DBRS Ratings Limited (DBRS Morningstar) confirmed the United Kingdom of Great Britain and Northern Ireland’s (the United Kingdom or the UK) Long-Term Foreign and Local Currency – Issuer Ratings at AA (high). At the same time, DBRS Morningstar confirmed the 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 Morningstar’s view that risks to the ratings are balanced, despite the dual ongoing challenges related first to the economic recovery from the severe crisis brought about by the Coronavirus Disease (COVID-19) pandemic, and second to the adaptation to a new post-Brexit relationship with the European Union (EU). After contracting by a sharp 9.8% in 2020, UK real GDP contracted in Q1 2021, likely reflecting a third lockdown at the beginning of the year and the initial effects of the new less-advantageous trade arrangement with the EU. Nevertheless, with the number of infection cases falling, the government began to re-open the economy from April 2021. Moreover, the vaccination rollout in the UK has advanced rapidly. In DBRS Morningstar's view, these developments, together with the substantial fiscal and monetary support in place, should allow for a fairly steady recovery of the UK economy.
The substantial fiscal support still in place will keep the government balance in large deficit in 2021, forecast at around 11% of GDP, although this is smaller than in 2020 and projected to continue declining. Government debt, forecast at 107% in 2021, is expected to increase further in the coming years but at a modest pace, while interest costs are projected to continue falling. DBRS Morningstar expects a gradual improvement in government finances over time.
The rating for the UK is supported by its large, diverse and wealthy economy, very strong governance indicators, including the rule of law and government effectiveness, and its robust and credible monetary policy, with the Bank of England (BoE) overseeing one of the world’s primary reserve currencies that supports the country’s substantial capacity for external adjustment. The reserve currency status of the pound sterling, alongside the UK’s deep and liquid capital markets, supports the UK’s significant degree of financing flexibility and makes it a safe haven. However, the country also faces credit challenges stemming from weakened public sector finances – given its large fiscal deficit and high government debt – and external imbalances, with a persistent current account deficit. Political divisions among the four UK nations could also intensify and pose some challenges.
An upgrade could occur if, in the medium term, the public debt ratio resumes its downward path and the UK economy turns more dynamic, with higher productivity growth.
A downgrade could occur if (1) the economic shocks related to COVID-19 and Brexit have a more severe adverse effect on the fiscal accounts than currently expected, or (2) the likelihood of a break-up of the UK materially increases.
After a Sharp Impact from COVID-19 the UK Economy Seems on Course to A Steady Recovery
The UK economy has been severely affected by the global pandemic, with the impact compounded with the uncertainty over a new trade relationship with the EU and subsequent implementation of the new trade arrangement. In 2020, the UK economy posted the worst performance among the seven largest advanced economies (G7), contracting by almost 10%. At the start of 2021, economic activity was again hit by a third lockdown, as the UK experienced a severe third wave of infections. At the same time, the implementation of the new trade arrangement with the EU, with the introduction of border checks, has led to some trade disruptions and higher trade costs. The UK left the EU single market and customs union at the end of December 2020, after formally exiting the block at the end of January 2020. The UK’s new trade relationship with the EU was agreed under the UK-EU Trade and Co-operation Agreement (TCA).
Nevertheless, after recording one of the highest mortality rates in the world during the pandemic, the UK has now been one of the leaders in the rollout of the COVID-19 vaccine. At the beginning of May 2021, over 50% of the UK population had received at least one vaccine dose and close to 25% had been fully vaccinated. Infection cases have also fallen considerably over the past few weeks, allowing the phased re-opening of the economy.
At the same time, the labour market remains under policy support. The unemployment rate stood comparatively low at 4.8% in February 2021, up from 4.0% at the start of the pandemic. The government extended in March 2021 its job retention scheme once more to the end of September 2021, which should continue to constrain rises in unemployment. Nevertheless, the number of people claiming unemployment-related benefits remains high and the activity rate has yet to return to its long-run average. Once the job support is withdrawn, an increase in unemployment seems likely.
