The UK’s decision to leave the EU, taken at a referendum in June, will be harmful for the global economy. The response of financial markets to the decision showed that it took many investors by surprise. The S&P 500 dropped by 3.6% in a day, but once the shock had worn off the index recovered its losses within two weeks. The capriciousness of stockmarkets should not, however, be underestimated. The consequences of Brexit will be long and profound. The more telling indicators are the performance of sterling, which has fallen by more than 10% against the dollar and has yet to find a floor, and bond yields in developed markets, which have collapsed to new lows amid concerns about the economic outlook and expectations of looser monetary policy. The decision—and the uncertainty surrounding it—has fundamentally weakened the British economy and written a new chapter in Europe’s rolling crisis.
Events may diverge from The Economist Intelligence Unit’s forecast in ways that affect global business operations. The main risks are represented by the following scenarios.
Very high risk = greater than 40% probability that the scenario will occur over the next two years; high = 31-40%; moderate = 21-30%; low = 11-20%; very low = 0-10%.
Very high impact = change to global annual GDP compared with the baseline forecast of 2% or more (increase in GDP for positive scenarios, decrease for negative scenarios); high = 1-1.9%; moderate = 0.5-0.9%; low = 0.2-0.5%; very low = 0-0.1%.
Risk intensity is a product of probability and impact, on a 25-point scale.
Negative scenario—China experiences a hard landing
High risk; Very high impact; Risk intensity = 20
We assess the prospect of a sharp economic slowdown in China—in which economic growth drops by 2 percentage points or more compared with the previous year—as our top risk scenario, reflecting a continued deterioration in the country’s manufacturing sector, the ongoing build-up of its debt stock (which is now equivalent to at least 240% of GDP) and occasional downward pressure on the renminbi as capital outflows persist. The government’s means to revive economic confidence are limited. Its huge stimulus in 2009 led to a build-up of bad debt—a problem that the government has only exacerbated by stepping up lending once again in the first quarter of 2016—and the People’s Bank of China (the central bank) burnt through US$300bn of reserves between September and February in order to prop up the renminbi. Meanwhile, poorly managed official attempts to shore up the stockmarket have highlighted concerns that the government’s promise to put a floor under economic growth might not be credible—as well as showing the shallow nature of the government’s commitment to allowing market forces to play a role in raising productivity. If China’s economy slows by more than we currently expect, it will further feed the ongoing global commodity price slump (notably in oil and, in particular, metals), with a hugely detrimental impact on those Latin American, Middle Eastern and Sub-Saharan African states that had benefited from the earlier Chinese-driven boom in commodity prices. In addition, given the growing dependence of Western manufacturers and retailers on demand in China and other emerging markets, a prolonged deceleration in growth in China would have a severe knock-on effect across the EU and the US—far more than would have been the case in earlier decades.
Negative scenario—Currency depreciation and persistent weakness in commodity prices culminate in emerging-market corporate debt crisis
High risk; High impact; Risk intensity = 16
In December the Federal Reserve (the US central bank) implemented its first policy rate increase in almost a decade. Although expectations of further rate rises have been reined in following the Brexit referendum in the UK, the potential for a flight to safety amid the subsequent economic uncertainty could imperil a slew of emerging-market economies (a factor that contributed to the interest-rate rise in Mexico at the end of June). The countries most vulnerable to the shifting monetary cycle are those with wide fiscal and current-account deficits; those viewed as lacking political and policy credibility; and/or those heavily reliant on commodity exports (in Venezuela’s case, all three shortcomings, combined with policy shortcomings, have raised the prospects of hyperinflation and default). In addition, those countries especially exposed to US trade will be caught in the backdraft of US monetary tightening, forcing many to raise rates in order to avoid destabilising capital outflows and further major currency depreciation. Also vulnerable are emerging-market corporates, especially in Asia, which in recent years have eagerly taken advantage of debt investors’ hunt for yield. Since the global financial crisis in 2008, emerging-market corporate debt has risen from 50% of GDP to close to 75%, and Chinese credit is still growing at twice the rate of nominal GDP growth. This exposure to rising rates will be exacerbated by weakening local currencies, which will push up the cost of corporates’ foreign-currency borrowings—worth US$4.4trn in mid-2015, according to the Institute of International Finance. Any rolling emerging-market debt crisis would cause panic across the global capital markets and may require governments in several economies to step in to shield their banks from the fallout—risking a repeat of the banking crises witnessed in Europe at the start of this decade.
