Britannia Radio

The apocalypse is now actually being  forecast.

In Conway's first piece he has retracted his cautious warnings and 
gone for strong ones.  He says "the bail-out package unveiled 
yesterday has failed dismally" and adds (music to MY ears!) that the 
government , must urgently say "how they intend to cut government 
debt over the coming years - preferably with a set of swingeing 
spending cuts."

Ambrose Evans-Pritchard spells out the details and the scale of the 
disaster.

(More economic postings later)

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TELEGRAPH    21.1.09
1. A one-in-ten chance of a UK Government default
Posted By: Edmund Conway

So markets now reckon the UK stands a one in ten chance of defaulting 
on its sovereign debt over the next half decade. That, at least, is 
what the credit default swap on British government securities tells us*.

The CDSs are a measure of the amount investors are paying to insure 
against the likelihood of the UK defaulting. You have to take them 
with a pinch of salt, since they are a pretty illiquid and young 
market, but set against a rather terrifying backdrop they are telling 
us something profoundly alarming today. Britain's creditworthiness is 
crumbling.

In fact, a more reliable metric for this is the yield on the 10-year 
government bond. This has leapt by almost 50 basis points in the past 
few weeks, during which period the Bank of England has announced 
dramatic monetary policy measures which in a normal world would have 
sent gilts to record lows. Put this together with the fall in 
sterling, the CDS spread and the general sense of alarm I've picked 
up from money market traders since yesterday, and it is fast becoming 
clear that the bail-out package unveiled yesterday has failed dismally.

Far from reassuring investors, it has actually served to remind 
everyone in the markets just how exposed the UK is to the global 
financial crisis. Perhaps people hadn't really twigged just how 
inevitable it was that more banks would have to be nationalised; 
perhaps they thought the system would recover; perhaps they expected 
the Treasury to come out with a wonderplan, a silver shotgun 
cartridge with which to pepper the entire crisis. Either way, they 
were severely disappointed yesterday.

I have spent much of the past month or so trying to reassure my 
fellow colleagues and acquaintances that despite the pound's decline, 
the UK is not on the brink of either insolvency or disaster. I cannot 
do so any longer.

Most damaging of all has been the destruction of the illusion that 
anyone in Whitehall really has a clue how to sort out this crisis. I 
believe it is not impossible to bring us back from the edge but it 
will take a major and unprecedented turnaround on the part of the 
Government. They must come out - very soon - and set out precisely 
how they intend to cut government debt over the coming years - 
preferably with a set of swingeing spending cuts. These need not 
begin until the recession is over, but until the Government 
undertakes to carry them out, or produces a better bail-out package 
that involves a real "bad bank" and a means of pricing illiquid 
assets, the market will keep selling off sterling.

As the new leader of the free world said today, whatever happens, the 
next few years will be tough. However, our Government risks making 
them that bit tougher.
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* From Capital Economics today: "The 5-year credit default swap for 
the UK government has widened by 25bp since early January. Assuming a 
40pc recovery rate, the current cost of insurance implies a 
cumulative probability of default over the next half decade of 10pc"
====================AND---->
2.UK cannot take Iceland's soft option
The British government faces an excruciating choice. It cannot let 
Royal Bank of Scotland and its fellow mega-banks go to the wall. Yet 
it risks being swamped by the massive foreign debts of these lenders 
if it takes on their dollar, euro and yen exposure by opting for full 
nationalisation.

By Ambrose Evans-Pritchard

Britain has foreign reserves of under $61bn dollars (£43.7bn), less 
than Malaysia or Thailand. The foreign liabilities of the UK banks 
are $4.4 trillion - or twice annual GDP - according to the Bank of 
England. The mismatch is perilous.

It is why sterling has crashed 10 cents from $1.49 to $1.39 against 
the dollar in two days. The markets have given their verdict on 
Gordon Brown's latest effort to "save the world".

Credit default swaps (CDS) measuring risk on British debt have 
reached an all-time high of 125, just below Portugal. The yield 
spread on 10-year Gilts over German Bunds has doubled to 53 since 
last week.

Standard & Poor's has quashed rumours that it will soon strip Britain 
of its AAA credit rating - an indignity averted even after the 
International Monetary Fund bail-out in 1976. But there was a sting 
yesterday as it responded to the Treasury plan for the banks. "Market 
confidence in the sector has eroded to such a degree that it is not 
clear whether these measures by themselves will bring about a 
material improvement," the IMF said. "As a result, full 
nationalisation of some banks remains a possibility in our view."

Spain was relegated from AAA to AA+ on Monday, and Spain's public 
debt is a much lower share of GDP.

"If Spain can get downgraded, then the risks for the UK are self-
evident," said Graham Turner, of GFC Economics. "The increase in the 
UK gross public debt burden - 11.8 percentage points in just one year 
- is troubling. The market rightly fears the long-term fiscal costs 
of a collapsing banking system. Rising Gilt yields are the main 
impact of the botched move from the UK Treasury."

Mr Turner said the British Government had taken far too long to 
resort to quantitative easing - printing money - and had wasted 
months with fiscal frippery as debt deflation throttled the banks.

The parallels with Iceland are disturbing. The country was ruined by 
the antics of its three big banks. They built up foreign liabilities 
equal to 900pc of GDP. Operating as hedge funds, they borrowed in 
dollars, euros and pounds to speculate. However, the state lacked the 
foreign reserves to match this leverage.

But Iceland at least had the luxury of letting banks default - 
shifting losses on to the rest of the world. It refused to honour 
foreign debts.
"They drew a line," said Jerry Rawclifffe, who tracks Iceland for 
Fitch Ratings. "They created new banks, parking the old losses in 
resolution committees. It is not easy for other governments to walk 
away. They have a duty of care."

Indeed, if Britain walked away from UK banks' $4.4 trillion of 
foreign liabilities - worth eight times Lehman Brothers - it would 
destroy the credibility of the City and take the whole world into 
deeper depression.
"The UK cannot go down that route because it would set off an asset 
price death spiral," said Marc Ostwald, a bond expert at Monument 
Securities. "The Western banking system is already on life support. 
That would turn it off altogether."

So whatever the temptations, and whatever the feelings of 
righteousness over the follies of the RBS leadership in its debt-
driven campaign of Napoleonic expansion, the Treasury is wedded to 
the banks and all their sins. Chancellor Alistair Darling cannot copy 
Iceland.

S&P's lead UK analyst, Trevor Cullinan, said the Government faces a 
"severe test" and will be judged by its actions, but he doubts 
whether matters will reach such a dangerous pass.

"The challenges to UK banks are significant amid a correction in 
property prices and a contraction of GDP. Nevertheless, the situation 
is very different from Iceland. The UK benefits from sterling, which 
is a major global funding currency. UK access to external funding is 
far more secure. In a worst-case scenario we estimate the cost of 
recapitalising the UK banking system to be in the region of £83bn 
(5.7pc of GDP)," he said.

The Government can take out derivatives contracts on currency markets 
to hedge the foreign debt risk. Perhaps it already has. The banks 
have $4.4 trillion foreign assets to offset their liabilities, of 
course. But what is their real value in this climate?

Britain is not alone in its current distress, although the fall in 
sterling speaks for itself. The sovereign debt of Russia, Ukraine, 
Greece, Italy, Belgium, Austria, The Netherlands, Ireland, Australia, 
New Zealand and Korea is all being tested by the markets. The core of 
countries deemed safe is shrinking by the day to a half dozen. Sadly, 
Britain is no longer one of them.