How likely is a sterling crisis or: is London really Reykjavik-on-Thames?
November 13, 2008




With the pound sterling dropping like a stone against most other currencies and credit default swap rates on long-term UK sovereign debt beginning to edge up, this is a good time to revisit a suggestion I made earlier on a number of occasions (e.g. here, here and here), that there is a non-trivial risk of the UK becoming the next Iceland.


The risk of a triple crisis - a banking crisis, a currency crisis and a sovereign debt default crisis - is always there for countries that are afflicted with the inconsistent quartet identified by Anne Sibert and myself in our work on Iceland: (1) a small country with (2) a large internationally exposed banking sector, (3) a currency that is not a global reserve currency and (4) limited fiscal capacity.

The argument is simple. First consider the case where the banking sector is fundamentally solvent, in the sense that its assets, if held to maturity, would cover its liabilities. Iceland’s banks were supposed to have been in that position, although I have seen no verifiable information on the quality of the three formerly internationally active banks. There is no such thing as a safe bank, even if the bank is sound. Without an explicit or implicit government guarantee, there is always the risk of a bank run (a withdrawal of deposits or a refusal to renew maturing credit and to roll over maturing debt) or a sudden market seizure or ’strike’ in the markets for the bank’s assets bringing down a fundamentally sound bank.

To prevent a fundamentally sound bank succumbing to a deposit run or to asset market illiquidity, the central bank has to be able to act as lender of last resort, providing funding liquidity and as market maker of last resort, providing market liquidity to liquidity-constrained banks.

If the country has an internationally active banking and financial sector and if its foreign currency liabilities have a shorter maturity than its foreign currency assets, and especially if these foreign currency assets have become illiquid, the central bank has to be able to act as foreign currency lender of last resort and market maker of last resort if it is to be able to guarantee the survival of the banking sector when faced with a deposit run and/or illiquid markets for its assets.

The central bank of Iceland could be an effective lender of last resort in Icelandic krona, as it can print the stuff in unlimited quantities. It can be a lender of last resort and market maker of last resort in other currencies only to a limited extend - limited by the fact that the Icelandic krona is not a global reserve currency and by the fiscal spare capacity of the Icelandic sovereign.

If Iceland had been a member of the euro area, its central bank would have been part of the Eurosystem - the euro area central bank consisting of the ECB and the (currently 15) national central banks of the euro area member states. The euro is the junior of the two global reserve currencies. First is the US dollar, with around 64 percent of global official foreign exchange reserves held in US dollars. The euro’s share is around 27 percent. After the euro, there is nothing. Sterling’s share of 4.7 percent (at the overly flattering strong sterling exchange rate of late 2007) reflects its minor-league legacy reserve currency status. The Japanese yen and Swiss franc are completely irrelevant as global reserve currencies.

Clearly if a country has a major-league global reserve currency as its national currency, two consequences follow. First, it is likely to be able to borrow abroad using instruments denominated in its own currency rather than in that of the currency of the lender or some other global reserve currency - they are less affected by ‘original sin’ - in the currency-denomination-of-external-debt sense of the expression. Second, it will be possible for both private parties and for official parties like the central bank, to arrange access to foreign exchange (through swaps with other central banks, credit lines etc.) more easily and on better terms than are available to private parties, central banks and other official agents not blessed with a global reserve currency of their own.

As a member of the euro area, it would have been much easier and cheaper for Iceland to defend itself against speculative attacks on its banks - provided the banks and its government were indeed solvent and perceived to be so. With the krona, not only could solvent banks be brought down, even a solvent but illiquid (in foreign exchange) government could be brought down by a sufficiently large speculative attack on the banks, the currency and the public debt.

Of course, even with the euro, the banks could not have been saved by the Icelandic authorities if the banks were fundamentally unsound and if the government did not have the fiscal strength to recapitalise the banks. Under current circumstances, if the government injects capital into a bank to compensate for past and anticipated future losses, it may not achieve a risk-adjusted expected rate of return on this investment equal to its borrowing cost. The difference will have to be recouped through higher future primary surpluses, that is, higher future government budget surpluses excluding interest payments. If there is doubt in the markets about the ability or willingness of current and/or future governments to raise future taxes or cut future spending to generate the required increase in future primary surpluses, the default risk premium on the public debt will rise. We are seeing such increased default risk premia even for the most credit-worthy sovereigns, including the German government, the US government and the UK government. On Friday October 10, 2008, the spreads on 5 year sovereign CDS were 0.456% for the UK, 0.33% for the USA ad 0.265% for Germany, well above their post-war historical averages. On October 28, 2008, Bloomberg wrote:

“Credit-default swaps on [U.S.] Treasuries have risen nearly 40 percent since TARP was signed into law Oct. 3, and are now about the same as Mexican and Thai government debt before the credit markets began to seize up in June 2007.”

By bailing out the banks, and other bits of the financial system, the authorities reduce bank default risk but by increasing sovereign default risk. As long as there is sufficient fiscal spare capacity (the technical, economic and political prerequisites are met for raising future taxes and/or cutting future public spending by a sufficient amount to service the additional public debt and maintain long-run government solvency).

Iceland’s government did not have the fiscal resources to bail out its banks. All three internationally active banks were put into receivership. The domestic bits then were bought by the government out of the receivership. The Icelandic krona collapsed and is no longer internationally convertible: exchange rate restrictions have been imposed. It is an open issue whether Iceland will default on some of its sovereign debt obligations as well.

How and to what degree is this relevant to the UK? Iceland is a tiny country (about 300,000 people - the size of the city of Coventry). The UK has a population of over 61 million. Nevertheless, the UK is a small open economy for economic purposes: it is a price taker in the markets for its imports and exports and in global financial markets. Its share of world GDP in 2007 was 3.3% (at PPP exchange rates - somewhat higher at market exchange rates). Its currency is no longer a serious world reserve currency.

