Eurozone: Recovery intact, institutional turmoil ahead Global Economic Outlook, Q2 2016

Even though significant internal and external risks exist for the European Union, the main institutional and political risk is the possibility of a Brexit. While its consequences are difficult to predict, the political effects for the European Union could range between two scenarios.


In purely economic terms, the first quarter of 2016 has been unspectacular for the Eurozone. The moderate recovery continued, following its trend of the last two years. However, monetary policy decisions by the European Central Bank showed that the economic situation is still far from normal. Also, significant internal and external risks for the Eurozone and the European Union have emerged. These include the continuing refugee crisis and the Chinese growth slowdown, though the main institutional and political risk is the possibility of a “Brexit”: the United Kingdom exiting the European Union.

Given that EU skepticism has grown and nationalist parties are on the rise in many EU und Eurozone countries, a Brexit might serve as an example for political movements in other countries.

Consumers optimistic; investors and corporates less so

The consumer-led recovery in the Eurozone has continued. Household spending has been supported by various factors, especially rising employment. The unemployment rate in the Eurozone stood at 10.3 percent in January, which is one percentage point lower than last summer. Additionally, energy prices have remained low, contributing to higher spending power.

Generally, consumers are by far the most important factor of the Eurozone’s growth performance and seem to be unaffected by the various risks, while corporates and investors have become very sensitive to risk. Germany is a case in point. While the DAX equity index took a dip after the Chinese stock market turbulence in January, and corporate sentiment deteriorated substantially since summer, consumers seem unaffected, and consumer sentiment remains strong (figure 1).

Figure 1

The Brexit and the risks for the European Union

At an EU summit in late February, the United Kingdom and the European Union concluded renegotiations over the terms of British membership. The referendum on the United Kingdom’s EU membership will take place in late June. Apart from the risks for the United Kingdom itself, a possible Brexit would also pose risks for the institutional stability of the European Union.

While a possible Greek exit has been dominating the news for the last few years, the Brexit has received much less attention. This is strange because the United Kingdom is a prominent member of the European Union; in fact, it is the second-largest economy of the union. The United Kingdom accounts for 13 percent of the European Union’s population, 10 percent of its budget, 17 percent of its GDP, and 30 percent of its equity market capitalization.

While polls in the United Kingdom indicate that the “in” and “out” camps are fairly equal in size, in the European Union, the electorate clearly favors the United Kingdom staying part of the European Union.1 Research done by the University of Edinburgh in six European countries shows that at least two-thirds of respondents prefer the United Kingdom staying a member; in France, a majority shares the view, but the approval is considerably lower (figure 2).2

Figure 2

The political impact of a Brexit on the European Union

The consequences of a Brexit are difficult to predict as there are no historical precedents. No state has ever withdrawn from the European Union. Only Greenland—in a political union with Denmark—left the European Union in 1985 after a referendum. The impact on the European Union as well as on the United Kingdom will hinge on how relations are structured and develop after a Brexit, especially how access to the European Single Market is organized.

Nevertheless, the political effects for the European Union could range between two scenarios. In the first scenario, the Brexit would trigger a domino effect and be the start of a wider disintegration of the European Union. Given that EU skepticism has grown and nationalist parties are on the rise in many EU und Eurozone countries, a Brexit might serve as an example for political movements in other countries. There are different possible degrees of fragmentation. Complete disintegration is unlikely, but several more countries could leave the European Union or demand renegotiation of their terms of membership. The crucial question would be how the remaining countries react, and whether they choose to push further integration or loosen the ties among themselves.

In a second scenario at the other end of the spectrum, the Brexit might result in deeper integration of the EU 27 or the Eurozone. Such deeper integration often followed institutional crises; for example, the creation of the Single Market followed years of the so-called “eurosclerosis,” during which the European Union seemed to be unable to take any decisive action to counter economic stagnation. In this sense, the European countries might choose to accelerate integration in the face of the threat of the European Union breaking apart.

The impact on European firms

The political consequences are closely related to the economic ones. For European companies, the key question will be whether and how the United Kingdom is integrated into the Single Market after a Brexit. There are basically three possibilities. First, the United Kingdom could remain in the Single Market through the European Economic Area, a similar arrangement the European Union has with Norway. In this case, trading relations would not change much. Second, the European Union and the United Kingdom might conclude a free-trade arrangement similar to the EU-Switzerland agreement. Third, the United Kingdom completely drops out of the Single Market, with the likely consequence of tariffs and trade barriers being reintroduced.

While the European Union is the United Kingdom’s most important trading partner, the converse is not true, though the United Kingdom is still a significant trading partner for the Eurozone. For German exporters, for example, it is the ninth-largest export market. If tariffs are introduced, European exporters or companies with production facilities or assets in the United Kingdom would face higher costs and declining competitiveness in the UK market.

In the case of a free-trade arrangement, exporters would face uncertainty for a considerable amount of time. The access of Swiss firms to the Single Market includes 120 treaties; a similar arrangement for the United Kingdom would take years to conclude. The option of staying in the Single Market even after a Brexit depends entirely on the willingness of the European Union. It is difficult to foresee whether the European Union would be keen on granting the United Kingdom access to the Single Market if the latter decides not to be part of the club any longer. It seems that currently, at least, popular opinion in Europe is against such an outcome (figure 3).

Figure 3

These political and economic scenarios and the associated risk factors indicate that the European Union could develop into a different organization after a Brexit. Any direction taken will be very important for the European Union’s economic future.