The effects of the Euro crisis in the UK

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It was a case of what might have been for the pound last week. On Friday, Tuesday and Wednesday it made a break for the highs, peaking a cent above last Friday's opening level. Since then it has been on the retreat. When sterling opened in London this morning all it had to show for the week's efforts was 20 ticks, less than a quarter of a cent.

The week was all about growth (or the lack of it), the public sector workers' strike in Britain, a team effort by central banks to provide cheaper dollar liquidity to banks, oh, yes, and the European debt crisis. The German chancellor is adamant that jointly-guaranteed "eurobonds" are a no-go area and she is equally insistent that the European Central Bank is not, and never will be a lender of last resort. She will not sanction the ECB using its firepower to support the government bonds of Italy - or anywhere else - by buying them on a large scale.

President Sarkozy is reluctantly bowing to Germany's line and the two leaders will spend the next few days trying to persuade investors that a more long-distance strategy will restore confidence in euro zone government bonds, particularly the Italian ones they find so distasteful at the moment. Their idea is to apply a fiscal discipline to Euroland states that will be strictly enforced, unlike the Treaty of Maastricht 19 years ago that failed to do that job.

Italy certainly cannot afford to continue borrowing at interest rates like the 7.5% that it was forced to swallow twice in the last five days. Investors' reluctance to hold borderline Euroland debt stems in large part from the arrangements for Greece's restructuring (which has still not taken place). With Greek debt, the EU insisted on bondholders - lenders to the Greek government - voluntarily writing off a proportion of their loans. Because the write down will be voluntary, lenders will be unable to collect on the insurance that credit default swaps (CDS) were supposed to have provided. If they are unable to rely on their insurance to protect against default by euro zone sovereign borrowers, investors are bound to take a more cautious line, lending their money instead to a government that is sure to repay it at maturity.

Between now and next Friday, when EU leader muster for their umpteenth "crisis" summit meeting this year, the President and the Chancellor aim to have sufficient ducks in a line to persuade investors that all will be well and that the crisis is over. This is a big ask.

The governor of the Bank of England, at a press conference this week, offered an ominous view of the dire consequences should Euroland leaders not be able to pull a plausible rabbit out of their hat. He said: "An erosion of confidence, lower asset prices and tighter credit conditions are further damaging the prospects for economic activity and will affect the ability of companies, households and governments to repay their debts. This spiral is characteristic of a systemic crisis." He cannot be accused of understating the risk.

Crisis solution or not, there is little doubt that growth in Euroland and Britain in the next couple of years is going to be adversely affected. In Westminster on Wednesday, in his Autumn Statement, the chancellor was taking pride in Britain's distance from such troubles, noting that the country's borrowing costs are now similar to Germany's. There were no boasts about the economy though. The Office for Budgetary Responsibility has again slashed its forecast for UK economic growth and does not expect to see 3% expansion until 2015. And even that tentative prediction assumes a positive resolution of the Euroland debt crisis; without one the outcome will be "much worse".

For three months the sterling/euro exchange rates has been swinging between €1.14 and €1.17 - sometimes beyond those limits - without going anywhere. At the beginning of December the relationship between the two currencies was identical to its situation at the turn of the year. To paraphrase the opinion offered a week ago; cautious buyers of the euro should hedge their exposure by fixing a price for half the currency they will need. Those with an appetite for risk might consider covering less than half the amount, given the way each new solution to the debt crisis seems to fall on its face at the first hurdle.

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The effects of the Euro crisis in the UK

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