The UK banking sector’s balance sheet is about half the size of the Icelandic banking sector as a share of annual GDP: just under 450% at the end of 2007 as compared to Iceland’s almost 900%. Switzerland, another vulnerable country (small, no currency with global reserve currency status , large banking sector relative to GDP and limited central government fiscal capacity) has a banking sector balance sheet of just over 650% of annual GDP. With UK annual GDP around £1.5 trillion, that gives us a banking sector balance sheet of well over £ 6 trillion.

The first Chart below shows the size of the balance of the UK banking sector. This includes the Bank of England. If we exclude the Bank of England, the latest observation on the balance sheet of the banking sector and a percentage of annual GDP would still be around 420 percent. The deleveraging of the banking sector, visible at the very end of the sample period, has much further to go. The Chart also shows that foreign currency assets and liabilities of the banking sector are very evenly matched - the two lines are almost indistinguishable. Both now are just below 250% of GDP. I don’t have any data on the degree of mismatch by individual currency. Just the aggregate foreign currency exposure is shown.

While there is no net foreign exchange exposure of the banking system in the UK, banks are banks. The foreign currency liabilities of the banking system are therefore likely to have shorter maturities than the foreign currency assets. The foreign currency assets are also likely to be less liquid than the liabilities. I don’t have information on the maturity and liquidity composition of foreign currency assets and liabilities to confirm or refute this presumption. Let me just say that Iceland’s banks were brought down despite an aggregate match between foreign currency assets and foreign liabilities.

Source: Office for National Statistics

Not only are the UK banks rather large relative to the size of the economy, the gross external assets and liabilities of the British economy are also hefty - about the same size relative to UK GDP as the total assets of the banking sector (there is no deep reason for this coincidence). Chart 2 below shows the gross external asset and liability position and the net foreign investment position of the UK. While not in the Iceland league (Iceland had gross foreign assets and liabilities of around 800 percent of annual GDP at the end of 2007) the UK, with gross foreign assets and liabilities of well over 400 percent of annual GDP does look like a highly leveraged entity - like an investment bank or a hedge fund. By contrast, gross external assets and liabilities of the US straddle 100 percent of annual GDP.

Source: Office for National Statistics

Foreign currency illiquidity risk for the UK banks and authorities



Assume for the sake of argument that the UK’s banks are sound. Most of them obviously are not, which is why so many of them have had capital injected into them by the government, and why all of them benefit from explicit government guarantees on new bank debt issuance and implicit government guarantees that the government will come to their assistance should they be at risk of insolvency. With foreign currency assets of longer maturity and less liquid than foreign liabilities, the banks and the country would still be vulnerable to a foreign currency run on the banks (a refusal to renew foreign currency credit) or a seizing up of the markets in which the banks’ foreign currency assets are traded. The Bank of England’s foreign currency reserves are puny and the government’s foreign currency reserves are small - around US$43 billion, pocket change, really.

No doubt the Bank of England would be able to arrange swaps, credit lines or overdraft facilities with the systemically important central banks - the Fed, the ECB and the Bank of Japan. Given sound banks and sound fiscal fundamentals, it should be possible for the UK to defend the banking sector against runs or market strikes. There would, however, be a cost involved - the cost faced by any issuer of a currency that is not a global reserve currency and who therefore either has to insure ex-ante against the possibility of running short of global reserve currencies, or risk getting clobbered on the terms of an emergency currency swap or similar arrangement cobbled together when the enemies are already scaling the ramparts.

This cost of insuring against foreign currency illiquidity risk will make the City of London less competitive as a global financial center than rivals based in global reserve currency jurisdictions. 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.

The reason the costly handicap of a minor-league currency does not appear to have harmed the UK in the past is the same as the reason why I have not made the argument in the past. Before the current financial crisis, no-one could conceive of a world in which a financial crisis would start in the global financial heartland - Wall Street and the City of London - rather than in some developing country or emerging market, would paralyze most systemically important wholesale financial markets and lead to the government nationalising much of the north Atlantic region’s banking and wider financial system and underwriting or guaranteeing the rest. Well, most of the world now knows that this is the way things can be. If it retains sterling, the City of London will put itself at a competitive disadvantage (for those who remember then-Chancellor Brown’s Five Tests for euro area membership, this means that the fourth of these tests now has been met also).



Sovereign default risk for the UK


Even if the UK had the euro as its currency, its banks would still have been at risk if they were unsound (their assets, even if held to maturity, would not cover their financial obligations). In this case, bank insolvency would result unless the British authorities were both able and willing to bail them out. I assume in what follows that the government is willing to bail out the banks. The evidence thus far supports this.

Northern Rock and (rump) Bradford and Bingley were nationalised. The SLS allows all banks to swap illiquid asset-backed securities for Treasury Bills. For reasons that cannot be understood by ordinary mortals, the Treasury Bills lent/swapped by the SLS don’t count as public debt (something to do with Treasury bills with less than one year remaining maturity not being part of the public debt for some accounting and accountability purposes - don’t ask). The Bank of England is accepting a wider range of private securities as collateral at the discount window and in repos. The state has a 60 percent ownership stake in RBS and roughly 40 percent ownership stakes in HBOS and Lloyds-TSB. The government has made up to £25o billion available to guarantee new issuance of bank debt. The state stands behind the formal £50,000 deposit guarantee for bank retail deposits.

The key question is, can the government meet all these fiscal commitments, whether firm or flaccid, unconditional or contingent and explicit or implicit ? Does it have the resources, now and in the future, to issue the additional debt required to meet the growing volume of up-front obligations it has taken on?

To be solvent, the face value of the government’s net financial obligations has to be no larger than the present discounted value of current and future primary government surpluses (government surpluses excluding net interest and other investment income). The government argues that its net debt position is strong, with a net debt to annual GDP ratio still just below forty percent. That statistic is a prime example of lies, damned lies and government statistics.

