DBRS Morningstar Downgrades the United Kingdom to AA, Stable Trend

DBRS Ratings Limited (DBRS Morningstar) downgraded the United Kingdom of Great Britain and Northern Ireland’s (the United Kingdom or the UK) Long-Term Foreign and Local Currency – Issuer Ratings from AA (high) to AA. At the same time, DBRS Morningstar confirmed the United Kingdom’s Short-Term Foreign and Local Currency – Issuer Ratings at R-1 (high). The trend on all ratings is Stable.

KEY RATING CONSIDERATIONS
The downgrade concludes the ‘Under Review with Negative Implications’ on the UK’s ratings and reflects DBRS Morningstar’s assessment that the UK’s policy predictability has diminished and is no longer compatible with a AA (high) rating. DBRS Morningstar has assessed that UK policy has become less predictable than in the past, to a large extent as a result of divisive politics. Political divisions, compounded by the UK’s economic challenges, have led to changes in government and swift variations in economic policy, especially since September 2022. Unexpected hasty changes in policies led initially to significant economic uncertainty, financial market turmoil and tighter financial conditions, although concerns about the inconsistency between fiscal and monetary policies later receded with the reversal of the ‘mini-budget’ measures. These measures were proposed by a new government in September to reduce high inflation and to boost faltering growth. Then, another government in October 2022 presented a medium-term fiscal plan with more coherent measures and tighter fiscal policy with the aim of reversing fiscal deterioration. Although the high degree of uncertainty has receded, the swift changes in economic policies in recent months have affected the predictability of UK policy, in DBRS Morningstar’s view. The rating downgrade reflects the deterioration in the Political Environment building block.

The Stable trend reflects DBRS Morningstar’s view that risks to the rating are broadly balanced. While DBRS Morningstar recognises that economic conditions have deteriorated and that there are risks to the fiscal outlook, the government appears committed to a prudent fiscal strategy over the medium to long term. Public debt is expected to increase in the near term, but the government is aiming to reduce the public sector debt ratio by 2027-2028. At the same time, despite higher interest rates, financial vulnerabilities appear contained, limiting risks to financial stability and the economy.

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 UK’s deep and liquid capital markets, alongside the reserve currency status of the pound sterling, supports the UK’s significant degree of financing flexibility. The Bank of England (BoE) oversees a reserve currency that supports the country’s substantial capacity for external adjustment. However, the country also faces credit challenges stemming from weakened public sector finances – a large fiscal deficit and high government debt – low growth and external imbalances, with a persistent current account deficit. Uncertainty over the cohesion of the four-nation UK also poses some challenges.

RATING DRIVERS
An upgrade could occur if (1) the public debt ratio returns to a sustained downward path over the medium term, or (2) the UK’s growth prospects improve, with higher and 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.

RATING RATIONALE

UK Economic Policy Has Become Less Predictable Amid Recurrent Political Tensions

UK policy predictability has been affected after a number of political crises. The resignation of members of the cabinet prompted Prime Minister Boris Johnson to resign in July 2022, leading to a change in the Conservative party leader and UK Prime Minister in September, with the election of Liz Truss. Following substantial financial market turmoil and political pressures in response to her economic programme – 'The Growth Plan 2022' known as the ‘mini-budget’ – Prime Minister Truss resigned and new Prime Minister Rishi Sunak was elected in October, the fifth government since 2016. During the latest political events, policy uncertainty increased, amid an environment of high inflation and deteriorating economic conditions, with implications for investment decisions. Greater clarity on the new government’s fiscal policy emerged with the Autumn Statement. However, internal political divisions persist over how to tackle the UK’s main economic problems, including low growth, and over the challenges and opportunities from Brexit.

