Time for King to change his tune on sterling

LONDON Tue Jan 20, 2009 4:56pm GMT

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LONDON (Reuters) - Britain is not alone in entering uncharted waters as it threads its way through the global recession and financial crisis, but it may be unique among rich nations in facing a potential full-blown currency crisis.

Rocked by collapsing investor confidence in UK banks and an explosion of government borrowing and spending to mitigate the effects of the economic slump, sterling tumbled on the world's foreign exchange markets this week.

The words "currency" and "crisis" now pass the lips of those analysts who fear the sharp deterioration of the economic and fiscal outlook could trigger a downgrade in Britain's sovereign credit-worthiness.

That would hamper the country's ability to attract the foreign investment needed to plug its current account deficit and ensure the national books are balanced.

Sterling can't enjoy the backing offered by being part of a 16-nation strong bloc like the euro, nor does it enjoy the default support of being the world's reserve currency, like the dollar.

Sterling slumped as much as 4 percent against the dollar on Tuesday to its lowest level since June 2001, crashed to a record low against the Japanese yen and fell back closer towards the historic and as untested level of parity against the euro.

It's against this backdrop that Bank of England Governor Mervyn King, who has consistently highlighted the benefits to exports from a weak currency and adopted a de facto policy of benign neglect of the pound, makes his first keynote speech of the year later on Tuesday. He speaks in Nottingham at 8:20 p.m..

"There's a real danger of the decline in sterling becoming a full-blown crisis. The government and the Bank of England have to change their tune on the pound pretty quickly," said Neil MacKinnon, director and chief economist at ECU Group, a hedge fund based in London.

SEA OF DEBT

On Tuesday sterling fell as low as $1.3860 in its biggest one-day slide against the dollar since Britain crashed out of the Exchange Rate Mechanism, a pre-cursor to the euro, in 1992.

The latest wave of selling came a day after Prime Minister Gordon Brown unveiled new plans to shore up banks and gave the Bank of England scope to print money if needed.

Until now King and finance minister Alistair Darling have regularly referred to the benefits to exports from a weak pound.

But a growing number of analysts say this is no longer a viable stance. With the global economy in its most serious slump since the Second World War any competitive advantage for UK goods simply disappears into a void of non-existent demand.

Some say he has to quell speculation that the pound's slide could trigger a crisis of confidence among overseas investors in UK assets -- the last thing King and other policymakers want given the economy's reliance on foreign capital inflows.

"I would say we're close to a sterling crisis," said an analyst at one UK bank who asked not to be named.

He noted that the markets are making their view on the Bank's FX policy stance crystal clear: it has to change. "The market is doing it for him (King). Clearly, what's happened today has nothing to do with UK rate expectations."

Some of Britain's leading banks have already lost half their value or more in recent days on the stock market and government bond prices have fallen, pushing up the cost to the Treasury of servicing its ballooning debt.

The UK Debt Management Office has said planned gilt issuance this financial year will reach a record 146.6 billion pounds, and Darling has said the government will borrow 118 billion pounds in year 2009/10, some 8 percent of gross domestic product.

Ratings agencies Standard & Poor's, Moody's Investor Services and Fitch have all downplayed market-based speculation the UK could lose its top-rated credit-worthy status. Only last week S&P confirmed its triple-A rating.

But investors are stumping up increasing amounts on the credit default swap market to insure against the risk of UK default. The premium on five-year UK sovereign CDS this week reached 135 basis points, according to CMA Datavision, meaning investors are paying 135,000 to insure against default on 10 million pounds of government bonds.

Equivalent CDS on Spanish debt, which was this week downgraded by S&P to a notch below UK government debt, is not much higher, at 153 basis points.

Asked in Brussels at a meeting of European Union finance ministers if he was concerned about a run on sterling, Darling only said: "We have always made it clear that we will do everything we can to support our economy and to support people and to support businesses."

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