CR 18224

IMF Country Report No.
18/224
EURO AREA POLICIES

SELECTED ISSUES
July 2018
This Selected Issues paper on euro area policies was prepared by a staff team of the
International Monetary Fund as background documentation for the periodic consultation
with the member countries forming the euro area. It is based on the information
available at the time it was completed on June 29, 2018.
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© 2018 International Monetary Fund

EURO AREA POLICIES
SELECTED ISSUES
June 29, 2018
Approved By Prepared by Jiaqian Chen, Christian Ebeke, Li Lin, Haonan
European Department Qu, Hanni Schoelermann, and Jesse Siminitz (all EUR)
CONTENTS
LONG-TERM IMPACT OF BREXIT ON THE EU ___________________________________________3

A. Euro Area and U.K.: How Strong are the Links? _________________________________________ 3
B. A Synthetic Index of Exposure to the U.K. _______________________________________________ 5
C. An Econometric Investigation of the Long-Term Effects of Brexit on the EU __________ 11
D. A Model-Based Approach to Quantify Long-Term Effects of Brexit due to Higher
Trade Barriers ____________________________________________________________________________ 14
E. Summary of the Results _______________________________________________________________ 20
F. Conclusion _____________________________________________________________________________ 21
FIGURES
1. Trade in Goods, Services, and Financial Services ________________________________________ 6
2. Trade in Value Added and Migration ____________________________________________________ 7
3. Financial Flows __________________________________________________________________________ 8
4. Synthetic Index of Integration With the U.K. __________________________________________ 10
5. Gross Exports to the U.K. by Sector for Selected EA Countries ________________________ 15
6. Estimated Trade Elasticity by Sector ___________________________________________________ 18
7. Level of Non-Tariff Trade Costs in FTA Scenario ______________________________________ 18
8. Long-Term Impact of Brexit: FTA Scenario_____________________________________________ 19
9. Long-Term Impact of Brexit: WTO Scenario___________________________________________ 19
10. Comparison of Estimated Impact From Brexit for the EU27 __________________________ 20
TABLE
1. U.K. MFN Tariff With Non-EU Countries _______________________________________________ 19
APPENDIX
I. Principal Component Analysis Results _________________________________________________ 22
References________________________________________________________________________________ 24
EURO AREA POLICIES
YOUTH UNEMPLOYMENT DURING THE EURO AREA ECONOMIC RECOVERY ____________ 26

A. Recent Developments of Youth Unemployment in the Euro Area ___________________________ 26
B. Main Drivers: A Shrinking Labor Force and a Larger Share in Education and Training_______ 27
C. Job Creation and the Young _________________________________________________________________ 29
D. Macroeconomic Implications________________________________________________________________ 32
E. Boosting the Labor Market Prospects of the Young _________________________________________ 33
BOXES
1. Youth Unemployment—Cross-Country Dispersion __________________________________________ 34
2. The 3 Million Missing Young ________________________________________________________________ 35
TABLES
1. Multivariate Model Estimates ________________________________________________________________ 31
2. Data Definitions _____________________________________________________________________________ 36
References _____________________________________________________________________________________ 37
2 INTERNATIONAL MONETARY FUND

EURO AREA POLICIES
LONG-TERM IMPACT OF BREXIT ON THE EU1

The integration of EU27 countries and the United Kingdom has strengthened over time, reflecting
shared gains from the EU’s single market. Conversely, the departure of the U.K. from the EU
(Brexit) will inevitably represent a loss for both sides. In this paper we use two approaches to
estimate these losses. First, we create a multidimensional index that captures the depth and
evolution of integration between the U.K. and the rest of the EU, taking into account trade via
supply chains, financial linkages, as well as migration. We then use this index to estimate the
average long-term impact of several Brexit scenarios. Second, we use a standard multi-country
and multi-sector computable general equilibrium (CGE) model to estimate country- and sector-
specific impacts from higher trade barriers between the U.K. and the rest of the EU countries. We
find that the level of output of EU27 countries falls by between 0.06 and up to 1.5 percent in the
long run. The range of estimates depends on whether we assume a “soft” or “hard” Brexit, or
whether trade or other transmission channels are accounted for. These are likely losses that
should be interpreted with caution, given the important uncertainty characterizing the empirical
estimations. Moreover, there is substantial heterogeneity in the impact of higher trade barriers:
countries such as Ireland, Netherlands, and Belgium are among the most affected in the
simulations.
A. Euro Area and U.K.: How Strong are the Links?
Dimensions of Integration
1. EU-U.K. trade integration has benefited both parties. For example, the euro area (EA)
runs a modest trade surplus with the U.K., while the U.K. has a small surplus in financial services
trade with the euro area. In recent years, the euro area’s trade surplus with the U.K. increased
steadily, owing to rising exports of goods, reaching 1 percent of EA GDP in 2016. In gross terms,
total trade in goods and services between the euro area and the U.K. accounts for about 6 percent
of euro area GDP on average over the past two decades. Trade with the U.K. is most significant for
Ireland, the Netherlands, Belgium, and Luxembourg, relative to the respective sizes of their
economies. The U.K. is a net provider of financial services to the euro area, driven by its large
bilateral flows with Ireland. Excluding Ireland, the trade in financial services between the euro area
and the U.K. is close to balance (Figure 1).
2. Trade with the U.K. involves complex supply chain linkages. Most trade today—over
50 percent of goods and almost 70 percent of services trade—is in intermediate inputs, suggesting
the presence of supply chains.2 Therefore, it is important to capture also the indirect links via these
supply chains when assessing euro area countries’ trade with the U.K. Moreover, it is important to
account for the value added from third countries when assessing exports to, and imports from, the
1
Prepared by Christian Ebeke, Li Lin, Haonan Qu, Jiaqian Chen, and Jesse Siminitz (all EUR). We are grateful to Borja
Gracia (EUR) for substantive comments on the paper.
2
Remarks by OECD Secretary General Angel Gurría at the Istanbul G20 Trade Ministers meeting, October 6, 2015.
INTERNATIONAL MONETARY FUND 3

EURO AREA POLICIES
U.K. From a value-added perspective, euro area trade with the U.K. is a combination of direct and
indirect value-added exports transiting through third countries, suggesting that supply chains also
play a role. Smaller but open economies such as Ireland, Luxembourg, and Netherlands exhibit the
highest exposure in value-added terms with the U.K., though this exposure is smaller than what
gross trade statistics suggest (Figure 2).
3. EA-U.K. investment positions are substantial.
 Euro area total financial claims and liabilities with the U.K. amounted to about 55 percent of euro
area GDP in 2016 (Figure 3). Across countries, Ireland, Netherlands, and Luxembourg have the
largest financial positions relative to their own economic size. Notably, the two-way FDI stock
between Netherlands and U.K. is about 120 percent of Netherland’s GDP; the two-way portfolio
investments between Ireland and U.K. is slightly below 230 percent of Ireland’s GDP; and the
two-way bank claims between Luxembourg and U.K. is about 220 percent of Luxembourg’s GDP.
 In net terms, the euro area provides financial capital to the U.K amounting to about 9 percent of
euro area GDP. However, the aggregate number hides cross-country heterogeneities. The
Netherlands and Ireland contribute most to the net FDI investment position (about 2.1 percent of
euro area GDP in 2016). Ireland and Malta have large net portfolio investments position with the
U.K., whereas most other countries are net recipients. Finally, relative to their own GDPs,
Luxembourg and Ireland are large recipients of cross-border bank lending from the U.K. (more
than 170 percent of GDP in the case of Luxembourg and 58 percent of GDP in the case of Ireland).
4. Migration flows between the euro area and the U.K. are small, except for some
countries with historical ties to the U.K. The number of U.K. migrants living in the euro area is
small relative to the euro area population, but has increased somewhat over time. The euro area has
traditionally been a net sender of migrants to the U.K. for all skill levels, with a total balance of about
0.1 percent of the euro area population as of 2010. The number of migrants from Ireland, Cyprus,
and Malta living in the U.K is considerable, accounting for roughly 10 percent of these countries’
population. Regarding migration from the U.K. to the euro area, there is one U.K. migrant living in
the euro area for every four to five hundred euro area citizens. However, the U.K. migrant population
is larger in Ireland, Luxembourg, and Spain.3
What Do the Stylized Facts Suggest of the Potential Impacts of Brexit?
5. The strength of euro area-U.K. integration implies that there would be no Brexit
winners. First, the U.K. is among the top three main trading partners of the euro area. Second, the
gross trade exposure masks complex supply chain linkages. Third, cross-border capital flows
between the U.K. and the euro area are large. Finally, migration flows are considerable for some
countries. Higher barriers to trade, capital flows and people movements following Brexit could
3
OECD does not have a complete coverage of EA countries.

EURO AREA POLICIES
disrupt these links, reducing trade, investment and labor mobility. All empirical studies so far concur
that economic costs on both sides would be considerable. However, the EU27 would bear a
disproportionally smaller share of the total cost due to its larger size.4
6. The long-run impact of Brexit is likely to be unevenly distributed across countries,

with Ireland exhibiting the highest exposure. Losses would depend on bilateral integration with
the U.K., sectoral specialization, the positioning of sectors within the global supply chain and the
degree of substitutability between London and euro area capitals as financial centers. Countries that
are more integrated (Ireland, Luxembourg, Netherlands, Belgium, Malta, and Cyprus) will likely suffer
disproportionally from Brexit. Other countries, such as Germany, could also be affected via supply
chains links.5
B. A Synthetic Index of Exposure to the U.K.
7. To account for the complexity of the exposure of EU27 countries to the U.K., we build
a synthetic index for integration. As discussed in the previous section, the degree of integration
has several dimensions, which are often correlated. To measure the degree of integration and its
evolution over time in a less complex manner, we build a single index by aggregating the
subcomponents into a synthetic country-specific, time-varying index. This index captures all the
components of a EU27-U.K. economic relationships and can be used in the subsequent regressions
to assess effect on euro area output and employment from integration with the U.K. Being a single
index, it solves the multicollinearity problem that would arise if all the components of the economic
relationship were to be used in a regression.
4
There are a number of recent estimates of the cost of Brexit on the EU27. For a thorough review, please refer to
European Parliament (2017): An Assessment of the Economic Impact of Brexit on the EU27, March 2017. This review
of quantitative studies suggests an average long-term impact of Brexit on EU27 output between -0.2 and
-0.5 percent by 2030. Connell et al. (2017)’s new study that incorporates supply chain links between countries finds
an impact of Brexit on the EU in the order of -0.4 (for the ‘soft Brexit’ scenario) and -1.4 percent (for the ‘hard Brexit’
scenario). Very recently, the consultancy groups Oliver Wyman and Clifford Chance (2018) in a recent report find that
the annual ‘red tape’, or tariff and non-tariff, costs of Brexit for EU27 exporters is around £31 billion (0.3 percent of
EU27 GDP) even after initial steps to mitigate costs have been taken. This is proportionately four times larger for the
U.K. (when expressed in percent of output). The report also finds that 70 percent of the aggregate impact falls in just
five sectors in the EU27: automotive; agriculture, food & drink; chemicals & plastics; consumer goods; and industrials
will incur an estimated 75 percent of the impact. A future customs arrangement equivalent to the Customs Union
reduces the EU27 impact to around £14 billon (0.13 percent of EU27 GDP). Another study by Chen et al. (2018)
examined the exposure of regions in the EU27 to Brexit and conclude that regions in Ireland, Malta, Netherlands,
Belgium, and Germany are the most likely to be affected by Brexit. Ireland appears as a clear outlier being the only
EU27 country with regions facing Brexit-exposure levels similar to some U.K. regions (U.K. regions are far more
exposed than regions in other EU Member States).
5
Connell et al. (2017) identified that industrial sectors such as “motor vehicles” and “machinery & equipment” could
be the most affected sector in Germany in terms of value added.

