New credit squeeze could hit UK, warns IMF

A second credit squeeze and a £200bn national "funding gap" threatens to sabotage the recovery in the British economy, the IMF warned yesterday.

In its latest Global Financial Stability Report, the fund said that a combination of a soaring government deficit and the borrowing needs of British companies and consumers – coupled with a still broken banking system – would leave the UK with a national "funding gap" of 15 per cent of GDP, or around £200bn next year, much higher than in either the US or the euro area.

The IMF also pointed out that the UK's continuing need to borrow from abroad to plug this gap leaves the nation exposed to sharp changes in investment sentiment. Should such a change occur, says the IMF, then sterling could fall even further and interest rates would have to rise before the recovery had been fully secured. UK banks are also exposed to relatively large foreign loan books.

The report stated: "In terms of regional vulnerability, the United Kingdom appears most susceptible to credit constraints under our stylized scenario, given its significant reliance on the banking channel and the projected sharp decline in domestic bank balance sheets, as well as substantial public financing needs.... If foreign investors become concerned about long-term fiscal sustainability in these countries, interest rates on government securities would need to adjust higher and the exchange rate would depreciate."

José Viñals, the IMF's financial counsellor, said that the Bank of England would need to continue with its programme of buying gilts to help avert such a situation. He added that Britain was likely to face "difficulties" in meeting the demand for credit.

"Either there will have to be continuing support on the part of the authorities to underpin the credit process or there will be higher lending interest rates, or credit will be constrained," he said.

However, the fund also took the opportunity to say that the world economy had "turned a corner" and downgraded its global estimates for banking losses from $4trn to $3.4trn. In the UK, loss rates on bad loans are projected to be 7.3 per cent, and as high as 15 per cent of consumer debt, again high by international standards.