Perhaps it is unpatriotic of me to ask, but are France’s shrill politicians right? Is the United Kingdom the weak link?

From the Guardian:

The entente is no longer so cordiale. As the big credit rating firms assess whether to strip France of its prized AAA status, Bank of France chief Christian Noyer this week produced a long list of reasons why he believes the agencies should turn their fire on Britain before his own country. France’s finance minister François Baroin put things even more bluntly: “We’d rather be French than British in economic terms.” But is the outlook across the Channel really better than in Britain? Taking Noyer’s reasons to downgrade Britain – it “has more deficits, as much debt, more inflation, less growth than us” – he is certainly right on some counts. Britain’s deficit will stand at 7% of GDP next year, while France’s will be 4.6%, according to International Monetary Fund forecasts. But Britain’s net debt is put at 76.9% of GDP in 2012 and France’s at 83.5%. UK inflation has been way above the government-set target of 2% this year and the IMF forecasts it will be 2.4% in 2012. In France the rate is expected to be 1.4%. On growth, neither country can claim a stellar performance. France’s economy grew 0.4% in the third quarter and Britain’s 0.5%. Nor has either a particularly rosy outlook. In Britain the economy is expected to grow by 1.6% in 2012. But in the near term there is a 1-in-3 chance of a recession, according to the independent Office for Budget Responsibility. In France, the IMF predicts slightly slower 2012 growth of 1.4%. But in the near term France’s national statistics office predicts a technical, albeit short, recession.

There is one significant factor everyone is overlooking.

Total debt:

From Zero Hedge:

While we sympathize with England, and are stunned by the immature petulant response from France and its head banker Christian Noyer to the threat of an imminent S&P downgrade of its overblown AAA rating, the truth is that France is actually 100% correct in telling the world to shift its attention from France and to Britain. France should quietly and happily accept a downgrade, because the worst that could happen would be a few big French banks collapsing, and that’s it. If, on the other hand, the UK becomes the center of attention then this island, which far more so than the US is the true center of the global banking ponzi scheme, will suddenly find itself at the mercy of the market.

And why is the debt so high? Well, the superficial answer is that the UK is a “world financial centre”. The deeper answer is that the UK allows unlimited re-hypothecation of assets. Re-hypothecation is when a bank or broker re-uses collateral posted by clients, such as hedge funds, to back the broker’s own trades and borrowings. The practice of re-hypothecation runs into the trillions of dollars and is perfectly legal. It is justified by brokers on the basis that it is a capital efficient way of financing their operations. In the US brokers can re-hypothecate assets up to 140% of their book value.

In the UK, there is absolutely no statutory limit on the amount that can be re-hypothecated. Brokers are free to re-hypothecate all and even more than the assets deposited by clients. That is the kind of thing that creates huge interlinked webs of debt. And much of Britain’s huge debt load — particularly in the financial industry — is one giant web of endless re-hypothecation. Even firms (e.g. hedge funds) that do not internally re-hypothecate collateral are at risk, because their assets may have been re-hypothecated by a broker, or they may be owed money by a firm that re-hypothecates to high heaven. The problem here is the systemic fragility.

Simply, the UK financial sector has been attracting a lot of global capital because some British regulations are extremely lax. While it is pleasing to see the Vickers report, that recommends a British Glass-Steagall separation of investment and retail banking, becoming government policy, and while such a system might have insulated the real economy from the madness of unlimited re-hypothecation, the damage is already done. The debt already exists, and some day that debt web will have to be unwound.

Now Britain does have one clear advantage in over France. It can print its own money to recapitalise banks. But with inflation already prohibitively high, any such action is risky. If short sellers turn their fire on Britain, we could be in for a bumpy ride to hell and back.

UPDATE: Readers wanting to understand the true extent of economic degradation in some parts of the UK ought look no further than a recent post…