DBRS Morningstar Places the United Kingdom AA (high) Ratings Under Review with Negative Implications

DBRS Ratings Limited (DBRS Morningstar) placed the United Kingdom of Great Britain and Northern Ireland’s (the United Kingdom or the UK) Long-Term Foreign and Local Currency – Issuer Ratings of AA (high) Under Review with Negative Implications. At the same time, DBRS Morningstar confirmed the United Kingdom’s Short-Term Foreign and Local Currency – Issuer Ratings at R-1 (high) with a Stable Trend.

DEVIATION FROM DBRS MORNINGSTAR’S UK CALENDAR
This is a deviation from DBRS Morningstar’s UK Sovereign, Sub-Sovereign, and Supranational Calendar. While the next scheduled publication date for the UK’s ratings is 11 November 2022, DBRS Morningstar decided to deviate from the Calendar to assess the implications of the unexpected developments in the UK over the past weeks. The developments are related to the absence of clarity on the UK fiscal plans, concerns about UK policies, ongoing and considerable turmoil in the UK government bond market, a fall in pound sterling, an emergency response by the Bank of England, and higher market interest rates.

KEY RATING CONSIDERATIONS
The rating action reflects DBRS Morningstar’s concerns about increasing downside risks in three areas. First, the absence of a credible medium-term fiscal strategy weakens policy credibility and increases the risks to the fiscal outlook. Second, concerns about the inconsistency between fiscal and monetary policies led to a large sell-off of UK assets, including sterling and gilts, with government bond yields rising steeply. The sharp fall in sterling and severe volatility in the gilt market could increase risks to the UK financial flexibility. Third, expectations of much tighter monetary policy and steep rises in bond yields is leading to sharply higher interest rates for businesses and households, with adverse implications for the housing market. Much tighter financial conditions and persistent financial market volatility could increase risks to financial stability. The rating action reflects deterioration in the Political Environment and the Monetary Policy and Financial Stability building blocks.

The unexpected developments in the UK have unfolded in just a few weeks. The new government presented its Growth Plan, so called 'mini-budget’, involving tax cuts and support measures on 23 September 2022. The severe adverse market reaction to the mini-budget, exacerbated by liability-driven investment (LDI) funds, prompted the Bank of England (BoE) to intervene on 28 September to provide liquidity to UK pensions funds, one of the main holders of UK government bonds. The UK bond market reacted favourably to this intervention. However, the government’s commitment to its plans and the imminent end of the BoE’s temporary emergency support heightened investor concerns again the week of 10 October. The BoE purchases of long-dated gilts ended on 14 October. On the same day, the Prime Minister replaced the Chancellor of the Exchequer and announced reversals of proposed measures. The government has announced most of the tax cuts will not go ahead and that it will present a medium-term fiscal plan, together with an independent assessment and projections from the Office for Budget Responsibility (OBR), on 31 October 2022.

Overall, in DBRS Morningstar’s view, the policy inconsistency and an unclear medium-term fiscal outlook is causing a deterioration in UK policy credibility and predictability, and also increasing fiscal risks and potentially increasing risks to financial stability. DBRS Morningstar will maintain the UK’s ratings Under Review with Negative Implications looking for greater clarity on the government’s policies in the coming months.

RATING DRIVERS
A downgrade could take place if (1) DBRS Morningstar concludes that the recent deterioration in the UK government’s policy credibility and predictability has a lasting impact, (2) additional shocks have a more material adverse impact on the economy and fiscal accounts, diminishing the UK’s financing flexibility, or (3) the likelihood of a break-up of the UK materially increases.

A rating confirmation could occur (1) if a credible fiscal plan shows the public debt ratio decreasing over the medium term, and (2) financial vulnerabilities remain contained, limiting risks to the economy.