The 40 percent excludes such old sins as the debt incurred through the PFI (private finance initiatives). This will be brought into the total soon. It also does not yet include the net debt of Northern Rock and Bradford and Bingley. It also excludes the debt of RBS, where the government owns a majority stake and the debt of Lloyds-TSB and HBOS, where the government has a controlling minority stake. Under normal accounting practices, the debt of all three banks will have to be counted as public debt in the future.

Three large UK banks, HSBC, Barclays and Abbey (Santander) have not yet taken the King’s shilling - they are attempting to meet the capital raising targets they agreed with the government from sources other than the government. All three banks are, however, heavily exposed to emerging markets (Santander mainly in Latin America, HSBC in Asia, the Americas, Europe, the Middle East, and Africa and Barclays in Europe, Africa and Asia). This has been a source of strength until recently, compared to their competitors who were mainly exposed to the USA and Western Europe. However, with all emerging markets now severely affected by the financial crisis (both directly and through trade links with Western Europe and the USA), what was a source of strength is become a further source of weakness. The likelihood that some or all of the banks that have not yet received capital injections from the government will do so in the not too distant future is rising steadily.

It is not at all far-fetched to hold the view that the British government has effectively guaranteed the balance sheets of the entire UK banking sector. Let’s value this conservatively at 400 percent of annual GDP, some £ 6 trillion. The value of this guarantee depends on the likelihood it will be called upon, and on the amount of money the government would have to come up with if the guarantee is called. Both numbers are highly uncertain and any guestimate is bound to be subjective. The expected payments under the guarantee are, in my view, hardly likely to be less than £300 bn (on top of any money already paid out), some 20 percent of annual GDP. It could be much higher. With a recession of unknown depth and duration looming, there is a material risk that the government would have to come up with a multiple of the £300 bn just mentioned.

Of course, the value of the assets acquired by the government as shareholder has to be set against the explicit and implicit liabilities it has taken on. I would like to see a valuation of the equity stakes of the government that does not benefit from the recent scandalous relaxation of fair-value accounting and reporting that was forced upon the IASB. I don’t believe any valuation that relies on managerial discretion. With the regulatory constraints likely to be imposed on banks in the future, and the lower returns associated with banking-as-a-public utility, the government may well be getting rather poor financial returns on its investment in the banks. While that does not mean the government should not have made the capital injections - the systemic externalities associated with the failure of large banks don’t show up in the share price - it does mean that the immediate fiscal burden of the capital injections is likely to be only partially offset by future dividends and (re-)privatisation receipts.

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. If GDP falls peak-to-trough by, say 3.5 percent and recovers only slowly, we could have a seven percent of GDP or higher government deficit for 2009 and 2010. Together with the explicit or implicit fiscal commitments made to safeguard the British banking system, the numbers are likely to spook the markets.

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 with increasing vehemence. The CDS spreads on UK public debt will start rising. The notion that, except for currency, there may not be a safe sterling-denominated asset may come as a shock. But the same is true in the US. In 2009, the US government will have to sell (gross) at least $ 2 trillion worth of government debt (the sum of the Federal deficit plus asset purchases plus refinancing of maturing debt). The largest such figure ever in the past was $550 billion. In the US too, the markets will have to learn to do without a US dollar financial instrument that is free of default risk.

The fiscal dire straits the UK government are in limits their 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. But if the market takes fright and believes that the government will not raise future taxes or cut future public spending by the amounts required to safeguard government solvency despite greater current borrowing, it will add higher default risk premia to the longer-dated UK sovereign debt instruments.

Such mistrust in the temporary nature of a fiscal stimulus would not be irrational. After its first term in office, the government have thrown fiscal restraint to the wind and have engaged in a steady increase in public spending as a share of GDP which has been only partly matched by an increase in the tax burden as a share of GDP. Rising debt and deficits and a fondness for fiscal and accounting gimmicks designed to hide the increase in the debt burden have undermined public confidence in the fiscal rectitude of the government. With enough mistrust, the interest rates will rise by enough to 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. This is not the most likely outcome yet, in my view. But it is a distinct possibility.

Could the government monetise the deficits instead (i.e. sell gilts to the bank of England)? The Bank would only be willing to buy such debt (either directly or indirectly in the secondary markets) if it was consistent with its interpretation of its price stability mandate. The Bank appears to believe that short rates may have to go down quite a bit further if it is not to undershoot the inflation target by the end of next year. It may also view the monetisation of gilt issuance as consistent with its mandate.

If there is a conflict between the Bank of England and the government, the government could invoke the Treasury’s Reserve Powers. This is a clause in the Bank of England Act that allows the government to take back the power to set rates from the Bank of England, under exceptional and emergency conditions. It has never been invoked.

If the deficits get monetised, there will not be the upward pressure on real interest rates that would result from debt financing. But the markets may fear the long-term inflationary consequences of the monetary financing, especially if it were to be done by the government after invoking the Treasury’s Reserve Powers. So long nominal rates would be likely to rise if monetisation of the government’s deficits were chosen. Monetisation of deficits would also weaken sterling further.

All may still end up well (cyclically adjusted well, that is). But the piling of fiscal commitment on fiscal commitment by the government is not a risk-free option. The British government has limited fiscal spare capacity. 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.

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 dis********alities 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 unfavourable 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. Beggars can’t be choosers.

Could the UK face a sterling crisis, or are we in one already?


November 17, 2008




In an earlier post to this blog, I raised the possibility that the UK might face a triple financial crisis: a combined banking crisis, sovereign debt crisis and sterling crisis. Let me be clearer than I was before about what I mean by a financial crisis. A financial crisis is a situation where quantity rationing of would-be borrowers and would-be sellers of securities suddenly replaces normal market clearing through variations in interest rates or market prices of securities.

So a sterling crisis does not require a fixed or managed exchange rate regime for sterling. It can occur even when sterling floats, that is, when its external value is market-determined, as it is today.

The behaviour of sterling’s bilateral exchange rates with the US dollar and the euro is shown for monthly data in Chart 1 and for daily data in Chart 2. Both Charts also show the broad effective sterling exchange rate of the Bank of England. The pre-1999 data for the euro in Chart 1 refer of course to a synthetic euro.