In addition to the divisions within the Conservative party, a constitutional debate over the cohesion of the four-nation UK re-surfaced after the UK referendum on EU membership in 2016. A majority in Scotland and Northern Ireland voted to remain in the EU, while a majority England and Wales voted for Brexit. Regional elections in Northern Ireland in 2022, in which the nationalist Sinn Féin party won the most seats in the Northern Ireland Assembly but a regional government failed to be formed, and elections in Scotland in 2021, in which the pro-independence Scottish National Party remained the largest party in the Scottish parliament, added to the uncertainty over the UK constitutional integrity in the long term. The risk of a break-up of the UK has decreased after the UK Supreme Court ruled in November 2022 that the Scottish government does not have the power to legislate for a referendum on Scottish independence, but the issue seems unlikely to fade. 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 in Northern Ireland. To address the burden of these 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.

The UK still benefits from solid political institutions, with strong governance indicators including the rule of law, lessening some of the risks from domestic political tensions and regional divisions. Nevertheless, political divisions and the associated political and policy uncertainties have weighed on DBRS Morningstar’s assessment of the Political Environment building block.

UK Growth Has Slowed Substantially Affected By Cost of Living Pressures and Tighter Financial Conditions

The UK economy has a chronic low growth problem. Potential output growth has deteriorated over the past years, now estimated just below 2%, largely reflecting lower productivity growth. Business investment has been low for years, likely weighed on by Brexit, and more recently by the pandemic and the energy price shock, slowing growth in capital stock. The pandemic and Brexit seem to have also slowed growth in the labour force. The Office for Budget Responsibility (OBR) estimates a productivity loss of about 4% as a result of Brexit alone. Uncertainty remains over the impact of new trade deals on trade, investment and migration, and ultimately on UK potential output. It seems the government will continue to pursue the previous plan for economic growth intended to narrow regional disparities in income and to raise productivity, through investment in infrastructure, innovation, and skills, but the plan will take time to yield results. Both the OBR and the BoE are projecting lower potential growth in the next years.

The UK economy is facing a downturn. While some supply bottlenecks eased during 2022, inflationary pressures intensified with the Russian invasion of Ukraine and sterling depreciation. The annual inflation rate in the UK stood at 10.7% in November 2022. Thanks to the government's 'energy price guarantee', inflation is estimated to have peaked for now at 11.1% in October 2022. Tight financial conditions and persistent inflation are expected to continue weighing on consumption and investment in the near term. After rebounding 7.6% in 2021, real GDP growth is estimated to have slowed to 4.2% in 2022 and is now forecast to contract by 1.4% in 2023, according to the OBR. In DBRS Morningstar's view, downside risks to the near-term economic outlook include a further tightening in financial conditions, a more pronounced deterioration in economic sentiment, and an intensification of the energy crisis.

The Fiscal Position Has Deteriorated, With the Public Debt Ratio Projected to Increase in The Coming Years

The fiscal deficit is expected to remain large this year and next. Since March 2022, there have been five main fiscal statements, with the latest set of measures adopted in the Autumn Statement 2022 (AS) in November 2022. The AS included targeted fiscal support in the near term to help households and businesses cushion the impact from high inflation, as well as a combination of tax increases and spending cuts to reverse the fiscal deterioration. Since the Spring Statement in March 2022, the fiscal position has deteriorated markedly. Higher-than-expected inflation and interest rates, together with slowing economic activity and government support, have led to a larger deficit. The OBR is now forecasting the general government deficit to widen from 6.4% of GDP in the fiscal year (FY) 2021-22 to 7.1% in FY 2022-23, versus a previous forecast of 3.8%. The general government debt-to-GDP ratio is projected to continue rising from 101.9% in FY 2021-22 to reach a peak of 111.3% in FY 2025-26.

The government is planning to return public finances to a healthy path over time, but there are risks to the fiscal outlook. The fiscal and economic projections are subject to uncertainty, with risks to the downside as well as to the upside stemming from the dynamics in inflation, interest rates and growth. The government updated its fiscal rules in the AS 2022, which now require the public sector debt ratio to decline and the fiscal deficit to fall below 3% of GDP by the fifth year of the rolling forecast (2027-28). While fiscal policy will remain relatively supportive in 2022-23 and 2023-24, the policy stance is set to become more restrictive from 2024-25. Fiscal consolidation has largely been pushed back for later years. In DBRS Morningstar's view, backloading fiscal consolidation - with the debt ratio forecast to fall only by 2027-28 - increases the uncertainty over the fiscal path, as this becomes more susceptible to policy changes in view of the electoral cycle. The next general election is due by January 2025.

