Scale of the downturn sends sterling diving

Pound hits 24-year low as worst economic showing since 1980 troubles investors / Banks under renewed pressure and Barclays' shares hit by nationalisation fear
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The Independent Online

Confirmation that the UK eco-nomy seems set for its worst downturn since the Second World War sent shares and sterling plunging yesterday. The Office for National Statistics' declaration that the economy shrank in the closing months of last year was widely expected – but not the scale of the fall, which unnerved investors already fretting about the malfunctioning of Britain's financial system.

The UK's GDP fell by 1.5 per cent in the fourth quarter of 2008, the worst showing since 1980. Sterling promptly sunk to an all-time low against the yen, at ¥121.76 to the pound, a 24-year nadir against the dollar, reaching $1.35 at one point, and remained weak against the euro. Although it finished the day flat, at 4,052.47, up 0.24 points, the FTSE 100 index slipped more than 2 per cent to below the 4,000 mark during trading.

Sterling has lost 8.1 per cent versus the dollar and 5 per cent against the euro this week alone, and is one-third down on its international value of a year ago. The G7 is said to be ready to discuss the pound's precipitous decline, amid fears that the world could fall into a series of competitive devaluations.

The euro has also been strong bec-ause of a series of comments from European Central Bank policymakers hinting that they may not cut rates as aggressively as the Bank of England and the US Fed. Last night, an Italian economist and member of the ECB Executive Board, Bini Smaghi, cautioned against excessively low rates which would create the preconditions for the next crisis, and added that only if faced with an "extreme situation" would the ECB consider a "zero rate scenario".

Howard Archer, of Global Insight, added: "The very sharp contraction in GDP in the fourth quarter of 2008, coupled with the extremely worrying outlook and ongoing serious financial sector problems, intensifies pressure on the Bank of England to take further measures to support the economy. It is far from inconceivable that interest rates could come down to zero."

The banks came under renewed pressure, only days after the authorities announced a £400bn plan to ease the pain in the credit markets. The UK economy and her financial institutions are seen as particularly vulnerable because the British banks' liabilities represent such a large proportion of GDP – 400 to 450 per cent – and because so many of their liabilities are in foreign currency. Iceland's bust banks' liabilities ran to 600 per cent of GDP, hence the description of London as "Reykjavik-on-Thames" from some quarters.

In an interview published today, Lord Myners, Labour's Minister for the City, launched a bitter attack on banking executives and claimed the banking system was on the brink of collapse when the Government stepped in with a £500bn rescue package.

"We were very close on Friday October 10," he said. "There were two or three hours when things felt very bad, nervous and fragile. Major depositors were trying to withdraw –and willing to pay penalties for early withdrawal – from a number of large banks."

Lord Myners said there had been no economic justification for senior bank executives' high pay levels over the past 20 years.

"I have met more masters of the universe than I would like to, people who were grossly over-rewarded and did not recognise that," he said.

"They are people who have no sense of the broader society around them. There is quite a lot of annoyance and much of that is justified. Let us be quite clear: there has been mismanagement of our banks."

Barclays' shares fell 14 per cent to 51.2p, taking their plunge in nine straight days of losses to 72 per cent. Yesterday's drop came despite attempts late on Thursday by John Varley, its chief executive, to reassure the market that Barclays did not face massive credit losses or a capital shortage.

The UK banking sector still makes up 8 per cent of the all-share index. "Given that there is a fair share of foreign ownership of UK equities, if the risk is that the bank sector's equity weighting will fall further, then it is no surprise that the exchange rate is also suffering," Chris Iggo, the chief investment officer in fixed income at Axa Investment Managers, said.

In a further sign of market fears, the cost of insuring the bank's debt against default rose to the highest since just before the Government's first sector bailout in October.

Analysts at Bernstein Research said Barclays' share price assumed a nationalisation risk of at least 70 per cent. The analysts said that, though nationalisation was possible, the Government did not want to do it. They added that the authorities could help the banks by revising down the calculation of risk attached to their loans to whatever level would support capital ratios and stave off nationalisation.

Barclays was hit far worse than other banks, whose losses were relatively light despite the dire news. Shares in Royal Bank of Scotland and Lloyds Banking Group were little changed, while HSBC fell 2.2 per cent and Standard Chartered dropped 5.8 per cent.

Investors fear that the deeper-than- expected recession and continuing credit crunch will push more banks towards nationalisation. If the entire UK banking system had to be taken into public ownership, it would propel the ratio of public debt to the UK's GDP to over 500 per cent – about twice the previous peak of 262 per cent, seen just after the end of the Second World War. Such a prospect has led some commentators to speculate about Britain becoming "bankrupt".

However, Jonathan Loynes of Capital Economics said: "For a start, the Government will acquire assets as well as liabilities. Meanwhile, the UK's more general fiscal problems are not necessarily worse than those facing other countries. We're facing a deep and prolonged recession. But bankruptcy? For now at least, we don't think so."

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