Replies to post #34300 on Abet Chichi2 (Chichi2)

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Nouriel Roubini - Is the U.K. an Iceland 2? No but there are serious financing risks ahead. By Nouriel Roubini | Jan 23, 2009


I am in London for a few days and I was recently interviewed by BBC News TV and Radio about the state of the U.S., U.K. and global economy (links to these interviews are below in this piece). While in London I was repeatedly asked by media and financial sector folks whether the UK was an Iceland 2, i.e. whether it would end up having an insolvent government and country. The statements this week the by famed investor Jim Rogers - that the UK was essentially kaput and that investors should dump UK assets and the pound sterling - were widely reported here in the UK and caused a stir at the time when the economy was officially declared in a recession, when the pound is falling, when most UK banks look as insolvent as their US counterparts and when some people are starting to wonder whether the UK may need to go and beg the IMF for a bailout. Indeed most UK banks will be formally or informally nationalized with a significant fiscal cost of their bailout at the time when the fiscal deficit will surge because of a severe recession.

So what is the risk that the UK will be Iceland 2? Let us discuss next this issue in more detail:

In many ways the UK looks more like the US than Iceland: a housing and mortgage boom that got out of control; excessive borrowing (mortgage debt, credit cards, auto loans, etc.) and low savings by households; a large and rising current account deficit driven by the consumption boom (and private savings fall) and the real estate investment boom; an overvalued exchange rate; an over-bloated financial system that took excessive risks; a light-touch regulation and supervision system that failed to control the financial excesses; and now an ugly financial and economic crisis as the housing and credit boom turns into a bust. This will be the worst financial crisis and recession in the UK in the last few decades.

Iceland had the same macro and financial imbalances as the US and the UK but the Icelandic banks were both too big to fail and too big to be saved as their losses were much larger than the government capacity to bail them out. Thus, in Iceland you have a solvency crisis for the banks, for the government and for the country too leading to a currency crisis, systemic banking crisis and near sovereign debt crisis.

The US has also a busted banking system and an insolvent household sector (or part of it) but so far the sovereign has the willingness and ability to socialize such private losses via a vast increase in public debt.

This week in the UK investors started to worry that the UK government looks more like the Iceland one than the US: having banks that are too big to be saved given the fiscal/financial resources of the country.

But in principle the UK looks more like the US: the public debt to GDP is relatively low (in the 40s % range) and thus the sovereign should be able to absorb fiscal bailout costs and additional fiscal stimulus costs that may eventually increase that debt ratio by as high as 20% of GDP. Note that during WWII the UK public debt to GDP ratio peaked well above 150% and the UK government remained solvent.

But while even a huge fiscal bill of a bailout of the economy and of financial markets is in principle sustainable the UK government may soon face problems of financeability – rather than long-term solvency - of such larger deficits. Suppose investors worry about such solvency and start dumping pounds at an even faster rate, then: some government debt auctions may fail, spreads on UK government bonds may start rising sharply, the government may be eventually downgraded by the rating agencies, the expected capital losses from a pound depreciation may lead foreign investors to shun UK government bonds because of worries about losses from a weaker pound, and this vicious circle may eventually lead to a sharp increase in the cost of financing the large fiscal deficits and fiscal bailout costs and a sharp reduction in the willingness of domestic and foreign investors to finance such deficits.

Then, even if technically the UK government is solvent, near insolvency may be triggered by a financeability problem, i.e. the unwillingness of investors to increase their holdings of UK government debt and their failure to roll over debt coming to maturity. So an illiquidity crisis may eventually trigger a near insolvency crisis.

The problem is aggravated by the fact that most UK banks are not only near insolvent but they also have a significant amount of foreign currency liabilities whose real value is increased by the ongoing real depreciation of the British pound. It is true that those liabilities are in part matched by foreign currency assets (given the financial intermediation role that UK banks play). But some of those assets are not liquid and some of those assets have lost their market value because of the slaughter in global equity and credit markets.

So one cannot totally rule out the risk of a run on the cross-border uninsured liabilities of the banking system. And short of a credible government guarantee of all deposits/liabilities of the UK banking system one could not totally rule out the risk of a cross-border run on such liabilities. A run on domestic currency deposits can be managed by the Bank of England lender of last resort provision of pound liquidity; but a run on foreign currency liabilities of banks (well beyond their foreign currency liquid assets) could not be similarly resolved given the limited foreign currency reserves of the Bank of England and given the fact that the pound is less of an international reserve currency than the US dollar is.

Thus, the UK government faces massive risks: only a coherent and credible economic and financial rescue program can prevent a more severe financial crisis. The IMF would not even have enough resources to save the UK if a banking or sovereign liquidity/financing crisis occurs. The UK can rely on increased dollar liquidity from swap lines with the Fed to cover the rollover risk of UK banks and allowed them to match US dollar liabilities with US dollar liquidity. But the scale of such swap lines (effectively the US Fed playing the part of the IMF’s international lender of last resort) would have to be massively increased if a rollover crisis on UK cross-border liabilities were to occur.