DBRS Morningstar expects the recovery of the UK economy to take hold in the second half of the year, as confidence recovers and policies remain supportive. Notably, the government adopted in its 2021 Budget measures for an investment-led recovery driven by the private sector. The BoE recently revised up its 2021 growth forecast to 7¼% and revised down its 2022 forecast to 5¾%. This would bring UK GDP to its pre-pandemic level by the end of 2021. Nevertheless, downside risks to the outlook are still significant and include an emergence of new resistant variants of the virus. On the other hand, an upside risk to the outlook is the substantial new US fiscal stimulus that could boost external trade.
In the longer term, uncertainty remains over economic scarring from COVID-19 and over the long-term impact of the TCA and that of new trade deals with other countries on UK trade, investment and migration, and ultimately on potential output and the overall dynamism of the UK economy. Productivity growth was already weak before the UK exited the EU. The OBR has previously assumed a long-term loss of productivity of about 4% as a result of Brexit. Moreover, a trade agreement for the financial sector and other services, key for the UK economy, has not been agreed yet. On a positive note, to support more sustainable economic growth and address large regional disparities in income, the government announced, alongside the 2021 Budget, its plan for significant investment in skills, infrastructure and innovation over the next five years. Public investment is intended to contribute to productivity growth.
Only a Gradual Improvement in Government Finances is Expected Over Time
The COVID-19 pandemic has also had a material impact on the UK public sector finances. After posting an average deficit of around 3% of GDP in the five years to 2019, the deficit significantly increased to 13.4% in 2020, according to IMF forecasts. In 2021, the IMF is forecasting the deficit to remain large at 11.8%, as fiscal measures provide support to the economic recovery. In the 2021 Budget, the HM Treasury extended the emergency support for businesses and households and announced a two-year ‘super-deduction’ tax incentive for companies’ investment spending, among other measures. The fiscal framework remains under review meaning that there are no fiscal targets yet. Nevertheless, to start with the repair of the public sector’s balance sheet from 2023, the rate of corporation tax is set to increase to 25% from 19% currently. The deficit is projected to more than halve in 2022, as temporary measures expire, and subsequently trend towards 3% over the medium term.
Public debt is expected to increase further in the coming years but at a modest pace, while the debt profile remains favourable. As a result of the large deficit and the decline in GDP, the government debt ratio jumped from 84.4% of GDP in 2019 to 103.7% in 2020, according to the IMF. With the deficit remaining relatively large, the debt ratio is projected at 107% in 2021, increasing only moderately in the following years. The government expects the public sector debt ratio to peak in the fiscal year 2023-24.
Despite the rise in debt levels, interest costs have fallen, thanks to quantitative easing and the decline in interest rates, and are expected to remain at low levels. The purchases of gilts by the BoE through its Asset Purchase Facility has led to some shortening of the average maturity of government debt in recent years. Nevertheless, the average maturity of UK government debt remains very long at 14.7 years at the end of 2020. The UK also continues to enjoy a significant degree of financing flexibility, given sterling’s status as a reserve currency and the breadth and depth of the UK debt market. This supports DBRS Morningstar’s qualitative assessment of the “Debt and Liquidity” building block.
Brexit Has Brought Political Challenges
Recent elections for the Scottish Parliament and tensions in Northern Ireland have added a certain degree of uncertainty to the UK political landscape, particularly in relation to the integrity of the four-nation UK. A constitutional debate over a potential break-up of the United Kingdom re-emerged after the UK referendum on EU membership in 2016, as Scotland and Northern Ireland voted to remain in the EU, while England and Wales voted for Brexit. These political divisions and associated uncertainty have weighed on a negative qualitative assessment of DBRS Morningstar’s “Political Environment” building block.
The pro-independence Scottish National Party remained the largest party in the Scottish parliament after the May 2021 elections, and together with the Greens, has a majority. The result brings the question about Scottish independence back to the political fore, with the Scottish government expected to press for a referendum on independence during its five-year parliamentary term. A referendum on Scottish independence could significantly increase the risk of a break-up of the UK. In DBRS Morningstar’s view, the likelihood of a second referendum on Scottish independence in the near term appears low, as the recovery from COVID-19 takes priority and for as long as the UK government opposes it, especially as the government considers the question was already settled in the 2014 independence referendum. However, the issue is unlikely to fade away and instead could lead to constitutional uncertainty for some time.