EURO AREA POLICIES
Figure 1. Trade in Goods, Services, and Financial Services

The U.K. is an important trading partner of the EA, and the
...but there is significant heterogeneity in the relative size
EA’s bilateral trade surplus has widened over the past
of trade flows across countries.
decades…
Euro Area Total Exports and Imports vis-à-vis U.K. Total Exports of Goods and Services vis-à-vis the U.K.
(Percent of EA GDP) (Percent of country GDP, avg. 2014–16
30
4.5
EA total exports to UK EA total imports from UK
4.0
25
3.5 Goods exports to UK
Service exports to UK
3.0 20
Goods imports from UK
2.5 Service imports from UK

15
2.0
1.5 10
1.0
5
0.5
0.0 0
1995 1998 2001 2004 2007 2010 2013 2016
ITA
IRL
DEU
NLD
FRA
BEL
LUX
ESP
EA
Source: OECD TISP; IMF DOTS; and IMF WEO.
Sources: OECD TISP; IMF DOTS; and IMF WEO.
The U.K. is a net provider of financial services to the EA, In contrast, most of euro area countries are net exporters
except for some countries such as Germany and Spain. of nonfinancial services to the U.K.
Euro Area Financial Service Trade with the U.K. Euro Area Nonfinancial Service Trade with the U.K.
(Latest data point; in percent of GDP) (Latest data point; in percent of GDP)
7 4
6
Exports Imports Exports Imports
3
5
4
2
3
2
1
0 0
IRL NLD BEL Euro MLT FIN DEU ESP LUX FRA ITA IRL NLD BEL Euro MLT FIN DEU ESP LUX FRA ITA
Area Area
Source: IMF GVC WP and IMF-WEO. Source: IMF GVC WP and IMF-WEO.

EURO AREA POLICIES
Figure 2. Trade in Value Added and Migration

The domestic value-added (DVA) trade exposure to the
While most of EU exports of value added to the U.K. are
U.K. has been about 3.7 percent of EA GDP, representing
direct, supply chain links also play a role.
about 65 percent of the exposure in gross trade terms.
Domestic Value Added (DVA) Embedded in Exports Travel of Domestic Value Added in Exports to the U.K.
(Percent of country GDP, avg. 2009–11)
y g p (In percent of GDP; latest data available)
10 10
UK DVA in exports from UK to country and further Further re-exported by the U.K.
9 exported to 3rd country (% Country GDP) 9
Transiting through 3rd country then absorbed in the U.K.
8 UK DVA in foreign demand (% Country GDP)
8 Directly exported to, and absorbed in, the U.K.
7
Country DVA in exports from country to UK and 7
6 further exported to 3rd country (% Country GDP)
Country DVA in foreign demand (% Country GDP) 6

5
5
4
3 4
2 3
1 2
0
1
ITA
IRL
DEU
LUX
FRA
MLT
CYP
ESP
EA
0
Source: OECD TIVA and IMF-WEO.
Note: 19 EA countries included in sample due to availability through the entire IRL LUX NLD BEL ESP DEU PRT FRA ITA
sample period. Sources: OECD Trade in Value Added database; IMF staff calculations.
Bilateral migration positions have strengthened, including
...with significant cross-country heterogeneity.
skilled migrants living in both economies…
Euro Area and U.K. Migrants by Skill Level Country and U.K. Migrants by Skill Level
(Percent of Euro Area Population) (Percent of country population, 2010)
0.35 14.0
Low to Medium-skill UK migrant living in EA
Low to Medium-skill UK migrant living in country
High-skill UK migrant living in EA
High-skill UK migrant living in country
0.30 Low to Medium-skill EA migrant living in UK 12.0
Low to Medium-skill country migrant living in UK
High-skill EA migrant living in UK
High-skill country migrant living in UK
0.25 10.0
0.20 8.0
6.0
0.15
4.0
0.10
2.0
0.05
na
na
na
0.0
0.00
ITA
DEU
IRL
FRA
MLT
CYP
ESP
EA
1980 1985 1990 1995 2000 2005 2010

Source: IAB; and IMF-WEO.
Source: IAB; and IMF-WEO. Note: Data only available in 5-year intervals. Number of UK migrants living in
Note: Data only available in 5-year intervals. 9 EA countries included in sample due
country not available for CYP, MLT, and ITA.
to data availability. AUT, DEU, ESP, FIN, FRA, GRC, IRL, LUX, and PRT.

EURO AREA POLICIES
Figure 3. Financial Flows

Bilateral FDI positions are large (14 percent of EA GDP), ...mainly reflecting transactions in specific countries
and the EA has become a net exporter of FDI to the U.K…. (Ireland, Netherlands).
Euro Area FDI Stock Positions vis-à-vis the U.K. FDI Stock Position vis-à-vis the U.K.
(Percent of EA GDP) (Percent of country GDP, avg. 2014–16
12 80
Inward FDI to Rest of EA from UK Inward FDI to NLD from UK
Inward FDI from UK
Inward FDI to IRL from UK Outward FDI to UK from Rest of EA
10 Outward FDI to UK from NLD Outward FDI to UK from IRL 60 Outward FDI to UK
Net
8 40
6
20
8.7
5.6
4
0
2
-20
0
2001 2007 2010 2016 -40
IRL
ITA
EA
ESP
FIN
DEU
NLD
FRA
Source: OECD; IMF CDIS; and IMF-WEO. Source: OECD; and IMF CDIS and WEO.
Note: 9 EA countries included in sample due to availability through the entire
sample period. AUT, FIN, FRA, DEU, GRC, IRL, ITA, NLD, and ESP. Data for ESP, GRC,
and IRL have been extrapolated 1998-2001.
Total two-way portfolio investment amounts to about

…again mainly driven by Ireland.
21 percent of EA GDP…
Euro Area Portfolio Stock vis-à-vis U.K. Portfolio Stocks vis-à-vis U.K.
(Percent of EA GDP) ( ) (Percent of country GDP, avg. 2014–16)
16 180
IRL liabilities held by UK entities as cross-border portfolio assets
Rest of EA liabilities held by UK entities as cross-border portfolio assets
14 160 Country X holdings of cross-border portfolio assets in UK entities
IRL holdings of cross-border portfolio assets in UK entities
Rest of EA holdings of cross-border portfolio assets in UK entities Country X liabilities held by UK entities as cross-border portfolio assets
12 140
Net
120
10
100
8
80
6
60
4
40
2 20 12.1 10.7
0 0
2001 2007 2010 2016
Source: OECD; IMF CPIS; and IMF-WEO. -20
IRL
ITA
EA
ESP
DEU
MLT
NLD
FRA
Note: 15 EA countries included in sample due to availability through the entire

sample period. AUT, BEL, CYP, DEU, ESP, EST, FIN, FRA, GRC, IRL, ITA, LUX, MLT, NLD,
Source: OECD; and IMF CPIS and WEO.
and SVK. Data for AUT, CYP, ESP, EST, GRC, MLT, and SVK have been interpolated in
early years to cover full sample period.
After reaching a peak in 2007, international claims of

…but remain critical in several smaller EA countries.
banks located in both the U.K. and the EA have declined…
Euro Area Cross-Border Bank Positions vis-à-vis U.K. LBS Cross-Border Bank Stocks vis-à-vis U.K.
(Locational statistics; percent of EA GDP) (Percent of country GDP, avg. 2014–16)
25 200
EA-located banks cross-border claims held on UK entities
UK-located banks cross-border claims held on EA entities 150 Country-located banks cross-border claims held on UK entities
20 UK-located banks cross-border claims held on country entities
Net
100
15
50
12.3 9.9
10
0
5 -50
-100
0
1991 1994 1997 2000 2003 2006 2009 2012 2015
-150
IRL
EA
ESP
DEU
FIN
NLD
BEL
LUX
FRA
Source: BIS LBS; and IMF WEO.

Note: 11 EA countries included in sample due to bilateral data availability.
AUT, BEL, DEU, ESP, FIN, FRA, GRC, IRL, LUX, and NLD. LBS bank stocks Source: BIS LBS; and IMF WEO.
Note: LBS bank stocks have been adjusted for structural breaks and FX adjustments.
have been adjusted for structural breaks and FX adjustments.

EURO AREA POLICIES
8. To build the integration index, we use a principal component analysis. Principal

component analysis (PCA) can help resolve the dimensionality problem associated with the presence
of a large number of variables capturing various aspects of a common phenomenon (in this
instance, bilateral economic integration with the U.K.). Moreover, reducing the dimensionality
problem helps reduce the multicollinearity problem that would have otherwise arisen if each of the
channels of integration was introduced additively. We therefore focus on several indicators of
integration, and for which data are available for European and non-European countries and which
benefit from a sufficient coverage over time (starting in early 1990s):6
 Trade in domestic value added. We derive an indicator of trade openness between each country
and the U.K., measured as the sum of bilateral exports and imports of domestic value added
normalized by the country’s GDP. Data are based on Ignatenko et al. (2017).7
 Participation in supply chains. We use the sum of “backward” and “forward” trade linkages
between each country and the U.K., normalized by the country’s GDP. “Backward” linkages refer
to the foreign value-added embodied in the country’s and U.K.’s bilateral gross exports. The
“forward” linkages refer to the country’s and U.K.’s exports of value added further re-exported to
third countries. The overall indicator therefore captures the extent to which trade between the
country and the U.K. involves the exchange of foreign value added, but also respective domestic
value added embodied in exports and then further reexported to third countries. Data are from
Ignatenko et al. (2017).
 Openness in service trade. We use the sum of each country’s exports of services to, and imports
of services from, the U.K., normalized by GDP. Data are from Ignatenko et al. (2017).
 Cross-border banking positions. To capture the key role of London as financial center, including
for cross-border lending activities, we use the ratio of claims by international banks in the U.K.
on each receiving country from BIS locational data, normalized by GDP.
 Migration. We use the share of each country’s migrants residing in the U.K., normalized by the
country’s total number of migrants residing in 20 OECD countries. Data are from Brücker et al.
(2013) who relied on harmonized census data.8 Migrants are defined as foreign-born individuals
aged 25 years and older, living in each of the 20 considered OECD destination countries. 9
6
We use annual data covering the period 1993–2013. Due to data availability we could not retain bilateral FDI and
portfolio statistics for our index of integration. However, the remaining variables should account for bilateral
integration through the financial account (e.g., cross-border banking flows statistics). The index of integration with
the U.K. is computed for all countries in the world for which data on sub-components are available.
7
Ignatenko, Anna., Raei, Faezeh., Mircheva, Borislava, Tulin, Volodymyr (2017). Global Supply Chains: a new dataset
and insights for Europe, forthcoming IMF working paper.
8
Brücker H., Capuano, S. and Marfouk, A. (2013). Education, gender and international migration: insights from a
panel-dataset 1980-2010, mimeo.
9
As the database has a limited number of destination countries (20 OECD nations), it was not possible to derive
reverse migration ratios from the U.K. to other destination countries beyond these 20 OECD countries, a critical piece
(continued)

