Morningstar DBRS Confirms the United Kingdom at AA, Stable Trend

DBRS Ratings Limited (Morningstar DBRS) 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, Morningstar DBRS confirmed the Short-Term Foreign and Local Currency - Issuer Ratings at R-1 (high). The trend on all ratings is Stable.

KEY CREDIT RATING CONSIDERATIONS
The Stable trend reflects Morningstar DBRS' view that risks to the credit ratings are balanced. After posting 0.3% growth in 2023 the UK economy has started to recover. Economic growth is expected to gather pace as financial and external conditions improve. Real GDP growth is projected at 1.1% in 2024 and 2.0% in 2025. The Bank of England (BoE) lowered its policy rate for the second time this year as inflation fell to a three-year low in September 2024, below the BoE's 2% target rate. On October 30 the new Labour government presented its first budget, announcing increases in spending, taxation and borrowing. The general government deficit expected to be higher over the five-year forecast horizon and to decline slowly from 5.3% of GDP in the fiscal year (FY) 2024-25 to 2.7% in FY 2029-30. The slower pace of fiscal consolidation will result in the general government debt ratio rising gradually and reaching 106.1% of GDP in FY 2029-30. At the same time, the government announced changes to its fiscal rules requiring the current budget to be in surplus by 2029-30. In addition, it will now target a falling ratio of public sector net financial liabilities (PSNFL) to GDP by FY 2029-30. A high public debt may leave the government with less flexibility to respond to shocks. Downside risks to the fiscal outlook remain significant and are related to higher-than-expected interest rates or lower-than-expected economic growth. Financial vulnerabilities appear contained, limiting risks to financial stability.

The credit 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 weak public sector finances - a persistent fiscal deficit and high government debt - low economic growth and external imbalances, with a recurrent current account deficit. Uncertainty over the long-term cohesion of the four-nation UK also poses some challenges.

CREDIT RATING DRIVERS
An upgrade could occur if (1) the public debt ratio returns to a sustained downward path, 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.

CREDIT RATING RATIONALE

The Government Announces Increases in Spending and New Fiscal Rules

On October 30, 2024, the new Labour government presented its first autumn budget, announcing increases in spending, taxation and borrowing as well as changes to fiscal rules. The government announced significant increases in spending by around GBP 70 billion, of which one third is related to increases in spending of public investment and the rest relates to current spending. The increase in spending will be partially financed by tax rises, including increases in employer National Insurance contributions (NIC). Other revenue measures include increases in capital gains taxes, inheritance tax, and other taxes on assets, and expected improvements in tax compliance. The rest of the increase in spending will be funded through higher borrowing (GBP 32 billion or 1% of GDP a year). The Office for Budget Responsibility (OBR) is now forecasting the general government deficit to be higher over the five-year horizon and to decline slowly from 5.3% of GDP in the fiscal year (FY) 2024-25 to 2.7% in FY 2029-30. The slower pace of fiscal consolidation will result in the general government debt ratio gradually rising and reaching 106.1% of GDP in FY 2029-30.

The government announced also changes to its fiscal rules. Under the new fiscal mandate, the government targets the current budget, to be in surplus in 2029-30. In addition, it aims to reduce the public sector net financial liabilities (PSNFL) as a share of GDP by 2029-30, moving gradually to a three-year, rather than five-year timeframe, which reinforces its commitment to achieving fiscal consolidation in shorter period of time. By targeting PSNFL instead of public debt, the government has created some fiscal room. For more details, please see "The UK Autumn Budget 2024: Fiscal Loosening Amid New Fiscal Rules".

UK's debt profile remains broadly favourable, despite the increase in interest costs. The long average maturity of debt at just above 14 years, mitigates to some extent the impact from higher interest rates. Public debt interest spending increased significantly in FY 2022-23 compared with the previous year. This level of debt interest is forecast to remain high throughout the next few years primarily due to increased interest rates and high projected borrowing requirements. The OBR is forecasting interest spending to fall to 3.5% of GDP by 2025-26, before increasing slightly to 3.6% by 2029-30. On the investor base, major gilt holders include domestic insurance and pension funds with 22% of gilts, the BoE 28% and overseas investors 31%. Given the depth of the UK debt market and sterling's status as a reserve currency, the UK enjoys a high degree of financing flexibility. This supports Morningstar DBRS' Debt and Liquidity building block assessment.

