Britain dodges the worst of the debt crisis - so far

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Britain's responses to the financial collapse and the recession – considered the savviest and strongest in the European Union – are now wearing thin as the euro zone debt crisis intensifies.

In his autumn economic and fiscal forecast, Chancellor of the Exchequer George Osborne predicted that Britain would skirt recession, making it one of the few standouts in all of Europe. The economy, according to the government's Office for Budget Responsibility, will expand by 0.9 per cent this year, 0.7 per cent in 2012, then supposedly come roaring back, with annual growth between 2 and 3 per cent through 2016.

But Mr. Osborne has his doubters. Many believe another British recession is inevitable even though the country has stabilized its banks, launched a credible austerity program and allowed its currency to be devalued. That's because the economy is tightly linked to the euro zone, which is sagging under mountains of debt.

"The U.K. may be an island, but it is not a safe haven," said Phillip Colmar, global strategist and partner at MRB Partners of London and Montreal.

Mr. Osborne did hedge his bets, saying the outlook for Britain depends on the euro zone avoiding the sort of calamity that would trigger a deep recession. "If the rest of Europe heads into recession, it may be hard to avoid one here in the U.K.," he said.

That recession may already be in place, possibly making Mr. Osborne's forecasts for Britain unrealistically optimistic. Forecasts from the European Commission, the Organization for Economic Co-operation and Development (OECD), and many economists point to declining European growth and a probable recession in the 17-country euro zone.

Deutsche Bank's economists predict a 0.5 per cent euro zone contraction in 2012, with each of its biggest economies – Germany, France, Italy and Spain – experiencing zero growth or a shrinkage; Italy, the new epicentre of the debt crisis, is expected to contract by 1.1 per cent next year.

For its part, the OECD on Monday said Britain was headed for a double-dip recession, with a decline in economic output in the final quarter of this year and the first quarter of next year. For all of 2012, the OECD expects Britain to expand by just 0.5 per cent.

U.K. government borrowings are forecast to climb by £87-billion ($140-billion) between this year and 2014-15. That will push up the debt-to-gross domestic product ratio to a peak of 78 per cent, a significant increase from the 71 per cent forecast only a few months ago.

Things could get worse for Britain as the euro zone deteriorates. The debt crisis in Italy, a country considered too big to fail and too big to bail out, is getting deeper even though Silvio Berlusconi is gone and the new government is under the control of Prime Minister Mario Monti, a sober-minded economist who has pledged to restore growth and eliminate the budget deficit.

On Tuesday, the Italian treasury was forced to offer a yield of 7.56 per cent – a euro-area record – to sell new 10-year bonds. Greece, Ireland and Portugal all sought bailouts after their yields breached 7 per cent. Saving Italy is expected to be the main topic at the EU summit on Dec. 8 and several economists think the economy is headed for a bailout or debt restructuring as its bond yields thrust into unsustainable territory.

"What is needed is a resolution to the euro zone sovereign debt crisis, and this shows little sign of happening any time soon and is out of the U.K. government's hands in any case," said ING Financial Markets economist James Knightley.

The British government has one hugely valuable asset – rock-bottom borrowing costs – thanks to the Bank of England's support for the British bond market and an unwavering austerity program that is considered effective without being harsh. At 2.2 per cent, yields on British bonds (known as gilts) are even lower than those of Germany, long considered the Europe's safest debt.

But the bonds' bastion-of-stability status may not last, according to some economists and strategists. Mr. Colmar, of MRB, is advising clients to avoid the bonds as the euro zone and British economies deteriorate and the threat of a fresh banking crisis looms. "Gilts are ill-prepared for any bad news, and there are mounting risks regardless of which extreme economic/financial outcome occurs," he said in a note.

Rising borrowing costs would only add to Britain's financial pain. Already, Mr. Osborne is conceding that austerity measures won't disappear any time soon as fiscal health deteriorates. If the OECD and the economists are right, a British recession is coming and could put the country firmly among the victims of the debt crisis.