EURO AREA POLICIES
The principal component analysis (PCA) identifies the relative importance, e.g., weights of the
different indicators in order to build the exposure index. The exposure index is rescaled so that it
ranges between 0 (minimal exposure) and 10 (highest exposure). Overall, the first principal
component explains 60 percent of the total variance and is positively correlated with the seven
variables used to build the exposure index. For more details regarding the PCA, see the Appendix.
9. The integration index shows that euro area-U.K. integration has strengthened over the
years. The intensity of integration has increased by 40 percent over the past 25 years, split in three
distinctive phases. The first one, increasing by 20 percent, in the runup to euro adoption, the second
one (after euro adoption) with the index staying relatively flat, and the last phase in the aftermath of
the global financial crisis when integration increases by another 20 percent. Increased integration is
in large part driven by a handful of countries such as Ireland, Belgium, the Netherlands, and Malta.
Other countries that exhibit considerable economic ties with the U.K. are Germany, Finland, Cyprus,
and other non-euro area countries such as Denmark and Sweden.
Figure 4. Synthetic Index of Integration With the U.K.
Euro Area Index of Integration with the U.K. Index of Integration with the U.K.
(Euro Area) (Cross-sectional averages)
( ) ( g )
1.5
1.5
1
Index
Index
1
.5
.5
1995 2000 2005 2010 2015 1995 2000 2005 2010 2015
Median Mean Euro area Other non-EU AEs (*)

Sources: IMF staff estimates, various sources. Sources: (*) USA, JPN, CAN, AUS, and KOR. IMF staff estimates, various sources.
Index of Integration with the U.K. Index of Integration with the U.K.
European countries Excludes Ireland
10
3
8
2
6
Index
Index
4
1
2
0
0
ROM
HUN
CZE
FRA
AUT
MLT
PRT
DEU
FIN
DNK
HRV
ITA
LUX
LVA
SWE
EST
BEL
IRL
BGR
GRC
LTU
NLD
NOR
SVN
ESP
SVK
ISL
POL
CYP
CZE
FRA
ROM
AUT
MLT
PRT
HUN
DNK
HRV
ITA
LUX
LVA
SWE
EST
BEL
DEU
FIN
ESP
SVK
BGR
GRC
ISL
LTU
NLD
NOR
POL
SVN
CYP
Sources: IMF staff estimates, various sources. Sources: IMF staff estimates, various sources
of information needed to make the index of integration available to several countries, including non-OECD countries.
Recall, the objective is to construct an index of integration with the U.K. between each country in the world and the
U.K., as the index will be further used in world-wide gravity equations to derive the impacts of alternative trade
arrangements.

EURO AREA POLICIES
C. An Econometric Investigation of the Long-Term Effects of Brexit on the

EU
Empirical Design
10. In the empirical analysis, we assess the long-term effect on EU27 output and
employment of Brexit, modeled as a partial reversal of EU27 integration with the U.K. First, we
determine the relationship between EU27 countries’ output and employment dynamics and their
integration with the U.K., by regressing output and employment on several control variables and the
integration index. Second, we will assess the impact on output and employment of a decline in
integration, under different scenarios of the future relationship between the U.K. and the EU27.
11. We use panel cointegration techniques to estimate the long-run effect of the bilateral
integration with the U.K. on output and employment. Three econometric issues arise. First, the
integration index could suffer from endogeneity arising from an omitted variable bias or other
sources. Second, the degree of integration reflects structural variables that are relatively slow
moving (trade openness, participation into supply chains, financial integration, migration ties) and
likely to affect output and employment mainly over a longer horizon. We are therefore interested in
modelling the long-run relationships. One source of bias is that the index of bilateral integration
with the U.K. can be confounded with the EU Single Market on countries or the overall degree of
trade openness of a country. If this bias is not controlled for, the estimated effect of the index of
bilateral integration with the U.K. will be unreliable. To reduce these concerns, the models will
control for the trade openness variable for each country in the sample (total exports plus imports
over GDP). We also further reduce endogeneity concerns by controlling for other determinants of
output and employment such as a country’s domestic investment ratio, inflation rate, and total
population. The model finally controls for country fixed effects to capture the influence of time
invariant or other slow-moving factors that may affect the estimations. The model is formally
represented as follows:
∆ Γ∆ Γ∆ Γ , [1]
where y is the real GDP (or total employment level), I is the index of bilateral integration with the
U.K., and X is a matrix of control variables (overall trade openness, domestic investment ratio,
inflation rate, and total population).10 The sub-index i stands for countries, and t for the time
dimension. Our main parameter of interest is , which captures the long-run effect of the bilateral
integration with the U.K. on EU27 output or employment.11
10
The annual macro variables are drawn from the IMF World Economic Outlook and World Development Indicators
databases.
11
The model is estimated for the period 1993–2013 given the availability of the index of integration. The sample is
restricted to European countries.

EURO AREA POLICIES
12. As expected, we find a positive long-run effect of integration with the U.K. on EU27
output and employment. There is a positive long-run relationship between the degree of bilateral
integration with the U.K. (our synthetic index) and EU27 output and employment with a long-run
semi-elasticity around 0.11 and 0.05, respectively. These results already preview a key conclusion of
our paper: a decline in the level of integration, through a departure from the current EU
membership arrangement, will negatively affect output and employment in the EU27.12
13. We then calibrate the change in the integration index from post-Brexit scenarios. The
main goal is to answer the following question: controlling for the traditional factors that drive the
bilateral integration with the U.K. (such as distance, language, common border, size), what are the
effects of EU membership, European Economic Association membership, and other Free Trade
Agreements (FTAs) on the index of integration? To do this, we use a gravity model for the index of
integration with the U.K. and introduce a dummy variable capturing the different economic
arrangements. To ensure sufficient variability to reflect alternative trade relationships, the sample of
countries is extended to non-EU countries but excludes low-income countries.13 More specifically,
the equation takes the following form:
Γ , [2]
where I is the bilateral index of integration with the U.K., X is the matrix of gravitational factors
(bilateral distance vis-à-vis the U.K., common border with the U.K., common language with the U.K.,
regional dummies, population size and GDP level). We also control for year fixed effects to capture
the influence of common shocks.
14. The parameters of interest are the ones associated with each economic arrangement
that exist between the U.K. and its trading partners. We have grouped them into three dummy
variables: EU membership ( , which denotes the effect of EU membership on the integration index),
the European Economic Area arrangement currently in force with countries such as Norway and
Iceland ( , which denotes the impact of the EEA membership), and a standard free trade
agreement ( , which is the effect of the FTA dummy). Data on these arrangements come from Baier
and Bergstrand (2009).14 From equation 2, we derive the reduction in integration with the U.K. that is
consistent with some specific scenarios:15
12
This is consistent with recent findings by Connell et al. (2017) who showed that Brexit would adversely affect both
output and employment in the EU.
13
Extending the regression sample to include non-EU countries helps identify the effect of variables such as the EU
membership (taking 1 for EU member states and 0 in the rest of world), the European Economic Association, and
other non-EU specific trade arrangements on the bilateral integration with the U.K.
14
In economic terms, the EEA would be close, but not identical, to the status quo for a full EU membership, with full
inclusion in the single market for all four freedoms, and compliance with all EEA-relevant regulatory legislation by the
EU. But it excludes membership of the EU’s custom union, as well as agricultural and fisheries policies.
15
Ideally, one would have also allowed for interactions between the various trade arrangements to reflect hybrid
arrangements. However, there are not enough variations in the data regarding various combinations.

EURO AREA POLICIES
 : This refers to the decline in integration going from EU membership to an EEA.
 : This refers to the decline in integration going from EU membership to an FTA.
 : This refers to the decline in integration from EU membership to the default WTO.
15. The results confirm the expected hierarchy of the Reduction in the Index of Integration due
impact of various arrangements on integration. First, the to Trade Frictions
(Decline in units; estimated from a gravity model
model estimates confirm that the EU membership produces with various controls) g y
the highest degree of integration with the U.K. of all trade 0.15
arrangements considered here. Second, settling on an EEA

arrangement would lead to a moderate loss of economic
integration compared with other alternative arrangements 0.1
(an FTA). Third, the estimates of the integration shocks are

statistically significant and with a relatively good precision.16
0.05
16. Results suggest a negative, but rather small

effect of Brexit on EU output and employment in the
0
long run. These impacts are derived by multiplying the WTO FTA EEA
various degrees of integration losses computed from Sources: IMF staff estimates
Equation 2, by the long-term effect of the index of integration on output and employment
estimated in Equation 1. A scenario in which access to the single market is preserved while the
custom union is sacrificed (the EEA model or ‘soft Brexit’) would imply an almost zero cost
(0.06 percent) for the EU as a whole, for both output and employment. In contrast, introducing more
trade frictions by reverting to a standard FTA or to a no-deal outcome (WTO default) would lead to
higher losses in the order of 0.8 and 1.5 percent for output, respectively. For employment, these
losses would be comprised between 0.3 and 0.7 percent. These estimates on average are higher
compared to previous studies that used standard CGE trade models, but are broadly similar to new
studies that have augmented CGE trade models with supply chain links (e.g., Connell et al., 2017). In
contrast to these previous studies, which solely modelled the effect of Brexit through trade channels,
the econometric approach used in this study incorporates additional channels of integration.
EU27: Long-Run Output Loss Due to Brexit EU27: Employment Loss Due to Brexit
(in percent) (in percent)
2
3
1.5
2
1
1
.5
0
EEA FTA WTO EEA FTA WTO

Source: IMF staff estimates. Source: IMF staff estimates.
16
The Delta method is used to assess the statistical significance of the differences in coefficients.

