DBRS Confirms United Kingdom’s AAA Ratings on Continued Commitment to Fiscal Consolidation

DBRS Ratings Limited (DBRS) has today confirmed the AAA ratings on the foreign and local currency securities of the United Kingdom (the U.K. or Britain). The ratings are underpinned by the size, openness and diversity of the British economy, its fiscal and monetary policy flexibility, a historical track record of fiscal consolidation, and relatively flexible product and labour markets. In addition, the U.K. benefits from having deep, efficient domestic capital markets and the sterling’s status as a secondary reserve currency.

The legacy of the 2008-2009 global financial crisis, which resulted in a large structural deficit and a high debt burden, continues to weigh on the country’s credit profile. However, the trend on both ratings is Stable, and is mainly supported by the government’s pledge to implement its far-ranging fiscal adjustment, demonstrating a firm commitment to reducing the deficit and stabilising public debt. DBRS notes, however, that the sizeable fiscal austerity efforts introduced by the government since 2010, and further extended in 2011, will likely weigh on the economy. Although the U.K. exited recession, economic recovery has been muted, with GDP growth of 1.4% in 2010 and estimated to dip to 0.9% in 2011 and 0.7% in 2012. DBRS is concerned that the ongoing economic slowdown exacerbated by the Euro zone crisis could leave the economy close to recession in 2012, further heightening the scale of the budgetary challenges and the fiscal capacity to absorb additional adverse economic and financial shocks.

The evolution of the U.K.’s ratings ultimately depends on the government’s continuous commitment to credible medium-term fiscal consolidation in order to achieve fiscal sustainability. DBRS may change the Stable trend to Negative, if (1) there is a prolonged period of very low economic growth in which higher net exports, private sector consumption and investment fail to materialise, making stabilising debt ratios more challenging, (2) rising political divisions within the governing coalition were to prevent implementation of the fiscal austerity measures, (3) contingent liabilities rise as a result of financial sector pressures resulting in government support programmes that lead to larger budget deficits, or (4) there is a sharp rise in funding costs, driven by an external shock or deterioration in market confidence.

In November 2011, the Office for Budget Responsibility (OBR) revised its U.K. GDP growth forecasts downward, from 1.7% to 0.9% in 2011 and from 2.5% to 0.7% for 2012, and lowered its estimate of the U.K. economy’s productive capacity by the end of the 2015-16 period by approximately 3.5 percentage points. As a result, the government expects to continue to meet its mandate of eliminating the cyclically-adjusted current deficit at the end of the five year rolling forecast in 2016-17 – albeit, two years later than the OBR’s previous estimate of 2014-15. The government responded to the deterioration in the economic and fiscal outlook in its Autumn Statement with additional tightening measures amounting to £15 billion (0.8% of GDP) by 2016-17. This ensures that the fiscal rules are met while preserving the target objective of reducing the public sector net debt as a share of GDP from 2015-2016.

The U.K. fiscal deficit is estimated to be 8.4% in 2011 (previously 7.9%) down from 9.5% of GDP in 2010, but is the third highest among G7 countries after the United States and Japan. Government debt surged from 42% to 76.5% of GDP between 2005 and 2010, and is expected to peak at approximately 93.9% of GDP in 2014, before gradually declining thereafter. While related forecasts for interest costs have been revised down, largely due to record low bond yields, their level as a share of government revenue has risen and is expected to reach 7.9% in 2011. DBRS notes, however, that the long average maturity of the public debt stock – 13.5 years in 2011, by far the longest among advanced economies – limits refinancing risk, reducing fiscal exposure to temporary spikes in yields.

The AAA ratings reflect the U.K.’s well-established institutional framework and strong fiscal resilience. The political system gives the government strong executive powers to set and implement fiscal policy. The budget is usually passed into law with only minor technical changes, and it is rare for a government to be defeated in Parliament on a significant proposed tax change. Moreover, DBRS notes that the fiscal rules set by the government and their close oversight by the independent OBR create an important constraint against a relaxation of fiscal discipline even if economic activity were to underperform expectations.

The slowing global economy, together with growing concerns over the Euro zone sovereign debt crisis, is increasingly affecting U.K. growth. As a result, the OBR expects that the U.K. will post relatively modest growth of 1.6% on average from 2011 to 2014, lower than the previous forecast of 2.5%. The rebalancing of the economy away from private consumption and investment in housing and towards business investment and more externally focused sectors is also proving to be a slower process than anticipated. Nevertheless, DBRS believes that the Bank of England’s accommodative policy stance and the adoption of a second wave of quantitative easing (QE) should provide some support to the economy, as low interest rates keep private-sector debt-servicing costs low, and the currency at competitive levels.

Renewed stress in the financial system also poses additional risks to the U.K.’s credit profile. DBRS is concerned that constrained bank credit availability and funding problems have resumed, reflecting large bank refinancing needs (£140 billion by end-2012), reliance on short-term wholesale borrowing, and counterparty risk stemming from interlinks with the weakened European financial system. Whilst British banks have already taken steps to improve the resilience of their balance sheets, DBRS believes that persistent funding pressures could make it harder for British banks to do so without further reducing lending to the real economy. With banks also facing a levy and global regulatory demands for tighter capital and liquidity requirements, these strains could force a resumption of government support programmes that would lead to additional pressure on public finances.

The strong commitment to consolidate public finances continues to underpin the ratings. However, DBRS emphasises that a careful balance between reducing the deficit in the near- term, and controlling long-term spending while addressing structural impediments to growth, will continue to be required to maintain the Stable trends. Ultimately, the success of the fiscal consolidation plan will depend not only on the capacity to raise taxation and cut spending, but also on ensuring that the economy does not fall into a prolonged recession. A domestic political crisis that derails the fiscal programme, or a disorderly escalation of the European sovereign debt crisis, followed by a deep and extended recession could lead to downward rating pressure.

Notes:
All figures are in GBP unless otherwise noted.

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

The sources of information used for this rating include the Bank of England, HM Treasury, Office for Budget Responsibility, U.K. Debt Management Office, Office for National Statistics, OECD, Eurostat, Haver Analytics and IMF. DBRS considers the information available to it for the purposes of providing this rating was of satisfactory quality.

Ratings assigned by DBRS Ratings Limited are subject to EU regulations only.

Lead Analyst: Giacomo Barisone
Rating Committee Chair: Alan G. Reid
Initial Rating Date: 19 July 2010
Most Recent Rating Update: 19 July 2010

For additional information on this rating, please refer to the linking document under Related Research.