DBRS Confirms the United Kingdom at AAA, Stable Trend

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

KEY RATING CONSIDERATIONS

The Stable trend reflects DBRS’s view that since our last review growth in the U.K. along with in other European economies may be slowing, but official sector medium-term U.K. economic forecasts are little changed. No new fiscal policy measures were announced in the Spring Statement. The government’s headroom against its fiscal targets is also unchanged compared to the previous Office for Budget Responsibility (OBR) forecast. Fiscal consolidation continues and the public debt ratio is expected to decline this fiscal year. Brexit negotiation and related legislation is in progress.

While we see potential risks from Brexit as outlined in our rating drivers, the AAA rating level reflects 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 very favourable maturity structure of public debt is a key credit strength. 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 that match the discipline of European Union (EU) frameworks.

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 RATIONALE

Minority Conservative Government, but so far Durable Relationship with the DUP

Last year’s snap national elections resulted in a hung parliament. The subsequent agreement between the minority Conservative Party and the Democratic Unionist Party (DUP) securing DUP confidence-and-supply support has been followed by a period of challenges, not least with respect to Brexit negotiations. Nonetheless, the arrangement has so far proved durable. In addition, the challenge of narrowing divergent views within the Conservative Party related to the characteristics of the future relationship with the EU imposes strain on the leadership and the Party. Despite the political noise and elevated rhetoric, political institutional strengths including checks and balances in the legislature, help underpin the credit rating.

Many steps remain in EU exit-related decision-making and in obtaining the required approvals in what is now a very tight time frame for EU exit, but debate and negotiations are ongoing. Decisions on the customs union potentially affecting the border between the Republic of Ireland and Northern Ireland are among the most challenging. The agreement in principle on a possible transition period to end-2020 when the U.K. remains in the single market and customs union allowing time for economic and financial adjustment is encouraging. The U.K. proposal to the EU for a U.K. customs backstop arrangement beyond 2020 is in progress. The EU withdrawal bill is moving slowly through the U.K.’s legislature and more clarity is expected in coming months.

Despite Scotland voting to remain in the EU, the recent elevation of the Scottish independence issue by the Scottish National Party (SNP) leadership is unlikely to gain traction. This relates to the fact that the U.K. parliament seems unlikely to support a second referendum; the SNP lost a large share of their parliamentary seats in last year’s elections; and there doesn’t appear to be majority popular support for either a second referendum or for independence. Nonetheless, the tail risk of a significant increase in the likelihood of a break-up of the U.K. remains one of the downward credit rating drivers for now.

Growth may be Slowing, but the U.K. Unemployment Rate is at an Historically Low Level

The U.K. is the fifth-largest economy in the world and is one of the most advanced, with strong economic performance in past years. However, headline growth has moderated more recently possibly reflecting uncertainty over the U.K.’s future relationship with the EU stalling investment and the impact of low wage growth and higher inflation on consumer spending. The OBR expects the economy to grow by 1.5% this year, compared to 1.8% in 2017. This may be followed by slowing growth of 1.3% in 2019 and 2020, but improving to 1.4% in 2021 and 1.5% in 2022. Employment continues to grow and the unemployment rate at 4.2% is the lowest rate since 1975. The labour participation rate is 79%, the highest since records began in 1971. In the longer term, however, the economic impact of the U.K.’s exit could adversely impact trade, investment and migration leading to potential growth slippage that could negatively impact long term debt dynamics. Other economic risks come from geopolitics and global protectionist policies.

Continued Fiscal Consolidation Expected to Support a Slow Reduction in the Debt Ratio

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 2.2% of GDP in 2017/18. Tax revenues have surprised on the upside and the deficit is expected to fall to 1.8% this year and 1.7% next year. This includes some 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, with broadly the same fiscal headroom published by the OBR last November. The target of ensuring that welfare expenditure in 2022-23 is under a predetermined cap seems achievable. Nonetheless, DBRS recognises the spending pressures on public services. The U.K. authorities are expected to conduct a spending review in 2019.

Long Public Debt Maturity Profile Mitigates against Debt Payment Risks

After a pronounced increase in the U.K.’s public debt ratio following the global financial crisis, this ratio appears to be stabilising, amounting to 86.7% of GDP in the last three fiscal years on the European Commission (EC) definition basis. The EC forecasts 85.5% this year and 84.3% next year. This level of debt is high and reduces the U.K.’s scope for fiscal flexibility, but for comparison it is close to the Euro area average of 86.7% (2017). 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 and a government decision was made to reduce the proportion of debt to be issued as index-linked gilts. 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 the £37.1bn ‘Brexit bill’ will have phased implementation, but should a bullet payment be required, DBRS views the U.K. to have sufficient funding flexibility.

The Economic Forecast and Risks Suggest an Extended Period of Low Interest Rates

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 returning the Bank Rate to the pre-August 2016 level of 0.5% in November 2017. Inflation peaked at 3.1% in November, currently 2.4% (May 2018). 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; modest rises in interest rates are expected over the next few years. The process of leaving the EU poses one risk to financial stability should there be an adverse outcome. Other risks include high household debt, 89.7% of GDP and 133.3% of household disposable income (end-2017), 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 <a href="https://www.dbrs.com/research/328586/dbrs-uk-banks-underlying-performance-solid-in-1q18-mixed-impact-of-ifrs-9" target="_blank">DBRS Comment on U.K. Banks’ 1Q18</a>).

External Balances Improving

The current account deficit has been shrinking, to 4.1% of GDP in 2017 (5.8% in 2016), and according to the EC forecast to improve to 3.5% this year, limiting this source of external vulnerability. The recent improvement is related to a narrowing in the trade deficit and higher earnings on investment abroad related to global economic growth and the weaker pound. Despite the current account deficit, the United Kingdom’s net external liability position has been moderate just 12.8% of GDP in 2017. In the longer term, the impact of the U.K.’s exit from the EU on the external accounts is highly uncertain.

RATING COMMITTEE SUMMARY

The DBRS Sovereign Scorecard generates a result in the AAA – AA range. The main points discussed during the Rating Committee include GDP performance, fiscal consolidation and potential Brexit impact.

KEY INDICATORS

Fiscal Balance (% GDP): -2.2 (2017/18); -1.8 (2018/19F); -1.7 (2019/20F)
Gross Debt (% GDP): 86.7 (2017/18); 85.5 (2018/19F); 84.3 (2019/20F)
Nominal GDP (GBP billions): 2,038 (2017); 2,111 (2018F); 2,172 (2019F)
GDP per Capita (GBP): 30,849 (2017); 31,754 (2018F); 32,483(2019F)
Real GDP Growth (%): 1.8 (2017); 1.5 (2018F); 1.3 (2019F)
Consumer Price Inflation (%): 2.7 (2017); 2.7 (2018F); 2.2 (2019F)
Domestic Credit (% GDP): 184.7(2016); 185.2 (2017)
Current Account (% GDP): -4.1 (2017); -3.7 (2018F); -3.4 (2019F)
International Investment Position (% GDP): -4.4 (2016); -12.8 (2017)
Gross External Debt (% GDP): 310.5 (2016); 313.4 (2017)
Governance Indicator (percentile rank): 92.8 (2016)
Human Development Index: 0.91 (2015)

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.

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, YouGov, Survation/Scottish Independence Referendum Party. 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: Alan G. Reid, Group Managing Director, Global FIG and Sovereign Ratings

Initial Rating Date: 19 July 2010

Last Rating Date: 15 December 2017

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