EURO AREA POLICIES
17. These results should be interpreted with some caution. They remain conditional on the
statistical power of the tests conducted and only represent average effects for the EU.17 Despite its
technical appeal, the econometric estimations remain subject to statistical uncertainty. Furthermore,
these results mask inevitable cross-country and cross-sector differences that reflect different
exposures to the U.K. The economic uncertainty surrounding the post-Brexit period arrangement is
also a non-negligible factor, although uncertainty is most likely to have a short-run impact.
Moreover, the results assumed only polar and rigid post-Brexit scenarios, and do not incorporate
the possibility, for example, that the EU and U.K. agree on a hybrid arrangement.
D. A Model-Based Approach to Quantify Long-Term Effects of Brexit Due

to Higher Trade Barriers
18. We rely on a CGE model to explore country-by-country and sector-by-sector effects.
The econometric investigations performed so far have helped in producing average effects of post-
Brexit scenarios on the euro area, but have not identified any heterogeneous effects on individual
member states. Digging one step further, data reveals trade exposures to the U.K. also vary
significantly across sectors (Figure 5). Against this background, this section aims to quantify the
impacts from higher trade barriers on individual countries in the euro area as well as sectors within
each country using a multi-country and multi-sector CGE model. In addition to the rich structure, the
model is well suited to investigate ex-ante the implications of trade policies in counterfactual
scenarios.
19. The core of the model is to infer changes in real income associated with changes in
trade barriers.18 In the Armington model (a simple CGE model), there are n countries, with each
supplying its own distinct goods. There are thus n goods, with country being the only supplier of
good in fixed quantity, which corresponds to the country’s endowment of the good. A
representative household in each country maximizes its utility by consuming a variety of goods
subject to a budget constraint. This implies that total expenditure (i.e., goods imported from other
countries including associated trade costs) must be no greater than income (i.e., revenues from
exporting good). In this case, the demand for goods from other countries (i.e., trade flows) is
determined by the preference, income, cost of trade (i.e., tariffs) and price of foreign goods. Market
equilibrium conditions imply demand for any good needs to equal to the supply. Hence, when
there is a change in trade costs, we solve the model by finding the pattern of income changes that is
consistent with the new set of bilateral trade costs while respecting market clearing conditions. From
a single-country perspective, an increase in trade cost decreases the revenues from exports as other
countries buy less, reducing income with knock-on effects to other countries even if trade costs have
not changed for these countries. To maintain sustainable external balance over the long run, imports
will also have to fall too. In the new equilibrium, households are worse off by having lower income
and consuming less varieties of goods. The key insight from the Armington model carries into more
complex frameworks.
17
The next section will provide detailed results at the country and sector levels using a CGE modelling approach of
the effects of Brexit via the trade channel.
18
We defer readers to Costinot and Rodriguez-Clare (2013) on the details of the model, but focusing to illustrate the
main intuitions with a simple Armington model.

Figure 5. Gross Exports to the U.K. by Sector for Selected EA Countries
(percent of sector gross output, 2011)
Germany France
Chemicals and Chemical Products Chemicals and Chemical Products
Coke, Refined Petroleum and Nuclear Fuel Coke, Refined Petroleum and Nuclear Fuel
Pulp, Pape r, Printing and Publishing Pulp, Pape r, Printing and Publishing
Wood and Products of W ood and Cork Wood and Products of Wood and Cork
Leather, Leather and Footwear Leather, Leather and Footwear
Te xtiles and Textile Products Te xtiles and Textile Products
Private H ouseholds with Employed Persons Private H ouseholds with Employed Persons
Other Community, Social and Personal Services Other Community, Social and Personal Services
Health and Social Work DVA_final Health and Social Work

Education
Education
Public Admin and Defence; Compulsory S ocia l Security Public Admin and Defence; Compulsory S ocia l Security
DVA_final
Renting of M&Eq and Othe r Bus iness Activities
Food, Beverages and Tobacco
DVA_int Renting of M&Eq and Othe r Bus iness Activities
DVA_int
Real Estate Activities Real Estate Activities
Financial Intermediation
DVA_3rd
Pos t and Telecommunications Pos t and Telecommunications
Other Supporting and Auxiliary Transport Activities; Activities of Travel Agencies Other Supporting and Auxiliary Transport Activities; Activities of Travel Agencies
Air Transport Air Transport DVA_3rd

Water Transport
Inland Transport
FVA Water Transport
Inland Transport
Hote ls and Restaurants
Retail Trade, Except of Motor Vehicles and Motorcycles; Repair of Household Goods
Hote ls and Restaurants
Retail Trade, Except of Motor Vehicles and Motorcycles; Repair of Household Goods
FVA
Wholes ale Trade and Commission Trade , Except of Motor V ehicles and Motorcycles Wholes ale Trade and Commission Trade , Except of Motor V ehicles and Motorcycles
Mining and Quarrying Mining and Quarrying
Sale, Maintenance and R epair of Motor V ehicles and Motorcycles; R etail Sale of Fuel Sale, Maintenance and R epair of Motor V ehicles and Motorcycles; R etail Sale of Fuel
Construction Construction
Electricity, Gas and W ater Supply Electricity, Gas and Water Supply
Manufacturing, Nec; Recycling Manufacturing, Nec; Recycling
Transport Equipment Transport Equipment
Electrical and Optical Equipment Electrical and Optical Equipment

Machinery, Nec Machinery, N ec
Basic Metals and Fabricated Metal Basic Metals and Fabricated Metal
Other Non-Metallic Mineral Other Non-Metallic Mineral
Rubber and Plastics Rubber and Plastics
Agriculture , Hunting, Forestry and Fishing Agriculture , Hunting, Forestry and Fishing
0 2 4 6 8 10 12 14 0 2 4 6 8 10 12 14
Note: DVA_final stands for domestic value added of exports of final goods to the U.K. DVA_int depicts domestic value added of exports of intermediate goods to the U.K. and
consumed in the U.K. DVA_3rd depicts domestic value added of exports of goods to the U.K. then re-exported to a 3rd country. FVA depicts the foreign value added. The
EURO AREA POLICIES

decomposition is based on Wang, Wei and Zhu (2013). Sources: World Input-Output Tables and IMF staff calculations.
EURO AREA POLICIES
Figure 5. Gross Exports to the U.K. by Sector for Selected EA Countries (concluded)
(percent of sector gross output, 2011)
Spain Italy
Chemicals and Chemical Products Chemicals and Chemical Products
DVA_final
Coke, Refined Petroleum and Nuclear Fuel Coke, Refined Petroleum and Nuclear Fuel
Pulp, Pape r, Printing and Publishing Pulp, Pape r, Printing and Publishing
Wood and Products of Wood and Cork Wood and Products of W ood and Cork
Leather, Leather and Footwear
DVA_int
Leather, Leather and Footwear
Te xtiles and Textile Products Te xtiles and Textile Products
Private H ouseholds with Employed Persons Private H ouseholds with Employed Persons
Other Community, Social and Personal Services Other Community, Social and Personal Services
Health and Social Work
Education
DVA_3rd Health and Social Work
DVA_final
Education
Public Admin and Defence; Compulsory S ocia l Security Public Admin and Defence; Compulsory Socia l Security
Renting of M&Eq and Othe r Bus iness Activities
FVA Renting of M&Eq and Othe r Bus iness Activities
Food, Beverages and Tobacco DVA_int
Real Estate Activities Real Estate Activities
Financial Intermediation Financial Intermediation
Pos t and Telecommunications
Other Supporting and Auxiliary Transport Activities; Activities of Travel Agencies
Pos t and Telecommunications DVA_3rd
Other Supporting and Auxiliary Transport Activities; Activities of Travel Agencies
Air Transport Air Transport
Water Transport
Inland Transport
Water Transport
Inland Transport
FVA
Hote ls and Restaurants Hote ls and Restaurants
Retail Trade, Except of Motor Vehicles and Motorcycles; Repair of Household Goods Retail Trade, Except of Motor Vehicles and Motorcycles; Repair of Household Goods
Wholes ale Trade and Commission Trade , Except of Motor V ehicles and Motorcycles Wholes ale Trade and Commission Trade , Except of Motor V ehicles and Motorcycles
Mining and Quarrying Mining and Quarrying
Sale, Maintenance and R epair of Motor V ehicles and Motorcycles; R etail Sale of Fuel Sale, Maintenance and R epair of Motor V ehicles and Motorcycles; R etail Sale of Fuel
Construction Construction
Electricity, Gas and W ater Supply Electricity, Gas and W ater Supply
Manufacturing, Nec; Recycling Manufacturing, Nec; Recycling
Transport Equipment Transport Equipment
Electrical and Optical Equipment Electrical and Optical Equipment
Machinery, N ec Machinery, Nec
Basic Metals and Fabricated Metal Basic Metals and Fabricated Metal
Other Non-Metallic Mineral Other Non-Metallic Mineral
Rubber and Plastics Rubber and Plastics
Agriculture , Hunting, Forestry and Fishing Agriculture , Hunting, Forestry and Fishing
0 2 4 6 8 10 12 14 0 2 4 6 8 10 12 14
Note: DVA_final stands for domestic value added of exports of final goods to the U.K. DVA_int depicts domestic value added of exports of intermediate goods to the U.K. and
consumed in the U.K. DVA_3rd depicts domestic value added of exports of goods to the U.K. then re-exported to a 3rd country. FVA depicts the foreign value added. The
decomposition is based on Wang, Wei and Zhu (2013). Sources: World Input-Output Tables and IMF staff calculations.
EURO AREA POLICIES
20. Our baseline model covers 34 countries and 31 sectors, assumes monopolistic
competition among firms, and captures global supply chain linkages. We consider three
versions of the CGE model as in Costinot and Rodriguez-Clare (2013), differing by the climate of
competition among firms. The first model considers multiple countries and sectors (34 countries
plus the rest of the world and 31 sectors) and tradable intermediate inputs for production to capture
global supply chain linkages. It assumes perfect competition among the production firms which has
been shown to provide a lower bound to the welfare effects of changes in trade costs. We then
extend the model to incorporate monopolistic competition, as in Krugman (1980), which implies
firm-level product differentiation of symmetric varieties. Finally, we allow for firm heterogeneity
consistent with Melitz (2003) at the cost of focusing on a much smaller set of countries and sectors
(10 countries and 16 sectors) to reduce computational burden. Geared with these models, we
calculate the changes in real income (therefore consumption and welfare) after Brexit by defining
distinct scenarios. The income loss from Brexit is obtained by comparing welfare in a scenario where
the U.K. remains an EU member and in a scenario in which U.K. does not. In view of the benefit of
having a more realistic market structure (i.e., monopolistic competition) and the advantage of
covering a broader set of countries and sectors, in what follows, the discussion focuses on the
results from the model with monopolistic competition.
Data
21. The model draws on data and assumptions from various sources:
 Trade linkage data are based on the World Input-Output Database (WIOD) for the year 2011.
This database aggregates the world into 40 countries and covers 35 sectors which we further
aggregate into 34 countries, the rest of the world and 31 sectors consistent with the setup of the
model.
 Data on the applied most favored nation (MFN) tariff by the EU are taken from Dhingra et al.
(2016), who calculated MFN tariff for the 31 sectors (consistent with the ones in the WIOD
database) using information on tariffs from the World Trade Organization weighted by the EU
and U.K. trade shares.
 Non-tariff trade barriers are related to costs of differences in product regulations, legal barriers,
and other transaction costs for both goods and services—several authors point out that such
costs are higher than formal tariffs (Anderson and van Wincoop, 2004). The primary source for
the non-tariff trade barriers between U.K. and EU trade is from the published EU Exit Analysis
Cross Whitehall Briefing paper. However, the paper does not present the estimated non-tariff
trade costs on all the sectors of interest, thus we complement the published measures with the
estimates provided by Berden et al. (2009, 2013). The authors calculated tariffs equivalent of
non-tariff barriers between the U.S.A. and the EU trade, using econometric techniques and
business survey.

