How the eurozone crisis affects us

The growing crises in Spain and Greece could damage your finances back home in Britain!

The eurozone crisis continues to cause pandemonium across the European mainland. But many of us here in the UK might just shrug our shoulders and ask "Why should I worry about Europe?"

 In fact, everyone in Britain – from politicians to pensioners and from homeowners to workers – should worry about the situation.

A $1 trillion problem?

At the moment, the two weakest links in the eurozone are Greece and Spain.

Greece has a relatively small economy: its GDP (Gross Domestic Product, or total national output) was just $305 billion in 2011, making it only the world's 36th-largest economy. What's more, Greece accounts for just a sixtieth (1.7%) of the 27-nation European Union's total GDP of $17.6 billion.

However, since the single currency launched on 1 January 1999, Greece has been a member of the eurozone, so it is a key link in this chain of 17 nations.

Today, there are growing fears that Greece's huge state debts and bank borrowings will bring down its economy, worsening an already deep recession. What's more, a second General Election called for 17 June could be the trigger to fire Greece out of the euro and back to the drachma.

If this were to happen, then this 'debt contagion' could spread to Spain, the world's 12th-largest economy with a GDP approaching $1.5 trillion. Spain is already struggling with recession and a loss of confidence in its banks, plus nearly one in four Spanish adults (24.4%) is unemployed.

In this situation, some economists predict that total losses from a euro breakdown could exceed $1 trillion, or around 1.4% of world output. The resulting meltdown would cause chaos in financial markets as investors sell risky investments and rush to the safety of rock-solid government bonds.

Here are six reasons why this matters to us.

1. Falling share prices

On Friday 16 March, the blue-chip FTSE 100 index of elite British businesses hit a 2012 high of 5,966. Last Friday, 18 May, the Footsie closed at 5,268. The UK's main stock market index has fallen by nearly 700 points (almost 12%) in nine weeks.

Therefore, if you directly own shares, either in certificated form or inside tax-free ISAs, then they've probably lost quite a bit of value in the past couple of months. Even if you don't own individual stocks, you've probably lose money because of a fall in the value of your pension pots, insurance policies and other investment plans.

In addition, more Euro-pain could see the FTSE 100 crash below last year's low of 4,791, which it hit on 9 August. Investors will need a lot of nerve to cope with increased market volatility in the coming months.

2. Credit crunch II

The European Union is the UK's biggest trading partner, taking in around half of British exports. Hence, if the PIGS (Portugal, Ireland, Greece and Spain) economies weaken further, then the UK economy would also take a knock, due to lower exports.

Also, fears about the strength and solvency of Greek and Spanish banks have led savers to pull billions of euros out of weaker institutions in a small 'bank run'. In addition, foreign banks are becoming increasingly wary of lending to ailing Mediterranean banks.

This increased nervousness among banks has caused inter-bank lending costs to creep up. If the situation suddenly took a turn for the worst, then we could see another credit crunch, causing lending to collapse.

This could have similar effects to the failure of US investment bank Lehman Brothers in mid-September 2008 – an event which effectively shut down the wholesale lending markets. And if inter-bank rates rise and lending criteria tighten, then loans to businesses and individuals will become more expensive and difficult to get. This event has already been dubbed 'credit crunch II'.

Furthermore, Santander UK – the British arm of Spanish banking giant Banco Santander – last week had its credit rating downgraded one notch to A2, its second cut in under a year. As a result, it issued a statement reassuring its savers that their UK deposits are safe. Despite this, some UK councils withdrew their money or stopped putting further money into Santander, having had their fingers burned once by the collapse of the Icelandic banks.

3. Higher mortgage rates

Although Britain's biggest banks have sharply reduced their exposure to Greece, Spain and Italy, they could still lose billions if one of these states were to default on its bonds or suffered a widespread banking meltdown.

Also, any further credit squeeze would force mortgage rates upwards, as banks seek to preserve their profit margins by raising rates. Since the beginning of this year, rates for the best fixed-rate mortgages have risen by between 0.25% and 0.5% a year. This adds as much as £750 a year to the interest bill for a £150,000 interest-only mortgage.

With banks facing losses on eurozone writedowns, plus inter-bank funding costs inching up, it seems almost inevitable that homeowners who aren’t on fixed deals will face higher monthly mortgage repayments later this year and into 2013 and beyond.

4. Falling house prices

If mortgage rates do rise and lending standards tighten, then this is sure to harm future house prices.

Also, mortgage lending slumped in April, diving almost a fifth (19%) to £10.2 billion, compared to £12.6 billion in March. This fall came following the end of a Stamp Duty holiday. For houses sold for up to £250,000, 1% stamp duty has returned for sales completed after 25 March.

While house prices outside 'fortress London' have been limping along for a year or so, any escalation in the eurozone's problems could undermine the UK's already fragile housing market. In the words of the Council of Mortgage Lenders, there is "potential for a sharper downwards correction on bad eurozone news".

5. Lower pension incomes

Recently, in a 'safe haven' rush, investors have been selling risky assets such as shares and buying solid government bonds. This buying pressure pushes up bond prices and, because the incomes from bonds (the coupon) are fixed, this reduced bond yields (their interest rates).

Today, the UK government can borrow for 10 years at a fixed rate of 1.85% a year. Although this is the lowest rate since Bank of England records began in 1703, it could yet fall further. Alas, falling bond yields are bad for newly retired pensioners looking to buy annuities (guaranteed incomes for life bought using pension pots or other lump sums).

As annuity rates are closely tied to bond yields, they stand at record lows. Financial advisers are urging pensioners to buy annuities now, as any delay could see rates fall further still.

6. Stronger pound

The eurozone weakness has had one positive benefit. The euro has been falling against the pound, making your pounds more valuable when you convert them into euros to spend abroad.

At the start of 2012, £1 would buy you €1.20, so a euro was worth around 83p. Today, £1 buys €1.24, so a euro is now worth just 81p. This 3.3% improvement in the strength of the pound means that you're getting an extra euro for every €33 you buy or spend in the eurozone.

The pound's strength is good news for holidaymakers, but bad news for British exporters, as it makes their goods more expensive overseas. This means even this news is something of a mixed blessing.

In summary, don't believe for one second that the UK is an island, safely isolated from the eurozone's storms.

English poet John Donne once wrote: "No man is an island, entire of itself; every man is a piece of the continent, a part of the main".

Right now, this famous quote seems more appropriate than ever.

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