Britain risks becoming the first country in the G10 bloc of major economies to risk capital flight and a full-blown debt crisis over coming months, according to a client note by Morgan Stanley.

By Ambrose Evans-Pritchard

LONDON, England - November 30, 2009 - The U.S. investment bank Morgan Stanley said there is a danger that Britain’s toxic mix of problems will come to a head as soon as next year, triggered by fears that Westminster may prove unable to restore fiscal credibility.

“Growing fears over a hung parliament would likely weigh on both the currency and gilt yields as it would represent something of a leap into the unknown, and would increase the probability that some of the rating agencies remove the UK’s AAA status,” said the report, written by the bank’s European investment team of Ronan Carr, Teun Draaisma, and Graham Secker.

“In an extreme situation a fiscal crisis could lead to some domestic capital flight, severe pound weakness, and a sell-off in UK government bonds. The Bank of England may feel forced to hike rates to shore up confidence in monetary policy and stabilize the currency, threatening the fragile economic recovery,” the report said.

Morgan Stanley said that such a chain of events could drive up yields on 10-year UK gilts by 150 basis points. This would raise borrowing costs to well over 5% - the sort of level now confronting Greece, and far higher than costs for Italy, Mexico, or Brazil.