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. Russia’s invasion of Ukraine is affecting the UK economy mainly through higher inflation. This is weakening consumption and has worsened the economic outlook in the near term. The UK economy is now expected to grow by less than 4% in 2022. Nevertheless, inflation is expected to fall next year. Moreover, a better-than-expected fiscal performance last year has allowed the Government to adopt some fiscal measures to somewhat cushion the impact on consumers from high energy bills, while maintaining its aim to return public finances to a sustainable path. After the shock from the Coronavirus Disease (COVID-19) pandemic on public finances, the general government debt ratio is estimated to have fallen below 100% of GDP in 2021. DBRS Morningstar expects slow economic growth in the near term and 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, its financing flexibility and its robust and credible monetary policy. The Bank of England (BoE) oversees 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 fiscal deficit and high government debt – and external imbalances, with a persistent current account deficit. Uncertainty over the cohesion of the four-nation UK also poses some challenges.
An upgrade could occur if (1) the public debt ratio maintains 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.
UK Growth Is Affected By Cost of Living Pressures, Clouding Its Near-Term Outlook
The UK’s economic recovery from the COVID-19 pandemic was faster than expected, with UK GDP returning to its pre-pandemic level at the end of 2021, but growth has slowed. Continued policy support and swift vaccination supported the recovery in 2021, though the economy also faced challenges from supply bottlenecks, labour shortages, and rising prices. Higher inflation in the UK reflects a combination of factors some more long-lasting than others, including pent-up demand, some base effects from the temporary measures, as well as global supply disruptions and shortages and higher commodity prices, including natural gas prices.
While some bottlenecks have eased, inflationary pressures have intensified, particularly since the Russian invasion of Ukraine. The main channel through which the conflict is affecting the UK economy is through even higher oil, gas and agricultural commodity prices. The annual inflation rate in the UK reached 7.0% in March 2022, the highest in 30 years. Moreover, a tight labour market increases the risk of more persistent inflation. The number of persons unemployed has continued to fall, with the unemployment rate falling to 3.8% in February 2022. At the same time, the number of job vacancies has increased significantly reflecting worker shortages, which puts upward pressure on wages.
Persistent high inflation, compounded with other factors, is weighing on consumption. Higher prices are not the only factor affecting households this year. Incomes are also being eroded by the withdrawal of the government's pandemic -related support measures, while a rise in national insurance contribution rates from April also adds to the cost of living pressures. After an increase during the pandemic, the household saving ratio has fallen back to previous levels and thus savings might not provide a major cushion against inflation in the coming months. With spending expected to weaken, growth forecasts have been revised downward. After rebounding 7.4% in 2021, UK real GDP growth is now forecast to slow significantly to 3.8% in 2022. Growth forecasts indicate even lower growth in 2023. Downside risks to the outlook have weighed on DBRS Morningstar’s assessment of the Economic Structure and Performance building block.
In DBRS Morningstar's view, downside risks to the economic outlook in the near term are significant and include higher inflation and the economic implications of an intensification in the conflict in Ukraine. Although the UK’s reliance on Russia’s oil and gas is limited, disruptions in Russian oil and gas supplies are likely to impact the UK economy, through higher energy prices given that the UK is a net energy importer with a relatively high reliance on gas and oil. The pandemic remains an additional risk.
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 on trade, investment and migration, and ultimately on potential output of the UK economy. Productivity growth was already weak by historical levels before the UK exited the EU. The Office for Budget Responsibility (OBR) estimates a long-term productivity loss of about 4% as a result of Brexit, compared with scarring of 2% on potential output from the pandemic. On a positive note, the government is pursuing its plan for economic growth, intended to narrow large regional disparities in income and to raise productivity, through investment in infrastructure, innovation, and skills.
The Current Account Deficit Remains Contained
So far, Brexit has led to a fall in UK trade volumes, but the UK’s external position has not deteriorated. The current account remains in deficit but this has reduced over the past five years. It was down to 2.6% of GDP in 2021 from 5.3% in 2016. The deficit is largely accounted for by the deficit in goods trade and in the income account, while the services balance has remained in surplus of around 5.5% of GDP over the past ten years. The UK finances the current account deficit mainly through net financial inflows. The UK net external liability position has deteriorated but remains moderate at 32% of GDP as of end-2021. In the near term, the current account is expected to deteriorate given the impact of energy price-related terms of trade and higher imports related to higher investment.
