DBRS Confirms the United Kingdom at AAA, Stable Trend

DBRS Ratings Limited (DBRS) has confirmed the United Kingdom of Great Britain and Northern Ireland’s (the United Kingdom or U.K.) Long-Term Foreign Currency – Issuer Rating and Long-Term Local Currency – Issuer Rating at AAA and Short-Term Foreign Currency – Issuer Rating and Short-Term Local Currency – Issuer Rating at R-1 (high). The trend on all ratings is Stable.

The Stable trend reflects DBRS’s view that, despite concerns over the immense challenge of negotiating and then implementing European Union (EU) exit, Brexit-related uncertainty weighing on investment decisions, and recent downward revisions to the economic growth forecast for the U.K., these factors are outweighed by credit strengths. The U.K.’s labour market is highly flexible, employment growth is strong and the unemployment rate is at an historical low. Public finances are performing better than expected in the near term and, albeit with smaller headroom, the government is on track to meet its interim fiscal targets.

The AAA rating level reflect the size and resilience of the U.K.’s economy and financial markets. HM Treasury and the Bank of England (BoE) oversee one of the world’s primary currencies and reserve assets. This facilitates low-cost local currency borrowing across a broad range of maturities, even during periods of investor risk aversion. The U.K.’s large and advanced economy, its strong institutions and rule of law and its very favourable maturity structure of public debt underpin the AAA rating level and mitigate credit challenges. Other supportive rating factors that DBRS expects will remain unchanged regardless of the outcome of Brexit, include Central Bank independence, a sound financial supervision structure, and statutory fiscal rules.

Credit challenges include the difficult political task of negotiating the U.K.’s exit from the EU and the subsequent process of implementing new structures and systems. Also, the high level of government debt that limits fiscal flexibility in economic slowdowns such as that currently occurring. DBRS views that sustained progress with fiscal consolidation is necessary to place public debt on a downward path. Moreover, the current account deficit has recently been subject to negative revisions related to net investment income, and Brexit brings uncertainties to the capital account.

DBRS’s previous review of the U.K. occurred shortly after the snap elections on 8 June 2017 that resulted in a hung parliament. The subsequent agreement between the Conservative Party and the Democratic Unionist Party (DUP) securing DUP confidence-and-supply support has been followed by a period of challenging events for the leadership both at home and abroad, but the arrangement so far has proved durable. The exceptional challenge of negotiating an EU exit imposes a strain on the agreement, in particular with respect to the border between Northern Ireland and the Republic of Ireland. Today, the European Council decided that progress achieved in the first phase of negotiations related to the U.K.’s withdrawal is sufficient to move to the second phase related to transition and the framework for the future relationship. DBRS views these upcoming discussion to also be difficult. Nevertheless, DBRS currently expects a transition deal for the U.K. that should allow for a more orderly structural adjustment.

The U.K. is the fifth-largest economy in the world and is one of the most advanced, with strong economic performance in recent years. However, growth has moderated more recently reflecting uncertainty over the U.K.’s future relationship with the rest of Europe and the impact of higher inflation on consumer spending. The November 2017 official forecasts were revised down by 0.4 percentage points a year on average to 2021/22 relative to the March 2017 forecast. The Office for Budget Responsibility (OBR) now expects the economy to grow by 1.5% in 2017, compared to 1.8% in 2016. This may be followed by slowing growth of 1.4% in 2018, 1.3% in 2019 and 2020, but improving to 1.5% in 2021 and 1.6% in 2022. These revisions to GDP growth forecasts were in part related to a more pessimistic view than previously of future productivity performance that reduces potential growth in the future. However, cross-country comparisons of the forecasted trend growth of output per person employed suggest that the U.K. is not too dissimilar from other developed countries. In the longer term, however, the economic impact of the UK’s exit could impact trade and migration. In DBRS’s view the U.K.’s flexible labour market and its strong institutions are mitigants for the risk of economic dislocation due to Brexit, although it is now apparent that the economic outlook has weakened with the potential to reduce fiscal revenues.