RATING RATIONALE
Uncertainty Over the Fiscal Outlook and Public Debt Path Increased

Fiscal measures are being reviewed after the mini-budget marked a significant change in policy. The mini-budget, which was aimed at reducing inflation and supporting growth, consisted of significant permanent and unfunded tax cuts, including a reversal to the increase in National Insurance contributions introduced in April this year, the elimination of the 45% top rate of income tax, the increase in the threshold for stamp duty land tax, and the cancellation of the increase in the corporation tax, planned for next year. On the spending side, caps on energy bills for households and firms were announced. In the absence of offsetting fiscal measures, the mini budget was on course to lead to a wider fiscal deficit and a higher public sector debt ratio. Moreover, the plan was presented without the independent assessment from the OBR and a credible medium-term fiscal strategy to return public finances to a healthy path over time. The government later announced the reversal of most of the tax measures not yet legislated. The government will be presenting detailed measures and a medium-term fiscal plan in the coming weeks.

Before the announcement of the mini-budget, the UK’s fiscal position was improving. According to the IMF, the fiscal deficit fell from 12.8% of GDP in 2020 to 8.0% in 2021, with its latest forecasts pointing to a deficit of 4.3% in 2022. On public debt, the government debt to GDP ratio had also started to fall from a peak of 103% in 2020 to 95% in 2021, with the IMF forecasting 87% in 2022. However, in view of updated fiscal measures, these forecasts are set to change. It is unclear if the government will make changes to its fiscal rules contained in the revised Charter for Budget Responsibility adopted in November 2021.

The debt profile has remained favourable, although interest costs are rising rapidly. The average maturity of UK debt remains very long at over 14 years, lessening the impact of higher interest rates. Long conventional bonds accounted for 28% of the gilt and Treasury bill portfolio as of June 2022. However, bond yields have spiked recently amid a sell-off of UK assets. Higher inflation is also driving up the cost of index-linked bonds, which account for 25% of the UK debt portfolio. Insurance and pension funds hold almost 30% of gilts, overseas investors another 30% and the BoE 33%. Despite the recent volatility in the gilt market, the UK still enjoys a high 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. However, DBRS Morningstar notes the risk that volatility in the gilt market could turn more long lasting and that the fall in sterling is partly reflecting a loss of investor confidence. Persistent pressures and dysfunction in the gilt market could pose risks to the UK's financial stability. The health of the pension fund sector and the efficient functioning of the gilt market remain crucial.

UK Growth Is Set to Weaken Affected By Cost of Living Pressures and Tighter Financial Conditions

The UK’s economic recovery from the COVID-19 pandemic was faster than expected, but growth has slowed. While some supply bottlenecks have eased, inflationary pressures have intensified, particularly since the Russian invasion of Ukraine. The annual inflation rate in the UK reached 10.1% in September 2022. The labour market remains tight, posing a risk to a more persistent inflation. The number of job vacancies, although no longer rising, remains at high levels. The unemployment rate remains low at 3.5% in July 2022.

The outlook is for weaker growth. Policy uncertainty is clouding the growth outlook, amid still high inflation, monetary tightening, and financial market volatility. Persistent high inflation is set to continue to weigh on consumption, despite recent support measures. Thanks to the government's 'energy price guarantee', inflation should peak in October at a lower level than previously expected. Nevertheless, the adverse market developments following the announcement of the mini-budget have tightened financial conditions, which is likely to weigh on spending and investment. Growth forecasts have been revised downwards. After rebounding 7.5% in 2021, UK real GDP growth is now forecast to slow significantly to 3.6% in 2022 and 0.3% in 2023, according to the IMF. In DBRS Morningstar's view, downside risks to the near-term economic outlook include a further tightening in financial conditions, a more pronounced weakening in economic sentiment, and an intensification of the energy crisis.

Further Monetary Policy Tightening is Expected, While Some Financial Vulnerabilities Have Been Exposed

The BoE has continued tightening its policy. At its latest monetary policy meeting in September 2022, the BoE increased Bank Rate for a seventh successive time since December 2021, by a further 50 basis points to 2.25%. Quantitative tightening also started, with the BoE ending the reinvestment of proceeds from maturing gilts since March 2022. The start of active sales of government bonds was postponed, from 6 October to 1 November 2022, as a result of the financial stability intervention by the BoE. Owing to a responsive central bank, the UK enjoys a high degree of monetary policy credibility and flexibility.