So, at best, the UK faces an economic and financial crisis that will be as bad as the US one: a severe and protracted recession that could last two years with very weak growth recovery once it is over; a near insolvent financial system, most of which will be formally or informally nationalized; a large fiscal costs of budget deficits surging because of the recession and the bailout of financial institutions; a weakening currency that may risk a hard landing if the crisis is not properly managed. A more dramatic run on the cross-border liabilities of banks, a run on the government debt and a hard landing of the pound can be prevented by coherent and forceful policy action.

A credible and consistent economic plan requires: very easy and unorthodox monetary policy (zero policy rates, quantitative easing and other unorthodox programs to thaw money markets and credit markets); a fiscal stimulus package that combines near-term easing with commitment to fiscal discipline over the medium terms; a coherent plan to clean up the financial system (triage between solvent and insolvent banks; takeover and workout of insolvent ones; recapitalization and clean-up of solvent ones with separation of good and bad asset and conversion of unsecured bank debt into equity to reduce the fiscal costs of the bailout); a plan to reduce the debt burden of the part of the household sector that is insolvent; a plan to stop a free fall of the housing market and of home prices including foreclosure forbearance.

This is the same set of policy challenges that the US faces. A coherent plan can ensure that the outcome is closer to the US (a still nasty and protracted economic and financial crisis, but one short of insolvency) rather than outright insolvency of the entire banking system, of the government and of the country as in the case of Iceland.

George.

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Nouriel Roubini - Latest Roubini Interview With Bloomberg On The Global Slowdown and US Financial Losses By Nouriel Roubini | Jan 28, 2009

Bloomberg (1/27, 2009): Roubini Sees Negative Growth Remaining Through 2009

From Bloomberg:

Stock market declines globally are increasingly correlated and emerging economies will follow developed nations into a “severe recession,” according to New York University Professor Nouriel Roubini.

Roubini said economic growth in China will slow to less than 5 percent and the U.S. will lose 6 million jobs. The American economy will expand 1 percent at most in 2010 as private spending falls and unemployment climbs to 9 percent, Roubini said.

“There is nowhere to hide,” Roubini, an economics professor at NYU’s Stern School of Business who predicted the financial crisis, said in an interview with Bloomberg Television. “We have for the first time in decades a global synchronized recession. Markets have become perfectly correlated and economies are also becoming perfectly correlated. This is not your kind of traditional minor recession.”

Roubini said the U.S. government should nationalize the biggest banks and absorb their bad holdings because losses will exceed assets, threatening to push them into bankruptcy. The banks could be privatized again in two or three years, Roubini said. The professor reiterated his previous prediction that U.S. financial losses may reach $3.6 trillion.

“Nobody’s in favor of long-term ownership of the U.S. banking system by the government, but if you don’t do it this way you end up like Japan where you kept alive for decade zombie banks that were never restructured,” he said. “That’s going to be much worse. It’s better to clean it up, nationalize it and sell it to the private sector.”

‘Lost Decade’

Japanese policy makers hesitated in addressing a banking crisis in the 1990s and then struggled to revive growth as deflation and recessions stranded the nation in what is known as the “Lost Decade.”

In July 2006, Roubini predicted the financial crisis. In February of last year, he forecast a “catastrophic” meltdown that central bankers would fail to prevent, leading to the bankruptcy of large banks with mortgage holdings and a “sharp drop” in equities. Since then, Bear Stearns Cos. was forced into a sale and Lehman Brothers Holdings Inc. went bankrupt, prompting banks to hoard cash and depriving businesses and households of access to capital.

The world’s biggest economies are sliding deeper into recession as the fall-out from the global financial crisis hobbles manufacturing output and punctures consumer spending from New York to Beijing. The U.S. economy probably contracted at 5.5 percent pace in the fourth quarter, the fastest in 26 years, a survey of economists showed.

26-Year High

Caterpillar Inc., Sprint Nextel Corp., Home Depot Inc. and ING Groep NV led companies announcing at least 77,000 job cuts yesterday as sales withered while U.S. jobless claims touched a 26-year high of 589,000 in the week ended Jan. 17. President Barack Obama is pushing congress to approve an $825 billion stimulus package to create 3 million to 4 million new jobs.

In China, the urban unemployment rate, which doesn’t include millions of migrant workers, rose for the first time since 2003 in the fourth quarter. The government is targeting a rate of 4.6 percent for the year, which would be the highest since 1980. The slowdown may destabilize the country’s communist government, Albert Edwards, a strategist at Societe Generale in London, said in a Jan. 15 research note.

George.

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