Britain's Prime Minister is pleading for a resolution to the euro zone crisis before it pushes the country's fragile economy into reverse, wrecking its already battered banks along the way.
The British economy has stalled, the budget deficit refuses to disappear, unemployment is rising and now the euro zone banking crisis, which claimed its first victim over the weekend when the Franco-Belgian lender Dexia was dismantled, threatens to leap the English Channel.
The government's rising anxiety was highlighted on Monday when Prime Minister David Cameron urged European leaders to take a "big bazooka" to the growing euro zone crisis. Among other things, he is lobbying for the European Financial Stability Facility, the euro zone's €440-billion ($616-billion) bailout fund, to take on extra firepower.
Mr. Cameron's comments in Monday's Financial Times came as German Chancellor Angela Merkel and French President Nicolas Sarkozy met in Berlin to devise a bank rescue program. The two leaders promised to do "everything possible" to ensure the banks have adequate capital to survive the crisis, sending the markets up on both sides of the Atlantic on Monday in spite of the lack of details about the package's size and delivery mechanism.
On the same day, European Union president Herman Van Rompuy said he is delaying next week's summit of EU leaders until Oct. 23 because they need more time to finalize a plan to fight the debt crisis.
Britain was hurting even before the banking crisis picked up momentum a few months ago. After Wall Street investment bank Lehman Brothers collapsed in 2008, the government came to the rescue of most of the U.K. banking industry. Northern Rock, the first casualty, was nationalized, as was Royal Bank of Scotland. Lloyds Bank was partly nationalized, leaving HSBC as the only British bank of any size to escape a direct bailout.
Then came the austerity programs, designed to rein in a budget deficit of near-Greek proportions. This year's deficit is forecast at 8.2 per cent of gross domestic product, not far short of Greece's expected 9.6-per-cent deficit.
Ed Balls, the opposition finance critic, has argued that the aggressive austerity programs are smothering growth and killing jobs, and he may be right. In the fourth quarter of 2010, Britain slipped back into negative growth. Since then, growth has returned, but it's anemic. In the second quarter of this year, growth was a mere 0.1 per cent and there is no shortage of economists who say several quarters of flat growth, and possibly a recession, loom. In an effort to keep the economy afloat, the Bank of England is embarking on its second round of quantitative easing, worth £75-billion ($121-billion).
While the economy struggles, the big new worry is the health of the British banks. By last year, the worst seemed to be over for the euro zone and British banks. But the Bank of England didn't share the optimistic scenario. Last December it warned that the prime risk to the financial system was "Contagion of sovereign concerns, interacting with and amplifying the bank fragility in Europe."
The warning was not exaggerated. The British banks' exposure to continental Europe is equivalent to about 250 per cent of their Tier 1 capital (a key measure of any bank's financial health, and includes common stock and retained earnings). That's more than the banks in any other region of the world.
Making the situation potentially worse is the sheer size of the British banking system. At its height, in 2007, the assets of banks were equivalent to nine times GDP. The ratio last year was about four times GDP, still one of the world's highest. In a worst-case scenario – the shattering of the euro zone – the British banks might not survive. "The shock to the euro area banking system from a euro area breakup would immediately be transmitted to the U.K. banking system and tip the U.K. economy back into deep recession," Société Générale economist Brian Hilliard said in a recent note.
Fears about the stability of the British banking system intensified when Dexia was broken up and partly nationalized by the Belgian and French governments. On Monday, several other banks, all of them small, ran into trouble. Austria's Erste Group Bank said it will report a loss of almost €1-billion in the first nine months due to the sovereign debt crisis and writedowns on subsidiaries in Hungary and Romania. Greece's Proton Bank was seized by the government, as was ailing Danish lender Max Bank.
Mr. Cameron is bound to keep piling pressure on EU leaders to find a solution to the debt crisis before the Group of 20 summit in Cannes, France, in early November. He knows that island status and the use of a currency, the pound, that can be devalued gives the country no protection. "The U.K. and the euro sink or swim together," Mr. Hilliard said.
Eric Reguly