Read a good article on risks of a further Sterling weakening, here are the main points:
Risks FOR U.K. Bank Runs:
a) The UK banking sector’s balance sheet is about half the size of the Icelandic banking sector as a share of annual GDP: about 450% at the end of 2007 as compared to Iceland’s 900%.
b) The gross external assets and liabilities of the British economy are about the same size relative to UK GDP
c) England’s foreign currency reserves are puny and the government’s foreign currency reserves are small - around US$43 billion
d) Among the larger European countries, the UK government’s exposure, formal or implicit, to its banking sector is by far the highest. Switzerland, Denmark and Sweden are in a similar pickle, with the banking sector solvency gap threatening to become larger than the fiscal spare capacity of the state.
No doubt the Bank of England would be able to arrange swaps, credit lines or overdraft facilities with the Fed, the ECB or the Bank of Japan. And given sound banks and sound fiscal fundamentals, it should be possible for the UK to defend the banking sector against runs or market strikes.
Sterling Risk
By bailing out the banks, and other bits of the financial system, the authorities reduce bank default risk but at the cost of increasing sovereign default risk.
In addition to the debt that has been and will be issued to finance asset purchases by the government, there are the future debt issuance associated with the large cyclical and structural government deficits that will be a feature of the coming recession. A seven percent GDP or higher government deficit for 2009 and 2010 look probable. Together with the explicit or implicit fiscal commitments made to safeguard the British banking system, the numbers are likely to higher.
Costs to U.K. PLC
With the true net public debt to GDP ratio probably already well above 100 percent of GDP and rising, and with massive public sector deficits, partly cyclical and partly structural about to materialise, the markets will question the fiscal-financial sustainability of the government’s programme. The CDS spreads on UK public debt will start rising.
The current deficits limits capacity to engage in a discretionary fiscal stimulus to boost domestic demand. For it to be meaningful, a debt or money-financed stimulus of at least one percent of GDP and more likely two percent of GDP is called for. Higher default risk premia to the longer-dated UK sovereign debt instruments will be priced in if the market believes that the government’s ability to raise future taxes or cut future public spending to safeguard solvency is weak.
The resulting interest rates rise can crowd out completely the stimulus to private demand provided by the tax cut or public spending increase.
Lack of confidence in the government’s fiscal sustainability would also undermine confidence in sterling. In the worst case, we could see a run on the banks, on the public debt and on sterling all at the same time. It provides another strong argument for the UK adopting the euro and for the Bank of England becoming part of the Eurosystem as soon as the other EU member states will let it
a) The UK banking sector’s balance sheet is about half the size of the Icelandic banking sector as a share of annual GDP: about 450% at the end of 2007 as compared to Iceland’s 900%.
b) The gross external assets and liabilities of the British economy are about the same size relative to UK GDP
c) England’s foreign currency reserves are puny and the government’s foreign currency reserves are small - around US$43 billion
d) Among the larger European countries, the UK government’s exposure, formal or implicit, to its banking sector is by far the highest. Switzerland, Denmark and Sweden are in a similar pickle, with the banking sector solvency gap threatening to become larger than the fiscal spare capacity of the state.
No doubt the Bank of England would be able to arrange swaps, credit lines or overdraft facilities with the Fed, the ECB or the Bank of Japan. And given sound banks and sound fiscal fundamentals, it should be possible for the UK to defend the banking sector against runs or market strikes.
Sterling Risk
By bailing out the banks, and other bits of the financial system, the authorities reduce bank default risk but at the cost of increasing sovereign default risk.
In addition to the debt that has been and will be issued to finance asset purchases by the government, there are the future debt issuance associated with the large cyclical and structural government deficits that will be a feature of the coming recession. A seven percent GDP or higher government deficit for 2009 and 2010 look probable. Together with the explicit or implicit fiscal commitments made to safeguard the British banking system, the numbers are likely to higher.
Costs to U.K. PLC
With the true net public debt to GDP ratio probably already well above 100 percent of GDP and rising, and with massive public sector deficits, partly cyclical and partly structural about to materialise, the markets will question the fiscal-financial sustainability of the government’s programme. The CDS spreads on UK public debt will start rising.
The current deficits limits capacity to engage in a discretionary fiscal stimulus to boost domestic demand. For it to be meaningful, a debt or money-financed stimulus of at least one percent of GDP and more likely two percent of GDP is called for. Higher default risk premia to the longer-dated UK sovereign debt instruments will be priced in if the market believes that the government’s ability to raise future taxes or cut future public spending to safeguard solvency is weak.
The resulting interest rates rise can crowd out completely the stimulus to private demand provided by the tax cut or public spending increase.
Lack of confidence in the government’s fiscal sustainability would also undermine confidence in sterling. In the worst case, we could see a run on the banks, on the public debt and on sterling all at the same time. It provides another strong argument for the UK adopting the euro and for the Bank of England becoming part of the Eurosystem as soon as the other EU member states will let it
Proposals
The British government should go easy on the discretionary fiscal stimulus it applies, lest it risk a triple bank, sterling and public debt crisis. Better to first let the Bank of England use the 300 basis points worth of Bank Rate cuts that it still can play with. Even better to combine rate cuts with measures to directly target the disfunctionalities in the interbank market, such as government guarantees for (cross-border) interbank lending.
The UK shares with the United States of America the predicament that unfavorable fiscal circumstances make the wisdom of a significant fiscal stimulus questionable. In the US as in the UK the twin deficits (government and current account) severely constrain the government’s fiscal elbow room. Both countries need all the help they can get from fiscal stimuli abroad, in China, in Germany and in the Gulf
http://blogs.ft.com/maverecon/
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