Monetary Policy Has Been Tightened But Inflation is Yet to Peak
The outlook is for inflation to rise further despite monetary tightening. The UK inflation rate has been at or above the Bank of England’s inflation target of 2% since May 2021. Though the rise in inflation has been driven to a large extent by energy prices, core inflation has also increased significantly, reaching 5.7% in March 2022. The BoE projects annual headline inflation to continue increasing and to peak at around 10% in Q4 2022, as the next increase in the regulated retail energy price cap will take effect from October. At its latest monetary policy meeting in May 2022, the BoE increased Bank Rate for a fourth successive time by a further 25 basis points to 1.0%. This brought the policy rate above its pre-pandemic level and the highest level since 2009. Quantitative tightening has also started, with the BoE ending the reinvestment of proceeds from maturing gilts since March 2022. 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 since 2021. Household debt remains high at 133% of disposable income in mid-2021, which could pose a risk if unemployment rises sharply, although credit growth has been moderate. Moreover, house price growth has remained strong since 2021. Nevertheless, the UK banking system remains resilient to various economic scenarios, according to the BoE. Moreover, the BoE is currently carrying out the Climate Biennial Exploratory Scenario (BES) exercise, with the aim to explore the financial risks posed by climate change for the largest UK banks and insurers.
Government Finances Are Improving But Some Risks to the Fiscal Outlook Remain
The fiscal position has recovered better than expected, after a material deterioration in public finances related to the pandemic. In the fiscal year (FY) 2021-22, the deficit is estimated to have declined below 6% of GDP from 15.1% the previous year, according to the OBR. This reflects higher-than-expected tax revenues, lower spending as investment projects have been affected by supply bottlenecks, and the expiry of emergency support measures. In the recently-presented Spring Statement 2022, the government adopted fiscal measures to somewhat cushion the impact on consumers from high energy bills, including some tax cuts. Despite the support measures and higher debt interest costs, the government is forecasting a deficit of 3.8% in FY 2022-23. The deficit is then projected to fall below 2% in the following years, as the government tightens policy to meet its fiscal mandate, including through the increase in the corporation tax rate to 25% in 2023 from 19% among other measures.
The government is aiming to return public finances to a sustainable path, but fiscal risks could materialise. In November 2021, the government presented a revision to the Charter for Budget Responsibility with 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. The government seems on track to meet its fiscal mandate, but risks to the fiscal outlook include a higher cost of debt, higher inflation, and slower economic growth. The OBR has also highlighted risks from climate change, which could require higher-than-anticipated public investment.
Public debt has started to decline. After reaching a peak of 103% of GDP in 2020, the general government debt ratio is estimated to have fallen to around 95% in 2021, according to the IMF, and projected to maintain a downward trend, falling below 80% by 2024. The debt profile remains favourable despite rising interest costs. The purchases of government bonds by the BoE 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 December 2021, lessening the impact of higher interest rates on debt. Higher inflation is driving up the cost of index-linked bonds, although the proportion of this debt has declined in recent years, accounting for 23.9% of the gilt and Treasury bill portfolio as of December 2021. 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.
Potential Political Challenges Lie Ahead
Regional elections in Northern Ireland in May 2022 and in Scotland in 2021 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 UK 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 nationalist Sinn Féin party won the most seats in the Northern Ireland Assembly, which could in the longer term increase the chances of a border poll. Meanwhile, 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 seems be low 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 faced difficulties. The new requirements put in place by the Northern Ireland Protocol have heightened social tensions and led to protests in Northern Ireland. To address the burden of these new requirements, the UK government has temporarily suspended 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/39678.
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 (Spring Statement 2022, Build Back Better plan March 2021), Office of Budget Responsibility (Economic and Fiscal Outlook March 2022, Fiscal Risks Report July 2021), HM Government (British Energy Security Strategy April 2022, UK Net Zero Strategy October 2021), Bank of England (Monetary Policy Report May 2022 and November 2021, Financial Stability Report December 2021), Debt Management Office, UK Office for National Statistics, IMF, OECD, BIS, World Bank, World Economic Forum (Fostering Effective Energy Transition 2021), 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/396786.
This rating is endorsed by DBRS Ratings GmbH for use in the European Union.
Lead Analyst: Adriana Alvarado, Senior 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 12, 2021
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