DBRS Ratings GmbH (DBRS Morningstar) downgraded the United Kingdom of Great Britain and Northern Ireland’s (the United Kingdom or U.K.) Long-Term Foreign and Local Currency – Issuer Ratings to AA (high) from AAA. At the same time, DBRS Morningstar confirmed the Short-Term Foreign and Local Currency – Issuer Ratings at R-1 (high). The trend on the Long-Term Foreign and Local Currency – Issuer Ratings is changed to Stable from Negative and the trend on the Short-Term Foreign and Local Currency – Issuer Ratings remains Stable.
KEY RATING CONSIDERATIONS
The downgrade reflects DBRS Morningstar’s view that the Coronavirus Disease (COVID-19) will materially impact the U.K.’s economy and public sector finances in the context of an already slowing economy and expansionary fiscal policy related to Brexit. While the U.K. is a highly flexible economy, the disruption caused by EU exit will slow the pace of recovery relative to other countries and will delay fiscal re-balancing. The debt-to-GDP ratio is now expected to rise from 85.4% in 2019 to 104.4% by the end of this year, 111.0% by end-2021 and 113.7% by end 2022, according to the European Commission (EC). By contrast, in the rating review a year ago, the expectation was for a decline in the debt ratio this year. Competitiveness and productivity will likely be strengthened only slowly weighing on debt sustainability. The downgrade reflects deterioration in the “Fiscal Management and Policy” and the “Debt and Liquidity” building blocks.
The return to Stable trend reflects the fact that despite the current adverse economic climate and a likely 10% GDP contraction this year, according to the latest EC forecasts, DBRS Morningstar maintains the view that the U.K. holds a high degree of resilience with the shock-absorbing benefits of the country’s own monetary policy and flexible exchange rate. 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 and gilt yields are historically low; and the Bank of England, through its quantitative easing bond-buying programme, is another key source of market confidence at present. The U.K.’s maturity structure of public debt at around 15 years is the longest average maturity in the G7; this helps reduce the adverse funding impact of a temporary shock.
An upgrade could occur if, in the medium term, the public debt ratio resumes its downward path and the UK economy is more dynamic, with higher productivity growth.
A downgrade could occur if (1) the likelihood of a break-up of the United Kingdom materially increases; (2) the economic shocks related to Covid-19 and Brexit have a more severe adverse effect on the fiscal accounts than currently expected.
The Impact of COVID-19 Combined with the U.K’s EU Exit Bring Downside Economic Risks
The U.K. is highly negatively affected by the health crisis. In terms of the economy, recent forecasts by the EC include a 10.3% GDP contraction this year, followed by a very gradual recovery of 3.3% in 2021 and 2.1% in 2022. The forecast is based on the assumption that the U.K. will trade on WTO MFN rules from 1 January 2021. Amidst the crisis the majority Conservative U.K. government and the EU remain in discussion over a Free Trade Agreement (FTA), and while agreement is still possible, hurdles to its conclusion are evident. With or without an agreement, the temporary disruption caused by the end of the transition period at the end of this year is likely to delay full economic recovery. DBRS Morningstar considers delays in agreement on a EU-U.K. future relationship as evidence of the UK’s weaker capacity to address economic challenges. This has resulted in a negative qualitative assessment of DBRS Morningstar’s “Political Environment” building block.
The U.K. Economy and Labour Market Adversely Affected by Covid-19
The U.K. is the fifth-largest global economy, with strong economic performance in past years until the Brexit uncertainty weighed on economic activity. The coronavirus fiscal response of the U.K. authorities has been timely and targeted with measures estimated by the EC amounting to around 10.0% of GDP excluding the cost of more recent measures related to the more recent lockdown. The Bank of England has also responded by cutting Bank Rate and announcing additional quantitative easing and the government’s credit guarantees for bank loans amount to liquidity equivalent to 16% of GDP. These measures notwithstanding, the economy will materially contract this year and the recovery will be gradual. Private consumption and gross fixed capital formation may be most adversely affected, while government consumption will contribute positively to growth. The net trade effect on growth will likely be more negligible as both exports and imports contract.
Employment was growing before the crisis and the average unemployment rate of 3.8% in 2019 was amongst the lowest historically, but could increase to 5.0% of the economically active population this year according to EC forecasts, as support measures soften the adverse labour market effect. The employment rate reached a record of 76.6% of all people aged from 16 to 64 years in the three months to February 2020, before falling to 75.3% in the three months to September 2020. The unemployment rate is expected to peak in 2021 and the EC forecast a rate of 7.3% before declining to 6.2% in 2022. In the longer term, the adverse economic impact of the U.K.’s EU exit on trade, investment and migration, leading to lower potential growth that could negatively impact long term debt dynamics, is now complicated by COVID-19-related factors.
