The UK & the Euro

25 Jun

According to the latest Business confidence monitor (ICAEW), confidence has improved significantly in the last 3 months, suggesting a return to growth.  Exports are 4.1% higher than this time last year however companies expect capital investment to grow by only 1.4%, so it’s a mixed bag which reflects the mood, that whilst the current recession is expected to be short lived, the UK economy is expected to fluctuate over the next year as it is still very fragile.  The outlook is so uncertain at present due to the on-going euro crisis and the potential effects it can have on the UK economy.

For those who are not so sure how the crisis came to be, here is a summary:  when the Euro was created a pact was made between its members not to borrow more than 0.5% of their economy each year.  This pact was broken by nearly everyone to varying degrees.  Before the recession in 2008, when southern European countries joined the Euro, they had access to very low interest rates which gave rise to a debt fuelled boom mainly through the private sectors.  This drove up wages in these countries, making their exports less competitive compared to Germany whose unions agreed to hold their wages.  Germany became an export power house, selling a lot more than it was buying, however all the surplus money it made has subsequently been lent to the southern European countries.  Countries like Spain and Italy are now in a lot of trouble because businesses and mortgage borrowers are trying to pay off their debts, exports remain uncompetitive and governments who borrowed far too much (since the 2008 recession ruined their economies) have now agreed to massive spending cuts.

If you cut spending there will be no investment in revitalising business, unemployment will rise (currently 24.1% in Spain) and wages will fall making it harder for people to repay their debts and the recession will deepen.  However if you don’t cut spending you risk a financial meltdown as borrowing costs soar, your economy remains weak and uncompetitive within the Euro, markets lose confidence as you become laiden with more debt and other Euro countries may not have enough money to bail you out.  The European central bank is unable to lend due to its mandate, signalling to the rest of the world that they shouldn’t either.

What does this mean for the UK? Well more than 50% of our total trade is within the European Union (5-6% GDP), so a deeper recession in the EU will directly affect demand for our goods and services.

In addition to this, the UK is dependent on foreign money to finance its own trade deficit. If the banking crisis became critical and spilled over into the UK, a currency crisis could be instigated, with foreign investors leaving the pound, the pound’s value collapsing, and the government’s borrowing cost rising sharply along with the cost of imports.  However because the UK control their own currency, the worst case scenario is that we finance our borrowing needs by printing money (something the Eurozone members can’t do). The real risk then becomes one of inflation, rather than of the government being unable to pay its debts.

A longer term problem to the UK could be its political isolation in Europe, with Eurozone members agreeing their own rules on other matters that affect UK business with the continent, denying the UK any say. For example, the potential banning of the trading of euro-denominated financial securities in non-Eurozone countries would harm the City of London.

It is important to note that it is not just a problem for Europe.  Russia, China and India have all agreed to increase their contributions to the IMF crisis-fighting reserve for what has been referred to at the recent G20 summit as the ‘single biggest risk for the world economy’.  As Greece vote to stay in the euro, it is still unclear how things will pan out. The euro may still need to be dismantled at some point and this could just be delaying and exacerbating a future exit.  If indeed they do leave, what is to come of Ireland, Italy, Portugal and Spain?

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