EURO AREA POLICIES
 Trade elasticities (Figure 6) for

Figure 6. Estimated Trade Elasticity by Sector
agriculture and manufacturing
(percent, -epsilon)
sectors are from Caliendo and 18
Caliendo and Parro (2014) Egger and Kaynak (2017) Cabral and Manteu(2011) IMF staff
Parro (2015) as their estimation 16
14
procedure is consistent with all 12
quantitative trade models 10
8
satisfying the sector-level 6
gravity equations, while trade 4
elasticity for service sectors is

2
simply held equal to the
Paper
Minerals
Metal products
Petroleum
Agriculture
Electrical
Textiles
Mining
Food
Transport Equipment
Chemicals
Basic metals
Wood
Plastic
Machinery n.e.c
aggregate trade elasticity of 5
following Costinot and
Sources: IMF staff calculations and WP sources shown.
Rodriguez-Clare (2013).19
Alternative Post-Brexit Scenarios
22. We model post-Brexit scenarios as increase in goods tariffs and non-tariff barriers for
both goods and services trade. In particular, we consider two cases:
 ‘FTA’ scenario: We assume that the U.K. leaves the single market and the customs union, but the
U.K. and the EU agree on a broad free trade agreement. Specifically, the scenario assumes that
tariffs on goods trade remain at zero, and
Figure 7. Level of Non-Tariff Trade Costs in
non-tariff costs increase moderately. With
FTA Scenario
respect to the financial sector, we calibrate (percent)
the size of the non-tariff trade cost such that 20
IMF staff
net exports of financial services from the U.K.

18
House of Commons Exiting the
16 European Union Committee (FTA)
Berden and others (2009, 2013)
to the EU fall by about 40 percent, which is 14
12
broadly consistent with the assumption that 10
London-based financial firms continue to 6
provide some cross-border financial services

4
based on regulatory equivalence. We have 0

Metal products
Mining
Chemicals
Construction
Other Business
Education
Water Transport
Air Transport
Agriculture
Paper
Plastic
Textiles
Baseic metals
Hotels and Restaurants
Other transport services

Inland Transport
Health
Postal
Food
Wood
Machinery n.e.c
Wholesale trade
Real Estate Activities

Electrical
Transport Equipment
Petroleum
Minerals
Other services
Electricity
Retail Trade
also assumed a higher increase of non-tariff

trade costs on the transportation equipment
sector than the other studies to reflect the Sources: IMF staff calculations and WP sources shown.
complicated supply chain linkage.20 Figure 7 illustrates the assumed increase in non-tariff trade
costs (in tariff equivalent terms) for different sector under the scenarios.
19
There are two exceptions, we set the estimated trade elasticity on coke, refined petroleum and nuclear fuel sector
to close to 0 to avoid implausible sectoral level results. In addition, we calibrated the trade elasticity for transport
equipment sector to be in line with the estimates in Egger and Kaynak (2017).
20
We have run robustness checks using lower tariffs on the transportation equipment sector, and the results do not
change significantly.

EURO AREA POLICIES
 ‘Hard Brexit’ scenario (WTO scenario): We Table 1. UK MFN Tariff With Non-EU
assume that the U.K. is no longer part of the Countries
single market nor the customs union and will (Percent)
trade with the remaining EU countries on the Sectors Imports Exports
Agriculture, Hunting, forestry and fishing 5.9 5.63
WTO terms. The U.K. would apply the MFN Mining and quarrying 0 0
tariffs (see Table 1) on goods imported from the Food, beverages and tobacco 7.26 4.96
Textiles and textile products, Leather 9.58 9.7
EU, while the EU would apply the MFN tariffs on Wood and products of wood and cork 2.35 3.62
goods originating from the U.K. In addition, we Pulp, paper, printing and publishing 0.04 0.1
Coke, refined petroleum and nuclear fuel 2.69 2.81
assume that the non-tariff trade costs would Chemicals and chemical products 2.71 2.16
increase by twice as much as in the FTA scenario Rubber and plastics 5.35 5.05
Other non-metallic minerals 3.78 3.32
for all sectors.21
Basic metals and fabricated metal 2.05 1.89
Machines, etc 2.05 2.13
Results Electrical and optical equipment 1.97 1.55
Transport equipment 8.09 7.22
Manufacturing, etc. 1.71 1.69
23. Calculations from our baseline model Weighted average (by EU trade) 4.43 3.29
show EU output losses of 0.2 to 0.5 percent in Sources: Dhingra and others (2016)
the “FTA” and “hard Brexit” scenario, respectively. However, the effects vary significantly across
country: Ireland’s real income is estimated to fall by about 2.5 to 4 percent similar to the estimated
impact on the U.K.; Netherland’s and Belgium’s real income is estimated to fall by about 0.7 and
0.5 percent, respectively, in the FTA scenario and by about 1 percent in the WTO scenario (see
Figures 8 and 9).
Figure 8 Figure 9
Long-Term Impact of Brexit: FTA Scenario Long-Term Impact of Brexit: WTO Scenario
(Decline in the level of output compared to a non-Brexit (Decline in the level of output compared to a non-Brexit
scenario; in percent) scenario; in percent
Source: IMF staff estimates. Source: IMF staff estimates.
24. However, it is important to note that the quantitative results rest on important
assumptions in the model as well as the estimated trade elasticities in the literature. For
example, the model assumes linear cost function, and Dixit-Stiglitz preferences. Although these
assumptions are common in macro models, they may be too restrictive to give a full representation
21
In both scenarios, we assume the U.K. and EU will transition smoothly to the new trading arrangement.

EURO AREA POLICIES
of the reality. Moreover, the quantitative estimates hinge on the assumed trade elasticities. But as
pointed out by Hummels and Hillberry (2012) it is econometrically very challenging to estimate
trade elasticities, and the existing estimates can vary quite significantly across paper (McDaniel and
Balistreris, 2003). Furthermore, the model does not capture some important channels through which
Brexit would affect the euro area. For example, the potential relocation of U.K. subsidiaries of
multinational firms is not considered. That said, Caliendo and Parro (2015) show that the CGE model
in their paper does a reasonably good job in capturing the impact of tariffs changes caused by
NAFTA between 1993 and 2005. And CGE model remains a cornerstone of trade policy evaluation
(Baldwin and Venable, 1995; Piermartini and Teh, 2005).
E. Summary of the Results
25. The estimated impacts in both empirical approaches used in this paper fall within the
range of the estimates in the literature. In the pessimistic scenario, staff estimates suggest a
range of output loss of between of 0.5 and 1.5 percent over the long run and with the econometric
model pointing to larger impacts than CGE model-based estimates as it considers broader channels
beyond trade (Figure 10).
Figure 10. Comparison of Estimated Impact From Brexit for the EU27 1/
(percent deviation of real GDP from no-Brexit scenario)
Optimistic Pessimistic (WTO scenario)
0 0
-0.2 Ottaviano -0.2
Aichele/Felbermayr/IFO
-0.4 -0.4
OECD
-0.6 -0.6
Cental Planning Bureau, NL
-0.8 -0.8
Staff, econometric model 2/
-1 -1
Staff, CGE baseline model 3/
-1.2 Connel et al, 2017 -1.2
-1.4 OECD -1.4
-1.6 Booth/Open Europe -1.6
-1.8 -1.8
1/ Staff estimates correspond to the average effect of the euro area countries.
2/ Optimistic scenario corresponds to an EEA arrangement as discussed in paragraph 16.
3/ Optimistic scenario corresponds to a "FTA" type of arrangement as discussed in paragraph 22.
26. The range falls within the estimates in the literature, which partly reflects uncertainty
around the estimates. The CGE model used in this paper delivers estimates that are broadly similar
to the results in the literature which has focused on the trade effects of Brexit (Dhingra et al., 2016;
Aichele and Felbermayr, 2015; OECD, 2016; Roja-Romagosa, 2016; and Booth et al., 2016). In
contrast, we find higher impacts from the econometric model which takes into account the
multiplicity of possible transmission channels beyond trade. Nevertheless, the study by Connell et
al. (2017) which uses a deeper CGE model with complex supply chain linkages give similar results for
the EU27 as those derived from the econometric model.

EURO AREA POLICIES
F. Conclusion
27. This paper has examined the consequences of Brexit on the EU27 under various post-
Brexit scenarios and using two different, complementary, approaches. Our results, which are
broadly in line with recent findings in the literature, are two-fold.
28. First, Brexit would have negative effects on the EU27 as well, given the depth and the
complexity of the EU-U.K. integration. Similar to various empirical studies, we find that the
estimated long-term output and employment losses (in percent) for the EU27 in our study are on
average lower than the corresponding losses for the U.K. estimated in the literature (Dhingra et
al., 2016; Aichele and Felbermayr, 2015; OECD, 2016; Roja-Romagosa, 2016; and Booth et al., 2016).
The level of output and employment are estimated to fall at most by up to 1.5 percent and
0.7 percent in the long run in the event of a ‘hard’ Brexit scenario, respectively. A ‘soft’ Brexit
outcome would lead to much lower losses.
29. Second, there is significant cross-country heterogeneity. For example, very open
economies such as Ireland, the Netherlands, and Belgium are among the most exposed economies
to Brexit-related adverse shocks. Ireland is the only EU27 country exhibiting Brexit-related output
losses of similar magnitude to those estimated for the U.K. in the literature.

