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AAA Q&A: why the UK's rating downgrade matters

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AAA Q&A: why the UK's rating downgrade matters

What has Moody’s done?

Moody’s, one of the world’s three leading credit ratings agencies, has cut the UK’s government bond rating from a top AAA rating to AA1.

The agency warned it was thinking of downgrading the UK a year ago so the move is not a shock although the timing was a nasty surprise for the chancellor George Osborne.

The chancellor pinned the government’s austerity programme on cutting the country’s debts and preserving the AAA rating. Coming a month before his budget, Moody’s is effectively saying there is nothing Osborne can do in the short term to improve the UK’s financial situation.

Although the one-notch move is not huge in itself, it is the first time the UK has lost its top credit rating. The other agencies Standard & Poor’s and Fitch still have the UK on AAA although they have previously said they are considering a cut like Moody’s.

Next: Why is Moody’s concerned?

Why is Moody’s concerned?

Although a AA1 rating is still high, Moody’s says the downgrade was needed to reflect continued weakness in the UK economy and the country’s rising debt burden. It is concerned by the chancellor’s decision to delay his debt reduction target until beyond the next election.

London, 22 February 2013 -- Moody's Investors Service has today downgraded the domestic- and foreign-currency government bond ratings of the United Kingdom by one notch to Aa1 from Aaa. The outlook on the ratings is now stable.

The key interrelated drivers of today's action are:

1. The continuing weakness in the UK's medium-term growth outlook, with a period of sluggish growth which Moody's now expects will extend into the second half of the decade;

2. The challenges that subdued medium-term growth prospects pose to the government's fiscal consolidation programme, which will now extend well into the next parliament;

3. And, as a consequence of the UK's high and rising debt burden, a deterioration in the shock-absorption capacity of the government's balance sheet, which is unlikely to reverse before 2016.

At the same time, Moody's explains that the UK's creditworthiness remains extremely high, rated at Aa1, because of the country's significant credit strengths. These include (i) a highly competitive, well-diversified economy; (ii) a strong track record of fiscal consolidation and a robust institutional structure; and (iii) a favourable debt structure, with supportive domestic demand for government debt, the longest average maturity structure (15 years) among all highly rated sovereigns globally and the resulting reduced interest rate risk on UK debt.

The stable outlook on the UK's Aa1 sovereign rating reflects Moody's expectation that a combination of political will and medium-term fundamental underlying economic strengths will, in time, allow the government to implement its fiscal consolidation plan and reverse the UK's debt trajectory. Moreover, although the UK's economy has considerable risk exposure through trade and financial linkages to a potential escalation in the euro area sovereign debt crisis, its contagion risk is mitigated by the flexibility afforded by the UK's independent monetary policy framework and sterling's global reserve currency status.

In a related rating action, Moody's has today also downgraded the ratings of the Bank of England to Aa1 from Aaa. The issuer's P-1 rating is unaffected by this rating action. The rating outlook for this entity is now also stable.

RATINGS RATIONALE

The main driver underpinning Moody's decision to downgrade the UK's government bond rating to Aa1 is the increasing clarity that, despite considerable structural economic strengths, the UK's economic growth will remain sluggish over the next few years due to the anticipated slow growth of the global economy and the drag on the UK economy from the ongoing domestic public- and private-sector deleveraging process. Moody's says that the country's current economic recovery has already proven to be significantly slower -- and believes that it will likely remain so -- compared with the recovery observed after previous recessions, such as those of the 1970s, early 1980s and early 1990s. Moreover, while the government's recent Funding for Lending Scheme has the potential to support a surge in growth, Moody's believes the risks to the growth outlook remain skewed to the downside.

The sluggish growth environment in turn poses an increasing challenge to the government's fiscal consolidation efforts, which represents the second driver informing Moody's one-notch downgrade of the UK's sovereign rating. When Moody's changed the outlook on the UK's rating to negative in February 2012, the rating agency cited concerns over the increased uncertainty regarding the pace of fiscal consolidation due to materially weaker growth prospects, which contributed to higher than previously expected projections for the deficit, and consequently also an expected rise in the debt burden. Moody's now expects that the UK's gross general government debt level will peak at just over 96% of GDP in 2016. The rating agency says that it would have expected it to peak at a higher level if the government had not reduced its debt stock by transferring funds from the Asset Purchase Facility -- which will equal to roughly 3.7% of GDP in total -- as announced in November 2012.

