The alarming developments of the last few days threaten the onset of a whole new leg to the financial market turmoil. The government rescuers of the embattled financial sector are themselves coming under huge financial pressure.
Sterling has collapsed by ten US cents in just two days, from 1.49 to 1.39. The UK government's five-year credit-default swap spread rose to 133 basis points. Ominously, the longer-dated maturities in the gilt market came under pressure on Tuesday, as investors started to take fright at the possibility of the potentially crippling liabilities of the banking system being added to the government's balance sheet.
Around Europe, a number of other governments are coming under similar, if not worse strain. Ireland's five-year CDS spread has ballooned over ninefold since last autumn, rising from around 30 basis points only four months ago to 280 b.p. on Tuesday, a direct result of its government's decision to guarantee all bank deposits on 30 September last year. This decision, which was hailed as a masterstroke at the time by many commentators, now looks like a disaster. Austria's CDS rate has hit 157 b.p., Spain's 156. Italy and Greece are under pressure too.
Putting some figures on the UK government's financial strains, Ambrose Evans-Pritchard of the Daily Telegraph points out that the UK's foreign currency reserves stand at $61 billion, while the combined foreign currency liabilities of the UK's banks are $4.4 trillion. This is a mismatch indeed.
So it is no longer a question of whether the UK government should or should not bail out its banks, nationalise them, introduce insurance schemes, draft good/bad bank legislation, Jim, the critical question is whether it can do as it wishes, or whether its creditors will impose their own conditions first.
In fact the answer to this question may well have been given by the markets over the last few days. There is no way the UK state can assume the balance sheets of the banks in toto without crippling the sovereign debt market and the currency. Arguably we have already gone beyond the point of no return, and the UK's credit is impaired for good.
Many bank share prices are heading fast towards an eventual destination of zero, and debt holders are going to have to take a hit too.
I think that governments are going to be forced to meet their obligations under deposit insurance schemes, but will be able to do little more, unless they want to plunge their countries into bankruptcy. The CDS market is probably giving a pretty accurate view of the most likely candidates.
Arguably, the plight of some of the peripheral Euro member countries is even worse than that of the UK. They may not have the outsized financial sector of the UK relative to the size of their economies, but they are locked into the Euro, and have little leeway to extricate themselves from the financial straits they find themselves in. There could be huge problems ahead for the Euro itself.
It looks as though 2009 could turn out to be an even more dramatic year than last.