Q&A: What does the eurozone debt crisis mean for the UK?

Euro and pound coin Just over 50% of the UK's exports go to other EU countries

As the outlines of an agreement emerge from the EU's make-or-break summit to save the euro, there is one point that is now certain: The UK will not be part of it.

But while the political stakes for Britain may have become starkly clear, the economic and financial stakes remain wide open.

For the UK stands to gain or lose enormously depending on whether the euro succeeds or fails - an outcome over which the UK now has very little influence.

How does the proposed euro agreement affect the UK?

On the face of it, it will have very little direct effect, as the UK will be excluded from the new treaty.

Proposals for new rules on government borrowing, and a possible harmonisation of corporate tax rates, are only aimed at eurozone countries.

David Cameron has ducked the tax on financial transactions - the "Tobin tax" or "Robin Hood tax" - being pushed by France and Germany, which he said would damage the City's global competitiveness as a financial centre, unless it were also adopted in the US and elsewhere.

Will the UK have to pay for any more bailouts?

Probably not.

The summit aims to boost the size of one bailout fund - the European Financial Stability Facility (EFSF) - and bring forward to next year the introduction of another, the European Stabilisation Mechanism (ESM). But the UK contributes to neither of these.

There is speculation that the summit will pave the way for the European Central Bank to step up its purchases of Italian and Spanish government debt - a back-door way of reducing those countries' currently punitive costs of borrowing. But the UK does not contribute to the ECB either.

There are also plans to increase contributions to the International Monetary Fund by 200bn euros (£170bn, $270bn). Of that, 150bn euros will come from the various national central banks within the eurozone. It is unclear whether the Bank of England will contribute towards the remaining 50bn euros. In any case, if the IMF provides rescue loans to a eurozone country, then - just as with any IMF rescue - the money that the UK has already put into the fund would back those loans.

The UK can of course still volunteer to help finance a future bailout, as it already did in the case of the Irish Republic late last year. After all, a collapse of the eurozone could be a disaster for everyone, the UK included.

How might the eurozone financial crisis impact the UK?

There have been two aspects to the crisis:

  • A banking crisis: Eurozone banks have found it harder to borrow money, especially in foreign currencies such as the US dollar
  • A government debt crisis: Southern European governments have seen their borrowing costs increase sharply.

Both of these could spill over into the UK.

So UK banks are at risk?

Although UK banks have fairly limited direct exposure to the more troubled eurozone countries (except the Irish Republic), they do have a lot of exposure to France and the French banks. And the French banks in turn have lent a lot to Italy and Spain.

If a major bank, in France or elsewhere, went bust, then UK banks could very easily find their ability to borrow in financial markets severely restricted.

UK banks should be able to turn to the Bank of England for support if they have trouble borrowing in sterling. Indeed the Bank just introduced a new crisis facility to cover just this risk.

UK banks also have a lot of foreign currency debts, which they have used to make matching foreign currency investments. If they are unable to borrow in foreign currency, they may be forced to sell off their investments in a hurry and at a big loss. Again, central banks, including the Bank of England, have put in place agreements that will help them provide emergency loans to their banks in each others' currencies.

What about the government?

The Treasury has seemingly benefited so far. Chancellor George Osborne has been keen to highlight how the UK government has been able to borrow at historically low interest rates during the crisis.

He claims this is because the UK's strict adherence to austerity has made it a "safe haven" - as Germany has become within the eurozone - though some economists say it is actually because the UK economy is so depressed (like Japan's).

The UK is still very dependent on foreign money to finance its persistent trade deficit. If the banking crisis became critical and spilled over into the UK, it could lead to a currency crisis for the UK, with foreign investors exiting the pound, the pound's value collapsing, and the government's borrowing cost rising sharply.

However - in contrast with the eurozone members - the UK government borrows almost entirely in a currency it controls, namely sterling. A loss of confidence in the UK would be reflected mainly in a fall in sterling's value - which would push up the cost of imported goods.

In the worst case, the Treasury could order the Bank of England to finance its borrowing needs by printing money. That is a luxury that eurozone members do not enjoy. So the real risk in the UK is one of inflation, rather than of the government being unable to pay its debts.

How would UK trade and business with Europe be affected?

More than 50% of the UK's total trade is done with the European Union . That's equivalent to 5%-6% of British GDP.

So a deep recession in the rest of the EU will be a direct hit to the demand for goods and services in the UK.

An intensification of the crisis may also go hand-in-hand with a weakening of the euro - not something that has been especially evident yet - which in turn would give eurozone exporters a competitive price edge over the UK.

A more pernicious and longer-term threat to the UK could be its political isolation in Europe. It could set a precedent for the eurozone members to agree their own rules on other matters that affect UK business and trade with the continent, without the UK having a say.

For example, there have been calls to ban the trading of euro-denominated financial securities in non-eurozone countries - something that would harm the City of London.

What would it mean for the UK if the eurozone breaks up?

It could well be a disaster.

It would be very difficult for the eurozone to break up in a controlled, negotiated way. Expectations of a weaker country, such as Spain or Italy, leaving the euro could lead to bank runs and a collapse in the country's banking system. Once one country had crashed out, it would create enormous financial pressures for others to follow suit.

People and companies would find it very hard to borrow money. Companies could go bust overnight because their assets and liabilities end up in different currencies of very different value. There could be protracted legal wranglings over whether contracts could be redenominated into new currencies.

All of which means the UK could face a massive recession in its main export market.

Furthermore, it could provoke a global financial crisis, placing huge strains on the City of London.

As we discovered in 2008-09, the UK is more dependent than most other countries on its banks. They finance our mortgages, keep the cash flowing through our economy, employ tens of thousands of people and pay a big chunk of the Treasury's tax revenues.

But most scary of all, many economists predict it could be another moment like the collapse of Lehman Brothers in 2008. Only this time governments have much less capacity to bail the financial system out. A global depression may beckon.

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