Source: Bank of England

A sterling crisis would be preceded by a sharp decline in the bilateral and effective spot exchange rates of sterling and sharply higher interest rates on sterling securities, reflecting expectations of future further currency depreciation. As the incipient crisis became more likely/moved closer, the depreciation of the currency would accelerate and become a rout. The crisis would be upon us when the spot market for sterling, the futures and swap markets, and other sterling derivative markets seized up and it became effectively impossible to sell sterling in exchange for other currencies.

On the basis of the behaviour of sterling’s spot exchange rate in recent months and weeks it would appear that it is premature to say that a sterling crisis has already started. It is true, as is clear from Chart 1, that the depreciation of sterling’s effective exchange rate this past year is larger than that in the year following the UK’s exit from ERMI in 1992. Some greater detail on the steep decline of sterling in the past year can be extracted from Chart 2. But in these data there is nothing that cannot be explained as a (long overdue) correction of a persistent overvaluation of sterling - a misalignment that has biased the economic playing field against industries, both exporting and import competing, that would have had a fairer crack of the whip at a more reasonable exchange rate.

One interpretation of the drivers of this persistent overvaluation would be a Dutch disease story, where the role of the natural resource sector in the standard version of the Dutch disease is taking by the UK banking sector. In this interpretation, a long financial industry bubble in the UK has driven up the real exchange rate in the whole economy and crowded out other sectors producing internationally tradable commodities. The recent sharp depreciation of sterling corrects this long-standing anomaly.

Clearly, this conjecture requires further thought and research. There can be little doubt, however, that there is a point at which the weakness of sterling ceases to be the correction of an anomaly and becomes an anomaly and a problem. I believe we are close to that point. If sterling continues to weaken, the further competitive stimulus this provides will be outweighed by the portfolio dislocations caused by these sharp revaluations of assets and liabilities. The continuing depreciation will also given at least a temporary boost to inflation, through the cost of imported consumer goods and services and through the cost of imported raw materials and intermediate inputs. This can occur despite the presence of widespread and rising unemployment and spare capacity at home. It could put the MPC in a right policy pickle.

Finally, when taken in conjunction with the banking crisis the UK is in already, and with the growing tensions surrounding the government’s fiscal-financial sustainability, the continued weakening of sterling should be a cause for concern.

A banking crisis is a funding crisis for banks. In the period leading up to a banking crisis the access of banks to both funding liquidity and market liquidity would become progressively more costly and difficult, as reflected in rising Libor spreads over the corresponding OIS and Treasury Bill rates, rising credit default swap spreads for banks and rising spreads of bank bonds over Treasury bonds of the same maturity. Unsecured (inter-)bank borrowing effectively disappears, and even secured bank borrowing becomes increasingly costly and difficult.

Another sure sign of increasing banking sector vulnerability is the shortening of the period for which counterparties are willing to lend to banks. Sharply declining stock market valuations are another useful indicator. The seizing up of the wholesale funding markets in which banks have funded themselves to an increasing extent during the years before the crisis first hit in August 2007 should have been a warning that many banks would soon be unable to fund themselves anywhere on commercial terms. When banks have increasing recourse to the discount window of the central bank; when collateral requirements at the discount window and in repos are relaxed; when new facilities (such as the SLS) are created to liquefy the otherwise hopelessly illiquid, you know that you are close to or already in a banking crisis. The need to call on the good offices of the governments to obtain funding or to guarantee liabilities is evidence that quantity rationing is here. We have been in a UK banking crisis since at least the middle of September 2008 - the demise of Lehman brothers - and quite possibly for some time before that.

A UK sovereign debt crisis is a funding crisis for the UK sovereign. Its possible occurrence is signalled by marked increases in credit default swaps on UK sovereign debt, by increasing spreads of UK sovereign debt over other debt instruments denominated in the same currency and of the same maturity, and by a shortening of the maturity structure of new government borrowing driven by the market’s unwillingness to acquire long-term claims on the government. The crisis is upon us when the government is incapable of borrowing in the markets on commercial terms at any rate. This can, but need not necessarily, lead to a sovereign default. Other options are savage fiscal contractions to free up the resources required to service the public debt, or access to financial resources on non-commercial terms. These resources could come either from bilateral official sources (friendly governments, if there are such things) and institutions like the IMF or the EU.


As demonstrated in my previous post on the subject, the UK government has taken on a massive contingent exposure through its policies to bail out and support the UK banking sector. Very soon, for instance, it is likely to own around 60 percent of all RBS stock. At the end of 2007, the balance sheet of the RBS Group was just under £2 trillion. Against this roughly £2 trillion increase in the UK government’s liabilities, one has to set the value of the assets of RBS Group. I doubt whether the fair value (let alone the mark-to-market value) of the assets of RBS Group is anywhere near the value of the liabilities. This is not based on any direct information on the quality of the assets, but on two observations. First, a de-facto government take-over was required to keep the bank alive by restoring its access to external funding. Second (and not unrelated) its market valuation was plummeting before the government stepped in. The situation of the other banks in which the UK government has either a majority stake or a large (controlling) minority stake is unlikely to be much better. Demands on the budget may also be made in the not too distant future by non-bank financial intermediaries, including insurance companies and pension funds, and by large non-financial companies, if the US experience with AIG and the Detroit car manufacturers is anything to go by.

The UK government is severely fiscally stretched by its wide range of explicit and implicit, formal and informal, firm and flaccid financial commitments to the UK banking sector. It is not clear that the government debt issuance implied by both this massive actual and contingent exposure to the banking sector and by the discretionary fiscal stimulus the government is preparing, will be financeable in the global capital market. There is no guarantee that the market will be willing to absorb the additional debt issues the government must be planning for the next few years. It will do so only if it believes that the government is able - economically, administratively and politically - to raise future taxes and/or to cut future public spending by enough to ensure that the increase in its total indebtedness net of the increase in the assets it acquires is matched by a correspondingly higher present discounted value of future primary government budget surpluses.

