U.K. faces a disastrous economic scenario

The source of the problem is crystal clear - the banking bailouts are costing too much.

(Bloomberg) -- U.K. government support for the banking system has risen to 1.4 trillion pounds ($2 trillion) and may climb higher as the financial crisis spreads to building societies and economists warn lenders may need more aid.
The amount invested in, loaned to or pledged to back bank assets now equals Britain’s gross domestic product, or 22,800 pounds for every person in the U.K.

The amount of money spent propping up the British banking system is unprecedented, and unaffordable. There comes a time when this sort of deficit spending hits the wall, when the number of interested buyers simply runs out.

That day is fast approaching.

The U.K.’s plan to sell a record 220 billion pounds ($318 billion) of gilts this year to revive the economy may cause investor “indigestion,” according to some of Britain’s biggest bond traders.
The amount, 50 percent more than the 146.4 billion pounds sold in the fiscal year that ended March 31, may be too much for the market to absorb, according to Royal Bank of Scotland Group Plc.

Only a month ago, a sale of sovereign bonds failed when not enough buyers turned out for the auction.

The IMF is predicting that the budget deficit of the U.K. could hit as high as 13.4% of GDP this year, the highest of any industrialized nation other than Ireland. Furthermore, it predicts the U.K. economy to shrink by 4.1% this year, and more the next year.
Commercial real estate prices in the U.K. have fallen 40% from the peak, while residential prices have fallen about half that. British banks have written off $200 Billion in losses so far this year.

"the recession is expected to be... quite severe in the United Kingdom, which is being hit by the end of the boom in real estate and financial services".
- IMF report

All this borrowing is causing foreign investors to shy away from English Pounds. The worry, now openly voiced, is that unless the U.K.'s economic outlook suddenly changes for the better foreign investors will stop buying the debt altogether, and this would prompt a full-scale currency crisis.

Officials at the Bank of England are haunted by a nightmare scenario: a loss of overseas investor confidence that leaves the government unable to sell bonds and triggers a collapse in sterling.

Wednesday's reckless budget has brought that scenario a step closer, even if it is not yet what the BOE expects. But the government's plan to borrow 12.6% of gross domestic product this year and £700 billion ($1.02 billion) over the next five years certainly makes the BOE's task much harder. At the least, higher borrowing costs seem inevitable, making it less likely the BOE can hit its inflation target without a further risky expansion of quantitative easing.
Of course, the BOE can always print more money. That may be what the market expects. The relationship between the government's net cash requirement and 10-year asset-swapped gilt yields, which usually move together, has completely broken down; yields are 70 basis points below where they should be, according to Barclays Capital. That only makes sense if the market thinks the BOE will foot the bill for the government's debts.

But a big expansion in quantitative easing -- already huge at 5% of GDP -- carries risks. It stores up trouble for the future, increasing bank sector reserves that will eventually need to be mopped up before they trigger an inflationary surge while adding to the BOE's stock of gilts that will one day need to be sold.

More importantly, it would fuel suspicions the BOE is simply monetizing the government's debt, further undermining the U.K.'s credibility -- and potentially precipitating the BOE's nightmare scenario.

If a third-world nation were to run a budget deficit of 5%, the markets would turn on that country in a heartbeat, and charge it usury interest rates.
But to run a budget deficit of 12-13%, while monetizing around 40% of it is fiscal madness. It's a sure ticket to bankruptcy and default. That interest rates in the U.K. are still affordable are a tribute to managing expectations. However, reality will eventually intervene.

Darling said the government’s budget deficit this year will reach 175 billion pounds, or 12.4 percent of gross domestic product. That’s the biggest shortfall in the Group of 20 nations and surpasses the 12 percent forecast in the U.S.

The U.K. will raise gilt issuance to over 240 billion pounds in the next fiscal year and to almost 250 billion pounds in the fiscal 2011-12, according to Citigroup Inc.

“The U.K. is mortgaged up to the hilt,” Paul Day, chief market analyst at MIG Investments SA, said in an interview from Singapore yesterday.

Unless the U.K. economy rebounds soon, the ability of the nation to service its own debts will be impossible in a few years.