Credit crunch will squeeze London

The credit crunch may well have been overhyped. The global economy looks to be in decent shape, and markets have already recovered some of their nerve. That doesn't mean there won't be pockets of real pain.

Right now, the London economy is dangerously exposed. In the last five years it has boomed because of its turbo-charged financial-services industry. The City has drawn in talent from around the world. On some measures, it has overtaken New York as the number-one financial centre. The trouble is, its lead has been built on credit derivatives, hedge funds and buyout firms, precisely the areas that have been threatened by the credit crunch. London specialised in slicing and dicing risk in new ways, but if risk aversion increases, there won't be so many slicers. And if the City takes a hit, we will find out if the entire UK economy is dependent on the wealthy.

The Office of National Statistics said the UK economy grew 0.8% in the second quarter, while the business-and-finance sector expanded 1.5%, the fastest rate of any industry. "The London economy continues to outperform the UK in terms of annual output growth," said a recent report released by Mayor Ken Livingstone. "This strong performance has been led by the financial and business services sector."

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The source of that growth is the most interesting part. The City hasn't expanded by serving the rest of the UK economy, which has put in a more restrained performance in recent years. Nor is it at the heart of the European financial system: Britain hasn't even signed up to the euro. Instead, it has prospered by placing itself at the cutting-edge of finance. Looking for a structured derivative, based on a loan to a gold-mining firm in Uzbekistan? London was the place to get that deal done. Want a quant' hedge fund with a basement full of black boxes trading yak-hide futures? There are a dozen to choose from in Belgravia. As the mayor's office noted in its April report: "It has seen its share of new and innovative markets, such as derivatives, foreign exchange, debt finance, private equity and hedge funds, expand significantly." In some of the newest, fastest-growing sectors of the financial markets, it is London that has taken a decisive lead. The same report estimates Europe now has more than half the $52bn in revenue from worldwide derivatives trading, the bulk of which will be in London.

One way of looking at the credit crunch is as a rebellion by investors against all the innovation that has been thrown at them in recent years. There has been an explosion of new types of financial instruments. They may be good or bad. Right now, nobody is quite sure, and investors will examine them more carefully before buying them. That can only be bad for London. The market for credit derivatives will surely slow down. After all the volatility and closures of the last month, the hedge funds won't find it so easy to raise money. Some London-based firms are already closing their doors, such as Caliber Global Investment Ltd., which invested in subprime loans. Buyout funds will find it tougher, too. Lastly, in a market that has become more sensitive to risk, investors will be reluctant to put money into initial public offerings from Russia, China, and the former Soviet states another area where London has led the world. In short, it has been London that has led the way in persuading investors to buy riskier assets. As they become more risk-averse, it is likely the UK capital will suffer. That will hurt the wider economy. London-based consulting firm Capital Economics Ltd. estimates financial services account for 10% of the UK economy, and the recent turmoil could shave 0.2% from the nation's growth rate.

"Households have relied on a continuing flow of debt to keep consumer spending growing in an environment where disposable income has stagnated," David Miles, chief UK economist at Morgan Stanley, said in a note to investors. If borrowing becomes pricier particularly to people with poor credit records that will slow the whole economy down. Britain, with London leading the way, has been driven by financial innovation. Now that investors are becoming more wary, things will change. The global economy will still grow, although London may no longer set the pace.

This article originally appeared on Bloomberg.

Simon Nixon is away.