The U.K.'s decision to leave the EU is expected to weigh on euro zone growth, the International Monetary Fund (IMF) said on Friday, lowering its growth forecasts for the 19-country region.
The IMF said in its latest report on the euro area that the U.K.'s vote to leave the European Union (EU) would hamper growth prospects in the region, despite the single currency zone seeing a strengthening recovery recently which had been helped by lower oil prices and an accommodative monetary policy.
Euro area gross domestic product (GDP) growth is expected to decelerate from 1.6 percent this year to 1.4 percent in 2017, the IMF said, "mainly due to the negative impact of the U.K. referendum outcome."
The IMF warned that inflation expectations also remain "very low" and below the European Central Bank's medium-term price stability objective or around 2 percent. The IMF said that headline inflation is expected to increase from 0.2 percent this year to 1.1 percent next year, however, helped by gradually rising energy prices.
Still, "downside risks have grown," it said, laying out a litany of risks both within Europe and beyond.
"Externally, a further global slowdown could spill over and derail the domestic demand-led recovery. Domestically, the risks are largely political," the IMF noted.
"Further spillovers from the U.K. post-referendum situation, the refugee surge, or a heightening of security concerns could contribute to greater uncertainty, hurting growth and hindering progress on policies and reforms. Other risks include banking and financial sector weaknesses in some countries. Moreover, prolonged low growth and inflation themselves make the euro area increasingly vulnerable to shocks. Policy buffers to counter these risks are low," the IMF said.
The medium-term prospects for the euro zone were not much to cheer either, with the fund saying these were "mediocre" "with crisis legacies of high unemployment, elevated public and private debt, and deep-rooted structural weaknesses weighing on the outlook and productivity growth."
As a result, growth five years ahead is expected to be about 1.5 percent, with headline inflation reaching only 1.7 percent, the IMF said.
The fund said that "comprehensive and more balanced policies taken collectively are needed to respond to these risks, helping to boost growth, rebuild buffers, and strengthen integration."
It added that structural reforms to improve productivity and reduce macroeconomic imbalances, many of which have been encouraged in the euro zone following financial bailouts, need to be incentivized.
"Given limited fiscal space at the national level, an expansion of centralized fiscal support is needed, but should be accompanied by a stronger governance framework to ensure that members comply with the fiscal and structural rules. These measures would complement the current stance of monetary policy, providing a more balanced policy mix."
The IMF's remarks come at a difficult time for the European Commission that is trying to get euro zone members to stick to budget deficit rules – which state that deficits must not exceed 3 percent of GDP – while remaining wary of rising anti-EU sentiment and continuing economic pressures on countries still in recovery mode following the financial crisis.
Spain and Portugal have breached deficit rules despite being given some leeway to meet targets and on Thursday, the Commission determined that the countries had not taken "effective action," as Commission Vice President Valdis Dombrovskis said in a statement, to bring their budget deficits within EU limits.
The Commission concluded that Portugal did not correct its excessive deficit by the deadline of 2015 and that Spain is off track to correct it by the 2016 deadline. "For various reasons, the windfalls from higher growth and lower interest rates were insufficiently used to reduce deficits and debt," Dombrovskis said. The Commission said it had begun formal disciplinary procedures against both countries for their excessive deficits, which may lead to fines being levied against them.
Against this challenging backdrop, the IMF urged "strong collective actions to boost growth and strengthen the union, and cautioned that the cyclical recovery should not lead to complacency. Policies should prioritize structural reforms, enhancing investment and fiscal governance, maintaining supportive monetary policies, completing the banking union, and repairing balance sheets. (IMF) Directors warned that without decisive actions, the euro area will remain vulnerable to instability and repeated crises of confidence."