DBRS Morningstar Confirms the United Kingdom at AA, Stable Trend

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. 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 experiencing a slowdown reflecting persistent high inflation, tight financial conditions and industrial action. The fiscal deficit also remains large and the government debt ratio is projected to increase further in the coming years. Nevertheless, compared with a few months ago, the fiscal and economic outlooks have improved slightly. The cost of energy support measures has been lower than expected and tax receipts have been higher than anticipated. Moreover, although additional lagged effects from monetary tightening are yet to come, inflation is set to start falling soon, easing the squeeze in real incomes. Despite higher interest rates, financial vulnerabilities appear contained, limiting risks to financial stability and the economy. Furthermore, the government seems committed to its fiscal rule of reducing the high public sector debt ratio by 2027-2028. On the political front, the recently-agreed Windsor Framework should diminish tensions over trade between Great Britain and Northern Ireland.

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 in the long term 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) a severe economic or financial shock has a material adverse impact on the economy and fiscal accounts, damaging the UK’s financing flexibility, or (2) the likelihood of a break-up of the UK materially increases.

RATING RATIONALE

UK Growth Has Slowed Affected by Cost of Living Pressures, Tight Financial Conditions and Industrial Action

The UK economy is going through a slowdown and the outlook is for a gradual recovery. Economic activity has been affected by the energy crisis, high inflation, higher interest rates, and industrial action over the past several months. After reaching a peak of 11.1% in October 2022, the annual inflation rate has fallen only slightly remaining in double-digits at 10.1% in March 2023. While energy prices have fallen recently, food prices and services inflation have continued to rise. At the same time, labour market conditions have remained resilient, with unemployment at a still low rate of 3.8% in January 2023. In the near term, tighter financial conditions are expected to continue weighing on consumption and investment, while real household incomes are set to recover with inflation set to fall later in the year. After slowing to 4.1% in 2022, real GDP is forecast to contract by a milder-than-expected 0.2% in 2023 before growing by 1.8% in 2024, according to the Office for Budget Responsibility (OBR). The milder downturn reflects lower wholesale gas prices and interest rates than expected in November 2022. In DBRS Morningstar's view, downside risks to the near-term economic outlook include renewed financial market turmoil, even more persistent inflation, tighter-than-expected financial conditions, and an intensification of global geopolitical tensions.

Overall, the UK economy is struggling with a chronic low growth problem. Potential output growth has deteriorated over the past years, now estimated 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, with increased labour inactivity weighing on growth. At the same time, income inequality is relatively high. The OBR’s forecasts assume potential productivity about 4% lower compared to remaining in the EU as a result of Brexit alone. Uncertainty remains over the effects of new trade deals on trade, investment and migration, and ultimately on UK potential output. Both the OBR and the BoE are projecting lower potential growth in the next years. In March 2022, the government adopted measures to increase labour market participation, including increased childcare support, reforms to working-age benefits, disability employment support, and more generous pensions tax allowances. The effectiveness of the labour market measures and that of the temporary capital allowances on investment and growth prospects are yet to be proved.

The Fiscal Position Remains Weak, With the Public Debt Ratio Projected to Continue Increasing in the Coming Years

The fiscal deficit is expected to remain large this year and next. In its Spring Budget 2023, the government adopted measures aimed at further easing cost-of-living pressures on households, supporting economic growth in the medium term, and reducing the government debt ratio over the longer term. Against a more favourable economic background, and despite ongoing fiscal support, the OBR’s fiscal outlook improved slightly compared with the previous fiscal statement in November 2022. The improvement reflects lower-than-expected costs of energy support measures and debt interest payments as well as higher tax receipts, all of which led to a better-than-expected general government deficit of 6.0% of GDP in the fiscal year (FY) 2022-23. The deficit is forecast at 5.5% in FY 2023-24. As the economy recovers and temporary fiscal measures expire, the deficit is forecast to decline to 3.6% in FY 2024-25. The OBR’s forecasts for the general government debt-to-GDP ratio are also now lower, at 105.9% in FY 2023-24 and peaking at 107.3% in 2026-27.