EURO AREA POLICIES
Appendix. Principal Component Analysis Results
Table A1. Eigen Value and Cumulative Relative Frequencies

Principal component Eigen Values Proportion Cumulative relative frequencies
1 2.99 0.6 0.6
2 0.98 0.2 0.8
3 0.88 0.17 0.97
4 0.10 0.02 1.0
5 0.04 0.0 1.0
Table A2. Eigen Vectors

Variables P1
Trade in value added-to-GDP 0.57
Participation in supply chains 0.54
Service trade openness 0.56
Cross-border bank claims 0.1
Migration share 0.27

Table A3. Sectoral Aggregations
WIOD sector WIOD31 sector code Sector's description Sector name
1 1 Agriculture, Hunting, Forestry and Fishing Agriculture
2 2 Mining and Quarrying Mining
3 3 Food, Beverages and Tobacco Food
4 Textiles and Textile Products
4 Textiles
5 Leather, Leather and Footwear
6 5 Wood and Products of Wood and Cork Wood
7 6 Pulp, Paper, Printing and Publishing Paper
8 7 Coke, Refined Petroleum and Nuclear Fuel Petroleum
9 8 Chemicals and Chemical Products Chemicals
10 9 Rubber and Plastics Plastic
11 10 Other Non-Metallic Mineral Minerals
12 11 Basic Metals and Fabricated Metal Basic metals
13 12 Machinery, Nec Metal products
14 13 Electrical and Optical Equipment Electrical
15 14 Transport Equipment Transport Equipment
16 15 Manufacturing, Nec; Recycling Machinery n.e.c
17 16 Electricity, Gas and Water Supply Electricity
18 17 Construction Construction
19 Sale, Maintenance and Repair of Motor Vehicles and Motorcycles
20 18 Retail Sale of Fuel Wholesale trade
21 Wholesale Trade and Commission Trade, Except of Motor Vehicles and Motorcycles
22 19 Retail Trade, Except of Motor Vehicles and Motorcycles; Repair of Household Goods Retail Trade
23 20 Hotels and Restaurants Hotels and Restaurants
24 21 Inland Transport Inland Transport

25 22 Water Transport Water Transport
26 23 Air Transport Air Transport
27 24 Other Supporting and Auxiliary Transport Activities; Activities of Travel Agencies Other transport services
28 25 Post and Telecommunications Postal
29 26 Financial Intermediation Financial Intermediation
30 27 Real Estate Activities Real Estate Activities
EURO AREA POLICIES

31 28 Renting of M&Eq and Other Business Activities Other Business
32 29 Education Education
33 30 Health and Social Work Health
34 Other Community, Social and Personal Services
31 Other services
35 Private Households with Employed Persons
EURO AREA POLICIES
References
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Union. Guetersloh: Bertelsmann Stiftung.
Anderson, J.E., Van Wincoop, E. (2004). Trade Costs. Journal of Economic Literature 42 (3), 691–751.
Baldwin, R.E., Venables, A.J. (1995). Regional Economic Integration. In: Grossman, G.M., Rogoff, K. (Eds.),
Handbook of International Economics, Vol. 3. Elsevier.
Berden, K., J. Francois, S. Tamminen, M. Thelle, and P. Wymenga (2009): “Non-tariff Measures in EU-US
Trade and Investment: An Economic Analysis,” Final report, Ecorys.
Berden, K., J. Francois, S. Tamminen, M. Thelle, and P. Wymenga (2009) (2013): “Non-tariff Measures in
EU-US Trade and Investment: An Economic Analysis,” IIDE Discussion Papers 20090806, Institute for
International and Development Economics.
Booth, S., Howarth, C., and Persson, M. (2015) What if…? The Consequences, Challenges and
Opportunities Facing Britain Outside EU. Open Europe Report 3 (2015): 15. Brücker H., Capuano, S. and
Marfouk, A. (2013). Education, Gender and International Migration: Insights from a Panel-Dataset 1980–
2010, Mimeo.
Caliendo, Lorenzo and Fernando Parro (2015) “Estimates of the Trade and Welfare Effects of NAFTA” The
Review of Economic Studies, 82 (1): 1–44
Chen W, Los B, McCann P, Ortega-Argilés R, Thissen M, van Oort F. (2018). The Continental Divide?
Economic Exposure to Brexit in Regions and Countries on Both Sides of the Channel. Pap Reg Sci., 97:25–
54.
Connell, W, Simons, W and Vandenbussche, H. (2017). Global Value Chains, Trade Shocks and Jobs: An
Application to Brexit. London, Centre for Economic Policy Research.
Constinot Arnaud and Andres Rodriguez-Clare, 2014, “Trade Theory with Numbers: Quantifying the
Consequences of Globalization.” Handbook of International Economics, Vol. 4.
Dhingra Swati, Hanwei Huang, Gianmarco I. P. Ottaviano, Joao Paulo Pessoa, Thomas Sampson and John
Van Reenen (2017). "The Costs and Benefits of Leaving the EU: Trade Effects," CEP Discussion Papers
dp1478, Centre for Economic Performance, LSE.
European Parliament (2017): An Assessment of the Economic Impact of Brexit on the EU27, March 2017.
Hummels, D., Hillberry, R. (2012). Trade Elasticity Parameters for a CGE Model. In: Dixon, P.B., Jorgenson,
D.W. (Eds.), Handbook of Computable General Equilibrium Modeling. Elsevier.
Ignatenko, Anna., Raei, Faezeh., Mircheva, Borislava, Tulin, Volodymyr (2017). Global Supply Chains: A
New Dataset and Insights for Europe, forthcoming IMF Working Paper.

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OECD (2016). The Economic Consequences of Brexit: A Taxing Decision. OECD Economic Policy Papers 16
(2016): 1.
McDaniel, C., Balistreri, E.J. (2003). A Review of Armington Trade Substitution Elasticities. Integration and
Trade 18 (7), 161–173.
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EU: Trade Effects. Centre for Economic Performance Technical Report (2016).
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Piermartini, R., and R. Teh (2005): Demystifying Modelling Methods for Trade Policy, No. 10. WTO
Discussion Paper.

EURO AREA POLICIES
YOUTH UNEMPLOYMENT DURING THE EURO AREA

ECONOMIC RECOVERY1
The euro area youth unemployment rate has declined as the economic recovery has taken hold,
but remains elevated, especially in some countries. Job creation for the young, however, has been
sluggish. Instead, the decline in the unemployment rate mostly reflects a reduction in the size of
the young population and a higher share of young people in education. Higher educational
attainment can improve young people’s labor market prospect and boost productivity, but
measures are still needed to tackle youth unemployment and inactivity, by boosting new job
creation and facilitating labor-market entry for the young.
A. Recent Developments of Youth Unemployment in the Euro Area
1. The youth unemployment rate for the euro area has come down in recent years, but is
still high in some countries. It has declined by more than 5 percentage points to under 19 percent
by 2017, from its peak of 24 percent in 2013.2 This is
Text Figure 1
larger than the decline in the unemployment rate for
adult workers, which fell by close to 3 percentage
points, to 8 percent in 2017 (Text Figure 1). This is
consistent with Banerji et al. (2014), who show that
youth unemployment tends to be more cyclical than
adult unemployment.3 The biggest improvements in
youth unemployment since the crisis peak occurred
in Ireland, Slovakia, Lithuania, Latvia, and Portugal,
where youth unemployment rates dropped by more
than 10 percentage points. Nevertheless, the
dispersion among the countries is still high (see
Box 1). Among the eight countries (YU8) with the highest youth unemployment: Belgium, Cyprus,
Finland, France, Greece, Italy, Portugal, and Spain, the rate remains near or above 20 percent.
2. Youth employment only started to increase in 2016. Euro area growth has been positive
since 2013, but the number of employed young continued to decline until 2016. In contrast, adult
workers experienced net job creation as early as 2014 (Text Figure 2). As a result, the employment
1
Prepared by Haonan Qu and Hanni Schoelermann. The authors are grateful for helpful collaboration and
contributions from Angana Banerji at the early stage of the project. The paper has also benefited from excellent
research assistance from Xiaobo Shao and Jesse Siminitz.
2
In this paper, the young refer to the 15–24-year age group, adults refer to the 25–74-year age group, and prime-
age workers are 25 to 54 years old, and older workers refer to the 55+ age group, unless otherwise specified.
3
The higher cyclicality reflects a number of factors, including young workers’ less job-specific skills, lower job security
with a greater share of the young in temporary and part-time jobs, and even perceptions of social fairness in which
the young are considered to more easily cope with unemployment than older workers who may need to support
families.

EURO AREA POLICIES
rate (in percent of the total population) for the young fell throughout the crisis and has only started
to show signs of recovery recently, compared with a rising employment rate for adults since 2013.
Text Figure 2
Employment Growth Rate Employment Rate
(in percent) (in percent of total population)
4 45 70
40 65
0
-2
35 60
-4
-6
Youth (15-24 yrs) 30 55
Youth (15-24 yrs)
-8 Adults (25-75 yrs)
Adults (25-75 yrs, right axis)
-10 25 50
2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017
Source: Eurostat. Source: Eurostat.
3. This paper aims to answer the following questions:
 With only limited employment growth, how was the decline in the youth unemployment rate
achieved?
 Why did it take so long for the cyclical recovery to lead to new jobs for the young?
 How can one explain the different developments in unemployment and employment between
youth and adults?
B. Main Drivers: A Shrinking Labor Force and a Larger Share in Education

and Training
4. The decline in the youth unemployment rate has largely been driven by unemployed
people leaving the labor force, instead of job creation. The active young population started to
decline with the onset of the global financial crisis in Text Figure 3
2008, and only stabilized in 2016. The cumulative Euro Area: Annual Change in Labor Force
(in thousands of people)
reduction in the young labor force amounted to 1000
almost 3 million during 2008–17 (see Box 2). At the 500
same time, more than 3 million jobs were lost.

0
Looking at the period since 2013, the number of
unemployed young declined by 0.9 million. However, -500
employed
only 0.3 million new jobs were created, implying a -1000
unemployed
loss of more than 0.6 million unemployed people in -1500

active population
the young labor force. In other words, more than two 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017
thirds of the decline in the number of unemployed Source: Eurostat.

EURO AREA POLICIES
during this period was due to a shrinking labor Text Figure 4

force (Text Figure 3). The number of young people Euro Area: Change of Young Population
(in thousands of people)
employed only started to increase in 2016. 400
200
5. The primary reason for the decline in the 0
young labor force was the smaller size of new -200
youth cohorts, exacerbated by lower -400
-600
immigration following the crisis. The loss of total active
-800
young labor force has been mirrored by a similar total population
-1000
development in the young population since 2008
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
2017
(Text Figure 4). Prior to the crisis, net migration Source: Eurostat.
inflows kept the active young population broadly Text Figure 5

Euro Area: Migration Flow
unchanged. During 2008–16, however, inflows fell (thousands of people, age 15-24)
1000
to about 0.2 million annually, compared to an 800
Inflow Outflow Net
annual average of around 0.3 million during 2006– 600
07 (Text Figure 5). The surge of inflows in 2015–– 400
which was driven by non-EU immigrants––appears 200
to have helped stabilize the size of the young labor 0
force. The net inflows have been concentrated in -200
-400
countries with strong economic performance, such
-600
as Germany, and declined in countries such as 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016
Source: Eurostat.
France, Italy, and Spain, which have high youth
Text Figure 6
unemployment (Text Figure 6). Net Migration Flow
(thousands of people, age 15-24)
600
6. The decline in the young labor force also Germany France Italy
reflects an increasing share of young people in Spain Other Euro Area
400
education or training. The similar reduction of
young labor force and population in head counts 200
implies a more-than-proportionate decline in the

labor force. This is mostly explained by an 0
increasing share of young people investing in

education, especially in the years immediately -200
2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016
following the crisis (see Box 2). The proportion of
Source: Eurostat.
young people in education rose almost
Text Figure 7
5 percentage points since 2008, to 57 percent in Euro Area: Education and Employment
y
2017 (Text Figure 7). (in percent of total, age 15-24)
Employed Education & training 1/ Unemployed and discouraged

100
11 13 11
7. Finally, the share of young people that 80
are not in employment, education and training, 60 52

56 57
increased during the crisis, but is now on a 40
downward path. The share of 20–34 years old that 20 38 31 32
are not in employment, education or training 0

2007 2013 2017
(NEET) rose by several percentage points after 2008 Source: Eurostat.
1/ excluding employed young people in education or training.

