Q: Could you explain the developments in the U.K. economy over the last two years? What have been the major drivers?

A: We had a relative market weakness in 2007 after a mild rise in leading stock indexes in 2006. Market averages began to rise in 2002 on the back of benign economic conditions, came to a shuddering halt in the summer of 2007, when liquidity virtually dried up overnight in the wholesale money markets. That was the time of the Northern Rock crisis when, all of a sudden, we were in a credit crunch situation, tracking the U.S. sub-prime residential mortgage crisis. That’s where we are today.

Q: How large is the exposure of the U.K. banks to the U.S. credit market? Is the Northern Rock crisis a signal for deeper problems?

A: No, the Northern Rock business is not really representative. The bank was not one of the “big five” in the U.K., although it was a FTSE 100 index member. There is less concern about the major banks because they have diversified business models, both geographically and in terms of corporate and retail customers. For example, even if HSBC (Hong Kong and Shanghai Banking Corporation) has exposure to the U.S. sub-prime market, it also has significant exposure to the rising economies in Asia.

The Northern Rock’s business was quite different. Rather than lending money from existing deposits to customers requiring mortgages, it tended to borrow its money from the wholesale money markets. Northern relied for its sources of mortgage lending from the securities market which is far more volatile than the flows of bank customer deposits. When the money markets seized in the summer of 2007, Northern Rock was neither able to borrow money from the mortgage market nor able to sell or securitize mortgage that it had created. The sudden loss of faith in mortgage market created a liquidity crisis for most mortgage brokers, including Northern Rock.

Q: What’s your view on the current economic situation in the U.K. in terms of retail sales, consumer confidence, housing prices?

A: I believe that MPC, or the Monetary Policy Committee tasked with setting interest rates, currently faces situations, which requires a close monitoring of consumer solvency and inflation pressures. The most recent retail sales figures have been surprisingly resilient, and there are inflationary pressures by the rising oil and food prices.

The housing market is not that straightforward, because the U.K. has almost two different economies. There’s London in the Southeast part, which has traditionally been the more affluent part of the country. The housing prices there are certainly holding up, partly because of the strong demand and relatively fixed supply of properties. In the rest of the country, however, housing prices are either flattening or even slightly dropping.

That particular mix is among the reasons why the MPC has been less aggressive than the Fed in its efforts to steer the economy. We are still predicting that the U.K. economy is likely to slow over the next six to eighteen months and I believe that, at some stage, the MPC will have to cut the interest rates further to kickstart the economy. The general perception is that from the current base rate of 5%, we can expect one or two cuts with a quarter of a percentage before the year end.

Q: What is your view on the relationship between the U.K and the U.S. economies? The latest U.K. budget forecasts a bit of lower annual growth. Do you think that the U.K. is following the U.S. into a recession?

A: There is no question that the U.K. economy is in for a difficult time over the next six to 18 months, but I don’t think that we are likely to tip into recessionary territory. First, the MPC has to battle conflicting themes in the economy, and second, I don’t think that the pressures in the U.S. fully translate into the U.K., particularly the subprime crisis. Yes, there are institutions with exposure to the subprime market, mostly indirectly through collective investment vehicles, but the overall housing market isn’t in quite the same state as in the U.S.

The other difference is that, while the U.K. personal debt is at record levels, it is rarely mentioned that U.K. personal assets are at record levels as well. The latest figures suggest that U.K. individuals have personal debts of about 1 trillion pounds, compared to about 3 trillion pounds in assets. On that basis, the picture of the economy is down to the perception whether the consumer still feels confident and wealthy.

I believe that the consumers increasingly see that things are getting tighter, particularly because of the inflationary pressures, such as higher energy bills. For the moment, they’re being particularly resilient. Needless to say, the market picture in the U.K. is intertwined with the economic situation in the U.S. because so many companies in the FTSE 100 index, for example, are multinational. However, that hasn’t necessarily trickled down to the common man yet.

Q: In the U.S., we got used to hearing how rich everyone is based on the home prices, but when home prices decline, the mismatch between the liabilities and the assets becomes far more glaring. Do you think that’s relevant for the U.K. as well?

A: No, I don’t. Obviously, since the U.S. is the biggest economy in the world, it has an impact on the global picture. But my understanding is that this situation is also tied to equity release, or to freeing up the equity on the house to spend on other things. That happens in the U.K., but definitely not on a large scale, so the ratio of 3 trillion of assets to 1 trillion of debt is meaningful. So far, we have kept ourselves on top of repossessions and bad debt. There is little evidence of any major defaults at the moment. Of course, one of the economic factors to bear in mind is unemployment and, for the moment, that particular market is holding up.

Q: What’s your view on the dollarpound dynamics? What are possible scenarios for this year?

A: Traditionally, there has been a big comparison between the U.S. dollar and the sterling, but the very strong currency for the moment is the euro. The European Central Bank has been very strict regarding its own economic policy and hasn’t yet gotten to any rate-cutting spree. So, it has made the currency attractive for the investors, who decided to switch out of the dollar and into an alternative currency.

Forward-looking, I think that the euro will probably remain the favorite destination. The dollar faces further potential rate cuts by the Fed, which will make it a less attractive investment. We tend to see a switch not only into the euro, but also to other safe havens. The gold, for example, has recently gone through the roof, first, because of the de-risking attitude and, second, for better returns.

The difficulty with the pound is that there isn’t an easy way for the U.K. to export itself out. With finance being the main industry of the U.K., there aren’t any widgets to ramp up production and sell it elsewhere. On that basis, we remain net importers of goods.

Q: Do you see the trade deficit as an inflationary pressure in the short term?