Governor Mervyn King’s warning on global economy

THE state of the world’s economy is worse than it was two years ago and will hamper the UK’s recovery, the Governor of the Bank of England, Sir Mervyn King, has warned.

In a deeply gloomy assessment, Sir Mervyn said that the problem had gone well beyond the eurozone and had spread to major developing economies such as China, India and Brazil.

His pessimistic speech came after Chancellor George Osborne used his Mansion House address in the City to warn there “could still be worse to come” for eurozone countries and suggested the radical measures needed to save the single currency may only come about if Greece was to leave it.

Their comments came as Europe was hit by fresh economic shockwaves yesterday. A leading ratings agency downgraded Spain’s credit rating to one notch above “junk”, sending the country’s borrowing costs to a euro-era record high and raising fears the bail-out of its banks had failed.

In Greece, unemployment reached a record high, with more than half of young people now out of work. The country is facing a crucial re-run general election on Sunday, with its future in the euro at stake. Sir Mervyn said: “The world economy is a much less welcoming environment in which to rebalance the UK economy than two years ago.

“Not only have the euro-area problems escalated to the point where exit for Greece and other periphery countries is the subject of widespread speculation, but signs of a slowing in China, India and other previously buoyant emerging economies, such as Brazil, are appearing daily.”

But the Governor raised some hope in the gloomy statistics. “That slowing does have a silver lining. Energy and other commodity prices have fallen, re-inforcing the welcome decline in inflation from 5.2 per cent last September to 3 per cent,” he said.

“And as inflation at home falls back, families will see an ease to the squeeze on real take-home pay.”

However, Sir Mervyn warned that there was little hope for a proper recovery until the eurozone crisis is resolved. “The other effect of the euro-area crisis has been to create a large black cloud of uncertainty hanging over not only the euro area but our economy too, and indeed the world economy as a whole.

“Complete uncertainty means that the risks to prospective investments that will yield returns in five or ten years’ time are simply impossible to quantify.”

He said that businesses and households were battening down the hatches to prepare for the storms ahead. “The result is that lower spending leads to lower incomes and a self- reinforcing weaker picture for growth.”

The crisis needed an honest assessment of the banking system in Europe and how much debt it holds, he went on.

“An honest recognition of those losses would require a major recapitalisation of the European banking system. Hope in markets will fade if the wrong diagnosis is made. Fundamentally, a cumulative loss of competitiveness in periphery economies, leading to continuing external deficits and large external debt, is at the root of the euro-area crisis.

“Until competitiveness can be restored, some way must be found to finance those external deficits.”

Earlier, in an effort to calm City nerves, Mr Osborne insisted that the UK could withstand the collapse of the euro. But he again pushed for large-scale political integration to try to stave off disaster.

“We are not powerless in the face of the eurozone debt storm,” the Chancellor said. “Together we can deploy new firepower to defend our economy from the crisis on our doorstep.”

He also threw his weight behind banking union in the eurozone and further political integration just short of a United States of Europe.

He said: “The political paradox Europe faces right now is this: some or all of these things are needed for the existing countries in the eurozone to make their currency work, but it may take Greek exit to make it happen.”

He went on: “One thing is for sure: if exit is the chosen route, then the eurozone must have a very good plan in place to prevent contagion.”

In a message to eurosceptics in his party, Mr Osborne warned that the UK should “not stand in the way” of the reform required in the eurozone because “the consequences of a disorderly collapse are huge”.

However, he promised that Britain would not be involved in banking union and no European banks would be bailed out by the British taxpayer.

He insisted that there would be no changes to the UK strategy of austerity and getting the debt down.

He said: “We can see across the eurozone that rising market interest rates and market instability are catastrophic for the process of recovery.

“These risks are very real, not imaginary. Consolidation is politically painful – I know that better than anyone. So promises of consolidation tomorrow are not credible.”

Mr Osborne also dismissed Labour’s calls for the UK to follow the US lead and spend more to kick-start the economy.

He said: “When evaluating the risks, it is also important to bear in mind some important differences between the UK and the US.

“What we see all too clearly elsewhere, a banking sector balance sheet worth 500 per cent of GDP – compared to just one fifth of that in the US – creates the very real risk of a destructive negative feedback loop between the sovereign and the financial sector.”

He added: “Sterling doesn’t enjoy the dollar’s status as the global reserve currency, which means the UK is much more exposed to market sentiment than the US.”

On banking reform, Mr Osborne insisted that the British taxpayer would be better protected against a repeat of the near-collapse of RBS or Northern Rock despite criticism that the reforms have been watered down.

He said: “I believe that we have found a workable way to solve what I called the ‘British dilemma’ – protecting British taxpayers in a way that does not make the UK uncompetitive as a home of global banks.”

There were also mounting concerns over the knock-on cost of the reforms.

The Treasury estimates in a white paper that changes will cost UK banks an initial outlay of £2.5bn, followed by between £4bn and £7bn a year

The reforms follow last year’s recommendations by the Independent Commission on Banking (ICB), led by Sir John Vickers, on how to make the banking sector safer and give greater protection to depositors. Mr Osborne is pressing ahead with the ICB’s more contentious proposals on depositor preference when a bank fails, as well as plans to make bank account switching easier, to aid competition.

James Barty, senior financial consultant at the independent think-tank, the Policy Exchange, said: “If the Chancellor truly wants to get the economy moving he has to try and stop gold-plating the banks now.

“In an ideal world, he should put his white paper on bank reform on the backburner.”