EURO AREA POLICIES
(Text Figure 8). Partly reflecting the economic Text Figure 8

recovery, the NEET rate started to decline gradually Young People Not In Employment, Education or Training
Share of respective age group
in recent years, and it was back to the pre-crisis level 25
15-19 20-24 25-29 30-34
for the 15–24 age group by 2017. Nevertheless, the
20
NEET rate is elevated and dispersion among
countries remains large (see Box 1). A prolonged 15
period of inactivity could make young people’s entry 10
into the labor market more difficult and likely lead

5
to lifetime income losses.
0
C. Job Creation and the Young

2000 2002 2004 2006 2008 2010 2012 2014 2016
Source: Eurostat.
Text Figure 9
8. The jobs created in the economic Employment Growth by Industry
(in percent, 2017 vs. 2013)
recovery were skewed towards skill-intensive
sectors that demand high levels of education and
work experience. The high demand for skills may
have acted as a pull factor for young people to
move into education. Over the period 2013–17, total
employment grew by 5.4 percent, compared with
3.1 percent employment growth for the young. Job
creation in skill-intensive sectors such as ICT,
finance, energy, professional services, and health
accounted for close to 60 percent of this increase in
employment. In sectors in which youth employment
is traditionally concentrated—such as construction,
accommodation, manufacturing and retail trade—employment growth was weaker, accounting for
less than 45 percent of the total employment increase. The contribution of the young to
employment growth in these sectors was below average except for the transport and
accommodation sector (Text Figure 9). The young experienced job loss in construction and retail
trade, despite an overall employment increase in these sectors. In contrast, older workers (i.e., 55+
age group) enjoyed employment growth in all sectors except for agriculture and mining where there
was an overall job loss during the recovery period.
9. New jobs for the young were almost exclusively part time. Part-time jobs grew by about
10 percent for the young over 2013–17, but there was no increase in full-time jobs. In contrast, adult
workers, particularly the older workers, benefited more evenly between part-time and full-time
contracts. When looking at employment creation by education level, job growth was the highest for
the highly educated, at close to 13 percent over 2013–17, and the increase was almost 19 percent
for the young workers (Text Figure 10).4 The bulk of new jobs for the highly educated went to prime-
age workers, who accounted for over 73 percent of this employment segment. Older workers gained
4
The education attainment level is coded according to the International Standard Classification of Education: “Low”
indicates less than primary, primary and lower secondary education; “Medium” indicates upper secondary and post-
secondary non-tertiary education; and “High” indicates tertiary education.

EURO AREA POLICIES
a large share of jobs for low- and medium-education level. Job prospects were less favorable for the
young without tertiary education, especially for those with low education attainment level.
Text Figure 10
10. The weak employment growth for the young could also reflect that the economic
downturn rendered more difficult the adjustment to increased female and old-age labor force
participation. There has been a continued upward trend of longer working lives in recent years,
especially for women, which did not slow during the crisis (Text Figure 11). At the same time, several
countries reformed pensions systems and increased the retirement age during the crisis. Higher
labor force participation helps alleviate pressures from ageing populations, and gives a boost to
economic growth that leads to more job opportunities over the medium term, which will benefit the
young. Nevertheless, during an economic downturn like the global financial crisis, extended working
lives may have increased the burden on the young (Boeri and Jimeno, 2016). In the short run,
competition from more experienced workers and fewer vacancies due to higher effective retirement
age could adversely affect the job prospects for the young who possess limited experience and job-
specific skills in an environment that lacks growth to create enough new jobs.5 At the same time, it
may have acted as a push factor for young people to move into education.
Text Figure 11
Duration of Working Life in the Euro Area Euro Area: Labor Market Participation Rate by Age Group
In years Index, 2000=100.
39 200
15-24 25-54 55-64 65-74
37 180
35
160
33
140
31
All 120
29
Males
100
27 Females
80
25
2000 2002 2004 2006 2008 2010 2012 2014 2016
2000 2002 2004 2006 2008 2010 2012 2014 2016
Source: Eurostat (LFS). Sources: Eurostat and IMF staff calculations.
5
Boeri and Jimeno (2016) Boeri et al. (2016) looked at the 2011 pension reform in Italy which increased retirement
age by up to five years for some categories of workers. They found that firms that were more exposed to the increase
in employment duration of senior workers significantly reduced youth hiring. Vestad (2013) also identified positive
impact of early retirement of pensioners on youth employment using a micro-level dataset in Norway.

EURO AREA POLICIES
11. An empirical analysis shows that several labor market features play a role in youth
employment. The approach focuses on differentiating the impact on the young versus prime-age
workers. Similar to Banerji et al. (2014), the following multivariate model considers the effect of
several labor market features, while allowing the impact of the business cycle to vary across
countries. In addition, the analysis looked into both the unemployment and the employment rates,
as this analysis shows that the developments in the unemployment rate alone do not tell the full
story. More specifically,
∗
, , , , , Σ , , ,
where , is the level of the employment or unemployment rate of country at time for the
respective age group (i.e., the youth and prime-age population), , ∗
, is the output gap, and
, , represents labor market feature , in country at year . The panel regression covers the period
of 2000–16, and the results are presented in Table 1.6
Table 1. EU: Multivariate Model Estimates

Employment Rate Unemployment Rate
(1) (2) (3) (4) (5) (6) (7) (8)
Variables Age 15‐24 Age 25‐54 Age 15‐24 Age 25‐54 Age 15‐24 Age 25‐54 Age 15‐24 Age 25‐54
Tax wedge ‐0.38*** ‐0.19* ‐0.37*** ‐0.24* 0.70*** 0.32*** 0.67*** 0.38***
(0.07) (0.10) (0.10) (0.12) (0.13) (0.08) (0.16) (0.08)
ALMP spending 0.53*** 0.35** 0.43*** 0.26 ‐0.95*** ‐0.34*** ‐0.92*** ‐0.32***
(0.08) (0.16) (0.06) (0.16) (0.10) (0.05) (0.13) (0.06)
Net replacement rate ‐0.07** ‐0.03 ‐0.07** ‐0.02 ‐0.06 ‐0.01 ‐0.05 ‐0.01
(0.03) (0.03) (0.03) (0.04) (0.05) (0.02) (0.05) (0.02)
Coordination of wage setting 0.64* 0.50 ‐0.61 ‐0.58*
(0.34) (0.31) (0.51) (0.27)
Country‐specific output gap coefficient Yes Yes Yes Yes Yes Yes Yes Yes
Country fixed effect Yes Yes Yes Yes Yes Yes Yes Yes
Number of observations 354 354 300 300 354 354 300 300
R‐squared 0.667 0.605 0.703 0.664 0.750 0.744 0.772 0.789
Source: IMF staff calculations.
Note: Employment rate is calcualted as the ratio of employed over total population for respective age groups. Driscoll‐Kraay
standard errors are in parentheses. ALMP = active labor market policy.
*p< 0.1; ** p<0.05; ***p<0.01.
 A high labor tax wedge appears to be particularly harmful for the young: The estimated effect
for the young is more than double the effect on prime-age workers when looking at both
employment and unemployment rates. Young workers usually earn lower wages than more
experienced workers due to productivity differentials, and the marginal cost of taxation is
relatively high to hire the young when the progressivity of taxation is low (as is the case with
most social security contributions), especially when minimum wages are more binding.
6
Please see Table 2 for full description of variable definitions and sources.

EURO AREA POLICIES
 Active Labor Market Policies (ALMPs) that focus on training and education, while boosting both
young and prime-age employment, appear particularly beneficial for the young.
 A higher replacement rate can provide disincentives to work. The net replacement rate variable
captures the ratio of out-of-work net income and net income while working. It takes into
account unemployment benefits as well as income from other social assistance programs. While
the estimates are not significant for unemployment regressions, the associated decrease in
employment rate is significant for the young.
 In order to check the robustness of the results, we include coordination of wage setting index as
an additional control variable and it does not seem to affect our findings (Table 1, columns 3–4,
7–8).
D. Macroeconomic Implications
12. A larger proportion of temporary contracts makes the young more vulnerable to
downturns than adult workers. The share of temporary workers in the euro area is high compared
to other advanced economies and continued to rise after the crisis, particularly in the YU8 where
more than half of the young workers are on temporary contracts (Text Figure 12). While the risk of
unemployment for the young could be even higher in the absence of temporary contracts, they
usually offer less security. The high share of temporary contracts, therefore, makes the young more
vulnerable than adult workers in an economic downturn (Chen et al., 2018). Temporary contracts
may also negatively affect productivity by reducing employees’ effort (Dolado et al., 2016), or
decreasing the provision of on-the-job training by firms (Albert et al., 2005, 2010), thereby
damaging the career prospects for young people (Cazes and Tonin 2010; OECD 2015).
Text Figure 12
Share of Temporary Workers Ages 15–24 Share of Workers on Temporary Contracts
(Percent of total employment) (2007-2017, Percent)
60 60
Pre-crisis (2007) Pre-crisis (2007)
50 Peak-crisis (2013) 50 Peak-crisis (2013)
Latest (2016) Latest (2017)
40 40
30 30
20 20
10 10
0
0
YU8 EA-rest YU8 EA-rest
USA JPN OECD EA EA highest 8 EA
YUR 1/ excluding Share of youth workers on temporary Share of adult workers on temporary
Source: OECD.
top 8 contracts contracts
Note: 1/ Eight euro area countries with highest youth unemployment
rates. Source: Eurostat.
13. Unemployment benefits offer only limited support for the young. Reflecting fiscal
constraints during the crisis, access to unemployment benefits have in many cases been tightened.
Because of eligibility criteria such as duration of employment and duration of unemployment
benefits, many young people are not covered by unemployment benefits. Consequently, the share