The U.K.’s fiscal framework is sound and transparent, supported by flexible fiscal rules and the independent OBR providing economic forecasts. Since 2010, material progress was made in reducing the Maastricht treaty deficit, from 10% of GDP in 2009/10 to 2.4% of GDP in 2017/18. This much lower level is only a small increase from 2.3% of GDP in 2016/17, attributable to revenue-timing effects, and is expected to decline to 2% in 2018/19. Positive fiscal revisions in the near term are offset by negative forecast revisions that are projected to increase due to fiscal stimulus in 2018/19 and 2019/20. The latter stimulus includes net tax cuts, lower than planned reductions in departmental spending and additional capital spending. Still, the government’s interim targets for fiscal policy of reducing the cyclically-adjusted deficit below 2% of GDP by 2020-21, and lowering the public sector net debt as a share of GDP in 2020-2021 are expected to be met, but with reduced fiscal headroom. The target of ensuring that welfare expenditure in 2022-23 is under a predetermined cap seems achievable at the moment.

After a pronounced increase in the U.K.’s public debt ratio following the global financial crisis, this ratio is broadly stabilising, amounting to 86.8% of GDP in 2016/17, with forecasts of 87.0% in 2017/18 and 87.3% in 2018/19. This level of debt is high and reduces the U.K.’s scope for fiscal flexibility, but it is close to the Euro area average of 87.2% (end-2017 forecast), and below France (96.9%). In terms of net debt, the U.K. figure of 77.8% favourably compares with the United States of America (U.S.A) at 108.1%. DBRS assesses the country’s commitment and capacity to meet its debt servicing needs as strong. Public borrowing is in British pounds sterling and the majority of gilt holders are domestic investors. The U.K. government is considering the appropriate balance between index-linked and conventional gilts in the coming years. The high share of index-linked debt, which is around 26% of total debt, relates to strong structural demand from domestic pension funds. By comparison, France’s share of index-linked debt is close to 10%; U.S.A. around 8%; and Canada 6%. The expectation is that any ‘Brexit bill’ will have phased implementation, but should a bullet payment be required, DBRS views the U.K. to have sufficient funding flexibility.

The U.K. enjoys a high degree of monetary policy flexibility, owing to a responsive central bank and sterling’s status as a reserve currency. The BoE took important measures to address financial volatility that occurred in the aftermath of the U.K. vote to leave the EU and, in August 2016, reduced Bank Rate to 0.25%. It has conducted a loose monetary policy for many years, only recently returning the Bank Rate to the pre-August 2016 level of 0.5%. Inflation has accelerated since the last review, averaging 2.8% in the third quarter of 2017 and 3.1% in November, but the BoE’s central forecast assumes that a very gradual and limited tightening would constrain inflation back towards the two percent target in 2018 and 2019. The process of leaving the EU poses one risk to financial stability. Other risks include high household debt, currently 94.4% of GDP and 140.0% of household disposable income, and housing price growth, although this has recently decelerated. The U.K.’s banking system has improved its results, but still carries some risks from consumer lending (link to DBRS Comment on UK Banks’ 3Q17 Results and DBRS comment on the BoE 2017 Stress Test Results).

The current account deficit is large, 5.9% of GDP in 2016, and is a source of external vulnerability, although it is set to decline in the next few years. The deficit mainly reflects the goods trade deficit; however, the income balance deteriorated in recent years and has recently been subject to a negative revision. The revision relates to interest income earned by foreign owners of U.K. corporate bonds, which was materially revised upwards. Despite the current account deficit, the United Kingdom’s net external liability position has been moderate just 1.1% of GDP in 2016, an improvement on previous years. In the longer term, the impact of the U.K’s exit from the EU on the external accounts is highly uncertain.
RATING DRIVERS

The U.K.’s ratings are well placed in the AAA rating category. The ratings could come under downward pressure from one of the following factors or a combination of these factors (1) a Brexit outcome that materially diminishes economic resilience and erodes the government’s debt financing flexibility; (2) economic and financial dislocations that deteriorate banking sector fundamentals or the country’s fiscal position; and (3) a significant increase in the likelihood of a break-up of the United Kingdom.

