Westminster blog

It’s the question being asked today – and the best explanation I’ve seen is in this morning’s Lex column:

Britain came off the gold standard in 1931 and sterling devalued by 28 per cent. The economic crisis that followed marked the end of the UK as a global power. It also led to an effective default on almost half the national debt, which was restructured into bonds still outstanding. Parallels with today are eerie. Since the middle of 2007, the trade-weighted pound has fallen by 27 per cent. Furthermore, as the government shoulders contingent liabilities for ever greater amounts of delinquent bank debt, worries are growing about the state’s finances.

British banks have about £4,000bn of assets on their balance sheets, equivalent to 2.5 times gross domestic product. If losses on these assets accelerate, the banking bail-out could segue into a sovereign debt crisis. Investors might push up borrowing costs, then, if rattled, refuse to buy UK government debt altogether, triggering another run on the pound.

So far it has not panned out that way. Spreads of 10-year UK government bonds over German bunds tightened up to Christmas. This year, though, spreads have widened and the cost of insuring against sovereign default has risen. In the credit default swaps market, the UK is viewed as a riskier borrower than France and similar to Spain.

A back of the envelope calculation illustrates why. Assume the state takes ultimate responsibility for all of Britain’s banks. Further, assume that 15 per cent of those banks’ assets are worth nothing. The write-off would be equivalent to about £600bn or a third of GDP. Britain’s debt to GDP ratio is about 54 per cent; add in these and other bail-out costs and the ratio could easily double. That would make the UK comparable to Belgium, Greece and Italy – none of which, as Merrill Lynch notes, has a triple A credit rating.

A downgrade could cost the UK dear. Investors obliged to hold only triple A paper would have to sell – as Spain may soon discover following its own rating downgrade yesterday. In another world, this might cause a run on the pound. In this world, however, sterling’s saving grace is that no other currency, even the euro, is in a much better situation.

UPDATE

Latest news: sterling plummets