Saturday, January 24, 2009

Roubini: The U.K. is NOT Iceland

by Calculated Risk on 1/24/2009 09:24:00 AM

From Professor Roubini: Is the U.K. an Iceland 2? No but there are serious financing risks ahead. Also: BBC News TV and Radio Interviews.

... [I]s 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.

... 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.
I agree with Roubini that the U.K. will probably not be the next Iceland, but the U.K. clearly has some serious problems.