Pledge to fiscal consolidation and accommodative monetary policy underpin the UK’s AAA, Stable Trend

The future evolution of the credit risk profile of the United Kingdom of Great Britain and Northern Ireland (the U.K.) largely hinges on two factors: economic growth and fiscal consolidation. Although the government faces challenges in both areas, DBRS believes that the U.K. has the willingness and ability to meet these challenges. DBRS recognises, as key factors supporting the AAA rating with a Stable trend: (i) the government’s pledge to implement its far-ranging fiscal adjustment despite the deterioration in the economic growth outlook; and (ii) the support provided by the accommodative policy stance pursued by the Bank of England which has reduced the cost of funding faced by the government and its reliance on the market.

The U.K. has one of Europe’s most diverse and open advanced economies, with several distinguishing features from its Euro zone peers. The U.K benefits from a well-established institutional framework, strong fiscal and monetary policy flexibility and flexible product and labour markets. In addition, the U.K. benefits from having deep, efficient domestic capital markets, and the financial flexibility afforded by its internationally traded currency which has depreciated by 23% in trade-weighted terms since January 2007.

These strengths are counterbalanced by significant fiscal and debt challenges. According to the Maastricht definition, the U.K.’s fiscal deficit is estimated at 5.9% of GDP in 2012-13, down from 7.7% in 2011-12. General government gross debt is expected to reach 90.8% of GDP in 2012-13, and to peak at approximately 97.4% of GDP in 2015-16, before gradually declining thereafter. DBRS notes, however, that the long average maturity of the public debt stock, at more than 14 years in 2012, is by far the longest among advanced economies. This limits refinancing risk and reduces the sensitivity of the consolidation plan to interest rate shocks.

DBRS further acknowledges that the government’s fiscal consolidation plans set out in the June 2010 Budget and extended in 2011 and 2012 have come under pressure due to weaker than expected growth, as this has resulted in lower tax returns and increased spending on social benefits which have in turn translated into higher public sector net borrowing than previously forecast. However, the independent Office for Budget Responsibility (OBR) still expects the government to meet its target of eliminating the underlying structural deficit by 2017-18 a year early, in 2016-17. The government is however unlikely to meet its supplementary target of achieving a declining public sector net debt as a share of GDP in 2015-16.

Although debt has yet to stabilise and financing needs have increased, DBRS takes comfort in the U.K.’s high commitment and capacity to meet its debt servicing needs. This is partly due to the fact that public borrowing is concentrated in Sterling and the majority of gilts holders are domestic investors. Approximately 30.2% of U.K. government debt is held by non-residents, the third lowest level among G7 countries after Canada and Japan and well below the average level in advanced economies of approximately 40%. Furthermore, around 6% of external investors are central banks, and others include reserve and buy-and-hold hedge fund managers. Market confidence in the U.K. is also evident in the prevailing real interest rates on index-linked gilts, which are currently below 1% across the curve. DBRS thus expects financing costs to remain manageable, even as debt ratios rise in the coming years.

DBRS notes, however, that the sizeable fiscal austerity efforts introduced by the government since 2010 adversely weigh on the growth outlook. Prospects for the U.K. economy remain fragile due to the combination of fiscal consolidation, private sector deleveraging and poor credit availability, further exacerbated by subdued economic growth prospects in the Euro zone. The OBR expects the economy to contract by -0.1% in 2012 and to grow by 1.2% in 2013, compared to a previous growth forecast of 0.8% and 2%, respectively. Output is not expected to exceed its 2007 pre-crisis peak until the end of 2014 as the rebalancing of the economy away from private consumption and government spending towards business investment and trade proves to be slower than anticipated.

In addition to the weak domestic environment, the evolution of the Euro zone debt crisis continues to weigh on the British economy through a range of trade, confidence and financial channels. DBRS believes that although the easing of financial market tensions in the Euro zone in recent months has diminished the risks, tensions are on-going and could intensify. DBRS further acknowledges that although the exposure to the private non-financial sector of some Euro zone economies remains significant, U.K. banks have been improving their capital ratios and are only marginally exposed to the weaker Euro zone sovereigns.

In DBRS’s view, the government’s revisions to the pace of the fiscal consolidation, as a result of the weaker than expected economy, are likely to reduce the pressure on domestic demand by spreading the adjustment over a longer time horizon. Nevertheless, there are still potential implementation risks to consolidation, as only 52% of the planned tightening is now scheduled to occur before the 2015 election, with three additional years of tightening due to take place beyond it. Despite this, DBRS believes that the government's commitment to its long term fiscal stance continues to provide an anchor for market expectations, resulting in low government bond yields.

While the deteriorating growth outlook for the U.K. is affecting the credit metrics of the country, the economy is showing resilience as the unemployment rate declined to 7.8% in the three months to December 2012, down from its peak of 8.3% in late 2011. DBRS notes that favourable labour market dynamics have also provided some degree of support to tax revenues. In addition, DBRS expects the Bank of England’s accommodative policy stance to continue in 2013, providing relief to households and businesses, as low interest rates help to keep private sector debt-servicing costs low and the currency competitive. DBRS notes however, that a weaker currency whilst likely to facilitate an export-led recovery, it is also likely to be less tax-revenue friendly thus potentially putting added pressure on fiscal revenues and the deficit.

Going forward, the evolution of the U.K.’s ratings ultimately depends on the government’s continued commitment to long term fiscal consolidation in order to achieve debt sustainability. DBRS may change the Stable trend to Negative in case of: (i) a material downward revision of the U.K.'s medium-term growth potential which would call into question the government’s ability to keep the debt trajectory on a sustainable path; (ii) significant fiscal slippage resulting in further delays in the implementation of fiscal consolidation measures; or (iii) a sharp rise in funding costs, driven by an external shock or deterioration in market confidence.

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

A copy of the latest rating report on the United Kingdom of Great Britain and Northern Ireland is available on this page by following the link under Related Research or by contacting us at info@dbrs.com.