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. The UK economy is recovering from the severe crisis brought about by the Coronavirus Disease (COVID-19) pandemic and the UK government is aiming to return public finances to a sustainable path. Real GDP grew strongly by 8.9% on an annual basis in the first half of 2021, although activity is now slowing to a more moderate pace, with the economy also facing challenges from supply bottlenecks, labour shortages and rising energy prices. General government debt, which peaked at 103.6% of GDP in the fiscal year 2020-2021, is expected to start declining from next year, as presented in the Autumn Budget and Spending Review 2021. 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 (1) the public debt ratio resumes its downward path in the medium term, or (2) the UK economy turns more dynamic, with higher sustained productivity growth.
A downgrade could occur if (1) the likelihood of a break-up of the UK materially increases, or (2) a severe economic or financial shock has a material adverse impact on the economy and fiscal accounts, damaging the UK’s financing flexibility.
The UK Economy is Recovering But Supply Bottlenecks Pose A Risk To The Economic Recovery
The UK economic recovery has been faster than expected but its pace is slowing. After contracting by a sharp 9.8% in 2020, with the contraction extending into Q1 2021, economic activity rebounded strongly in Q2, driven by consumption, largely reflecting the vaccination rollout and re-opening of the economy. More recently, economic activity has slowed as the economy has been affected by a series of successive shortages and bottlenecks, including shortages of heavy goods vehicle (HGV) drivers, a backlog of shipping containers, and shortages of some goods. Post-Brexit labour and trade regulations have added to the shortages. On the labour market, conditions have improved. The number of persons unemployed has fallen, with the unemployment rate standing low at 4.5% in August. However, these numbers do not yet reflect the end of the job retention scheme in September.
Reflecting better-than-expected growth in the first half of the 2021, the official growth forecast has been revised upwards from the beginning of the year. The Office for Budget Responsibility (OBR) now expects the economy to grow by 6.5% in 2021, followed by 6.0% in 2022. This compares with the Bank of England (BoE) growth projections of 7.0% in 2021 and 5.0% in 2022. This growth pace would bring UK GDP to its pre-pandemic level by the end of 2021. In DBRS Morningstar's view, downside risks to the economic outlook are still significant and include more persistent supply bottlenecks and the evolution of coronavirus, especially as the number of infection cases in the UK remains relatively high, despite a high vaccination rate. Moreover, high inflation has the potential of slowing the recovery.
Over the longer term, uncertainty remains over the lasting impact of the UK-EU Trade and Co-operation Agreement (TCA) and that of new trade deals with other countries on UK trade, investment and migration, and ultimately on potential output of the UK economy. Productivity growth was already weak before the UK exited the EU. The OBR estimates a long-term productivity loss of about 4% as a result of Brexit, compared with economic scarring of 2% on potential output from the COVID-19 pandemic. On a positive note, the government is pursuing its plan for economic growth, intended to help narrow large regional disparities in income and to raise productivity, through substantial investment in infrastructure, innovation, and skills.
Government Finances Are Improving But Some Risks to the Fiscal Outlook Lie Ahead
After a material deterioration in public finances related to the pandemic, the fiscal position is expected to return to a more sustainable path over the next two years. In the fiscal year (FY) 2020-21, the deficit reached 15.2% of GDP. With the expiry of emergency support measures and with the economy recovering at a better-than-expected pace, the budget position has also improved more than anticipated in the OBR’s fiscal outlook in March 2021. In the recently-presented Autumn Budget and Spending Review (SR) 2021, the government is forecasting a deficit of 7.9% in FY 2021-22, followed by 3.3% in FY 2022-23. The better fiscal performance so far is allowing the government to increase spending to continue to support the economic recovery in the near term, before tightening fiscal policy. To help repair the public sector’s balance sheet, the corporation tax rate is set to increase to 25% in 2023 from 19%, among other measures.
Over the longer term, the deficit is expected to decline but fiscal risks could materialise. The government projects the fiscal deficit to fall below 2% of GDP by 2024, as it tightens its fiscal policy stance to meet its new fiscal mandate. Along with the SR 2021, the government presented a revision to the Charter for Budget Responsibility, proposing new fiscal rules. A new fiscal mandate – to reduce public sector net debt excluding the BoE as a percentage of GDP by FY 2023-2024 – is accompanied by three supplementary targets: (1) to balance the current budget by FY 2023-2024, (2) to ensure that public sector net investment does not exceed 3% of GDP on average over the five-year forecast, and (3) to limit welfare expenditure within a predetermined cap set by the HM Treasury. Risks to the targets and overall fiscal outlook include a higher cost of debt, inflation risks with rising energy prices in particular increasing the risk of government intervention, and the evolution of the COVID-19 pandemic potentially slowing growth again. The OBR has also highlighted risks from climate change, which could require higher-than-anticipated public investment.