If there is doubt in the markets about whether the solvency gap of the banking system is smaller than the fiscal spare capacity of the government, we could have a UK public debt crisis. Fear of default would cause an across-the-board rush of out sterling assets. Fear that the authorities would choose to monetise the UK public debt and deficits rather than defaulting, would also cause a sharp decline in the value of sterling. The government would in all likelihood have to repatriate the monetary policy powers from the Monetary Policy Committee by invoking the Reserve Powers clause of the Bank of England Act, were it to wish to monetise public deficits and debt.

I also consider it unlikely that the authorities would be able to monetise enough of the debt of the state (including the socialised debt of the banks) to restore solvency. The reason is that much of the debt of the banking system is foreign-currency-denominated rather than sterling-denominated (total foreign currency liabilities and assets of the banking system are each over 200 percent of annual GDP). With the foreign currency liabilities of the banking system likely to have shorter remaining maturity and more liquid than its foreign currency assets (these are banks, after all), the UK would be likely to face a (partial) sovereign debt crisis as well as a foreign exchange liquidity crisis, even if the government tried to inflate its way out of trouble.

Because the Bank of England cannot issue foreign currency reserves, and because sterling is no longer a serious global reserve currency, the lender of last resort has to fall back on the deep pockets of last resort: the creditworthiness of the British state. That creditworthiness, I would argue, is now in worse shape than it has been since the days of the Stewarts. The reason is the fact that the UK authorities have effectively underwritten the balance sheet of the over-sized UK banking sector.


Recent sterling crises


Being a boring old fart is sometimes an advantage. My first year at university was 1967, the year of a sterling crisis - a 14 percent devaluation of sterling against the US dollar in a ‘fixed-but-adjustable’ (something like ‘slightly pregnant’) exchange rate regime with restricted international capital mobility. This was a twin crisis: a currency crisis and a government solvency crisis. These two coincident crises occurred because the political cost of (1) raising sterling interest rates to the level required to maintain the currency peg and (2) cutting public spending and/or raising taxes to restore government solvency, was deemed too high, even if it would have been economically and administratively feasible.

During the sterling crisis of the autumn of 1976, when the then Labour Chancellor Denis Healey had to go cap-in-hand to the IMF for a £2.3 bn support package, I was a Lecturer at the LSE, and could watch the crisis occur more or less in real time outside my window - the LSE is located just on the boundary between the City of Westminster and the City of London. The summer of 1976 I spent as a visitor at the IMF. This crisis too occurred under a fixed-but-adjustable exchange rate peg and limited capital mobility. It was a currency crisis and a government solvency crisis. The reasons were the same as for the 1967 crisis.

The sterling crisis of 1992, when the pound fell out of the narrow exchange rate band defining the ERMI regime (2.25% on either side of a parity defined with reference to the ECU) was an illustration of the inconsistent trio: free international financial capital mobility, autonomous national monetary policies and a fixed (or tightly managed) exchange rate. At least I got a book out of this crisis: Financial Markets and European Monetary Cooperation; The Lessons of the 92-93 ERM Crisis, Cambridge University Press, 1998, co-authored with Giancarlo Corsetti and Paolo Pesenti, two brilliant former Ph.D. students of mine. It again was a twin crisis: a currency crisis and a government solvency crisis. Again it was an unwillingness to raise Bank Rate to the level required to defend the ERM band and the political unwillingness to tackle the causes of the overvaluation of sterling through fiscal means (spending cuts and tax increases), that caused the crisis.


So a sterling crisis would not be something highly unusual, if your idea of the distant past is not the market trader’s last month. If we get a sterling crisis, it will be different from the three just discussed. This is, first, because it would be an exchange rate crisis in a floating exchange rate regime and, second, because it will not be a double crisis (sterling and sovereign debt) but a triple crisis (sterling, sovereign debt and banking).

The new sterling crisis that is threatening if the authorities persist in implementing a large fiscal stimulus without first reducing their exposure to the UK banking sector, can indeed be characterised as a ‘secondary’ or ‘derived’ crisis - mainly the reflection of a UK sovereign debt crisis. That UK sovereign debt crisis would itself be the result of an unsuccessful government attempt to save the UK banking system. The banking crisis is therefore the fundamental crisis of the triad: banking crisis, sovereign debt crisis, sterling crisis. Without the banking crisis, the government would not find itself exposed to a possibly unsustainable fiscal liability.

Mr. George Osborne, the shadow chancellor, has warned, quite fairly in my view (since I have written and said the same thing), that Gordon Brown’s proposals for tackling rising UK unemployment through fiscal measures that would materially increase the government deficit risked causing a run on the pound or a sterling crisis. Apparently, there is an unspoken convention in UK politics that opposition spokespersons do not say anything that might damage the economy and talk down the pound. This convention clearly has little or no merit. It is principally a neat trick for neutering the opposition during times of crisis. For some reason, talking up the pound is fine. More important, the convention does not tell you what to do when not saying something that might talk down the pound increases the risk that the government will engage in policies likely to damage the economy even more than would a run on the pound. Such, I would argue, is the position we find ourselves in today.

In any case, how likely is it that opposition warnings of a collapse of the pound if the government were to engage in reckless fiscal behaviour, would actually move the markets? At least one of the following two conditions would have to be satisfied.

First, the market was not aware of this risk before Mr. Osborne pointed it out. Well, I have news for the government. The markets have been aware of this risk for a long time. The sharp decline in sterling in the months before Mr. Osborne spoke is at least in part a reflection of the market’s fear that the government’s explicit and implicit commitments to save/bail out the over-sized UK banking sector may imply future demands on its resources that exceed its fiscal capacity.

