Tuesday, 1 December 2009

Even Morgan Stanley is thinking the unthinkable about the UK

In previous musings at this site I have suggested that the notion that the UK could face a sovereign debt crisis is far from unthinkable. And if there is one lesson which should be apparent from the gyrations in our financial system recently it is that we should all be prepared to think the unthinkable in what lies ahead. Maverick reporter Ambrose Evans Pritchard has the lead story in the Daily Telegraph Business section today in which he draws attention to a note from Morgan Stanley which suggests that not just mavericks are taking this possibility seriously.
The US investment bank said there is a danger Britain’s toxic mix of problems will come to a head as soon as next year, triggered by fears that Westminster may prove unable to restore fiscal credibility.

“Growing fears over a hung parliament would likely weigh on both the currency and gilt yields as it would represent something of a leap into the unknown, and would increase the probability that some of the rating agencies remove the UK's AAA status,” said the report, written by the bank’s European investment team of Ronan Carr, Teun Draaisma, and Graham Secker.

“In an extreme situation a fiscal crisis could lead to some domestic capital flight, severe pound weakness and a sell-off in UK government bonds. The Bank of England may feel forced to hike rates to shore up confidence in monetary policy and stabilize the currency, threatening the fragile economic recovery,” they said.

Morgan Stanley said that such a chain of events could drive up yields on 10-year UK gilts by 150 basis points. This would raise borrowing costs to well over 5pc - the sort of level now confronting Greece, and far higher than costs for Italy, Mexico, or Brazil.
Below are just some of the issues which make the UK situation especially worrisome and aggravate the problem which it shares with many G10 states, namely the dire state of the public finances and the lack of a robust tax base to pay for the bloated bureaucracies and commitments to public and corporate (i.e. bankers) welfare.

1. During the most recent year which has seen the issuance of approximately £200 billion of UK government securities, the large majority of these have been purchased by the Bank of England as part of its QE program. This cannot be extended indefinitely and there is a real question as to who is going to step up at the auctions when the Bank is no longer dutifully purchasing the seemingly endless flow of gilts that the Treasury needs to sell for years to come.
2. Not being part of the eurozone may prove to be a mixed blessing for the UK. On the one hand, the ability to let sterling slide has (perhaps) aided the export efforts of what remains of British manufacturing. On the other hand if foreigners have a concern about the creditworthiness of the UK government - the fact that sterling does not have to be a core holding of foreign central bank reserves could cause a repeat of previously witnessed sterling crises. In a worst case scenario it is not unthinkable that the UK government may have to seriously consider joining the eurozone with all of the loss of policy making "flexibility" that would be entailed.
3. The chances of an indecisive election result next May or June could produce a coalition style government which, given the fractiousness between the parties, could inhibit decisive moves being made to restore financial rectitude to the UK public sector.
4. The recent appointment of a new EU finance minister, known to be antipathetic to free wheeling Anglo-Saxon style capitalism could lead to far less "light touch" in the way that the City works and, if the financial sector is less profitable, and with the UK having relied on buoyancy in this sector for sizable chunks of its tax revenues, an even wider gap between income and expenditures for the Treasury.
5. The UK officially remains in recession, the last of the G20 countries to be in that situation (if the official statistics are to be relied upon), its credit rating is under review, the government and opposition are ducking the key questions about tax increases, and Alistair Darling has to present his pre-budget report to parliament next week.

Will capital markets remain benignly neglectful of the mounting problems and give the UK the benefit of the doubt until the dust settles from the election next summer or will the early adopters start fleeing sterling sooner rather than later?

For the sake of not wrecking the vibe over the festive season let's hope that even the first rumblings of any potential crisis can be postponed at least until January.

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