More specifically, projected tax revenue increases have been difficult to achieve in the UK due to the challenging economic environment. As a result, the weaker economic outturn has substantially slowed the anticipated pace of deficit and debt-to-GDP reduction, and is likely to continue to do so over the medium term. After it was elected in 2010, the government outlined a fiscal consolidation programme that would run through this parliament's five-year term and place the net public-sector debt-to-GDP ratio on a declining trajectory by the 2015-16 financial year. (Although it was not one of the government's targets, Moody's had expected the UK's gross general government debt -- a key debt metric in the rating agency's analysis -- to start declining in the 2014-15 financial year.) Now, however, the government has announced that fiscal consolidation will extend into the next parliament, which necessarily makes their implementation less certain.

Taken together, the slower-than-expected recovery, the higher debt load and the policy uncertainties combine to form the third driver of today's rating action -- namely, the erosion of the shock-absorption capacity of the UK's balance sheet. Moody's believes that the mounting debt levels in a low-growth environment have impaired the sovereign's ability to contain and quickly reverse the impact of adverse economic or financial shocks. For example, given the pace of deficit and debt reduction that Moody's has observed since 2010, there is a risk that the UK government may not be able to reverse the debt trajectory before the next economic shock or cyclical downturn in the economy.

In summary, although the UK's debt-servicing capacity remains very strong and very capable of withstanding further adverse economic and financial shocks, it does not at present possess the extraordinary resilience common to other Aaa-rated issuers.

RATIONALE FOR STABLE OUTLOOK

The stable outlook on the UK's Aa1 sovereign rating partly reflects the strengths that underpin the Aa1 rating itself -- the underlying economic strength and fiscal policy commitment which Moody's expects will ultimately allow the UK government to reverse the debt trajectory. The stable outlook is also an indication of the fact that Moody's does not expect further additional material deterioration in the UK's economic prospects or additional material difficulties in implementing fiscal consolidation. It also reflects the greater capacity of the UK government compared with its euro area peers to absorb shocks resulting from any further escalation in the euro area sovereign debt crisis, given (1) the absence of the contingent liabilities from mutual support mechanisms that euro area members face; (2) the UK's more limited trade dependence on the euro area; and (3) the policy flexibility that the UK derives from having its own national currency, which is a global reserve currency. Lastly, the UK also benefits from a considerably longer-than-average debt-maturity schedule, making the country's debt-servicing costs less vulnerable to swings in interest rates.

WHAT COULD MOVE THE RATING UP/DOWN

As reflected by the stable rating outlook, Moody's does not anticipate any movement in the rating over the next 12-18 months. However, downward pressure on the rating could arise if government policies were unable to stabilise and begin to ease the UK's debt burden during the multi-year fiscal consolidation programme. Moody's could also downgrade the UK's government debt rating further in the event of an additional material deterioration in the country's economic prospects or reduced political commitment to fiscal consolidation.

Conversely, Moody's would consider changing the outlook on the UK's rating to positive, and ultimately upgrading the rating back to Aaa, in the event of much more rapid economic growth and debt-to-GDP reduction than Moody's is currently anticipating.

COUNTRY CEILINGS

The UK's foreign- and local-currency bond and deposit ceilings remain unchanged at Aaa. The short-term foreign-currency bond and deposit ceilings remain Prime-1.

IMPACT ON OTHER RATINGS

Moody's will assess the implications of this action for the debt obligations of other issuers which benefit from a guarantee from the UK sovereign, and will announce its conclusions shortly in accordance with EU regulatory requirements. Moody's does not consider that the one-notch downgrade of the UK sovereign has any implications for the standalone strength of UK financial institutions, or for the systemic support uplift factored into certain UK financial institutions' unguaranteed debt ratings.

PREVIOUS RATING ACTION

Moody's previous action on the UK's sovereign rating and the Bank of England was implemented on 13 February 2012, when the rating agency changed the outlook on both Aaa ratings to negative from stable. For the UK sovereign, the actions prior to that were Moody's assignment of a Aaa rating to the UK's government bonds in March 1978 and the assignment of a stable outlook in March 1997. For the Bank of England, the action prior to the one from February 2012 was the assignment of a Aaa rating and stable outlook in March 2010.

The principal methodology used in these ratings was Sovereign Bond Ratings published in September 2008. Please see the Credit Policy page on www.moodys.com for a copy of this methodology.