Negative scenario—Donald Trump wins the US presidential election
High risk; High impact; Risk intensity = 16
Donald Trump, a businessman and political novice, has now been endorsed by the Republican establishment as the party’s official presidential nominee, and polls between him and (the almost as divisive) presumptive Democratic nominee, Hillary Clinton, have narrowed of late. Although we still do not expect Mr Trump to defeat Ms Clinton, there are risks to this forecast, especially in the event of a sudden economic downturn or further terrorist attacks on US soil. Thus far Mr Trump has given few details of his policies—and these tend to be prone to constant revision—but a few themes have become apparent. First, he has been exceptionally hostile towards free trade, notably the North American Free-Trade Agreement (NAFTA), and has repeatedly labelled China as a “currency manipulator”. He has also taken an exceptionally aggressive stance on Middle East and jihadi terrorism, including, among other things, advocating the killing of families of terrorists and launching a land incursion into Syria to wipe out Islamic State (IS; and acquire its oil). In the event of a Trump victory, his hostile attitude to free trade, and alienation of Mexico and China in particular, could escalate rapidly into a trade war—or at least scupper the Trans-Pacific Partnership between the US and 11 other American and Asian states, signed in February 2016. His militaristic tendencies towards the Middle East (and ban on all Muslim travel to the US) would be a potent recruitment tool for jihadi groups, increasing their threat both within the region and beyond, while his vocal scepticism towards NATO would weaken efforts to contain Russia’s expansionist tendencies. Elsewhere, and arguably even more alarmingly, his stated indifference towards nuclear proliferation in Asia raises the prospect of a nuclear arms race in the world’s most heavily populated continent. However, it is worth noting that the innate hostility within the Republican hierarchy towards him, combined with the inevitable virulent Democratic opposition, would see many of Mr Trump’s more radical policies blocked in Congress—although such internal bickering will also undermine the coherence of domestic and foreign policymaking.
Negative scenario—”Grexit” is followed by a euro zone break-up
Moderate risk; Very high impact; Risk intensity = 15
Although an 11th-hour agreement between Greece and its euro zone creditors for a third bail-out in July 2015 removed the immediate risk of “Grexit”, the country’s future within the euro zone remains at risk. The fragile, Syriza-led governing coalition finally managed to agree a raft of pension and income tax measures imposed by its creditors in early May, but the reforms prompted violent protests, and, despite IMF pressure, the euro zone finance ministers pushed back any decision on a badly needed debt-forgiveness deal until 2018—a situation that will lessen the government’s already weak appetite to implement the remainder of the bail-out programme’s economic reforms. In the event that Greece were to fail to abide by the terms of its bail-out, prompting a renewed domestic bank run, the return of capital controls and ultimately its departure from the currency, the idea that membership is irrevocable would no longer hold and attention would turn to other highly indebted countries in the single-currency area. The Greek debacle has shown the fundamental difficulties associated with creating a single currency zone without a concurrent fiscal union (as demonstrated by the ongoing stand-off over the European Commission’s proposed fine for Portugal and Spain for breaching the Fiscal Compact). With the euro zone’s political and economic problems mounting, these inadequacies will no doubt return to the fore—especially if the worsening Italian banking crisis were to escalate, dragging the Italian government down with it. If Grexit were to lead to other countries leaving the euro zone, this would be hugely destabilising for the global economy. Countries leaving the zone under duress would suffer large devaluations and be unable to service euro-denominated debts. In turn, banks would suffer huge losses on their sovereign bond portfolios and the global economy would return to recession.
