Financial markets uncertainty and economic policy uncertainty, which usually
co-move closely, have decoupled recently. However, the two may remain
interconnected in the long run, and their divergence is most likely of temporary
nature. They will probably converge again in the coming quarters, either through
an increasing financial markets uncertainty or a declining EPU.
High levels of EPU tend to be transmitted to firms’ borrowing costs, i.e. Result in
higher corporate bond spreads.
Significant cross-country EPU transmissions are observable within the EU, with
a peak around the Brexit vote. UK EPU is transmitted to Germany and France in
particular, to a lesser extent to Spain and to the least extent to Italy. Economic
policy coordination and convergence after Brexit are thus necessary among the
remaining EU states to effectively reduce financial stability risks.
Banks could turn out to be a central channel through which EPU is transmitted
to the real economy. Higher levels of EPU result in subdued bank lending to
non-financial corporations and households. This effect is particularly
pronounced in Spain and Italy, as well as when it comes to lending to SMEs.
Considering the pivotal role of SMEs in employment and value added, spillovers
from elevated EPU to SME lending can dampen the pace of recovery in Europe.