Bill Jamieson: Sun setting on Europe

TO THE question: How bad might it get, came an ominous reply last week: a lot worse. Sterling tumbled to a 24-year low against the dollar on growing talk that UK debt could suffer a humiliating downgrade in global credit markets.

How likely is this? And what might be the consequences? Nerves were set on edge by a new precipitous collapse in UK bank shares and growing talk of outright nationalisation – a move that would add hundreds of billions of pounds of liabilities to the Government's books. A clue as to where this might all be leading came from rating agency Standard & Poors, when it stripped Spain of its prized 'AAA' status to 'AA+' last week, citing structural weakness in the economy.

The EU warned last week that Spain – which has been hit hard by the undoing of a property and construction bubble – is likely to run a deficit equal to 6.2% of GDP in 2009 and that unemployment, currently at 11.3%, would reach 19%.

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This came hard on the heels of a credit downgrade of Greek government debt to 'A–', kindling concerns that other European economies could suffer a similar fate as they seek to spend their way out of recession. Greece already has a debt burden equivalent to 94% of its GDP and concern over public finances during the global credit crunch has pushed up the yield of Greek debt. The spread of 10-year Greek bonds over benchmark German Bunds hit a historic high for a eurozone member near 281 basis points last week.

The Greek government has said it needs to borrow ?42bn in 2009 to service its debt and finance public expenditure. Analysts said Greece would cover its borrowing needs – despite a flood of other sovereign issues – but it would prove costly.

S&P said it is also reviewing Ireland's 'AAA' status and Portugal's 'AA–'. Concern is growing over Ireland, whose bank shares also plunged sharply last week. The country may be heading towards a coalition government as the economy suffered a drastic fall in the fourth quarter. Now economies as big as the UK may be coming under searching scrutiny.

Such a move would almost certainly trigger a political crisis and a sharp rise in the cost of servicing a rapidly rising debt pile. It could catapult the UK into the arms of the International Monetary Fund. And if, as some fear, our debts by then could have spiralled to a scale too big even for the IMF, this could raise the spectre of a sovereign debt default: a suspension of interest payments that could send the gilt market crashing.

We are a long way from that, and assurance was taken from remarks by rival rating agency Moodys last week that it had no plans to alter Britain's top grade AAA status for now. But the speed and scale of this global downturn is catching everyone out and has smashed through all previous worst case scenarios.

Figures on Friday showed that Britain's economy is not teetering on the edge of a cliff, as Liberal Democrat leader, Nick Clegg, claimed in the Commons, but has already fallen off it. Figures for the fourth quarter of 2008 show the economy contracted by 1.5%, the worst quarter on quarter decline since 1980 and a 1.8% fall on the same quarter a year ago.

The figures brought to an end the most wretched week yet for the economy. It witnessed a dramatic collapse in bank shares. The most spectacular decline was seen at the Royal Bank of Scotland, which plunged by two-thirds on Monday, even though the Government unveiled its second bailout of the sector in a further attempt to deal with the toxic assets on the banks' balance sheets. Its current share price of 12.1p compares dismally with the 3 plus it was trading at just a year ago and marks a further savage wipe-out for shareholders, on top of the HBOS collapse. Billions have been lost from pension funds and individual savings.

The week also brought news of unemployment climbing to 1.9 million, a dismal Bank of England agents report, and a further downward lurch in the pound to multi-year lows against the dollar and the euro. Meanwhile the flow of poor company results, closures and redundancies has turned into a torrent.

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What is particularly unnerving overseas investors is the alarming surge in the Government's budget deficit. This soared in December alone to 14.9bn, almost double the previous record deficit for December. The budget deficit for the nine months to the end of December now stands at 71.1bn. Michael Saunders, chief UK economist at Citigroup, forecasts it will hit 80-90bn for the full year or about 5.5% of GDP, before hitting 130-140bn for 2009-10 (9-10% of GDP).

These estimates are before taking into account the liabilities assumed in the latest round of bank underpinning and refinancing (guarantees for asset- backed securities, an asset protection scheme for banks, a 10bn working capital scheme for small and medium-sized businesses and other measures). These put the UK on course for the highest level of borrowing as a percentage of GDP since the Second World War.

"All this", says Saunders, "is raising worries that UK sovereign debt might even be downgraded… The economic downturn is so severe, and the prospective fiscal deficit so colossal, the risk that the economic and financial crisis develops into a true fiscal and sovereign debt crisis cannot be totally dismissed. And, of course, if that were to happen, then prospects of UK economic recovery would become even more distant, and the emphasis would fall ever more clearly on currency weakness and quantitative easing to generate recovery."

Saunders is not alone in these concerns. Stephen Lewis, economist at Monument Securities, says: "The unpalatable truth that policymakers have to accept is that a depression is not the worst fate that can befall an economy.

"The collapse of the currency and of the nexus of financial claims and liabilities in that economy can be even more destructive of social order and political stability," he added.

In European capitals, a beady eye is being kept on Britain for being seen to steal a competitive advantage during the crisis. France's finance minister, Christine Lagarde, attacked the Bank of England for failing to provide enough support for the pound. But Bank governor Mervyn King insists the fall in the pound is a necessary adjustment for the British economy provided it has not occurred because of a complete lack of confidence in Britain's assets.

And that is the risk we face as the Government is dragged into ever more desperate rescue packages for the banks, and with no economic upturn in sight, more companies are going to fail and bigger provisions will have to be made for bad and doubtful debt. In the meantime, there is no clarity as to how the new measures announced last week will work, still less how much they will cost.

The Government is not due to make a further statement on its bank package until mid-February. But continuing pressure on the pound could force it to act sooner. And it will be particularly anxious to avoid a spill-over into the gilt-edged market for Government debt. If prices here start to weaken and yields rise – last week brought some ominous tremors – the crisis could take on a greater and altogether more worrying dimension. Time is what the Government needs. And time is not what it appears to have.