The UK Economy Gathers Momentum While Long-term Challenges Persist

After growing by 4.8% in 2022, the UK economy's growth rate moderated in 2023. Real GDP expanded by only 0.3% in 2023, mainly reflecting the challenging external environment, high inflation, and tighter financing conditions. However, the economic activity is expected to pick up as household purchasing power recovers, external conditions improve, and financial conditions ease further. Headline inflation rate has now fallen below the Bank of England's target rate, to 1.7% in September 2024, due to the impact of restrictive monetary policy and lower energy and goods price growth. By contrast, services inflation remains relatively high, at 4.9% in September, and is expected to ease gradually as wage growth weakens further. Looking forward, although uncertainty remains high, the Bank of England expects inflation to stabilize around 2% for the rest of the year. With stronger GDP in recent quarters and the fiscal support from the Autumn 2024 Budget, the OBR is forecasting UK real GDP to grow by 1.1% in 2024, followed by a stronger 2.0% in 2025. Nevertheless, the net effect of the policy measures is expected to fade in the medium term, with real GDP returning to a more moderate 1.5% growth for the 2026-2029 period. In Morningstar DBRS' view, downside risks to the near-term economic outlook include a resurge in inflation, tighter-for-longer financial conditions, renewed financial market turmoil, or an intensification of global geopolitical tensions.

Since the global financial crisis (GFC) the UK economy has experienced low growth, with real GDP growth softening from an average of 2.9% between 1993 to 2007 to just 1.2% between 2009 and 2019, reflecting mostly lower productivity growth. Brexit, the pandemic and the energy price shock have weighed on business investment in recent years. A rise in long-term sickness combined with Brexit seems to have also slowed growth in the labour force, with increased labour inactivity. The Labour government has made fostering economic growth a key priority. The government published "Invest 2035: the UK's modern industrial strategy" for public consultation. This strategic initiative aims to boost economic growth, foster investment in sectors with the highest growth potential and enhance global competitiveness. The strategy also details the government's objectives to promote a stable regulatory framework to provide businesses with the stability they need to invest. The measures adopted in the Autumn Budget 2024, will keep public investment broadly flat at around 2.5% of GDP over the next five years, rather than dropping to the 1.7% assumed in the previous government's plans. However, the effectiveness of these policy measures is yet to be proved.

BoE Eases Monetary Policy; Banking Sector Has Remained Resilient

The UK enjoys a high degree of monetary policy credibility and flexibility. Following a rate cut in August 2024 of 0.25 percentage points, the BoE lowered its policy rate again in November 2024 bringing it to 4.75%. Inflation fell to a three-year low in September 2024, falling below the BoE's 2% target rate, making it possible for the BoE to ease its monetary policy. BoE forecasts average annual inflation at 2.25% for 2024. But core and services inflation remain relatively high, at 3.2% and 4.9% respectively in September, and are expected to easy gradually as wage growth weakens further remains. The BoE continues to look closely at the labour market, wage growth in the private sector, and services inflation, as indicators of inflation persistence. At the same time, quantitative tightening is progressing.

Risks to financial stability appear contained. UK's banking system remains resilient, despite the challenges posed by the adverse macroeconomic environment. The banking system is well capitalised and banks maintain strong liquidity positions. Higher interest rates continue to put pressure on households and businesses, but asset quality for major UK banks remains strong. Household debt remained high at 121.3% of disposable income in Q2 2024, which could pose a risk if unemployment rises sharply. The higher interest rates as well as the high cost of living and high house prices have resulted in a deterioration in housing affordability as higher mortgage rates continue to increase the average debt servicing burden for the UK households. Despite the prolonged period of high interest rates, the nationwide house price index shows that house prices started to recover in 2024, growing by 1.6% YoY in the first ten months of the year, after a decline of 2.9% in 2023 as the consecutive mortgage interest rate increases weighed on demand. Moreover, mortgage lending growth remains positive since April 2024, providing further evidence that the housing market will most likely stabilise, supported also by the ongoing economic recovery, the easing of monetary policy, the still tight labour market with the unemployment rate at 4.3%. Risks from high interest rates have weighed on Morningstar DBRS' assessment of the Monetary and Financial Stability building block. In other parts of the UK financial system, after a rapid increase in gilt yields in September 2022 affected part of the UK pension fund market, particularly liability-driven investment funds, their shock absorption capacity has been reinforced with the adoption of new standards.