EURO AREA POLICIES
of unemployed young receiving unemployment Text Figure 13

benefits has declined since 2007, and is substantially Beneficiaries of Unemployment Benefits in the EU by
Age Group and Type of Contract
lower than the corresponding share for the older (in percent of unemployed)
unemployed (Text Figure 13). 70
60 2007 2013
50
14. The number of young people at risk-of- 40
poverty continues to rise in the euro area. As a 30
20
result of high youth unemployment, an increase in
10
the number of discouraged workers, and precarious 0
employment conditions, the young have become A job of limited Dismissed or A job of limited Dismissed or
duration has made duration has made
the most at risk-of-poverty among all age groups ended redundant ended redundant
(Text Figure 14).7 Prolonged unemployment and 15-24 30-64
inactivity can have long-lasting effects on young Source: Janine Leschke (2015).
people’s skills and incomes due to hysteresis effects, Text Figure 14

adversely affecting human capital. Poor job EA19: At-Risk-of-Poverty Rate
(percent of total)
prospects for the young can make them increasingly 25
dependent on their family wealth, therefore

reducing social mobility. All in all, lower human 20
15-24 25-54 55-65 65+
capital and growing inequality of opportunity will in
the long term be detrimental to the euro area’s
15
growth potential (IMF, 2017).
E. Boosting the Labor Market 10

2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016
Prospects of the Young Source: Eurostat.
15. The declining youth unemployment rate masks a shrinking young labor force, but also
a higher share of young people in education. The decline in the labor force reflects shrinking
young cohorts, exacerbated by reduced immigration flows. The jobs created during the recovery
were skewed towards skill-intensive sectors which demand relatively high levels of education and
work experience, possibly representing a pull factor for the young to move into education. At the
same time, the economic downturn may have rendered the adjustment to increasing female and
old-age labor force participation temporarily more difficult, weakening the job prospects for the
young, which may have represented a push factor for the young to move into education.
16. Deeper structural reforms can help tackle youth unemployment, by facilitating labor-
market entry and creating sufficient number of jobs for the young, particularly:
 Labor market reforms: Tackling labor market duality and ensuring efficient collective bargaining
process; addressing skill mismatches and retraining through well-designed apprenticeship
systems as well as ALMPs; and providing an adequate social protection system that adapts to a
changing job market.
7
At-risk-of-poverty rate measure is from the Eurostat and presents the share of people with equivalized disposable
income (after taxes and social transfers) below 60 percent of the national median.

EURO AREA POLICIES
 Fiscal policy: Reducing labor tax wedge; ringfencing and increasing the efficiency of education
spending; and targeting education spending to high-labor-demand and high-productivity areas.
 Product market reforms to unlock growth potential and boost labor market demand to create
new jobs: Improving the business environment by cutting red tape, opening up regulated
professions to facilitate market entry, and promoting further integration within the EU to benefit
from economy of scale from the single market. Deeper financial markets and better personal
insolvency laws can also help to promote entrepreneurship and innovation.
Box 1. Youth Unemployment—Cross-Country Dispersion

Youth unemployment remains unevenly distributed among Text Figure 1.1
euro area countries. There were a little over 2.6 million
unemployed young in the euro area in 2017, of which roughly
2 million or more than 77 percent reside in eight euro area
countries that account for 61 percent of the euro area young
population. While the number of unemployed young reduced
from 3.6 million peak in 2013 for the euro area as a whole, the
significant dispersion in youth unemployment rates reflect uneven
economic recoveries and persistent productivity gaps among euro
area countries.
Even after taking into account the young in education or
training, the significant disparities among euro area countries
remain. The young who are not in employment, education, or Text Figure 1.2
training (NEET) in percent of the total population in the euro area
fell by close to 2 percentage points from the crisis peak of
13 percent, compared with a 5 percentage point reduction of
youth unemployment during the same period. The euro area
countries with the highest youth unemployment rates—Belgium,
Cyprus, Finland, France, Greece, Italy, Portugal, and Spain—also
have the highest NEET rate at 14.1 percent as a group, compared
with 6.6 percent for the rest of euro area countries in 2017.

EURO AREA POLICIES
Box 2. The 3 Million Missing Young

The euro area experienced a significant reduction in its young labor force since the onset of the
global financial crisis. Over the period 2008–17, over 3 million young workers lost their jobs, accompanied
by a close to 3 million reduction in the active young population, or 17 percent of the young labor force in
2007. This loss was concentrated in the years immediately after the crisis (2008–13), during which youth
employment was reduced by over 3.3 million and the youth labor force was reduced by about 2.3 million.
The loss of young labor force largely reflects a reduction in the young population, rather than a
growing pool of inactive young. The drop in the young population, reflecting the adverse demographic
trend, affected both active and inactive young. However, the similar reduction in labor force and the total
population in absolute terms implies that the labor
Text Figure 2.1
force, which has a smaller base, was disproportionally
affected: The young labor force shrank by 17 percent, Cumulative Change of EA Young
(in millions, age 15-24)
compared with a decline of young population by 1.0
2008-13 2014-17
8 percent over 2008–17. A simple counterfactual 0.5
analysis is performed, under which all categories of 0.0

-0.5
young moved proportionally to the total population. -1.0
The results show that, while the adverse demographic -1.5
Active population
trend remains the main driver of the shrinking young -2.0
Education & training
-2.5
labor force, many young people either started -3.0
Discouraged
investing in education or became discouraged (i.e., not -3.5

Total population
Actual Counterfactual Actual Counterfactual

in labor force, education, or training) possibly 1/ 1/
reflecting the poor job prospects (Text Figure 2.1). As Source: Eurostat and IMF staff estimation.
1/ The percentage change of population applies to all categories.
the unemployment rate was crawling up in the years
immediately following the crisis, many young people returned to schools or stayed in schools longer,
resulting an increase in the number of young in education or training despite the large population drop. This
also pushed a larger reduction of discouraged young had they moved in tandem with the population during
2008–13. As the unemployment rate came down, the young labor force continued to shrink with the
population over the period of 2014–17, though young people in education started to drop and discouraged
young increased as a result of prolonged poor job
prospects for the young. Text Figure 2.2
Cumulative Change of YU8 Young
The pattern observed in the YU8 was more volatile (in millions, age 15-24)
than in the rest of the euro area. As the crisis had a 1.0
2008-13 2014-17
more adverse impact on the young in the YU8, the 0.5

decline of the labor force even exceeded that of the 0.0
population during both the recession and the -0.5
economic recovery, resulting a growing pool of Active population
-1.0
inactive young as many went for education. While the Education & training
-1.5 Discouraged
young in education continue to increase during the Total population
-2.0
decline of youth unemployment in the YU8, the Actual Counterfactual Actual Counterfactual
number of discouraged young started to rise, similar 1/
Source: Eurostat and IMF staff estimation.
1/
to the rest of the countries. 1/ The percentage change of population applies to all categories.

EURO AREA POLICIES
Table 2. Data Definitions

Variables Definition Source
ALMP spending Spending on active labor market policy measures (categories 2-7) millions of purchasing-power- Eurostat
parity euros per thousand unemployed. These categories include: training; job rotation and job
sharing; employment incentives; supported employment and rehabilitation; direct job creation
and start-up incentives. They exclude labor market services (category 1), out-of-work income
maintenance and support (category 8), and early retirement schemes (category 9).
Coordination of wage setting Index from 1 to 5. Institutional Characteristics

1=fragmented wage bargaining, confined largely to individual firms or plants of Trade Unions, Wage
2=mixed industry and firm-level bargaining, weak government coordination Setting, State Intervention
through minimum wage setting or wage indexation and Social Pacts database
3=negotiation guidelines based on centralized bargaining
4=wage norms based on centralized bargaining by peak associations with or
without government involvement
5=maximum or minimum wage rates/increases based on centralized bargaining
Employment rate Employed population as percent of total population in corresponding age cohort. Eurostat
Net replacement rate Net benefits replacement rate is defined as the ratio of net income while out of work (mainly European Comission Tax and
unemployment benefits if unemployed, or means-tested benefits, if on social assistance) divided Benefits Indicators Database
by net income while in work. A lower net replacement rate is associated with greater incentive to
search for and take up a job when unemployed.
Output gap (Real GDP - Real potential GDP) as percent of real potential GDP. WEO
Tax wedge Proportional difference between the costs of a worker to their employer and the employee's net European Commission Tax
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IMF Country Report No.

EURO AREA POLICIES

Copies of this report are available to the public from

International Monetary Fund • Publication Services

International Monetary Fund

© 2018 International Monetary Fund

LONG-TERM IMPACT OF BREXIT ON THE EU ___________________________________________3

YOUTH UNEMPLOYMENT DURING THE EURO AREA ECONOMIC RECOVERY ____________ 26

2 INTERNATIONAL MONETARY FUND

LONG-TERM IMPACT OF BREXIT ON THE EU1

A. Euro Area and U.K.: How Strong are the Links?

INTERNATIONAL MONETARY FUND 3

3. EA-U.K. investment positions are substantial.

What Do the Stylized Facts Suggest of the Potential Impacts of Brexit?

4 INTERNATIONAL MONETARY FUND

6. The long-run impact of Brexit is likely to be unevenly distributed across countries,

B. A Synthetic Index of Exposure to the U.K.

INTERNATIONAL MONETARY FUND 5

Figure 1. Trade in Goods, Services, and Financial Services

2.5 Service imports from UK

6 INTERNATIONAL MONETARY FUND

Figure 2. Trade in Value Added and Migration

Country DVA in foreign demand (% Country GDP) 6

1980 1985 1990 1995 2000 2005 2010

INTERNATIONAL MONETARY FUND 7

Figure 3. Financial Flows

Total two-way portfolio investment amounts to about

Note: 15 EA countries included in sample due to availability through the entire

After reaching a peak in 2007, international claims of

Source: BIS LBS; and IMF WEO.

8 INTERNATIONAL MONETARY FUND

8. To build the integration index, we use a principal component analysis. Principal

INTERNATIONAL MONETARY FUND 9

Figure 4. Synthetic Index of Integration With the U.K.

Median Mean Euro area Other non-EU AEs (*)

10 INTERNATIONAL MONETARY FUND

C. An Econometric Investigation of the Long-Term Effects of Brexit on the

INTERNATIONAL MONETARY FUND 11

12 INTERNATIONAL MONETARY FUND

 : This refers to the decline in integration going from EU membership to an EEA.

 : This refers to the decline in integration going from EU membership to an FTA.

arrangements considered here. Second, settling on an EEA

(an FTA). Third, the estimates of the integration shocks are

16. Results suggest a negative, but rather small

EEA FTA WTO EEA FTA WTO

INTERNATIONAL MONETARY FUND 13

D. A Model-Based Approach to Quantify Long-Term Effects of Brexit Due

14 INTERNATIONAL MONETARY FUND

Leather, Leather and Footwear Leather, Leather and Footwear

Te xtiles and Textile Products Te xtiles and Textile Products

Health and Social Work DVA_final Health and Social Work

Air Transport Air Transport DVA_3rd

Electrical and Optical Equipment Electrical and Optical Equipment

EURO AREA POLICIES

INTERNATIONAL MONETARY FUND 17

 Trade elasticities (Figure 6) for

Parro (2015) as their estimation 16