Edmund Conway

Think we are on the road to recovery, that economies and financial systems are now back in rude health, that interest rate cuts and quantitative easing are likely to push us out of recession and generate another boom? Not so fast.

Sure, many of the major Western banks have been rescued from full-scale implosion after governments took drastic measures to shore up their capital and ensure their survival. But the mountain of debt that poisoned the financial system has not disappeared overnight. Instead, it has been shifted from the private sector onto the public sector balance sheet. Britain, for example, has taken on hundreds of billions of pounds of bank debt and stands behind potentially trillions of dollars of contingent liabilities.

If the first stage of the crisis was the financial implosion and the second the economic crunch, the third stage is where governments start to topple under the weight of this debt. If 2008 was a year of private sector bankruptcies, 2009 and 2010, it goes, will be the years of government insolvency.

That, at least, is the horror story. It was one underlined by Standard and Poor’s (S&P) decision to change the outlook on Britain’s debt from “stable” to “negative”. While the United Kingdom still clings on to its prized AAA rating, it now stands a very real chance of losing it within two years. Questionable as are the credentials of the agencies following the financial crisis, the significance should not be underestimated. A cut in S&P’s ratings would reflect a considered opinion that the UK may default for the first time in its history.

If Japan’s experience in 2001 is anything to go by, it would also trigger an instant exodus of cash from foreign investors, since many of their reserve managers are obliged to invest the vast bulk of their cash in AAA-rated currencies.

But in spite of all this potential fire and brimstone, the reaction from financial markets in the wake of the S&P announcement last Thursday was hardly dramatic.

Indeed, so far as markets were concerned, a couple of disastrous headlines for the government — the S&P decision and the International Monetary Fund’s verdict on the management of the economy the previous day — were no more a concern than the latest nasty set of economic output or employment data.

Still, capital markets are unpredictable. As emerging markets — which have suffered sudden crises as international investors abandoned ship — know to their cost, creditors can turn on a sixpence. Foreign investors hold around a third of UK debt — most of it in the short-term gilt market. Unlike Japan, which had a massive savings glut when it lost its AAA-rating, the UK is directly vulnerable if their central banks and sovereign wealth funds turn a cold shoulder on sterling.

As things stand, the UK is the first of the major G7 economies to have been put on watch during this crisis (Japan is already AA). Were it the only country under real threat of downgrade, it would be easy to make baleful predictions about the impact.

However, the economic crisis has touched every nation. The UK is likely to be joined by other countries as the full scale of the downturn becomes apparent and more financial skeletons are pulled from the sub-prime closet.

So while we may suspect this is how the next stage of the financial crisis will look, it is harder to grasp which countries, or for that matter, which businesses or investments will benefit and which will suffer.

Central banks are likely to invest some of their cash in commodities such as gold and oil; tangible assets will become more desirable. For governments, survival is based on relative rather than absolute strengths. Countries that provide the most feasible and sensible fiscal plans are likely to thrive as they garner investment and support, while those that churn public money while failing to mend their financial systems are the most likely to suffer.

For in the final stage of this crisis, those countries that recover and start to flourish will be those that face up soonest to the new period of fiscal austerity that must last for the next decade.

This is an abridged version of a commentary that was published in The Daily Telegraph yesterday.

From TODAYOnline.com, Business – Monday, 25-May-2009; see the source article here.

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