

Assessing the Political Risks Stemming from Brexit
  • Economist survey predicts 0.6pp shaved off output through 2018
  • Expanded ECB stimulus seen likely by September, economists say

Frexit. Quitaly. The names are amusing, the reality would be anything but.

In the days since the U.K. voted to leave the European Union, the fact that commentators are scanning for the next country to worry about illustrates the existential crisis that the European project is having. For the euro area -- the 19-nation section of the EU that has pursued the deepest integration -- a dangerous loss of economic momentum is on the way, according to a Bloomberg survey.

Even with the economy entering its 14th quarter of expansion, unemployment is still above 10 percent and populist parties are on the rise from Germany to the Netherlands. Slower growth risks pushing political positions further toward extremes, yet questions still hang over issues including Italy’s failing banking system and reform of the bloc’s budget rules, and the European Central Bank looks like the only institution willing to act.

“Populism is a real threat to cohesion across Europe now, and a weaker growth environment makes solving the issues more difficult,” said Philippe Gudin, the Paris-based chief European economist at Barclays Plc. “To get out of this negative feedback loop we need a very strong message of confidence to the business sector on the future of Europe. The answer isn’t there yet.”

The ECB forecast economic growth for the euro area of 1.6 percent in 2016 and 1.7 percent in 2017 -- but it did so before the June 23 Brexit vote. The next update is scheduled for September.

Economists in the survey said the fallout from Brexit will shave off 0.1 percentage point of growth in gross domestic product, 0.3 percentage point in 2017 and 0.15 percentage point in 2018. That’s about 59 billion euros ($66 billion) of lost output.

Useful hard economic data won’t be available until September, when July’s figures will be reported. The political impact could be felt sooner though. Pressure from euroskeptic parties in France and Italy, the euro area’s second- and third-largest economies, mean leaders there are struggling to implement the policies needed to extricate their countries from the current low-growth trap.

A constitutional referendum in Italy slated for October and the fate of France’s labor-market reform ahead of a 2017 presidential election are political flash-points that could further ratchet up investor uncertainty and curb the growth outlook.

While ECB President Mario Draghi implored European leaders at the post-Brexit EU summit to “address bank vulnerabilities,” there’s little sign of a region-wide plan to do so. Quite the opposite: Italian Prime Minister Matteo Renzi’s efforts to design a 40 billion-euro bank bailout that can skirt EU rules are meeting stiff opposition from Germany and elsewhere.

“Each country doubts its neighbor’s ability to reform its economy and willingness to move forward together,” ECB Executive Board member Benoit Coeure said in an interview with Le Monde published July 1. “We cannot move forward under these conditions. Once confidence returns, it will be time to integrate further.”

Yet the euro-area now risks drifting even further apart. On Sunday, German finance minister Wolfgang Schaeuble said in a series of interviews that national governments should set the pace of change in the region -- if necessary sidestepping the EU’s executive, the European Commission.

“If the Commission isn’t coming along, then we’ll take matters into our own hands and solve problems between governments,” Schaeuble told Welt am Sonntag. “The Brexit decision has to be seen as a wake-up call for Europe.”

While the EU decides on its response to Brexit, a boost to the economy from either fiscal support or the pace of reform may go wanting. That would leave the ECB carrying the burden of countering the slowdown. More than 80 percent of economists surveyed said the central bank will have to add more stimulus, up from 67 percent in a similar survey at the end of May.

Of those who expect action, 90 percent said it will come at one of the next two meetings, either July 21 or Sept. 8, considerably more than said the same in May.

A similar share said Draghi will extend the 80 billion euros-a-month asset-purchase program beyond the scheduled end-date of March 2017. Thirty percent said the amount will be increased.

Aside from the economic hit from Brexit, the euro area may be at a fork in the road. Either it’s headed downhill, or it’s continuing along a bumpy path that residents should be familiar with. Two days after the U.K. result, voters in Spain pulled back from fringe parties and endorsed the center, following caretaker Prime Minister Mariano Rajoy’s call not to jeopardize the economic upturn.

“The euro-zone economy has shown itself to be remarkably resilient to external shocks over the past couple of years,” said Ben May, an economist at Oxford Economics Ltd. in London. “While Brexit could be the shock that brings the current self-sustaining recovery to a halt, we think it is far too soon to assume that this is inevitable.”

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