RATING COMMITTEE SUMMARY

The DBRS Sovereign Scorecard generates a result in the [AAA to AA (high)] range. The main points of the rating committee discussion included the U.K.’s economic resilience related to Brexit, revised official economic and fiscal forecasts, monetary policy and the banking system and the composition of public sector debt.

KEY INDICATORS

Fiscal Balance (% GDP): -2.3% (2016); -2.4% (2017F); -2.0% (2018F)
Gross Debt (% GDP): 86.8% (2016); 87.0% (2017F); 87.3% (2018F)
Nominal GDP (GBP billions): 1,961 (2016); 2,035 (2017F); 2,105 (2018F)
GDP per capita (GBP): 23,873 (2016); 30,817 (2017F); 31,658 (2018F)
Real GDP growth (%): 1.8% (2016); 1.5% (2017F); 1.4% (2018F)
Consumer Price Inflation (%): 0.7% (2016); 2.7% (2017F); 2.4% (2018F)
Domestic credit (% GDP): 163.8% (2016); 164.7 (Jun-2017)
Current Account (% GDP): -5.9% (2016); -4.6% (2017F); -4.7% (2018F)
International Investment Position (% GDP): -1.1% (2016); -5.1% (Jun-2017)
Gross External Debt (% GDP): 307.91 (2016); 307.0% (Jun-2017)
Governance Indicator (percentile rank): 92.8 (2016)
Human Development Index: 0.91 (2016)

Notes:

All figures are in GBP unless otherwise noted. Public finance statistics reported on a general government basis unless specified. General government gross debt is calculated on a Maastricht basis. Fiscal figures as at end of fiscal year. Governance indicator represents an average percentile rank (0-100) from Rule of Law, Voice and Accountability and Government Effectiveness indicators (all World Bank). Human Development Index (UNDP) ranges from 0-1, with 1 representing a very high level of human development. Key Indicators’ sources include: Office for National Statistics, Office for Budget Responsibility, International Monetary Fund, European Commission, World Bank, United Nations Development Programme (UNDP), Haver Analytics.

The principal applicable methodology is Rating Sovereign Governments, which can be found on the DBRS website www.dbrs.com at http://www.dbrs.com/about/methodologies. The principal applicable rating policies are Commercial Paper and Short-Term Debt, and Short-Term and Long-Term Rating Relationships, which can be found on our website at http://www.dbrs.com/ratingPolicies/list/name/rating+scales.

The sources of information used for this rating include UK Office for National Statistics, the Office of Budget Responsibility, HM Treasury, Debt Management Office, the Bank of England, International Monetary Fund, European Commission, Organization for Economic Co-operation and Development, United Nations Development Programme (UNDP), World Bank, Bloomberg L.P, Haver Analytics. DBRS considers the information available to it for the purposes of providing this rating to be of satisfactory quality.

This is an unsolicited rating. This credit rating was not initiated at the request of the issuer.

This rating included participation by the rated entity or any related third party. DBRS had no access to relevant internal documents for the rated entity or a related third party.

DBRS does not audit the information it receives in connection with the rating process, and it does not and cannot independently verify that information in every instance.

Generally, the conditions that lead to the assignment of a Negative or Positive Trend are resolved within a twelve month period. DBRS’s outlooks and ratings are under regular surveillance.

For further information on DBRS historical default rates published by the European Securities and Markets Authority (“ESMA”) in a central repository, see:
http://cerep.esma.europa.eu/cerep-web/statistics/defaults.xhtml.

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

Lead Analyst: Nichola James, Senior Vice President, Co-Head of Sovereign Ratings, Global Sovereign Ratings
Rating Committee Chair: Roger Lister, Managing Director, Chief Credit Officer, Global FIG and
Sovereign Ratings

Initial Rating Date: 19 July 2010

Last Rating Date: 16 June 2017

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