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
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 functioning 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.
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.