The debt profile remains broadly favourable, although interest costs have risen rapidly. The average maturity of debt remains very long at over 14 years, lessening the impact from higher interest rates. However, bond yields spiked in September 2022 amid a sell-off of UK assets, while higher inflation has also driven up the cost of index-linked bonds, which account for 26% of the UK debt portfolio. The OBR has estimated that debt interest spending will more than double to GBP 120.4 billion (4.8% of GDP) in this fiscal year compared with the previous year. Interest spending is then projected to average 3.4% of GDP between 2023-24 and 2027-28, up from an average of 2.0% over the past decade. On the investor base, insurance and pension funds hold almost 30% of gilts, overseas investors another 30% and the BoE 33%. Despite the volatility in the gilt market last year, the UK still enjoys a high degree of financing flexibility, given the depth of the UK debt market and sterling’s status as a reserve currency. However, DBRS Morningstar notes that a dysfunction in the gilt market could pose a risk to the UK's financial stability. The efficient functioning of the gilt market remains crucial.

Monetary Policy Has Been Tightened Further And the Housing Market is in Downturn

The UK enjoys a high degree of monetary policy credibility and flexibility. The BoE has continued tightening its policy, raising Bank Rate.by a further 50 basis points to 3.50% at its latest monetary policy meeting in December 2022 for a ninth successive time since December 2021. Quantitative tightening is also underway, with the BoE ending the reinvestment of proceeds from maturing gilts since March 2022 and starting the active sales of government bonds in November. These sales were postponed for just a few weeks as a result of the BoE’s financial stability intervention. To respond to the severe volatility in the gilt market in September and to safeguard financial stability especially in the UK pensions sector, the BoE launched a temporary bond-buying programme.

Risks to financial stability appear contained. Household debt remains high at 134% of disposable income in 2021, which could pose a risk if unemployment rises sharply, and house prices have reached high levels, weighing on affordability. Rapidly rising mortgage rates have had an adverse impact for the UK housing market. Housing market activity is dampening, with house prices and mortgage approvals falling in late 2022. The UK banking system, on the other hand, remains resilient to various adverse economic scenarios, according to the BoE. On other parts of the UK financial system, the rapid increase in gilt yields last September affected part of the UK pension fund market, particularly liability-driven investment funds, raising concerns. Although solvency in pension funds did not seem to be the issue, stresses and lack of confidence could have spread to the other financial market participants, including insurance companies, assets managers, banks and clearing houses. Potential risks to financial stability have weighed on DBRS Morningstar’s assessment of the Monetary and Financial Stability building block.

The Current Account Deficit Is Expected to Deteriorate In the Near Term

The current account remains in deficit. 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 over 5% of GDP on average in the past ten years. In the near term, the current account deficit is expected to deteriorate given the worsening in the terms of trade, related to the prices of energy and food. The UK is a net importer of gas. After declining to 1.5% of GDP in 2021, the current account deficit is estimated to have widened again to close to 5% in 2022 and is forecast above 4% in 2023, according to the IMF. The UK finances the current account deficit mainly through net financial inflows. The UK’s net external liability position has deteriorated in recent years, but remains moderate below 20% of GDP.

ENVIRONMENTAL, SOCIAL, GOVERNANCE CONSIDERATIONS

There were no Environmental/ Social/ Governance factor(s) 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: https://www.dbrsmorningstar.com/research/408374.

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). In addition DBRS Morningstar uses 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) in its consideration of ESG factors.

The sources of information used for this rating include HM Treasury (Autumn Statement 2022, Chancellor’s statement 17 October 2022, The Growth Plan September 2022), Office of Budget Responsibility (Economic and Fiscal Outlook November 2022, 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 November 2022, Financial Stability Report December 2022), Debt Management Office, 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: YES
With Access to Management: NO

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.

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/408375.

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: 19 October 2022

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