Financially the rating is important because it says that that the government bonds – or gilts – that the UK issues to borrow money from investors are not quite as secure as they were.

Gilts have enjoyed a ‘safe haven’ status since the financial crisis but if the Moody’s downgrade causes investors to sell gilts, it would mean interest rates would rise in the UK. This would hit mortgage and business borrowers and undermine any recovery in the economy. It would also push up the amount the UK pays in interest on its debts.

Moody’s also downgraded the Bank of England from AAA to AA1 as the Bank has bought over a third of all gilts since 2009. Under its controversial ‘quantitative easing’ programme the Bank has created £375 billion of new money with which to stimulate the economy. Buying gilts is the way it gets the money into circulation.

Some say the only achievement of QE has been to weaken the pound.

Next: Why is the pound falling?

Why is the pound falling?

The big impact of the rating downgrade has been on the currency markets. The pound, or sterling, has tumbled to just over $1.51 to the dollar today and a fall to below $1.50 in the next few days  looks likely. It has also slid against the euro to trade at 87.4p a euro.

Fears that the Bank of England will extend QE and ‘print’ more money has been one of the main factors in the pound falling 7% against the dollar since the start of the year. Last week it was revealed that Sir Mervyn King, governor of the Bank of England, had recently voted for more QE. More money in circulation means each pound is worth a bit less, hence the fall on currency markets.

Kathleen Brooks of Forex.com says the ratings downgrade makes it more likely that more QE will be sanctioned in a desperate bid to boost the flagging economy.

Next: what does it mean for UK government bonds?

What does it mean for UK government bonds?

The impact on UK government bonds, or gilts, is crucial. The government has so far managed to fund itself cheaply with low interest payments on its debt due to demand both from overseas and the Bank of England’s QE purchases.

First off, it is important to note that a downgrade was long expected and ‘priced-in’ to assets including government bonds.

Many factors affect gilt prices, including inflation, confidence in the public finances and ‘safe haven’ demand. The latter has already been eroded as investors have seen improvements in the eurozone, leading them to compare the UK’s finances unfavourably. But it is supported by the government’s control over its own currency, unlike eurozone nations, which depend on central bank control of the euro.

If other ratings agencies follow Moody's example, it could discourage institutional and overseas investors from lending to the UK. This would undermine the government's efforts to turn round the economy. However, big investors like this have a shrinking pool of AAA rated investments so ‘flight’ from UK gilts should be limited for the time being. 

What’s more, the Bank of England should support gilts. More QE will mean it will buy more gilts, keeping their prices high and their yields (interest rates) low. The Bank, which has become increasingly tolerant of inflation in order to generate growth, will likely continue down this path.

Next: What does it mean for Osborne and the economy?

What does it mean for Osborne and the economy?

The downgrade is undoubtedly a big political blow to George Osborne and the coalition government. It casts doubt on the credibility of its economic policies and dims its chances at the next election.

Economists say Osborne had it coming, that Moody’s is merely catching up with reality.

The government is being accused of making several key errors of judgement: basing its policy on something it couldn’t control, ie, credit ratings agencies’ judgements; using too much accounting jiggery pokery; and mouthing off too much about fixing the finances without actually doing it.

Osborne though is not expected to make any major changes to his policy. He can argue that his ‘Plan A’ of austerity measures is more important than ever, albeit with some tweaks.

And economists aren’t making big changes to their economic forecasts, pencilling in more of the same: quantitative easing, a weaker pound and above-target inflation.

But political instability in turn creates economic doubt, especially as we get closer to the 2015 election. What will be the commitment to austerity then?

Next: Will inflation rise further?

Next: Will inflation rise further?

Will inflation rise further?

Yes, a weak pound is inflationary as it makes the price of imported goods and services more expensive. This is bad news for savers and investors.

The only comfort is that, for now, the stock market is doing well. The FTSE 100 rose 38 points to 6,374 this morning. The blue chip index has surged 8% so far this year because it reflects more of what is going on in the global economy than in the UK.

Broadly speaking, there is growing confidence that China and the US are slowly pulling out of the slowdown caused by the 2008 financial crisis. Although the political deadlock in the US over 'sequestration', or forced spending cuts, casts a long shadow over markets, nevertheless the fact is the UK's budget problems do not figure too highly on a world scale.

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