EUR/USD: A WTO Brexit would be "Manageable" for the Eurozone says Capital Economics

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- Eurozone to muddle through WTO Brexit with limited damage.

- Euro's losses to be limited, will recover them quickly afterward.

- But WTO Brexit would see UK growth of just 1% in 2019 and 2020.

The Euro and Eurozone economy would muddle through a so-called no deal Brexit without any significant damage overall, according to economists at Capital Economics, and the Euro would recover from an initial sell-off quite quickly. 

Much has been made of the impact a complete break with the EU will have on the UK but less has been said about the implications for the Eurozone. 

Capital Economics says the likely hit to the Eurozone would be equal to only a fraction of the damage that could be wrought on the UK if it departs the union and defaults to trading with it on World Trade Organization (WTO) terms.

"Provided that it is reasonably orderly, a “no deal Brexit” would probably reduce economic activity in the euro-zone by 0.1-0.2% points next year, though the impact would be much larger for Ireland. The blow would be concentrated in Q2 and Q3, after which the economy should recover lost ground," says Jessica Hinds, a European economist at Capital Economics. 

This likely hit to the Eurozone economy is less than Capital Economics' forecast that UK growth in 2019 would be half the 2% rate they project if the country exits the EU on the Prime Minister's terms.

"If mitigating arrangements are made, we think that GDP would be about 1% lower by 2020 than in our central scenario. Otherwise, the hit to GDP could increase to up to 3%, causing GDP to flat line next year with an outright recession probable (i.e. two quarters of contraction)," says Andrew Wishart, a colleague of Hinds, in a separate note to clients.

There are good reasons for analysts and observers to think a WTO Brexit is becoming likely, not least of all because of the level of opposition Prime Minister Theresa May is facing after returning from Brussels this month with a highly contentious Withdrawal Agreement and Future Relationship Declaration. 

Sir Michael Fallon, a Conservative Party MP and former defence minister, said Tuesday that May's deal covering terms of the U.K.'s exit from the EU is "doomed" and that it should be renegotiated because too many of the government's parliamentarians oppose it.

A handful of lawmakers have already made a failed bid to topple Prime Minister Theresa May because they say her proposals, rather than "taking back control" from the EU, could actually enfranchise it with even more power over the UK.

"There may be some short-lived impact on euro-zone asset prices and the euro but we doubt that these moves will be very substantial," says Hinds. "The euro would probably come under some downward pressure against many currencies, including the dollar, but it may be offset by some appreciation against sterling – just as it was after the referendum."

The Euro-to-Dollar rate was quoted 0.45% higher at 1.1347 Wednesday but is down -5.4% for 2018. The Euro-to-Pound rate was -0.08% lower at 0.8859 but has risen 0.14% this year. The EUR/GBP rate is 16.6% higher than it was before the Brexit referendum result became known.

The PM and EU claim the conentious proposals are necessary to ensure any future trade arrangements will not compromise the EU single market and lead the EU to impose a physical border that divides the island of Ireland.

However, Northern Irish and Brexit-supporting British lawmakers disagree, and almost all of the UK parliament barring a handful of the May administration's stalwarts oppose it for one reason or another. 

"Our central scenario is still that this (or something close) is eventually ratified by both sides. However, there is a significant risk that it does not get through the UK parliament, in which case there could be a “no deal”," Hinds says.

Northern Irish lawmakers, on whose support the Prime Minister depends for a majority in parliament, say her proposals will undermine the province's union with Great Britain and have pledged to vote against it in the House of Commons.

Brexiteers say there are other ways of avoiding a division of Ireland and that the proposals hand the EU something close to a veto over the UK's departure from the union while committing the country to paying a £39 billion "Brexit Bill" from the outset. Many claim they'll vote against it in parliament.

The Prime Minister's Withdrawal Agreement and declaration setting out non-binding ambitions for the future relationship are scheduled for a vote in parliament on December 11. Most analysts are forecasting that it won't get through parliament.

Hinds says that in a WTO Brexit scenario the most likely source of economic damage on both sides of the English Channel would be disruptions to trade because new customs procedures might require some time to "bed down". But the extent of any damage would depend on how long logistical problems last for and how quickly alternative transport routes are found. 

"Given the damage which would result for both sides, a truly disorderly no deal Brexit seems highly unlikely. In contrast, an “orderly” no deal Brexit is more plausible. In this scenario we assume that side agreements are struck on issues such as customs checks, aviation and regulatory equivalence to limit the short-term disruption," says Hinds. "We estimate that UK GDP would be 1% lower than in our base case. This would have significant, though not huge, implications for the euro-zone."

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