Second, the statements of George Osborn shifted the focal point in a world with multiple equilibria for the same economic fundamentals to the disastrous equilibrium. For concreteness, consider a world with just two self-fulfilling equilibria: (a) there is a run on the pound, a sharp increase in interest rates on UK sovereign debt, severely restricted access by the UK government to the capital markets, and the collapse of a number of banks; the UK goes to the IMF and the EU for financial support; (b) there is no run on the pound, interest rates on UK sovereign debt remain moderate, the UK government can borrow freely in the international capital markets, and no major bank collapses; the Prime Minister goes to Washington and Brussels to lecture the world on how to manage financial crises.

As regards Mr. Osborne shifting the market’s focal point with the power of his rhetoric, I would have to say: possible, but not very likely. With the Labour government likely to postpone the next election to the last possible moment, Mr. Osborne will not have any economic policy instruments at his disposal for at least the next two years, other than his powers of persuasion. What kind of focal point would Mr. Osborne’s conjectures make?



What is to be done?


So what is to be done? The actions of the UK prime minister in Washington are not particularly useful, but won’t do any harm as long as he does not believe that they make a significant difference. I am a bit worried on that account. Every time I listen to Gordon Brown, his voice has descended another half octave. The only words he uses are: ‘statesmanship’, ‘leadership’, ‘responsibility’ and ‘determined and united global action’. Perhaps some UK voters are impressed by this increasingly lugubrious, smug and pompous-sounding migration from the camp of the light baritones to that of the basso profundo. Markets are not impressed. They want concrete policies and actions, not talk about action.


A couple of measures come to mind:

Reduce the exposure of the state to the banking sector.



If one or more systemically important UK banks were to be at risk of failing imminently, the distribution of the associated financial losses becomes a key political issue, financial stability issue and macroeconomic stability issue. Because the UK does not yet have a proper special resolution regime (SSR) for banks, the only ways the state can safeguard systemically important bits of the large UK banks is either by guaranteeing the liabilities or by injecting capital. The strongest version of a capital injection is nationalisation. The British state has done this for Northern Rock and Bradford and Bingley, neither of which was systemically important. It is about to tie the knot with RBS, which is systemically important. It has guaranteed new medium-term debt issuance by UK banks. It has de facto guaranteed all deposits, retail or wholesale. It has exposed itself to residential mortgage-backed securities and other asset-backed securities through the Special Liquidity Scheme.


The problem with nationalisation of the banks is that when the state owns a bank and the bank goes broke, if the state does not make all creditors whole (ensures that their claims are met in full), a bank default becomes effectively a sovereign default. To avoid that, it is essential that banks be put into some form of receivership before the state takes a controlling ownership stake in them. When the bank is in receivership, all holders of the bank’s unsecured debt, even the senior debt holders, and all other creditors, including unsecured senior creditors, can be made to pay a charge (suffer a haircut).

The alternative is that the tax payers or the current beneficiaries of public spending compensate in full the holders of unsecured bank debt and the banks’ other unsecured creditors. That would be outrageously unfair. It would also constitute the mother of all moral hazard. The creditors of the bank and the holders of the unsecured debt were essential participants in the process that created the excessive leverage taken on by the banks. There can be no reckless lending and investment by banks unless the banks have reckless creditors and reckless purchasers of their debt. These creditors and debt holders must be made to suffer financial losses if we are not to encourage even more reckless lending and investment in the future.

The problem with the insolvency process for banks in the UK is that there is no special insolvency process and insolvency regime for banks. When a bank is put into receivership, its creditors (including the retail depositors) find that their claims on the bank are frozen. Also, by the time the conditions for putting a bank into involuntary insolvency have been met (effectively balance sheet insolvency or liquidity insolvency), most of the systemic damage has already been done - all counterparty risk will have materialised and clearing and settlement systems for interbank payments and for securities sales and purchases will have been crippled. Financial paralysis will spread - think Lehman Brothers, where the absence of a proper SRR for investment banks/broker-dealers led to what Mohamed El-Erian calls a counterparty risk ‘cardiac arrest condition’ when Lehman sought bankruptcy protection on September 15.

It is incomprehensible to me why, almost 16 months after the start of the financial crisis, the UK still does not have a special resolution regime for banks. The failure to make this a top priority must count as a major dereliction of duty by the government.

An SRR with prompt corrective action (PCA) powers would allow a duly appointed Administrator or Conservator to take any systemically important bank or other systemically important highly leveraged institution into administration/conservatorship before the normal tests for insolvency (balance sheet insolvency or liquidity insolvency) had been met. The Conservator would replace board and management and suspend the voting rights and other decision rights of the shareholders. No dividends, share repurchases or other transfers of resources to the old shareholders could take place while the Conservatorship is in effect. The Conservator should be able to impose charges (haircuts) on all unsecured debt holders and other unsecured creditors, regardless of seniority. The Conservator would also be able to impose mandatory debt-to-equity conversions on all unsecured creditors and debt holders, with or without first extinguishing the equity of the old shareholders. The Conservator would have full authority to transfer liabilities, sell assets and generally to restructure the balance sheet and the activities of the business in any way deemed appropriate and lawful. Selling all or parts of the wreckage to the government would be an option. Finally, the Conservator would have the power to liquidate the company.

In the absence of a proper SRR for banks and other systemically important highly leveraged institutions, the government is faced with the choice between a messy and costly standard insolvency procedure and taking the bank into public ownership and thus making all unsecured creditors and holders of unsecured bank debt whole. That would be disastrous for medium and long-term financial stability in the UK.

By creating an effective SRR with appropriate PCA powers, the burden of a systemic rescue can be shifted from the government budget to the creditors of the banks and the holders of the banks’ debt - where it belongs. And this shifting of the burden need not impair the continued ********ing of the systemically important parts of the banks.

By thus limiting its contingent exposure to the balance sheet of the banking sector, the UK government would materially reduce the risk of a sovereign debt crisis and a sterling crisis triggered by a fear of government insolvency. Even fundamentally solvent entities, private or sovereign, can, however, be subject to illiquidity crunches.

