As British bankers and politicians contemplate the likely damage to their economy should member states start splitting off from the currency union across the English Channel, they are able to find solace in at least one consoling thought: They have had ample time for prepare for this slow train wreck of a crisis.
On Monday David Cameron, the Conservative Prime Minister, met the Bank of England Governor Sir Mervyn King and other officials to discuss contingency plans for a full-blown disaster in the euro zone. Central bankers and finance ministry bureaucrats have dusted off emergency plans to prevent a banking panic, such as liquidity injections. Government ministers are considering how to deal with the social and public order effects of the sudden arrival of economic migrants from troubled euro zone states. Civil servants are even working on how to get U.K. citizens home from Greece should the ouzo and ATM machines go dry and the ferries stop working.
However, preparation can only achieve so much. The British government can prevent an uncontrolled funk, should the euro zone start disintegrating. It cannot forestall a fall in output.
Most economists assume a Greek exit would plunge the euro zone as a whole into a severe recession. The money that oils the wheels of peripheral euro zone economies would flee for fear of currency redenomination, and business and consumer confidence would collapse in the 16 remaining member states.
Bank of America Merrill Lynch predicts a 4 percent drop in euro zone gross domestic product (GDP) should Greece leave — and a resulting 2 percent fall in U.K. GDP. The bulk of this would come from a drop in business with the euro zone — the destination for almost half of U.K. exports — and declines in consumer spending and business investment because of the damage to confidence. Some economists go further, putting the potential drop in U.K. GDP at 3.5 percent or more, but all acknowledge the high degree of uncertainty since global economic history does not offer clear precedents for a Greek exit.
Despite this unpromising backdrop, Bank of America Merrill Lynch thinks investors would flee to the U.K. if the euro zone started fragmenting. In a recent note, its analysts say, “Any type of exit scenario is unprecedented, but the initial reaction would likely be a massive decline in safe- haven government bond yields and strengthening of defensive currencies” — including the U.K.’s, since it is one of the dwindling number of countries to enjoy a triple-A rating from the major agencies.
But Philip Rush, U.K. economist at Nomura in London, reflects a growing tendency among analysts to fret over the sustainability of gilts’ safe-haven status. “Abundant unappealing features — including low growth, high inflation and high debt — do not endear the U.K. in isolation,” he says. “Nonetheless, the U.K.’s ambitious and relatively well-detailed fiscal consolidation program, underlined by credible institutions and responsive monetary policy, do serve to damp perceptions of relative default risk.”
Britain’s Conservative-Liberal Democrat coalition government has kept to stringent deficit-cutting plans since it came to power in 2010. Although Nick Clegg, the Liberal Democrat deputy prime minister, has in the past few weeks pushed to add more growth-focused policies to the mix, he has reassured investors by saying this is only possible because the government’s austerity plan is on course: As a result markets no longer “have their foot on our throats.” Bondholders lifted their feet even further on Wednesday as the yield on 10-year gilts fell 13 basis points to a record low of 1.64 percent on renewed fears over Spain and other peripheral euro zone economies.
However, some analysts are less optimistic than Bank of America-Merrill Lynch about the pound’s value should the euro zone begin to shatter. Rush of Nomura points to the recent strong correlation between the euro and sterling — which reflects the tight trading links between the two currency zones. If this correlation holds true, the pound’s value will fall sharply in sympathy with the euro’s, should the euro zone start falling apart. A drop in sterling’s value would drag down into negative territory returns on gilts made by many foreign institutional investors.
On Tuesday Britons will unwittingly subtract about 0.4 percentage points from GDP and keep the U.K. in recession for another quarter by taking a national holiday to celebrate the Diamond Jubilee Anniversary of Queen Elizabeth II — who came to the throne in 1952 when the decline of the British empire was strengthening the country’s economic interdependence with Europe. Sixty years on, Britain will be protected from the worst of the damage by the erstwhile decision of Her Majesty’s Government to keep the notes which bear her likeness rather than adopting the euro. But despite this, the economic ties with Europe continue to strengthen — potentially weakening the U.K. economy when it is already in a feeble state.
