RPT-COLUMN-Britain's credit shortfall: James Saft

(James Saft is a Reuters columnist. The opinions expressed are his own)

By James Saft

HUNTSVILLE, Alabama, October 1 (Reuters) - Britain faces a long credit drought extending through 2010, making continued government intervention in debt markets, subdued economic growth, and a weakening pound all good bets.

A highly open economy with an even higher tolerance for risk, Britain boomed in the early part of the decade, with credit growth increasing by more than 10 percent a year between 2002 and 2007, while saving first sagged and then turned negative.

Capital from outside the country flowed in through securitization and wholesale lending to British banks, intermediated by an outsized financial sector.

When the crash came, securitization and the international capital flows dried up, leaving Britain more dependent than ever on its own savings and the spindly capital base of its banks.

These same banks have been slower to recognize their losses and re-build their capital than their U.S. peers, setting up a slower and more painful recovery.

"In the case of the United Kingdom there is a significant tension between the credit that will be demanded by the public and private sector and the ability of the financial system to provide this credit at unchanged interest rates," said Jose Vinals of the International Monetary Fund, speaking at a press conference for the publication of its twice annual Global Financial Stability Report.

"Either there is a continuing support on the part of authorities to underpin the credit process or there will be higher lending interest rates or credit will be constrained."

I'm guessing it will be an uncomfortable mix of all three.

While the outlook for losses globally has improved as economies stabilize, Britain's banks are in a relatively poor position, at least compared to their U.S. peers.

The IMF estimates that they have only recognized about 40 percent of their ultimate write downs, as against 60 percent for U.S. banks. This leaves them needing to raise about 120 billion pounds in capital by the end of 2010 to bring the ratio of their assets to capital to a moderate 25 times.

In the absence of further government insurance or compulsion banks are not likely to want to lend as much as Britain is going to want to borrow, even giving an ongoing deleveraging by British households. That is in large part because while households and companies are trying to cut back on borrowing the government is borrowing far more.

THE FUTURE LOOKS QE

According to the IMF, Britain's government, non-financial companies, and households will need to borrow $280 billion more than its banks can supply in 2009 and another $150 billion more in 2010.

The 2009 shortfall has been in bulk offset by $180 billion in Bank of England purchases of debt, almost exclusively government debt, in 2009.

To put it in perspective, the combined credit shortfall - the amount Britain needs to borrow as compared to its financial sector's capacity to lend - in 2009 and 2010 is equal to about 15 percent of GDP.

When there is not enough of something to meet demand, the price should rise, and credit probably will become more expensive in Britain. This could easily derail an embryonic recovery. It also is a threat to the really miraculous turn around in the housing market, which has firmed in the midst of turmoil despite arguably still being fantastically expensive.

Housing is not the only asset that is sensitive to the availability of credit or the cost of capital. A corporate sector which must pay more to borrow and may have to maintain a higher ratio of equity to debt also should see its value fall relative to its ability to throw off profits.

Look for the Bank of England's experiment in quantitative easing to be extended and enlarged. David Miles of the Bank has recently argued that though bank lending may not have responded strongly to QE, it has made itself felt through companies issuing debt and equities through the public markets. Seen in that light QE is easing Britain's transition to a country with a smaller, better capitalized banking system and possibly one with more reliance on publicly issued capital rather than capital provided by banks.

That is well and good, but getting there will not be easy or painless.

For one thing, there is a good chance that sterling will weaken as markets come to the conclusion that credit will be tight and that the quantitative easing will have to be extended.

The currency sold off strongly after recent comments by Bank of England governor Mervyn King said that sterling weakness was aiding in the re-balancing of the economy.

And while the Bank has taken pains to reassure markets that it is not engineering a weaker pound, the recovery has not been as strong as the original selloff.

Britain has done, on the whole, pretty well this year given where it started, but it is not looking like a great winter ahead for sterling and sterling assets. (At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. For previous columns by James Saft, click on [SAFT/])