A break-up of the single European currency would have severe consequences on the UK economy, with unemployment pushing above 4 million, the pound appreciating sharply and major banks failing, analysts at ING wrote in a market note.
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Big Ben
More than 47 percent of UK exports went to the euro zone last year and 33 percent of imports came from there, making the single currency area Britain's most important trade partner.
While a break-up of the euro zone is not ING's base case view, talk about it has intensified and "it does not mean it cannot happen," James Knightley, senior economist at ING, wrote.
He looked at two scenarios, one in which only Greece would exit the euro zone, the other in which the whole euro area would collapse.
"Our FX strategy team estimate that sterling would appreciate by 25 percent against the euro (relative to our base case forecast) under the Greek exit scenario," Knightley said, adding that the Greek drachma would fall by 85 percent against the pound.
Greece only accounts for 0.5 percent of total UK exports but a Greek exit from the euro zone could still have significant effects on the British economy. Loss of competitiveness because of a surge in the pound combined with weaker growth in the euro zone could push UK exports down by more than 10 percent, he wrote.
"There is the potential for greater sterling appreciation against European currencies under the complete break-up scenario, given the prospect of a more intense overshoot caused by the scaled-up financial dislocation that such an event would cause," Knightley added.
The euro zone would go through a deep, double-digit recession if the break-up scenario were to come true, which means UK exports could fall by more than 25 percent, he also said.
Huge Hit for Banks
The financial sector would be hard hit by a break-up of the single European currency, as its exposure to the euro zone is around 653 billion pounds ($1 trillion), or 42 percent of gross domestic product, according to the ING analyst.
If only Greece exits the euro zone, this could be manageable in theory as the UK banking sector's exposure to the country is less than 8 billion pounds, he added.
"We assume that all of this would be wiped out based on our view of the 85 percent Greek drachma depreciation against sterling and the likelihood of massive banking and corporate insolvencies resulting from Greece’s withdrawal from the EMU," he wrote.
But he added that under a total break-up scenario, the situation would be "far worse." The pound would appreciate against all of the new 17 currencies, by approximately 25 percent versus the new German currency, 65 percent against the French currency and as much as 115 percent versus the Spanish one.
"Add in the effects of large asset price declines in these economies and the UK banking sector would inevitably need to be bailed out," Knightley wrote. "Indeed, even if banks heed Bank of England Governor Mervyn King’s advice to boost capital when possible, the scale of potential losses would liquidate all of the banks capital."
The big four UK banks – Barclays , HSBC , RBS and Lloyds – have a total exposure of 578 billion pounds to the euro zone, or 268 percent of core capital, according to the Bank of England.
The impact on asset markets of a total break-up of the euro zone would also be significant, even if policymakers respond quickly, according to Knightley.
"Equity markets would plunge as investors sought safe havens during the period of dislocation and gilt yields would fall sharply. Asking prices for property would collapse, yet there would be no transactions happening given the lack of credit," he wrote.
But he reiterated that his bank's base scenario was that the euro zone will be saved, as the cost of keeping it together was far less than that of keeping it apart.
"The hit to trade, confidence and financing would be significant and we suspect that, if anything, our numbers understate what may happen in reality," Knightley wrote.