Reduce the threat of a foreign exchange liquidity crunch by (a)announcing that the UK is actively pursuing EMU membership at the earliest possible date and (b) adopting a peg with the euro.


Immediate euro zone membership, with full access to the resources of the Eurosystem would be the first-best option for the UK today. Unfortunately, once the majority stake in RBS is accounted for, the UK does not meet the debt criterion for EMU membership (gross general government debt less than 60 percent of annual GDP). Nor does the UK meet the Maastricht deficit criterion (general government financial deficit less than 3 percent of GDP). The inflation criterion will probably be met, as the inflation spikes in the UK and in the rest of the EU seem to be well-synchronised. The interest rate criterion will not pose any problem. There will have to be some changes in the relationship between the Bank of England (which does not meet all the criteria for central bank independence demanded of Eurosystem-ready central banks) and the government, but these are minor issues.

By setting a fixed peg for sterling vis-a-vis the euro (or a central parity with very narrow fluctuation margins (no more than 1 percent either side of parity) the UK could start forthwith the (at least) two-year process of meeting the exchange rate criterion for EMU membership (two years of membership in the ERM without strains or stresses). It is possible that the European Council would decide to waive the Maastricht criteria for the UK: an exceptional country facing exceptional circumstances. Possible, but not likely.

For the UK to enter a narrow-band ERMII, the mandate of the Bank of England would have to be changed to an exchange rate target as the primary objective. Subject to that, the MPC would have to try to meet the inflation criterion for EMU membership. Subject to that, it could support the UK government’s other objectives, including growth and employment. It makes no sense to target two nominal variables at the same time. The exchange rate criterion has to take precedence over the inflation criterion, because you can launch a speculative attack on sterling but not on the general price level.

A currency peg with the euro would make sense only if it were done in full agreement with the ECB and with the complete support of the ECB and the other euro zone member states. It would probably be at a slightly less depreciated value of sterling than the current one, to avoid providing the UK with a temporary excessive competitive advantage.


“ERM II also comprises a commitment to unlimited intervention credit between the ECB and the central bank of the participating country”, as the Central Bank of Denmark (which is part of ERMII), points out on its website. What the website of the Central Bank of Denmark does not mention (although a link to the ECB document that does mention it is provided) is that, although the central rate against the euro and the standard fluctuation band will be in principle supported by automatic unlimited intervention at the margins, “… the ECB and the participating non-euro area national central banks could suspend automatic intervention if this were to conflict with their primary objective of maintaining price stability.” This suspension can be initiated unilaterally by either party.


What this means is that for ECB support (essential for the defense of the central parity and the band) to be forthcoming, policies acceptable to the ECB would have to be pursued by the British government across the spectrum of relevant policies, including the setting of Bank Rate, liquidity management and fiscal policy.

With the maintenance of an exchange rate peg as its overriding target, the Monetary Policy Committee of the Bank of England (MPC) would, if required, hike interest rates to deter or defeat an attack on the peg. Because the MPC would continue to be operationally independent, it would be unlikely to suffer the Norman Lamont credibility problem of 1992. The markets knew that no elected Chancellor of the Exchequer would be able to put Bank Rate up to 15 percent and survive. The peg (band) therefore collapsed.

With an unelected MPC, the threat that rates would be raised to whatever level required to defend the peg would be credible. Consequently, rates probably would not have to be raised to very high levels at all. With sufficient credibility, Bank Rate would follow the euro area official policy rate down. It would do so quite gradually, because the ECB is controlled by rabid gradualists. However, the alternative would not necessarily be a more rapid sequence of cuts in Bank Rate under the counterfactual of continued UK monetary independence. Instead, it could be a sequence of UK Bank Rate hikes and fiscal tightening measures to fight off a sterling collapse and a sovereign debt crisis. Hiking the official policy rate and fiscal tightening is, after all, what befell Iceland and Hungary after they lost fiscal credibility and were forced to seek out the tender mercies of the IMF. And 1976 is but 32 years ago.


Conclusion



I believe that the risk of a UK sovereign debt crisis and a full-blown sterling crisis would be much diminished if the authorities were to reduce their contingent exposure to the balance sheet of the UK banking system by legislating a special resolution regime for UK banks and other systemically important highly leveraged institutions. To attempt a significant fiscal stimulus (say 2 percent of GDP or £30 bn per year for two years) without at the same time reducing the government’s financial exposure to the UK banking sector would create an unacceptable risk of a sovereign debt crisis and sterling crisis. It would be reckless.

Pegging the bilateral exchange rate of sterling vis-a-vis the euro as part of the formal entry of sterling into ERMII would, if it were done with the full support of the ECB and Britain’s European partners, further stabilise the financial and macroeconomic situation of the country. Taken together, these two measures would do much to remove the sovereign insolvency and foreign exchange illiquidity risks faced by the British economy.

Iniciado por SilviuOG

Me lo tengo que leer todo para responderte ?
Alguien nos puede poner una resumen ?

Menudo tocho...

El personaje que está hundiendo el Reino Unido y al Santander con él

@S. McCoy - 18/11/2008 06:00h




Ha tomado el relevo de Roubini en cuanto a los mensajes apocalípticos se refiere. Un Roubini, por cierto, que la semana pasada se apuntó a la moda de S&P500 a 500 (40% de caída adicional) que tanto predicamento empieza a ganar al otro lado del Atlántico, vista la debilidad de la economía real norteamericana y su impacto sobre los beneficios empresariales. No es el único. El CEO de Best Buy ya comentó, coincidiendo con la publicación de resultados de su compañía el miércoles, que en 42 años vinculado a las distribución minorista jamás había visto una crisis del consumo con la actual en Estados Unidos; una demanda privada que, no lo olvidemos, supone más de dos terceras partes de su PIB nacional. El dinero percibido por los ciudadanos o se mete en el calcetín, con el consecuente y sustancial repunte de la tasa de ahorro que ha doblado en cinco meses (del 1,1% al 2,3%), o se dedica al repago de deudas. Poco más. Y en un entorno como éste, las ventas caen, los márgenes sufren y las deudas pesan más que nunca tanto en el balance como en la cuenta de resultados.

