Brexit decision may drive technical recession in euro area in H2 2016

With UK voting to leave the EU, the euro area is likely to experience a technical recession due to higher uncertainty and declining investment. The euro area is now likely to grow 1.2 percent in 2016 and 0.7 percent the next year, said Danke Bank in a research report. The most major economic impact is expected to be via sentiment.

A high negative impact is expected on overall sentiment, particularly business confidence that is likely to lead to reduced investments. A long period of negotiations might drag out the uncertainty; however, a major impact is expected to be seen in sharp decline in the second half of 2016. The euro area is likely to be in a technical recession in H2 2016.

Euro area’s trade is likely to be adversely impacted directly as the trade relationship between the UK and the EU is expected to be less beneficial than it is at present. The future relationship between the EU and the UK will show to which degree the trade channel weakens, noted Danske Bank.

Meanwhile, European banks’ exposure to the UK is significant and Brexit would be costly. However, it might move certain financial services to the EU over time. Moreover, the financial sector might also be impacted if investors speculate a lower return on UK investments. The financial sector accounts for a huge share of FDIs into the UK.

Meanwhile, the European Central Bank is likely to use current tools, to limit contagion. The ECB is likely to state that it is prepared to take action in case of an ‘unwarranted tightening’, according to Danske Bank. During the Grexit possibility, Draghi had mentioned the central bank’s readiness to take measures as he said the ECB has sufficient instruments in time with OMT, QE that they would certainly be used as a crisis time if required.

The ECB, in the near term, is expected to use the flexibility in the QE program. The central bank could potentially front-load purchases today already even without any official announcement. It might also but longer-dated bonds or purchase additional periphery bonds without announcing changes.

“Over the coming one-three months, we look for a stepup in the monthly QE purchases to EUR100bn. This should be in response to an unwarranted monetary tightening due to the negative market sentiment, which together with the weaker growth outlook threaten the medium-term outlook for inflation”, added Danske Bank.

Rate cuts are unlikely to be a tool to curb contagion and the ECB also appears to be less focused on a weaker euro.