Negative scenario—Beset by external and internal pressures, the EU begins to fracture
Moderate risk; Very high impact; Risk intensity = 15
The Brexit vote in the UK—the first country to leave the EU (excluding Greenland) since its inception—has raised concerns about the future viability of the Union. Although the UK has long had an ambivalent attitude towards Europe, the hostility of the UK Independence Party towards the EU is mirrored by other European “insurgent” parties, such as the Freedom Party in the Netherlands and Front National in France. With this in mind, there is a risk that the establishment parties in the EU will consider offering an in:out referendum in order to siphon off support from populist parties—a tactic disastrously employed by the former UK prime minister, David Cameron, and which ultimately led to the UK’s vote to leave. Although Mr Cameron’s fate may deter other European leaders from employing a similar tactic, in reality the arguments pushed by the Brexit campaigners—focused on immigration and loss of sovereignty—chime with much of Europe. The failure of the EU to agree a united response to the refugee crisis–which saw checks and barriers reappearing across Europe’s 22-member Schengen area—and the deep resentment in some of the Mediterranean countries towards the stifling austerity measures imposed by the EU (and often led by Germany) are indicative of the tendency of politicians to increasingly eschew co operation in favour of narrower national priorities. With the no cogent roadmap in place for the future of the “European project”, there is a growing risk of an existential crisis in the EU that could culminate in its eventual fracturing. In the event that the EU were to begin to fall apart and land borders were reimposed, trade flows and economic co operation would be hindered, harming growth in the world’s largest single trading bloc—notably in trade-reliant Germany, which shares land borders with ten fellow Schengen members—and leaving the fragile euro zone states more vulnerable in the event of another economic downturn.
Negative scenario—The rising threat of jihadi terrorism destabilises the global economy
Moderate risk; High impact; Risk intensity = 12
The threat of jihadi terrorism has moved towards the top of policymakers’ policy agenda after a series of devastating attacks in Lebanon, Turkey, Egypt, France, Belgium and Indonesia in recent months. Despite losing considerable territory in Iraq and Syria lately, IS remains an especially challenging group to counter: first, because of its self-declared, albeit diminishing, “caliphate” in Syria and Iraq (the existence of which provides both an operational base and a propaganda tool); and, second, owing to the ease with which it can seemingly recruit and motivate attackers globally (as demonstrated by the killing of 49 people in Orlando by a single gunman in June). Taking advantage of its decentralised nature—which allows individuals to operate under its banner anywhere in the world without prior contact with the group—IS has been able to strike a wide variety of targets across multiple continents. Besides its ability to win new adherents, IS’s other success has been to garner the backing of internationally established jihadi organisations such as Ansar Beit al Maqdis in Egypt and Boko Haram in Nigeria. The spread of IS and its influence poses a dilemma for global policymakers, who are under pressure to intervene militarily to suppress the group in its strongholds in the Middle East (especially now that hundreds of thousands of Syrian refugees are seeking sanctuary in Europe) but who in turn would risk reprisals in their home countries by radicalised IS sympathisers. This scenario may have played out with the destruction of a Russian airliner in Egypt in November and also with the multiple attacks on civilian targets in Paris in November and Brussels in March. Should this spiral of attack and counter-reprisal continue to escalate, it would no doubt begin to dent consumer and business confidence, which in turn could threaten to end the five-year bull run on the US and European stockmarkets.
Negative scenario—Chinese expansionism leads to a clash of arms in the South China Sea
Moderate risk; High impact; Risk intensity = 12
The ruling in July by the Permanent Court of Arbitration (PAC) in favour of the Philippines in its case against China’s claims in the South China Sea, notably including the Spratly Islands, has cast the escalating territorial tensions in the region in a new light. In recent years China has sought to exert its claimed historical rights to the sea areas demarcated by its so-called nine-dashed line, which encompasses around 85% of the South China Sea. Among other methods, this has included dredging work by Chinese vessels, seemingly focused on turning reefs, atolls and rocks in disputed parts of the South China Sea into artificial islands and, in some instances, military bases. This work has profound territorial implications: according to the UN Convention on the Law of the Sea, uninhabitable rocks have a 12 mile territorial zone, while habitable islands have 12 mile territorial waters and a 200 mile exclusive economic zone. However, in its ruling the PAC argued that there was “no legal basis” for the country to claim historical rights within its nine-dashed line. In response, China unsurprisingly declared the verdict null and void, although the Ministry of Foreign Affairs did say that it was open to negotiations over resolving the dispute. However, the ministry’s role in driving policy over the South China Sea has usually been secondary to that of the military and the leadership of the Chinese Community Party, neither of which has shown any predilection to adjust their tactics. With China mired in multiple island disputes elsewhere, including with South Korea and Japan, there is a risk that the court setback will provoke China to re-emphasise its de facto control of the disputed region, such as by declaring a no-fly zone. However such an approach could lead to a military build-up in the region, which, in turn, would raise the danger of an accident or miscalculation that might lead to a wider military escalation. Any worsening of the row could seriously undermine intra-regional economic ties, and potentially interrupt global trade flows and simultaneously depress global economic sentiment more broadly.
