Sunday, January 25, 2009
Britain's not Iceland. But is Europe the next Japan?
Posted by David Smith at 09:00 AM
Category: David Smith's other articles


What went wrong? The past few days should have been positive for the economy and the banking system but we were plunged into a mini-crisis.

I think I know. It is easy for pundits and opposition politicians to criticise but this is difficult stuff. Governments love precedent but there was not one here for, first, a rescue of the banking system and then measures to get damaged banks lending again.

So there is bound to be trial and error, though the package announced last week was not just thrown together. I was talking to Alistair Darling many weeks ago about changing Northern Rock's role from drain on the mortgage market to net lender.

Guarantees for new mortgage-backed securities had been in the offing since Sir James Crosby recommended them in November. Other elements of the package, including Bank of England purchases of corporate bonds, commercial paper and syndicated loans, came straight out of the Federal Reserve textbook.

The problem was that the government allowed speculation to build about a "bad bank" to take on banks' toxic assets, when the work had not been done on it.

When the chancellor announced he would instead insure the banks against some losses on these toxic assets, but that it was impossible to say how big they would be, the vultures began to circle. Even that would not have raised the alarm if not for Royal Bank of Scotland's announcement of losses of 7 billion to 8 billion for 2008, plus up to 20 billion of goodwill writedowns on its ABN-Amro acquisition.

Whose daft idea was it to spoil the banking package with such dire news, which set the tone for a bad week for bank shares and the pound? I present as evidence Gordon Brown's interview last weekend when he said banks should disclose their losses, but the government insists that RBS itself felt obliged to issue its profit warning.

That said, reaction in recent days verged on the hysterical. We have not seen the last of government efforts in this field, and may see full nationalisation of some banks, plus a "bad bank". But the measures were helpful, including the Financial Service Authority's relaxation of its capital rules.

People get things wrong. One scare story is that UK banks have foreign-currency liabilities equivalent to three times gross domestic product. If the government was liable for these, we could be in trouble.

But this refers to all banks in London, whether owned by EU countries, America or Japan. These foreign-currency liabilities are 4.6 trillion, which is indeed about three times our GDP. But they also have foreign-currency assets of 4.7 trillion.

British banks account for less than a third of these liabilities, just under 1.5 trillion, with foreign-currency assets of more than 1.5 trillion. Compared with Switzerland, where such liabilities are two and a half times GDP, or Iceland's seven, the UK's liabilities roughly equal to GDP look comfortable.

There are others ways in which the "Reykjavik-on-Thames" suggestion is ridiculous. I am told there was never a possibility ratings agencies would downgrade the AAA rating of Britain's sovereign debt and, sure enough, Moody's reaffirmed it, saying the UK was not even an outlier among AAA economies. But the rumour was reported.

Ben Broadbent of Goldman Sachs has taken the government's "toxic" assets programme, made aggressive assumptions, and concluded the maximum liability for taxpayers could be 120 billion, 8% of GDP, spread over several years. It is a lot, but a far cry from suggestions of many hundreds of billions, and should be partly offset by profits on other elements of the rescue. Broadbent concludes that, with UK government debt low by international standards, there was no case for a downgrade.

What should we make of the views of Jim Rogers? The "investment guru" said: "I would urge you to sell any sterling you might have. It's finished. I hate to say it, but I would not put any money in the UK."

Rogers has probably taken enough punishment but, apart from the fact that it is nonsense the world's fourth-largest reserve currency isn't finished and puzzlement that anybody gives him publicity, I found it mildly reassuring. He said much the same about the dollar in April, since when its average value has risen 12%.

Last June he said: "The bull market for oil has many years to go before it peters out." We know what happened next. He was speaking from Singapore, where he has moved to see the Asian miracle at first hand, and where the economy is officially expected to shrink 5% this year.

The same goes for Crispin Odey, the hedge-fund manager, who said the UK was "bankrupt". Odey, who makes money from short-selling, appears to have been put on Earth to give hedge funds a bad name.

Some hedge funds and trading arms of investment banks, having wrought havoc elsewhere, now see profit in currency volatility. There is also an element of cannibalism at work, heavy selling of bank shares being often provoked by bearish research notes issued by other banks.

For some, the more mayhem the better. But it is important to inject balance and this is not political. Wishing ill on the economy, banks or currency to hasten Brown's departure is strange. Long after he has gone, we would still be suffering.

Currencies rise and fall. Sterling's problems are partly related to the curtailment of international banking flows into the City and to the view among some that Britain will suffer a much worse recession than other big economies after Friday's figures showed a 1.5% drop in GDP in the fourth quarter. But Germany and America look at the very least similarly afflicted.

Some experts such as Neil Mackinnon, chief economist at the ECU Group, also think sterling is a proxy for global financial risk. When risk aversion rises in markets, sterling gets clobbered. These things pass. The pound was once a petrocurrency.

Episodes of sterling weakness are followed by periods when it rises too much. After the 1976 IMF crisis, it rose from $1.65 to above $2.40. Between 1996 and 1998 sterling climbed 25%. Exporters hope that at least some of today's depreciation holds.

If there was a currency I would be worried about at the moment, however, it would be the euro. Three of its members, Greece, Portugal and Spain, have had their credit ratings downgraded and Ireland is on "negative watch". The European Central Bank, having started well in the crisis, is now dragging its feet and seems in a similar state of denial to the Bank of Japan in the early 1990s, before the "lost decade".

European finance ministers last week rejected proposals to co-ordinate banking bailouts. Again, this looks like foot-dragging. Britain is not Iceland. But Europe, if it is not careful, could be the next Japan.

PS: I have had requests for an update on my skip index, an informal indicator based on the number of builders' skips in my street. It held up until Christmas, based on "can't move, will improve" demand, but now stands at zero. No green shoots there.

But something odd is happening. Recessions are grim but you expect compensations such as quiet roads, empty trains and helpful shop assistants.

This may be a London thing, but to me roads are busier and on train and Tube journeys I get closer to fellow passengers than is comfortable. As for shops, maybe the retail trade is too miserable, though it is common to find that, when you are ready to buy, the item is not in stock.

Finally, unfinished business from last week when I presented a calculation showing a 2% interest rate with zero inflation was better for savers than 5% with 3% inflation, because of tax. Plenty of pensioners point out that this may apply to young whippersnappers wanting to increase the real value of capital but not to most pensioners, drawing down savings and wanting maximum cash income from it. An interesting debate.

From The Sunday Times, January 25 2009