At the same time, the initial implementation of the UK-EU TCA has not been without difficulties, with border checks on the Irish Sea, as agreed on the Northern Ireland Protocol, heightening social tensions and violent protests in Northern Ireland. This led the UK government to temporarily suspend customs checks on some food exports from Great Britain to Northern Ireland. In turn, this decision prompted the EU to take legal action against the UK. Efforts to improve the implementation of the protocol are ongoing.
Despite these challenges and some potential constitutional uncertainty ahead, the UK still benefits from solid political institutions, lessening the risks from domestic political tensions and divisions. The UK also has very strong governance indicators, including the rule of law and government effectiveness.
Monetary Policy Remains Highly Accommodative
The UK enjoys a high degree of monetary policy flexibility and credibility, owing to a responsive central bank. In response to the crisis, the BoE cut the Bank Rate by 65 basis points to 0.1% and expanded its purchases of UK government bonds and non-financial investment-grade corporate bonds, among other measures. Monetary policy was complemented with macroprudential measures, particularly the removal of requirements for additional capital buffers, to boost banks’ ability to support the supply of credit to the economy.
The UK banking system also remains resilient to various economic scenarios, according to the BoE. Moreover, the extension of the stamp duty holiday and other government schemes are likely to continue supporting the housing market in the near term. Financial stability risks include high household debt at 130.6% of household disposable income in 2019, which could present financial challenges should higher levels of unemployment become endemic.
The Future Path of the External Accounts is Uncertain
The current account remains in deficit but this has been shrinking. It was down to 3.5% of GDP in 2020 from 5.4% in 2016. The deficit is largely accounted for by the goods trade deficit and the deficit in the income account, while the services balance has remained in surplus of around 5% of GDP over the past ten years. The UK finances the current account deficit mainly through net financial inflows. The net external liability position remains moderate but has been deteriorating, reaching 30.7% of GDP in 2020, up from just 15.1% in 2018. In the longer term, the impact of UK’s 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 can be found in the DBRS Morningstar Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings at https://www.dbrsmorningstar.com/research/373262.
For more information on the Rating Committee decision, please see the Scorecard Indicators and Building Block Assessments. https://www.dbrsmorningstar.com/research/378525.
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
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 (July 27, 2020). Other applicable methodologies include the DBRS Morningstar Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings https://www.dbrsmorningstar.com/research/373262/dbrs-morningstar-criteria-approach-to-environmental-social-and-governance-risk-factors-in-credit-ratings (February 3, 2021).
The sources of information used for this rating include HM Treasury (Budget 2021, Build Back Better plan March 2021), the Office of Budget Responsibility (Economic and Fiscal Outlook March 2021), HM Government (The Ten Point Plan for a Green Industrial Revolution November 2020), Bank of England (Monetary Policy Report May 2021, Financial Policy Summary March 2021, Financial Stability Report December 2020), Debt Management Office, UK Office for National Statistics, IMF (2020 Article IV), OECD, BIS, World Bank, UNDP, European Commission (2020 European Semester), Social Progress Imperative, Our World in Data, Haver Analytics. DBRS Morningstar considers the information available to it for the purposes of providing this rating to be of satisfactory quality.
With respect to FCA and ESMA regulations in the United Kingdom and European Union, respectively, this is an unsolicited credit 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: http://cerep.esma.europa.eu/cerep-web/statistics/defaults.xhtml. DBRS Morningstar understands further information on DBRS Morningstar historical default rates may be published by the Financial Conduct Authority (FCA) on its webpage: https://www.fca.org.uk/firms/credit-rating-agencies.
The sensitivity analysis of the relevant key rating assumptions can be found at: https://www.dbrsmorningstar.com/research/378526
This rating is endorsed by DBRS Ratings GmbH for use in the European Union.
Lead Analyst: Adriana Alvarado, Vice President, Global Sovereign Ratings
Rating Committee Chair: Nichola James, Managing Director, Co-Head of Sovereign Ratings, Global Sovereign Ratings
Initial Rating Date: July 19, 2010
Last Rating Date: November 13, 2020
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