Pero no nos distraigamos de nuestro tema central de hoy. ¿Quién puede equipararse a Roubini en el dudoso podio del “agorerismo”, al menos por lo que a la economía británica se refiere? Un viejo conocido de todos ustedes: Willem Buiter, profesor en la LSE y antiguo Economista Jefe del Banco Europeo para la Reconstrucción y el Desarrollo. Y lo hace a través de sendos artículos de reciente aparición en la prensa digital. El analista transita de lo genérico a lo específico en su blog del Financial Times Maverecon y, si el pasado día 13 se centraba en la posibilidad de que Reino Unido siga los desgraciados pasos de Islandia, llegando por tanto a la bancarrota, en el post de ayer lunes lo concreta en lo más específico y evidente: una más que plausible crisis de moneda que pasaría de una mera corrección de la sobrevaloración de la libra a un problema de asignación de activos e inflación. Ambas piezas son dignas de lectura pausada y, el hecho de que hayan sido publicadas precisamente antes y después de la Cumbre de Washington, no deja de poner de manifiesto la incredulidad, que con él comparto, acerca de la viabilidad final de los postulados del G-lo-que-sea en un entorno de “Sálvese quien pueda” a nivel nacional. Por su interés, a los efectos que nos ocupa, nos centraremos en el estudio de la primera que viene, no obstante, adecuadamente resumida en la segunda.

¿En qué se basa Buiter? Los problemas de UK no son muy distintos a los de Islandia en el sentido de que su peso en la economía global es reducido (apenas un 3,3% del PIB Mundial), depende extraordinariamente de la actividad exterior (hasta cuatro veces más que Estados Unidos) y es tomadora de precios tanto en la economía real como en la financiera; su sistema bancario está sobredimensionado (el balance agregado del sector es un 450% del PIB nacional, frente al 900% de Islandia y el 650% de Suiza pero sobre una base de cálculo muy superior) y excesivamente expuesto internacionalmente (algo más del 55% del total) a la vez que el Banco de Inglaterra carece de músculo suficiente para frenar la salida de capital denominado en divisa foránea; la libra esterlina no es moneda internacional de reserva (apenas el 4,7% del total mundial frente al 64% del dólar o el 27% del euro); y la capacidad fiscal del país es limitada y más después de las sucesivas intervenciones en el sistema financiero local.

La interrelación es a juicio del autor evidente. Hay una crisis bancaria que ha provocado la participación del dinero público en el sector. Un fenómeno que no se va a detener donde se encuentra ahora sino que se va a extender al conjunto de las principales entidades del país, incluido el Santander-Abbey, debido el deterioro del resto de los ámbitos geográficos en los que la entidad actúa. Para Buiter es un futurible realista. La nacionalización de TODA la banca implica, en su opinión, un coste de partida equivalente al 20% del PIB de UK (que podría ser muy superior si nos atenemos al augurio pesimista del Citi en este impagable post), deja su contabilidad nacional con un déficit 2009 cercano al 7%, consecuencia del aumento del numerador pero también de la caída del denominador, y dispara la deuda soberana por encima del 100%. La capacidad de maniobra del gobierno se ha reducido drásticamente y el aumento de las rentabilidades a ofrecer para captar en competencia liquidez en los mercados podría dejar sin efecto los estímulos fiscales al sector privado de la economía, generando lo que se llama efecto crowding out (algo de lo que ya hablamos el jueves en este Valor Añadido). No sólo eso. Podría darse el caso de que no hubiera quien financiara sus emisiones. La moneda es el mejor indicador para seguir la confianza del público en la economía de un país ya que suele actuar como preludio de dificultades de mayor calado. De ahí que sea fundamental seguir su curso. Y éste es, para el analista, si no dramático, al menos preocupante.

A partir de ahí, Buiter desarrolla tres propuestas paralelas para Reino Unido. Utilizar el margen de la política monetaria y rebajar adicionalmente los tipos de interés como contrapeso a la falta de cintura fiscal, en primer lugar. Reducir, en segundo término, el peso del sector bancario en las cuentas públicas mediante la creación de una figura de intervención de las firmas en dificultades que tenga libertad de acción y reordene, bajo supervisión de las autoridades, la actividad de las entidades afectadas pudiendo llegar incluso a obligar la conversión de deuda privada por capital, de forma tal que la responsabilidad y el perjuicio de la mala evolución de la sociedad quede en manos de sus accionistas y acreedores, como en cualquier otra empresa privada. Por último, entrada coordinada de la libra en el euro a través de un proceso temporal no superior a dos años que permita adecuar la economía británica a los requisitos de Maastricht (ah, Buiter, qué purista: ya me dirás tú dónde estarán en 24 meses los criterios antaño garantes de la sobriedad. Nos vamos a reir).

Señalaba hace poco Andrew Garthwaite de Credit Suisse que la economía británica se situaba dentro del Top-5 mundial de los países en peligro macro. La noticia no dejó de ser tomada como una anécdota por algunos. Ganas de darse significancia. Sin embargo, el riesgo está ahí. Y más cuando algunos expertos sitúan la recuperación del sector inmobiliario inglés (tan excesivo en precios como el español pero, ojo, mucho más reducido en oferta disponible) para dentro de una década. El riesgo para el Santander, no reflejado en sus CDS que siguen alrededor de los 80 puntos básicos, es evidente. Lo hemos dicho hasta la saciedad. Esta es una crisis única por su dimensión. Y por tratarse de la primera crisis global que hace de la diversificación geográfica un atenuante pero no un eximente de incertidumbre. La paciencia es un valor esencial en tiempos como los actuales ya que lo bueno es malo y lo malo peor de la noche a la mañana. Aunque cuando triunfan los adalides de la destrucción suele ser momento de mirar con cariño los mercados, aún no ha llegado la hora. Mejor mantener con cautela.