The International Monetary Fund cut its forecasts for global economic growth this year and next as the unexpected U.K. vote to leave the European Union creates a wave of uncertainty amid already-fragile business and consumer confidence. 

“The Brexit vote implies a substantial increase in economic, political, and institutional uncertainty, which is projected to have negative macroeconomic consequences, especially in advanced European economies,” according to the IMF’s World Economic Outlook Update released on 19 July 2016.

“Brexit has thrown a spanner in the works,” said Maurice Obstfeld, IMF Chief Economist and Economic Counsellor. And with the event still unfolding, the report says that it is still very difficult to quantify potential repercussions. 

The economies of the United Kingdom (U.K.) and Europe will be hit the hardest by fallout from the June 23 referendum, which prompted a change of government in Britain. Global growth, already sluggish, will suffer as a result, putting the onus on policy makers to strengthen banking systems and deliver on plans to carry out much-needed structural reforms. 

In particular, policymakers in the U.K. and the European Union (EU) will play a key role in tempering uncertainty that could further damage growth in Europe and elsewhere, the IMF said. It called on them to engineer a “smooth and predictable transition to a new set of post-Brexit trading and financial relationships that as much as possible preserves gains from trade between the U.K. and the EU.” 

Global growth remains muted, blow to UK growth

The global economy is projected to expand 3.1 percent this year and 3.4 percent in 2017, according to the IMF (see table). Those forecasts represent a 0.1 percentage point reduction for both years relative to the IMF’s April World Economic Outlook. 

The U.K. economy will expand 1.7 percent this year, the IMF said, 0.2 percentage point less than forecast in April. Next year, the nation’s growth will slow to 1.3 percent, down 0.9 point from the April estimate and the biggest reduction among advanced economies. For the euro area, the Fund raised its forecast by 0.1 point this year, to 1.6 percent, and lowered it by 0.2 point in 2017, to 1.4 percent. 

Had it not been for Brexit, the IMF was prepared to leave its outlook for this year broadly unchanged as better-than-expected euro area performance offset disappointing U.S. first-quarter growth. The IMF also had been prepared to raise its outlook for 2017 slightly, by 0.1 percentage point, on the back of improved performance in a few big emerging markets, in particular Brazil and Russia. 

The IMF said its forecasts were contingent on the “benign” assumptions that uncertainty following the U.K. referendum would gradually wane, the EU and U.K. would manage to avoid a large increase in economic barriers, and that financial market fallout would be limited. 

Likelihood of negative outcomes: two scenarios

Even so, the IMF warned that “more negative outcomes are a distinct possibility.” “The real effects of Brexit will play out gradually over time, adding elements of economic and political uncertainty,” said Obstfeld. “This overlay of extra uncertainty, in turn, may open the door to an amplified response of financial markets to negative shocks.” 

Because the future effects of Brexit are exceptionally uncertain, the report outlined two scenarios that would reduce world growth to less than 3 percent this year and next. 

In the first, “downside” scenario, financial conditions are tighter and consumer confidence weaker than currently assumed, both in the U.K. and the rest of the world, until the first half of 2017, and a portion of U.K. financial services gradually migrates to the euro area. The result would be a further slowdown of global growth this year and next. 

The second, “severe” scenario, envisages intensified financial stress, particularly in Europe, a sharper tightening of financial conditions and a bigger blow to confidence. Trade arrangements between the U.K. and the EU would revert to World Trade Organization norms. In this scenario, “the global economy would experience a more significant slowdown” through 2017 that would be more pronounced in advanced economies. 

Outlook in other advanced, emerging markets

Brexit’s fallout is likely to be felt in Japan, where a stronger yen will limit growth. The IMF cut its 2016 growth forecast by 0.2 percentage point, to 0.3 percent. Next year, Japan’s economy, the world’s third-largest, is expected to expand 0.1 percent, 0.2 percentage point more than predicted in April, due to postponement of the consumption tax increase. 

In the U.S., weaker-than-expected growth in the first quarter prompted the IMF to reduce its 2016 forecast to a gain of 2.2 percent, 0.2 percentage points less than the April outlook. The IMF left its 2017 forecast for U.S. growth unchanged at 2.5 percent. 

China’s growth forecast for 2016 is up 0.1 percentage point, to 6.6 percent, and is unchanged for 2017 at 6.2 percent. Brexit fallout is likely to be muted for China, the world’s second-largest economy, because of its limited trade and financial links with the U.K. 

“However, should growth in the European Union be affected significantly, the adverse effect on China could be material,” the IMF said. 

The outlook for other emerging and developing economies remains diverse and broadly unchanged relative to April. That said, gains in the emerging group are matched by losses in low-income economies. Indeed, low-income countries saw a large downward revision in 2016, in large part driven by the economic contraction in Nigeria, and also worsened outlook in South Africa, Angola, and Gabon.

Risks across the world

The IMF cited other risks to its outlook, which could be further exacerbated by Brexit. It cited “unresolved legacy issues in the European banking system, in particular in Italian and Portuguese banks.” 

“Protracted financial market turbulence and rising global risk aversion could have severe macroeconomic repercussions, including through the intensification of bank distress, particularly in vulnerable economies.” 

The Fund also warned that “political divisions within advanced economies may hamper efforts to tackle long-standing structural challenges and the refugee problem” and that “a shift toward protectionist policies is a distinct threat.” 

Geopolitical tensions and terrorism are also taking a heavy toll on the outlook in several economies, especially in the Middle East, with further cross border ramifications. 

Policy implications: more growth and stability needed

Turning to policy implications, the IMF said a “combination of near-term demand support and structural reforms to reinvigorate medium-term growth remain essential” in advanced economies, which continue to suffer from “significant economic slack and a weak inflation outlook.” 

The IMF urged advanced nations to avoid relying too heavily on monetary policy to spur their economies and to exploit synergies among a range of policy tools. 

“Stronger reliance on measures to support domestic demand, especially in creditor countries with policy space, would help reduce global imbalances while contributing to stronger world growth,” it said.