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Euro contagion

IN SEPTEMBER, chancellor George Osborne said there were six weeks to save the euro. It sounded melodramatic, but in the light of subsequent events, he was almost spot on. Those six weeks expired at Cannes in the first week of November – and the euro’s future was as confused and fragile as ever.

There has been talk of default, a rescue fund, bank recapitalisation and appeals to countries like China to help out. But nothing has been sorted and it seems that national self-interest dictated by domestic electoral cycles has counted for far more than economic logic or the European ideal.

It was no wonder that David Cameron seemed exasperated at his post-G20 press conference. Now, with attention switching from Greece to Italy, the risk of collateral damage to non-eurozone members was very evident and the prime minister was very well aware that in spite of the tough measures taken to try to restructure public finances in the UK and stimulate activity, the policies could all be blown off course by events in Europe over which the UK can exercise very little influence or control.

The risks to the UK come from several angles. Trade is the most obvious, since the EU, and especially the eurozone, is our largest market. In 2010, £142bn of our £265bn of exported goods went to the EU – a 54% share. Of the top eight destinations, only the US was not in the EU. Taking account of invisibles and services as well as goods, the value of Europe rises to almost £300bn.

With forecasts for growth in the area being marked down close to recession, the prospects of the UK using exports as an escape route to fill the hole left by weak domestic activity seem increasingly problematic. The adverse trade impact on the UK could be substantial. On the basis of past experience, exports could fall by as much as 1.5%, or around 0.2% of UK GDP. If eurozone weakness translated into stronger sterling, of course, the effects could be even more marked.

As serious as this sounds, an even bigger threat comes from the financial consequences of a disorderly default involving one or more countries. Although the contributions from the UK government to the rescue packages are relatively modest, there may be more to come if the IMF is involved.

However, the real worry would be the consequences for the banking system. Default means a loss of income and a rise in bad debts and many European banks would be vulnerable, which is why there was so much focus on the recapitalisation plans. The UK banks comfortably passed the stress tests on Greece, but a more widespread default would change the dynamics. And even if British banks have not lent directly to the affected countries, there could be indirect exposures to the banks which have and to companies which will struggle in a recessionary environment.

Some estimates have put the impact of the current crisis (including wealth and confidence effects) as a high as -1.5% of UK GDP, which could even double if the currency were to collapse. Since growth in 2012 is not expected to be much above 1.5%, the prospect is alarming. With very few cards left to play in terms of interest rates, quantitative easing and taxation, the chancellor’s concerns about the euro are perfectly understandable.

To believe the currency was always an accident waiting to happen and was flawed from day one does not mean its demise should be welcomed. The dislocation to trade, the damage to a fragile financial system and the haemorrhaging of business and consumer confidence all mean that even the most euro-sceptic have to hope the policymakers can find a way to muddle through this turmoil. ?

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