The Current Account Deficit Improved Slightly in 2023

As one of the most financially open economies in the world, the UK is exposed to external risks. The country has recorded persistent current account deficits over the recent decades, mainly reflecting negative trade and income balance, while services have registered a surplus of around 6% of GDP in the past ten years. The current account deficit improved slightly from 2.1% of GDP in 2022 to 2.0% in 2023 still weighed by the effects from higher energy and food prices. The IMF is forecasting a deficit below 3% in the coming years. The UK finances the current account deficit mainly through net financial inflows. The UK's net external liability position has also deteriorated, reaching 25% of GDP in 2023 from 12% in 2022, mainly reflecting negative valuation effects.

The New Labour Government Has a Strong Mandate

The UK benefits from solid political institutions, with strong governance indicators as reflected in the high scores from the World's Bank Worldwide Governance Indicators, lessening some of the risks from potential domestic political tensions and regional divisions that increased in recent years. The UK political environment turned divisive over the past years, with political tensions and crises affecting policy predictability. Successive changes in leadership, economic policy uncertainty and political disagreements over how to tackle the UK's main economic challenges increased, weighing on the investment environment.

Following the July 2024 parliamentary election, a new Labour government was formed, backed by 403 out of 630 seats in the House of Commons, securing a comfortable majority. The Labour government was elected on a mandate to revive economic growth, strengthen energy security and meet climate targets, and improve the public finances. In Morningstar DBRS' view, the government's large majority in parliament should enable a more decisive implementation of policies. The Labour's economic plan is subject to execution risks, and even if fully implemented, the results will take time to materialise. For more please see "The UK General Election: The Next Government Will Face the Same Significant Challenges".

ENVIRONMENTAL, SOCIAL, AND GOVERNANCE CONSIDERATIONS

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

A description of how Morningstar DBRS considers ESG factors within the Morningstar DBRS analytical framework can be found in the Morningstar DBRS Criteria: Approach to Environmental, Social, and Governance Factors in Credit Ratings (13 August, 2024) https://dbrs.morningstar.com/research/437781

For more information on the Rating Committee decision, please see the Scorecard Indicators and Building Block Assessments. https://www.dbrsmorningstar.com/research/443099.

Morningstar DBRS notes that this Press Release was amended on 5 December 2024 to incorporate the address of the issuing office.

Notes:
All figures are in British pound sterling 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 (15 July 2024) https://dbrs.morningstar.com/research/436000. In addition Morningstar DBRS uses the Morningstar DBRS Criteria: Approach to Environmental, Social, and Governance Factors in Credit Ratings https://dbrs.morningstar.com/research/437781 in its consideration of ESG factors.

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

The sources of information used for these credit ratings include HM Treasury (Autumn Budget 2024), Office of Budget Responsibility (Economic and Fiscal Outlook October 2024, Fiscal Risks and Sustainability Report September 2024), UK Debt Management Office (Quarterly Review April-June 2024), Bank of England (Monetary Policy Report November 2024, Financial Stability Report June 2024), Labour Party Manifesto 2024, Office for National Statistics, Department for Energy Security and Net Zero, IMF, OECD, BIS, World Bank, Macrobond, Haver Analytics. Morningstar DBRS considers the information available to it for the purposes of providing these credit ratings to be of satisfactory quality.

With respect to FCA and ESMA regulations in the United Kingdom and European Union, respectively, these are unsolicited credit ratings. These credit ratings were 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

Morningstar DBRS 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. Morningstar DBRS' outlooks and ratings are under regular surveillance.

For further information on Morningstar DBRS historical default rates published by the European Securities and Markets Authority (ESMA) in a central repository, see: https://registers.esma.europa.eu/cerep-publication. For further information on Morningstar DBRS 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 credit rating assumptions can be found at: https://www.dbrsmorningstar.com/research/443089.

These credit ratings are endorsed by DBRS Ratings GmbH for use in the European Union.

Lead Analyst: Spyridoula Tzima, Vice President, Global Sovereign Ratings
Rating Committee Chair: Thomas R. Torgerson, Managing Director, Global Sovereign Ratings
Initial Rating Date: July 19, 2010
Last Rating Date: May 17, 2024

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