Thought we were on the long road to recovery; that economies and financial systems were now back in rude health; that interest rate cuts and quantitative easing were likely to push us out of recession and generate another boom? Not so fast. When the ministers and central bankers from the world's richest nations met last month in Washington there was little room for back-slapping. Sure, they had seen their economies through the worst of the financial crisis. Most banks had been rescued from full-scale implosion. Governments had taken drastic measures to shore up their capital and ensure their survival. But the mountain of debt that had poisoned the financial system had not disappeared overnight. Instead, it has been shifted from the private sector onto the public sector balance sheet. Britain has taken on hundreds of billions of pounds of bank debt and stands behind potentially trillions of dollars of contingent liabilities. If the first stage of the crisis was the financial implosion and the second the economic crunch, the third stage – the one heralded by Johnson – is where governments start to topple under the weight of this debt. If 2008 was a year of private sector bankruptcies, 2009 and 2010, it goes, will be the years of government insolvency. That, at least, is the horror story. It was one underlined by S&P's decision to change the outlook on Britain's debt from "stable" to "negative". While the UK still clings on to its prized AAA rating, it now stands a very real chance of losing it within two years – 37pc if past experience is any guide. Questionable as are the credentials of the agencies following the financial crisis, the significance should not be underestimated – particularly not in the case of the UK. A cut in S&P's ratings would reflect a considered opinion that this country may default for the first time in its history. If Japan's experience in 2001 is anything to go by, it would also trigger an instant exodus of cash from foreign investors, since many of their reserve managers are obliged to invest the vast bulk of their cash in AAA-rated currencies. And all of this is before one even factors in the humiliation such an experience would be likely to inflict on the Government – whatever hue it is by then. But in spite of all this potential fire and brimstone, the reaction from financial markets in the wake of the S&P announcement was hardly dramatic. Gilt prices dipped sharply, but recovered their poise after a few hours. The FTSE 100 fell, but recovered the following day. After dropping precipitously straight after the announcement, the pound bounced back sharply. As the week ended it was knocking on $1.59 – the highest level since last November and hardly a currency in the midst of an obvious crisis. Moreover, according to Simon Derrick of Bank of New York Mellon, who monitors the actual flow of cash streaming in and out of the economy, there was little evidence from activity on Thursday and Friday to suggest that the S&P decision had suddenly swung investors away from the UK. "Flows into sterling-denominated fixed income have certainly flattened out over the past month," he said. "There is a caution about buying anything sterling-denominated. It's early days, but it hasn't deteriorated much further since Thursday. And the pound still compares very well against dollar and euro-denominated debt. It seems to me that investors aren't looking at the UK in any more negative a light than the US or eurozone." Indeed, so far as markets were concerned, a couple of disastrous headlines for the Government – the S&P decision and the IMF's verdict on the management of the economy the previous day – were no more a concern than the latest nasty set of economic output or employment data from the Office for National Statistics. Still, capital markets are unpredictable. As emerging markets – which have suffered sudden crises as international investors abandoned ship – know to their cost, creditors can turn on a sixpence. It is a cause for real concern in Whitehall, where officials and politicians are under little delusion about how reliant Britain is on support from the capital markets. The Government is set to run a major deficit for the next five years at least, as it borrows deep to avoid the recession intensifying and satisfy its spending pledges. Unless the Government can borrow this cash, it will be forced to raise taxes and cut spending at an eye-watering rate. Foreign investors hold around a third of UK debt – most of it in the short-term gilt market. Unlike Japan, which had a massive saving glut when it lost its AAA-rating, the UK is directly vulnerable if their central banks and sovereign wealth funds turn a cold shoulder on sterling. Says one money market insider from a major investment bank: "We were called in by a major foreign central bank only the other week. They were asking probing questions about the stability of British debt and the long-term stability of the UK economy. They are genuinely worried." But in reality the provenance of the cash is less important than the sheer level of revulsion towards the economy. In the 1970s, when the UK faced its last funding crisis and had to be rescued by the IMF, it was the exodus not of foreign investors but of domestic creditors, who relocated their cash to Switzerland and elsewhere, that caused the real problems. As things stand, the UK is the first of the major G7 economies to have been put on watch during this crisis (Japan is already AA). Were it the only country under real threat of downgrade, it would be easy to make baleful predictions about the impact. However, the economic crisis has touched every nation. The UK is likely to be joined by other countries as the full scale of the downturn becomes apparent and more financial skeletons are pulled from the sub-prime closet. Indeed, the day after the S&P announcement more attention was on the US, which, according to Bill Gross of bond giant Pimco, is just as likely to lose its AAA rating in the coming years. Indeed, the S&P decision seems in fact to have moved the US Treasury yield even more than it did Britain's gilt yield. Neither is it inconceivable that if the recession remains truly global and intensifies rather than mellows in the coming year, we could find ourselves in a world where there are no AAA-rated sovereigns. According to Julian Jessop of Capital Economics: "If conditions deteriorated to the extent that the US were downgraded, many other countries would presumably be in just as big a mess and any hit on the dollar might be at least partially offset by safe haven buying. Sterling could not rely on the same support. But overall, we suspect that the blow to national pride from a rating downgrade would be much greater than the additional harm caused to the financial markets." So while we may suspect this is how the next stage of the financial crisis will look, it is harder to grasp which countries, or for that matter which businesses or investments, will benefit and which will suffer. Central banks are likely to invest some of their cash in commodities such as gold and oil; tangible assets will become more desirable – perhaps housing may enjoy another boost. For Governments, survival is based on relative rather than absolute strengths. Countries that provide the most feasible and sensible fiscal plans are likely to thrive as they garner investment and support, while those that churn public money while failing to mend their financial systems are the most likely to suffer. And it is this final point which is perhaps the silver lining for the UK. The S&P announcement this week represented something of an ultimatum. The statement warned that unless the party that wins the election shows clear and convincing signs of putting the fiscal books back in order, a downgrade will surely follow. Neither Gordon Brown nor David Cameron will like it, but this could be the final stick that beats back their first Budget into order. It means they will be forced either to slash spending or raise taxes in as soon as a year. No one will much enjoy this but if it helps preserve Britain's ratings, and thus ensures the UK can keep financing itself, it will be a pain worth suffering. For in the final stage of this crisis, those countries that recover and start to flourish will be those that face up soonest to the new period of fiscal austerity that must last for the next decade.S&P’s warning to Britain marks the next stage of this global crisis
"This is the next stage of the global crisis." Simon Johnson, former chief economist of the International Monetary Fund (IMF), is hardly renowned for hyperbole, so his description of the events of the past week, including Standard & Poor's warning over Britain's creditworthiness, is difficult to ignore.
Sunday, 24 May 2009
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