The government is planning to return public finances to a healthy path over time, but there are risks to the near and medium fiscal outlook. The fiscal projections are subject to uncertainty, with risks to the downside and the upside stemming from the dynamics in inflation, interest rates and growth. While fiscal policy will remain supportive in the near term, the policy stance is set to become more restrictive from 2024-25. The government updated its fiscal rules in the Autumn Statement 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). 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 just below 14 years, lessening to some extent the impact from higher interest rates. However, higher inflation has driven up the cost of index-linked bonds, which account for 25% of the UK debt portfolio. The OBR estimated that debt interest spending more than doubled to 4.5% of GDP in FY 2022-23 compared with the previous year. Interest spending is then projected to fall and average 3.1% of GDP between 2023-24 and 2027-28, compared with an average of 2.0% over the past decade. Index-linked bonds meet demand from investors in the large domestic market. On the investor base, insurance and pension funds hold almost 27% of gilts, overseas investors another 30% and the BoE 34%. 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. This supports DBRS Morningstar’s qualitative assessment of the Debt and Liquidity building block.

The Windsor Framework Should Reduce Some Trade Uncertainties Lingering Since Brexit, but Politics Remain Divisive

The UK political environment has become more divisive over the past years with political tensions and crises affecting policy predictability. The resignation of Prime Minister Boris Johnson in July 2022 led to another 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 by the Conservative party in October 2022, the fifth Conservative Prime Minister since 2016. During times of political crises, economic policy uncertainty has increased, with adverse implications for investment decisions. Clarity on the new government’s fiscal policy emerged after the Autumn Statement, but political disagreements within the Conservative party persist over how to tackle the UK’s main economic problems, including low growth.

In addition to the political divisions, a constitutional debate over the long-term cohesion of the four-nation UK re-surfaced after the UK referendum on EU membership in 2016. A majority in Scotland and Northern Ireland (NI) 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 NI Assembly, 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 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. In Northern Ireland, a political stalemate remains unsolved as the Democratic Unionist Party continues to refuse to form a government given its disapproval of the NI protocol. Nevertheless, the Windsor Framework agreed between the UK and the EU in February 2023, which amends the legal text of the NI Protocol and clarifies the applicability of EU laws in NI, should smooth the flow of trade within the UK and herald a more constructive relationship with the EU.

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. Still, reginal political divisions and the associated political uncertainties continue to weigh on DBRS Morningstar’s assessment of the Political Environment building block.

Monetary Policy Has Been Tightened Further and Activity in the Housing Market Has Weakened

The UK enjoys a high degree of monetary policy credibility and flexibility. The BoE has continued tightening its policy, raising Bank Rate for a 12th successive time since December 2021 at its latest monetary policy meeting in May 2023, by a further 25 basis points to 4.50%. The BoE has indicated that it is looking closely at the tightness in the labour market, wage growth in the private sector, and services inflation, as the three indications of inflation persistence. Quantitative tightening is also underway, with the BoE starting the active sales of government bonds in November 2022. At the same time, the BoE has intervened to safeguard financial stability, responding to the severe volatility in the gilt market in September.

Risks to financial stability appear contained. Household debt remained 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 on the UK housing market, with house prices and mortgage approvals falling in late 2022. Prices have stabilised in recent months and approvals have started to increase, but mortgage lending remains subdued. The UK banking system, on the other hand, remains resilient to various adverse economic scenarios, according to the BoE. In 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 was not the issue, stresses 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 Deteriorated As a Result of the Terms of Trade Shock

The current account deficit worsened last year and is projected to remain relatively large in the next years. 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 in the past ten years. In 2022, the current account deficit deteriorated markedly reflecting the shock in the terms of trade from the very high import prices of energy and food. The UK is a net importer of gas. After narrowing to 1.5% of GDP in 2021, the current account deficit widened to 5.6% in 2022. The deficit is forecast to decline but to remain at around 4% in 2024-2025, 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/414263.

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 (29 August 2022) https://www.dbrsmorningstar.com/research/401817/global-methodology-for-rating-sovereign-governments. 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 in its consideration of ESG factors.

The credit rating methodologies used in the analysis of this transaction can be found at: https://www.dbrsmorningstar.com/about/methodologies.

The sources of information used for this rating include HM Treasury (Spring Budget 2023, Autumn Statement 2022), Office of Budget Responsibility (Economic and Fiscal Outlook March 2023, Forecasting Potential Output – The Potential Supply Side of the Economy November 2022), HM Government (The Windsor Framework February 2023, Powering Up Britain March 2023, British Energy Security Strategy April 2022, UK Net Zero Strategy October 2021), Bank of England (Monetary Policy Report May 2023, Financial Stability Report December 2022), UK Debt Management Office (Quarterly Review October-December 2022), 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: 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. For further information on DBRS Morningstar historical default rates published by the Financial Conduct Authority (FCA) in a central repository, see https://data.fca.org.uk/#/ceres/craStats.

The sensitivity analysis of the relevant key rating assumptions can be found at: https://www.dbrsmorningstar.com/research/414262.

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 January 2023

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