Bloomberg News

Britain Prepares for Worst as EU Strives to End Euro Crisis

February 07, 2012

(Updates with European markets in fifth paragraph.)

Feb. 6 (Bloomberg) -- As a debt-crisis remedy eludes European leaders, Britain is readying its economic defenses amid warnings that a breakup of the euro would spell havoc for the U.K. economy.

Though Britain has long refused to join the single currency, deep financial, trade and investment ties mean an escalation of the crisis might “snowball” and hurt the U.K., according to economist Philip Rush at Nomura Holdings Inc. in London. Almost half of British exports go to the 17 euro nations and U.K. banks are exposed to more than $1 trillion of borrowings in the region.

“What happens in the euro zone effectively determines what happens in the U.K.,” Rush said in a telephone interview. “You look at how correlated euro-area and U.K. growth are historically and it is clear how integrated the U.K. is with the euro area.”

Leaders are struggling to avert a Greek default and find a cure for the sovereign-borrowing crisis that is threatening to tip the $12 trillion euro-area economy into recession. The turmoil, sparked by a debt emergency in Athens more than two years ago, has led to unprecedented bailouts for Greece, Ireland and Portugal, cost France its top credit rating and shattered the belief that the 13-year-old single currency was unbreakable.

European stocks fell from a six-month high today and the euro declined the most in three weeks amid concern that efforts to secure a second aid package for Greece are faltering. The search for safer assets helped U.K. gilts advance. The benchmark 10-year gilt yield fell 3 basis points to 2.14 percent as of 11:23 a.m. in London.

Exposure Risk

Gilts, which last year outperformed all 26 government bond markets tracked by Bloomberg and the European Federation of Financial Analysts Societies, are lagging German Bunds and U.S. Treasuries in 2012 on speculation that current bond yields don’t reflect the risk of its exposure to the euro region.

Portuguese and Greek 10-year bond yields rose to record highs even after the European Central Bank provided unprecedented three-year loans to banks to ease market tension, a sign that investors remain unconvinced the debt crisis has reached a turning point.

While the Bank of England and government forecasters say the effects of a euro breakup are impossible to quantify, official concern was underlined late last year when Chancellor of the Exchequer George Osborne said that even the best preparations could do little more than limit the damage.

‘Fair Warning’

“We are planning for all eventualities, including successful outcomes,” he told a parliamentary committee on Dec. 9. “But I should give a fair warning that however much contingency planning you do, the disorderly collapse of the euro would do enormous damage to the British economy at this point.”

The euro-region debt crisis has already pushed up funding costs for British lenders and a European banking crisis, possibly sparked by a default, could severely affect their ability to borrow, triggering a fresh credit crunch.

In December, the Bank of England introduced a new sterling liquidity facility to address potential financial-market strains.

Danny Gabay, an economist at Fathom Consulting in London, estimates a disorderly euro breakup would inflict far more damage on the U.K. than the collapse of Lehman Brothers Holdings Inc. in 2008. Without central-bank intervention, the fallout could see the economy contract by 8 percent over the next two years and send the pound and gilt yields higher, torpedoing government plans to eliminate the budget deficit, he said.

‘Vulnerable’

The Office for Budget Responsibility, a nonpartisan body of economists that oversees forecasting for the Treasury, predicted in November that the economy will avoid another recession with growth of 0.7 percent this year and 2.1 percent in 2013.

While British banks have “limited” holdings of government bonds in “vulnerable” euro-area economies, they have larger exposures to private-sector debt in Italy, Spain and Ireland, the Bank of England said in its December Financial Stability Report. In addition, they have “significant exposures” to Germany and France, which in turn have lent heavily to euro countries with high debt levels

“The U.K. has a large banking sector in relation to its economy and a large part of that banking sector is exposed to the euro area, so any meltdown may be potentially cataclysmic,” said Grant Lewis, an economist at Daiwa Capital Europe Ltd. in London and a former official at the U.K. Treasury. “The government’s clearly very nervous about ending up having to pour more capital into these banks.”

BIS Estimates

U.K. bank holdings of government debt from Greece, Ireland, Portugal, Italy and Spain stood at $23 billion as of Sept. 30, interim data from the Basel, Switzerland-based Bank for International Settlements show. By contrast, lending to banks, business and consumers in those countries stood at $303 billion. Out of their $506 billion exposure to German and French debt, $140 billion relates to lending to French banks.

Royal Bank of Scotland Group Plc had the largest exposure to euro-area financial-institution debt as a proportion of its loss-bearing, or core tier 1, capital at more than 30 percent, the Bank of England said.

“As we found at the time of Lehman Brothers, it’s often those chains of exposure that imperil the system most because they’re not visible and therefore the hardest to manage,” Andy Haldane, the central bank’s executive director for financial stability, said last month. “That is a concern that is still there.”

Main Market

While Prime Minister David Cameron is urging companies to target emerging markets such as China, India and Brazil, the euro region is the largest destination for U.K. exports, accounting for 47 percent of foreign sales in the first 11 months of 2011.

Furthermore, investors fleeing euro-region assets could push up the value of the pound, making British exports less competitive and dealing a blow to government plans to rebalance the economy toward exports.

The Daily Telegraph newspaper reported in December that the Treasury was considering plans to erect capital controls to restrict the flow of money coming into Britain in the event of a euro breakup. In September, Switzerland imposed a ceiling on the franc for the first time in more than three decades to protect its trade-reliant economy.

--With assistance from Boris Groendahl in Vienna and Gonzalo Vina and Anchalee Worrachate in London. Editors: Andrew Atkinson, Eddie Buckle

To contact the reporter on this story: Scott Hamilton in London at shamilton8@bloomberg.net

To contact the editor responsible for this story: Craig Stirling at cstirling1@bloomberg.net


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