Public debt is expected to start declining gradually from next year while maintaining its favourable debt profile. The general government debt is expected to fall below 100% of GDP in 2023 and continue a downward trend. Despite the rise in debt levels, interest costs remained low, thanks to quantitative easing and the decline in interest rates. The purchases of government bonds by the BoE through its Asset Purchase Facility has led to some shortening of the average maturity of overall government debt. Nevertheless, the average maturity of UK debt remains very long at 14.7 years as of October 2021. Index-linked bonds, which expose debt to higher inflation are now also lower than in the past, expected to account for less than 14% of gilt issuance in 2021-22. Index-linked bonds meet demand from investors in the large domestic market. The UK 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.
Monetary Policy Is Expected to Be Tightened Soon As Inflation Has Risen
Inflation in the UK has risen rapidly in recent months. The annual inflation rate in the UK stood at 3.1% in September 2021, slightly below 3.2% in August, which was the highest reading since March 2012. The rise in inflation has been driven to a large extent by energy prices, particularly petrol prices. Core inflation has also increased significantly, reaching 2.9% in September. Higher inflation in the UK reflects a combination of domestic and external factors, including the re-opening of the economy since April releasing pent-up demand, some base effects from the temporary cut in the VAT rate for the hospitality sector last year and the end of the Eat Out to Help Out scheme, as well as higher commodity prices and global supply disruptions and shortages, leading to higher prices for some goods, including used cars. More recently, high natural gas prices are adding significantly to inflationary pressures.
The outlook is for inflation to rise further. The UK inflation rate has been above the Bank of England’s inflation target of 2% since May 2021. The BoE projects inflation to continue increasing and peak at around 5% in April 2022, when the next increase in the regulated energy price cap for retail gas and electricity prices will be effective. At its latest monetary policy meeting, the BoE left its accommodative monetary policy unchanged – the Bank Rate at 0.1%, the government bond purchases programme at GBP 875 billion and the corporate bond purchases programme at GBP 20 billion. However, it clearly pointed to a rise in the Bank Rate in the near term. Owing to a responsive central bank, the UK enjoys a high degree of monetary policy flexibility and credibility.
Risks to financial stability appear contained. The support provided by both the financial system and the government during the pandemic helped maintain business insolvencies at low levels, but insolvencies have increased in recent months. Household debt remains high at 133% of disposable income in 2020, which could pose a risk if unemployment rises sharply, although credit growth has been moderate. Moreover, housing market activity and house price growth have been strong in the first half of 2021. Nevertheless, the UK banking system remains resilient to various economic scenarios, according to the BoE.
The Current Account Deficit Remains Contained
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% of GDP in 2020.
Brexit Has Brought Political Challenges
Elections for the Scottish Parliament and tensions in Northern Ireland have added a certain degree of uncertainty to the British 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 DBRS Morningstar’s assessment of the 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. The UK government considers the question was already settled in the 2014 independence referendum. However, the issue is unlikely to fade away and instead could intensify and lead to constitutional uncertainty for some time.
At the same time, the 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. Efforts from both the UK and the EU to improve the implementation of the protocol remain 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.
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/387994.
All figures are in GBP unless otherwise noted. Public finance statistics reported on a general government basis unless specified.
The principal methodology is the Global Methodology for Rating Sovereign Governments https://www.dbrsmorningstar.com/research/381451/global-methodology-for-rating-sovereign-governments (July 9, 2021). 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 (Autumn Budget and Spending Review 2021, Build Back Better plan March 2021), Office of Budget Responsibility (Economic and Fiscal Outlook October 2021, Fiscal Risks Report July 2021), HM Government (UK Net Zero Strategy October 2021, The Ten Point Plan for a Green Industrial Revolution November 2020), Bank of England (Monetary Policy Report November 2021, Financial Stability Report July 2021), Debt Management Office, UK Office for National Statistics, IMF, OECD, BIS, World Bank, UNDP, World Economic Forum (Fostering Effective Energy Transition 2021), 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/387995.
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: May 14, 2021
DBRS Ratings Limited
20 Fenchurch Street, 31st Floor,
London EC3M 3BY United Kingdom
Tel. +44 (0) 20 7855 6600
Registered and incorporated under the laws of England and Wales: Company No. 7139960
For more information on this credit or on this industry, visit www.dbrsmorningstar.com.