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U.K.’s Osborne warns of tough times ahead

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British chancellor George Osborne said the economy will not slip into recession, though it is clearly slowing and could go into reverse if the euro zone debt crisis is not cured.

Presenting his autumn economic and fiscal forecast in parliament, Osborne said the economy will expand 0.9 percent this year, falling to 0.7 percent next year, a dramatic reduction from the previous forecast of 2.5 percent. The economy is expected to rebound to 2.1 percent in 2013.

He admitted that the growth slowdown means Britain will be unable to reach its target of eliminating the structural deficit by 2015.

Osborne stressed that his statement, which was based on forecasts made by the independent Office for Budget Responsibility (OBR), assumed that the euro zone debt crisis does not deepen. If it does, "then the OBR warned that there could be a much worse outcome from Britain," he said. "If the rest of Europe heads into recession, it may be hard to avoid one here in the UK."

His worst nightmare may come true. Forecasts from the European Commission, the Organization for Economic Co-operation and Development (OECD) and many economists forecast declining European growth and a probable recession in the 17-country euro zone.

Deutsche Bank predicts a 0.5-percent contraction in the euro zone in 2012, with each of its major economies recording zero to negative growth. Among the largest economies, Italy, with an expected 1.1-percent contraction next year, will be hit hardest.

The OECD's forecast for Britain alone is grimmer than OBR's. On Monday, it said Britain was headed for a double-dip recession, with negative economic output in the final quarter of this year and in the first quarter of 2012. For all of 2012, the OECD expects an expansion of just 0.5 percent.

With growth stalling, Osborne said British government debt will peak at 78 percent of gross domestic product in 2014-2015, up significantly from the previous forecast. The OECD expects a 100 percent debt-to-GDP ratio. "Our debt challenge is greater than we thought because the boom was bigger than we thought, the bust was deeper and the effects will last longer than we thought," he said.

In effect, the Britain's fiscal situation, while deteriorating, is being salvaged by very low interest rates on its sovereign debt. Throughout the debt crisis, Britain has been able to borrow at rates as low, or lower, than Germany as investors take faith in its austerity programs and the Bank of England's ongoing support of the treasury's debt market.

Government borrowing costs over the life of the parliament will be pounds 22-billion less than predicted because of extremely low interest rates.

But some investors think Britain's bonds, known as gilts, are headed for a fall, sending yields up. In a Nov. 25 report, MRB Partners of London and Montreal recommended that investors avoid gilts. "Gilts are ill-prepared for any bad news, and there are mounting risks regardless of which extreme economic/financial outcome occurs," its authors said.

Osborne's statement came as Italy produced more evidence that the euro zone debt crisis is fully intact. In Tuesday's sale of 10-year bonds, Rome was forced to offer a yield of 7.56 percent, up from 6.06 percent on a similar sale a month ago. The yield on the new 3-year bonds soared to 7.89 percent.

The sale, however, was fully subscribed and the spread between Italian and German 10-year bonds narrowed slightly after the auction.

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