Sterling in crisis – will it end in tears?

While some northerners see opportunity in the form of southern shoppers from sterling’s precipitous fall in recent months, others in Great Britain are less sanguine about the benefits accruing from the weakness of the British currency, not least because of Gordon Brown’s budget profligacy to try and encourage consumer spending in the UK as a whole. Willem Buiter, Professor of European Political Economy at the London School of Economics and Political Science highlights some of huge issues facing the British economy and the currency in particular. Buiter points to the exposure the British government has to the banking sector in the country:

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.

While Brown may be feted by the international community for his actions in the financial crisis to date, David McWilliams is less complimentary, believing he has made a huge mistake by “buying stakes in the British banks too early and has lost a fortune of taxpayers’ money as a result”.

More worringly, this exposure looks likely to grow, according to Buiter.

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, then there will be a further sharp decline in the value of sterling with the authorities unable 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.

While Buiter recommends the UK considers membership of the eurozone, this remains a political impossibility so what are the alternatives and, more importantly, the possible consequences?

The UK is on a borrowing spree it cannot afford. It runs a trade and current account deficit, which means that inflows of capital from abroad are required to balance its external accounts. But as the UK government spends and borrows more to help offset the recession, the returns for foreign investors have fallen. Also, further interest rate cuts and increased government spending mean the currency will most likely fall further.