DBRS Assigns AAA Ratings to U.K. on Fiscal Effort and Economic Flexibility

DBRS has assigned ratings of AAA to the United Kingdom’s (U.K. or Britain) foreign and local currency securities, with Stable trends.

“The trends on the AAA ratings are Stable because the flexibility of the exchange rate has increased competitiveness, while the U.K.’s flexible labour market will lead to higher productivity growth,” says Fergus McCormick, DBRS’s U.K. analyst. “Furthermore, the newly elected government coalition has introduced a far-ranging fiscal adjustment, demonstrating a firm commitment to reducing the deficit and stabilizing public debt.”

As households and financial institutions rebuild their balance sheets, the cuts to public services will be the deepest and most sustained since World War II. “Although it is not yet clear whether rapid fiscal consolidation will support growth and employment, the fiscal adjustment has helped to calm market concerns about Britain’s high debt levels,” adds Mr. McCormick.

On June 22 of this year, the government introduced an emergency budget designed to reduce the deficit over the next five years. “The new coalition faces a very major challenge in cutting the deficit in the near term while fostering the economy back to growth,” says Mr. McCormick. “Nevertheless, the stability of the ratings rests on Britain’s ability to balance these two objectives.”

The AAA ratings reflect the size, openness and diversity of the British economy. The general elections on May 6, 2010, in which a Conservative-Liberal Democrat coalition prevailed, provided evidence of Britain’s enduring parliamentary democracy. The government’s rescue of the financial system, combined with timely and aggressive fiscal stimulus and monetary easing, helped to avert a far deeper recession, although this came at a steep cost to the government in the form of a high deficit and rising public debt. Nevertheless, DBRS is reassured by efforts to restore credibility to fiscal management while shoring up bank balance sheets and fostering economic activity.

Since November 2007, sterling has depreciated 39% against the U.S. dollar and 24% in trade-weighted terms, providing scope for a more competitive export sector, especially as credit becomes more available. A more competitive currency will also help to contain the current account deficit, which was a very manageable 1.1% of GDP in 2009. Moreover, Britain’s labour markets are more flexible than those of eurozone countries and have shown signs of resilience. Rising private savings as firms and households deleverage from their debt overhang will dampen the recovery, but should support sustainable growth over the medium term. Finally, the U.K. has deep domestic capital markets, which together with the use of sterling as a secondary reserve currency, provide financing flexibility.

The British economy was deeply affected by the crisis, declining 6.4% between Q2 2008 and Q3 2009, the longest recession on record. This decline in output largely reflected a sharp decline in private sector demand, as confidence collapsed and credit conditions tightened. The crisis also exposed regulatory failings. British financial and non-financial institutions became over-leveraged to both domestic and foreign creditors. Although much of this exposure was matched by assets on bank and corporate balance sheets, the size of the borrowing exposed the financial sector to systemic risk.

As the crisis spread, the government stepped in to safeguard the financial sector. A small deficit of 2.4% of GDP in 2007-08, which was largely caused by generous spending programs prior to the crisis, was converted into a deficit of 11% of GDP in 2009-10 due to a decline in tax receipts, continued growth in government spending and temporary stimulus measures during the crisis.

The emergency budget set out a total consolidation of £128 billion by 2015-16. The Office for Budget Responsibility projects that if fully implemented, the deficit will decline to 1.1% of GDP in 2015-16. Around three-quarters of the measures, most of which will be announced in the Spending Review on October 20, 2010, are spending cuts, while approximately one-quarter are tax increases. The cuts will include reductions in welfare and tax credits, and a freezing of public sector wages. The cuts to departments will be draconian, averaging 14% in real terms over the next four years, with many departments suffering real cuts of up to 25%. The tax measures will include a hike in the value-added tax from 17.5% to 20%, an increase in the capital gains tax for high earners from 18% to 28%, higher income tax rates for higher earners and a new levy on banks and building societies. Net debt-to-GDP, which excludes net financial sector interventions, is expected to rise from 53.5% of GDP in March 2010 to a peak of 70.3% in 2013-14, before falling to 67.4 % in 2015-16.

DBRS may change the Stable trends to Negative at any time, and as early as the fourth quarter of this year, if (1) a lack of political unity prevents passage of fiscal or reform legislation, (2) the government fails to reduce public consumption as planned, (3) contingent liabilities rise as a result of significant additional financial sector failures, or (4) financial stress and contagion results in sustained increases in funding costs, weaker bank balance sheets, tighter lending conditions or greater exchange rate volatility. A fifth, longer term consideration is a prolonged period of low economic growth, in which higher net exports, private sector consumption and investment fail to materialize, making fiscal adjustment unlikely to stabilize debt ratios.

The effort to consolidate public finances has stabilized the U.K.’s ratings. However, DBRS emphasizes that a careful balance between reducing the deficit in the near term, controlling long-term spending and addressing structural impediments to growth will be required. “Ultimately,” says Mr. McCormick, “the success of the fiscal plan will depend not only on the capacity to raise taxation and cut spending, but also on the strength of the recovery and the political commitment to the programme over the coming years.”

Notes:
All figures are in U.K. sterling unless otherwise noted.

The applicable methodology is Rating Sovereign Governments, which can be found on the DBRS website under Methodologies.

This is a Public Finance (Sovereigns) rating.