Even in its darkest moments, the U.K. government can't have imagined a worse reception for its latest bailout package. Far from shoring up confidence in the banks, it has fueled doubts over the solvency of the entire U.K. economy. The collapse in bank shares has spread to sterling, down 5% this week amid talk of downgrades and defaults. Even so, the U.K. is a long way from turning into Iceland-on-Thames.
True, the economy is in a mess -- but that is true of almost every other country. The U.K. has particular drawbacks: a large current account deficit that relies on foreign investors for funding, high private sector debt, and an historic overreliance on finance sector jobs. And the pound is no longer a reserve currency so no one is obliged to own it.
But it also has advantages. Public sector debt is lower than in most developed countries and is forecast to hit around 60% of GDP over the next couple of years -- lower than many countries in the euro zone. Plus the U.K. has already received a substantial monetary and fiscal stimulus. And it still has its own currency, which is now down nearly 30% from its recent peak against a basket of other currencies -- providing another massive stimulus.
The case against sterling rests on the size of the U.K. banking sector, which has liabilities of more than three times GDP. But those liabilities are matched by assets - the bulk of them currently financeable via usual bank funding mechanisms, including deposits, the bond market and central bank repurchase operations. So it is misleading to suggest that bank nationalization would cause U.K. public debt to reach 350%.
What matters is not the future size of the U.K. public sector balance sheet but the scale of the likely losses it might have to absorb via the banking system. These are sure to be substantial, whether the government absorbs them as a result of a guarantee scheme, a bad bank or nationalization -- but not so large as to sink U.K. public finances.
Goldman Sachs reckons the three large U.K. banks -- Lloyds, Barclays and Royal Bank of Scotland -- have between them GBP350 billion of toxic assets, which includes all their commercial property exposure, all leveraged loans and around 10% of unsecured commercial loans. This is the amount it reckons the government would need to remove to feel comfortable the banks could absorb remaining losses from operating profits.
But that wouldn't mean the U.K. was on the hook for GBP350 billion. Assuming a 20% loss rate on secured debts and a 70% loss on unsecured, Goldman estimates losses -- spread over several years -- could hit GBP120 billion, a portion of which would be taken by the banks under the terms of the insurance scheme. But even if the government took all the losses, they amount to just 8% of GDP, leaving U.K. public debt still below the forecast 73% for the euro zone in 2011 and too low to trigger a downgrade.
That doesn't mean the U.K. is safe. Like any highly leveraged entity, it is vulnerable to a loss of confidence. And with net overseas liabilities equivalent to 25% of GDP, there is a limit to how far sterling can fall before a downgrade does become a possibility. But with an AAA rating only recently reaffirmed by S&P and a currency that already looks cheap on a purchasing power parity basis, it's hard to imagine things getting that bad. After all, other currency areas have their problems too.