To respond to the severe volatility in the gilt market following the announcement of the mini-budget, and to safeguard financial stability especially in the UK pensions sector, the BoE launched a temporary bond-buying programme. Risks to financial stability could be increasing. Household debt remains high at 134% of disposable income in 2021, which could pose a risk if unemployment rises sharply. House price growth has been strong in recent years and prices have reached high levels. Moreover, the rapid increase in gilt yields has affected part of the UK pension fund market, particularly LDI funds, exposing vulnerabilities and raising concerns. Although solvency in pension funds does not seem to be the key issue at the moment, stresses and lack of confidence could spread to the other financial market participants, including insurance companies, assets managers, banks and clearing houses. At the same time, expectations of higher Bank Rate is driving mortgage rates up rapidly, putting homeowners that have to refinance mortgages soon under pressure. Rapidly rising mortgage rates will also have adverse implications for the UK housing market. The UK banking system on the other hand remains resilient to various adverse economic scenarios, according to the BoE. Potentially rising risks to financial stability have weighed on DBRS Morningstar’s assessment of the Monetary and Financial Stability building block.

The Current Account Deficit Remains Contained

The current account remains in deficit but this has declined over the past five years. It was down to 2.0% of GDP in 2021 from 5.5% in 2016, according to ONS data. 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 5.4% 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 33% 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.

Potential Political Challenges Lie Ahead

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. Regional elections in Northern Ireland in May 2022, in which nationalist Sinn Féin party won the most seats in the Northern Ireland Assembly, and elections in Scotland in 2021, in which the pro-independence Scottish National Party remained the largest party in the Scottish parliament, added a certain degree of uncertainty to the British political landscape, particularly in relation to the integrity of the four-nation UK. The Scottish government is pressing for a referendum on independence. A referendum on Scottish independence could significantly increase the risk of a break-up of the UK. Moreover, policy uncertainty increased after a political crisis culminated in a change in the leader of the Conservative party and UK Prime Minister in September 2022. Political divisions and associated uncertainty are increasingly weighing on DBRS Morningstar’s assessment of the Political Environment building block.

At the same time, the implementation of the UK-EU Trade and Co-operation Agreement (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 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.

ENVIRONMENTAL, SOCIAL, GOVERNANCE CONSIDERATIONS

There were no Environmental/ Social/ Governance factors that had a significant or relevant effect on the credit analysis.

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/396929/dbrs-morningstar-criteria-approach-to-environmental-social-and-governance-risk-factors-in-credit-ratings. (17 May 2022).

For more information on the Rating Committee decision, please see the Scorecard Indicators and Building Block Assessments at https://www.dbrsmorningstar.com/research/404202.

Notes:
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/401817/global-methodology-for-rating-sovereign-governments (29 August 2022). Other applicable methodologies include the DBRS Morningstar Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings https://www.dbrsmorningstar.com/research/396929/dbrs-morningstar-criteria-approach-to-environmental-social-and-governance-risk-factors-in-credit-ratings. (17 May 2022).

The sources of information used for this rating include HM Treasury (The Growth Plan September 2022, Chancellor’s statement on 17 October 2022), Office of Budget Responsibility (Fiscal Risks Report July 2022), HM Government (British Energy Security Strategy April 2022, UK Net Zero Strategy October 2021), Bank of England (Monetary Policy Report August 2022, Financial Stability Report July 2022, Financial Stability Paper No.47), 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.

The conditions that lead to the assignment of a Negative or Positive trend are generally resolved within a 12-month period. DBRS Morningstar’s outlooks and ratings are under regular surveillance.

This rating is Under Review. Generally, the conditions that lead to the assignment of reviews are resolved within a 90-day period. DBRS Morningstar reviews 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: https://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/404200.

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: 19 July 2010
Last Rating Date: 13 May 2022

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