The UK's Problems Are Ours, Too

01/08/2010 9:35 am EST

Focus: MARKETS

Jim Jubak

Founder and Editor, JubakPicks.com

The United Kingdom is careening toward a possible currency and credit crisis that would make the world's investors even more leery of the United States.

It's one thing when it's Greece or Portugal. A credit downgrade or warning for those countries isn't exactly headline news for most investors. For most of our portfolios, these are peripheral markets.

Ireland in trouble, too? Yawn. Don't own any Irish stocks.

Italy? What's new? Italy's always running a deficit.

Spain? That's a surprise. Time to check the portfolio. But, whew, don't own any Spanish stocks.

The United Kingdom? Whoa. Now we're getting serious. How could the home of Big Ben, Queen Elizabeth II, the Bank of England, the pound sterling, and clotted cream be facing a credit downgrade?

Or maybe even worse?

The cost of insuring against a UK default in the derivatives market is only slightly lower than the price of insuring against a default by Portugal.

I don't think the United Kingdom is headed toward a default on its debt. But it is in the midst of a crisis that could reopen wounds in a global financial system that is still healing from the last crisis.

And it's not even on the radar screen for most US-based individual investors. I'd put a currency and credit crisis in the United Kingdom at the top of my list for huge, potentially market-shaking—and unexpected—events in 2010. (For more on the most expected, but still potentially market-shaking financial crisis of 2010—that is, Japan—see this recent post titled "Japan's huge budget gamble will push up global interest rates.")

Well, put the UK on your radar screen now. That fast-moving blip is one that you need to be tracking. A financial crisis in the United Kingdom would be bad enough on its own, but I'm 100% certain that the moment a crisis gets down-and-dirty nasty in London—and it's certainly headed that way—investors around the world will start asking: If it can happen in the United Kingdom, why not in the United States?

Fail, Britannia?

Here's the problem: The financial and economic collapse in the United Kingdom was even worse than in the United States. And the country, despite huge bailouts and stimulus spending, looks like it will be the last developed economy to return to economic growth.

Without growth, only scorched-earth budget cuts can bring the United Kingdom's deficit under control—even within five years. And with an election looming, neither the government nor the opposition is laying out a budget-cutting plan capable of convincing global financial markets that the country is committed to a solution.

That has sent the pound sterling plunging, interest rates on government debt climbing, and investors fleeing UK assets. The country is edging toward the point where the financial markets take control of the crisis out of the hands of the government.

The immediate problem goes back to the budget. Thanks to stimulus spending and weaker tax receipts, the UK's budget deficit is forecast to hit 12.6% in the fiscal year that ends in April.

But the long-term problem is that the country has been living beyond its means for years. A red-hot housing market built on cheap debt disguised the fact that UK consumers were spending more than they could afford and financing that spending with debt. The country's external accounts were just as out of balance. In 2006—that was before the global economic crisis—the UK showed a trade deficit of almost 56 billion pounds. That was the largest deficit since the country started keeping records in 1697.

Only oil production from the North Sea fields—and production there is now falling— kept the external deficit from being even worse.

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Does that sound like any other country in the world? I'll give you a hint: Its name also starts with a "U," and it's not Uganda, Uruguay, Ukraine, or Uzbekistan.

Projections built on the current budget call for the United Kingdom to borrow an additional $1.13 trillion (or 707 billion pound sterling) over the next five years— impressive when you remember that the UK economy is only about one-fifth as large as the US economy.

That borrowing would bring the UK national debt to about 98% of gross domestic product by 2014, according to the International Monetary Fund (IMF). In comparison, the United States, based on current trends, will finish 2014 with a debt-to-GDP ratio of 108%, according to the IMF. See why I'm worried that a UK crisis could easily become a US crisis?

Countries can run up as much debt as lenders will allow. And right now, the signs are that lenders are getting nervous about keeping the tab running for the United Kingdom.

The pound sterling is down 23% against a trade-weighted basket of currencies since September 2007, and it's down 29% against the euro.

Since November, the yield on UK government ten-year bonds has climbed to 3.96% from 3.52%, in order to keep investors buying. That's about twice the increase in the yield for German ten-year bonds during the same period. Interest rate increases in the United Kingdom have been that small only because the Bank of England has been buying government bonds as fast as it can. With everyone expecting that program to start winding down in 2010, the worry is that bond yields will start to zoom higher.

Bond traders are projecting that UK government yields could climb as much as two or three more percentage points in 2010.

Worry is increasing that the country's AAA debt rating could be at risk. Standard & Poor's lowered its credit outlook for the United Kingdom to negative from stable back in May.

And some big international bond investors have announced that they are cutting their holdings of UK government bonds. Pimco, for example, which manages $948 billion in assets, has said that it is cutting back on its holdings of UK bonds. (Pimco has also said it is cutting its holdings of US government bonds.)

It's Worse This Time

So how does this end? A lot depends on the UK elections scheduled for sometime before June. If that election results in a solid majority government—a Conservative win that ousts the current Labour government would be most likely to yield that result—that can present the financial markets with a budget plan that seems credible, then the country will dodge the worst of the crisis. Any solution, though, wouldn't be painless. It would require tax hikes, a depreciation of the pound sterling that lowers living standards, and major budget cuts that would fall hard on government services.

Yep, that's the good news. (And in its outline, it's what the United States would face if it got serious about its budget deficit.)

An election that resulted in a UK government too weak to deliver convincing financial change would be worse. The country would see capital flight, an even steeper drop in the value of the pound, and a rise in interest rates that could be enough to send the economy back into recession.

And a second recession would leave the country still facing a huge budget deficit and the stark choice of raising taxes in a recession or having investors flee the pound and UK government bonds.

A crisis wouldn't be the end of the United Kingdom. The country has been through horrible financial implosions in the past 40 years, including a crisis in the pound in 1976 that brought the International Monetary Fund in for a "rescue" and in 1992 when George Soros busted the pound and ended the country's role in the European exchange rate mechanism.

But this time, the crisis is more serious because it's not just a crisis for the United Kingdom, but for the developed economies of the United States, Japan, Spain, Italy, and…

Frankly, I'm really, really rooting for the United Kingdom to work its way of this bind without a full-scale financial crisis. The last thing I want is a crisis that would focus everyone's mind on how similar the budget picture looks here.

More from Jim Jubak:
How to Buy into Emerging Market Stocks Now
 
Jim Jubak has been writing "Jubak's Journal" and tracking the performance of his market-beating Jubak's Picks portfolio since 1997 on MSN Money. He is the author of a new book, The Jubak Picks, and he writes the Jubak Picks blog. He is also the senior markets editor at MoneyShow.com.

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