Positive scenario—Global growth surges in 2017 as emerging markets rally
Low risk; Very high impact; Risk intensity = 10
The start of 2016 was fraught for global currency and commodity markets, with oil prices slumping towards US$25/barrel and a raft of emerging-market currencies adversely affected by the start of US monetary tightening. The resulting dip in global equity markets was exacerbated by growing concerns over China’s economic slowdown and the depreciation of the renminbi. However, since February there has been a significant turnaround in investor sentiment, with global equity markets rallying to their pre-2016 highs, oil prices bouncing back to around US$50/b and the renminbi strengthening once again. Indeed, even after the Brexit vote, the financial market fallout was short-lived (albeit market uncertainty is likely to reappear at some stage), with global equity prices back to their previous levels by mid-July. As a consequence, with emerging markets having arguably endured the worst impacts of the commodity price collapse and the US rate-tightening cycle now likely to be less aggressive than previous envisaged, the stage may be set for a period of greater macroeconomic, currency and commodity stability, which could propel global growth, at market exchange rates, to 4% in 2017 (the highest level since 2010). A broad-based acceleration in growth would not only provide welcome relief to slow-growing euro zone countries, which remain heavily reliant on export demand, but could also assist in China’s economic rebalancing. An improvement in global, and in particular Chinese, demand would also provide a major fillip for global commodity prices, giving welcome relief to a slew of Latin American, Middle Eastern and African exporters.
Negative scenario—Rising tide of political populism in the OECD results in a retreat from globalisation
Moderate risk; Moderate impact; Risk intensity = 9
The UK vote to depart the EU marks a landmark setback for economic and political integration within the OECD, and will prompt major soul-searching—and in some cases outright panic—among many governments. As shown in the strong support for Donald Trump in the US and the growing influence of populist parties (both left and right) in, for example, Spain (Podemos), Italy (Five Star) and France (Front National), there is a powerful backlash under way against the consequences of globalisation. This backlash is, in some ways, understandable. The benefits of trade liberalisation tend to be spread thinly across the vast bulk of the population and often go little noticed; by contrast, the victims of globalisation, such as those living in areas heavily reliant on a dwindling manufacturing or industrial base, are often concentrated and disproportionately affected. This dichotomy has been exacerbated by a stagnation in living standards for many people across the OECD in the past decade. In the face of these headwinds, it will prove difficult to ratify trade agreements. We expect the long-mooted Transatlantic Trade and Investment Partnership (TTIP; a proposed trade agreement between the EU and the US) to fail to be agreed on, and the Trans Pacific Partnership (TPP; between the US and 11 other countries) also faces ratification difficulties. There is even a risk of a wholesale protectionist revival if, for example, the OECD were to go through another economic downturn. The impact of a protectionist wave would be felt around the world. In wealthy OECD countries with a dominant services sector, rising trade tariffs would push up living costs and depress domestic demand, causing economic growth to slow. Meanwhile, among major low-cost exporters, such as those concentrated in East Asia, higher barriers would curb exports, investment and job creation.
Negative scenario—A collapse in investment in the oil sector prompts a future oil price shock
Very low risk; High impact; Risk intensity = 4
The response of the world’s oil companies to lower prices should raise concerns about the long-term impact on future energy supplies. Around US$400bn-1trn dollars worth of oil and gas projects have been deferred or cancelled (a process that actually started before the decline in oil prices began), with, for example, the Brazilian state oil company, Petrobras, announcing in January 2016 that it was further cutting its original 2020 production target of 4.2m barrels/day (b/d) to 2.7m b/d. The shale oil industry in the US, although primarily responsible for the recent collapse in oil prices, is also vulnerable, given the surge in US oil independents’ debts in recent years. History provides repeated warnings of the long-term impact of oil-price slumps: the surge in oil prices to close to US$150/b in 2008, for example, can be traced back to the investment freeze across the industry in the wake of the oil-price collapse in 1998. Meanwhile, contrary to historical precedent, the oil market is still not taking into account geopolitical risks to supplies, ranging from war in the Middle East to political ructions in Venezuela and outages in Nigeria. Nevertheless, we believe that the risk of an oil price spike in 2016-20 remains low, reflecting the huge amounts of new output set to come on stream from low-cost producers such as Iraq (and post-sanctions Iran), as well as the ability of US shale oil producers to revive drilling activity rapidly in the event of a price recovery.