The Fiscal Position is Set to Materially Deteriorate as Lockdowns Prove Recurrent
Traditionally, the U.K.’s fiscal framework is transparent, supported by flexible fiscal rules and the independent OBR publishing its economic forecasts for use by government. Since 2010, material progress was made in reducing the Maastricht treaty deficit, from 10% of GDP in 2009/10 to 1.8% of GDP in 2018/19. Current EC projections point to a fiscal deficit of 14.7% this fiscal year compared with 2.8% in the previous fiscal year, 8.3% in 2021/22 and 7.3% in 2022/23. Fiscal support measures include additional funding for the health service, measures to support businesses including property tax holidays, direct grants for small firms and firms in the most affected sectors, the Coronavirus Jobs Retention Scheme and increasing payments under the Universal Credit Scheme. In addition, the government has launched three separate loan schemes to support business access to credit including with the British Business Bank the Coronavirus Business Interruption Scheme to support SMEs, the Coronavirus Large Business Interruption Loans Scheme to support larger firms and the Bounce Back loan scheme for SMEs, that include government guarantees. Government guarantees, potentially up to 16% of GDP, pose some risk to debt sustainability going forward.
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 declined to 85.4% of GDP at the end of 2019. The debt-GDP ratio is now expected to rise to 104.4% by the end of this year according to the EC, 111.0% by end-2021 and 113.7% by end 2022. DBRS Morningstar sees downside risks to placing the public debt ratio on a downward path in future years. Nonetheless, DBRS Morningstar assesses the U.K’s commitment and capacity to meet its debt servicing needs favourably. Public borrowing is in British pounds sterling and the majority of gilt holders are domestic investors now receiving extra confidence from the Bank of England’s (BoE) renewed and increased debt purchasing scheme to potentially take the total stock of government bond purchases to £875bn. DBRS Morningstar considers positively liquidity strength given sterling’s status as a reserve currency, the breadth and depth of the debt market, and the long maturity structure of around 15 years, the longest average maturity in the G7.
DBRS Morningstar Expects an Appropriate Monetary Policy Response to Economic and Inflation Conditions
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 Bank of England (BoE) took important measures to address financial volatility that occurred in the aftermath of the U.K. vote to leave the EU in August 2016 and has taken proactive measures in the current crisis. These measures include reducing Bank Rate by 65 basis points to 0.1%; expanding the central bank’s holdings of U.K. government bonds and non-financial corporate bonds; introducing a new Term Funding Scheme; launching the joint HM Treasury—Bank of England COVID Corporate Financing Facility which, together with the Coronavirus Business Loans Interruption Scheme, makes £330bn of loans and guarantees available to businesses (16% of GDP); and other measures. Financial stability risks include high household debt at 87.5% of GDP and 130.6% of household disposable income in 2019, that could present financial challenges should higher levels of unemployment become endemic.
The Future Path of the External Accounts is Highly Uncertain
The current account deficit has been shrinking. It was down to 4.3% of GDP in 2019 from 5.2% in 2016. The EC forecasts 3.1% this year and 2.9% next year. The U.K. finances the current account deficit mainly through net financial inflows, and the net external liability position is moderate, at just 26.1% of GDP in 2019. In the longer term, the impact of the current crisis as well as the U.K.’s full exit from the EU on the external accounts is highly uncertain.
A description of how DBRS Morningstar considers ESG factors within the DBRS Morningstar analytical framework and its methodologies can be found at: https://www.dbrsmorningstar.com/research/357792.
For more information on the Rating Committee decision, please see the Scorecard Indicators and Building Block Assessments: https://www.dbrsmorningstar.com/research/370020.
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.
The principal methodology is the Global Methodology for Rating Sovereign Governments https://www.dbrsmorningstar.com/research/364527/global-methodology-for-rating-sovereign-governments (27, July 2020)
For more information regarding rating methodologies and Coronavirus Disease (COVID-19), please see the following DBRS Morningstar press release: https://www.dbrsmorningstar.com/research/357883.
The sources of information used for this rating include: UK Office for National Statistics, the Office of Budget Responsibility – The OBR’s Coronavirus Analysis April 2020, Economic and Fiscal Outlook March 2020, Fiscal Sustainability Report – July 2020, HM Treasury, Debt Management Office, the Bank of England, International Monetary Fund, International Financial Statistics (IFS), HM Land Registry, BIS, European Commission – European Economic Forecast Autumn 2020, Organization for Economic Co-operation and Development, United Nations Development Programme (UNDP), World Bank, Bloomberg L.P, Haver Analytics. DBRS Morningstar 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.
With Rated Entity or Related Third Party Participation: YES
With Access to Internal Documents: NO
With Access to Management: YES
DBRS Morningstar 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 12-month period. DBRS Morningstar’s outlooks and ratings are under regular surveillance.
For further information on DBRS Morningstar historical default rates published by the European Securities and Markets Authority (ESMA) in a central repository, see:
The sensitivity analysis of the relevant key rating assumptions can be found at: https://www.dbrsmorningstar.com/research/370019.
Ratings assigned by DBRS Ratings GmbH are subject to EU and U.S. regulations only.
Lead Analyst: Nichola James, Managing Director, Credit Ratings
Rating Committee Chair: Roger Lister, Managing Director, Chief Credit Officer, Global FIG and Sovereign Ratings
Initial Rating Date: July 19, 2010
Last Rating Date: May 15, 2020
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