S&P Confirms UK AAA Rating, Outlook Negative, Says Increase In Debt Burden Would Be "Incompatible" With AAA
- The coalition government has set out what we view as a strong framework for fiscal consolidation in its June 2010 budget.
- We are affirming our 'AAA' long-term rating on the United Kingdom reflecting our view of the U.K.'s resources, as evidenced by its wealthy and diversified economy, ample fiscal and monetary policy flexibility, and adaptable product and labor markets.
- However, in our view, a number of large and politically challenging spending decisions are still to be made, and Standard & Poor's medium-term economic forecasts for the U.K. are less optimistic than the assumptions underlying the budget. We therefore believe there is still a material risk that the U.K.'s net general government debt burden may approach a level incompatible with the 'AAA' rating.
- As a consequence, we have maintained the negative outlook on the long-term rating on the U.K.
- We will continue to review the rating in light of further information over the coming months about the extent of the expenditure-led fiscal consolidation.
On July 12, 2010, Standard & Poor's Ratings Services affirmed its 'AAA' long-term and 'A-1+' short-term sovereign credit ratings on the United Kingdom (U.K.). The outlook remains negative. The transfer & convertibility assessment for the U.K. is 'AAA'.
A Standard & Poor's rating outlook indicates the potential direction of a long-term rating, typically over a period of six months to two years. A negative (or positive) outlook does not necessarily precede a rating change, nor does it suggest a change is inevitable; it indicates our view that there is at least a one-in-three likelihood of a rating change. We revised the outlook on the U.K. to negative on May 21, 2009.
The ratings on the U.K. are supported, in our view, by the country's wealthy and diversified economy, ample fiscal and monetary policy flexibility, and relatively adaptable product and labor markets. In addition, we view the U.K. as having deep capital markets with strong demand for long-dated gilts by domestic institutional investors. There is also significant demand for sterling-denominated U.K. government debt by nonresidents, which provides some diversification to the sovereign's investor base.
However, the U.K. faces challenges, mainly due to what we believe to be a substantial structural deterioration in public finances between 2007 and 2009, with gross general government debt increasing by 23% of GDP, more than in most other 'AAA' rated sovereigns. Yet, significantly supporting the rating is the newly-elected Conservative/Liberal Democrat coalition government's economic policy priority to close the fiscal gap. The government intends to eliminate the structural current budget deficit, with nearly three-quarters of the planned £113 billion (7.8% of GDP) adjustment to be delivered through lower spending by the 2014-2015 financial year.
We view the fiscal challenge facing the U.K. government as a formidable one. Based on our 2010 forecasts and under our assumptions of a 4% interest rate and nominal GDP growth of 4% annually, we estimate that an adjustment in the general government primary balance of close to 8% of GDP will be necessary to stabilize the general government debt burden. Our economic growth assumptions are lower than those of the new Office for Budget Responsibility (OBR), in large part because we think private sector deleveraging will depress demand to a greater extent than assumed by the OBR. We estimate domestic credit in the U.K. to be just over 200% of GDP in 2010, compared with a median of below 150% of GDP for 'AAA' rated sovereigns. So, while we agree with the OBR that a rebalancing of the economy will occur over the next five years with net exports contributing positively to growth (thanks to a 24% real effective depreciation in the exchange rate since 2007), we think the process will likely proceed more slowly.
In our base case, we believe that the estimated 11.3% of GDP general government deficit in 2009 could narrow to 4% of GDP in 2014. This 4% figure is lower than our forecast prior to the more comprehensive fiscal consolidation measures announced in the June 2010 budget, before which we expected the general government deficit to be closer to 6% of GDP in 2014. The 4% figure also incorporates a 0.2 percentage point of GDP improvement in the 2009 general government deficit against our earlier expectations. Our forecast is still higher than the government's expectation of a deficit of around 2% of GDP, however, as based on our view of a gradual rebalancing of the U.K. economy we expect the tax-rich components of economic growth will likely remain even weaker than in the OBR forecast. While in our view the governing coalition has so far demonstrated relatively strong cohesion and fiscal resolve, an important test of their fiscal consolidation plan will be how they address the remaining half of the £83 billion (6% of GDP) expenditure cuts still to be allocated as part of the October 2010 Spending Review.
In our base case, we project the general government gross and net debt burdens to continue on an upward trend toward 90% and 85% of GDP, respectively, in 2014. A sustained increase in the general government debt burden above these already relatively high levels, would, in our view, reduce the government's capacity to respond to future shocks and increasingly weigh upon the economy's growth potential. We therefore believe such an increase in the debt burden above our base case would be incompatible with a 'AAA' rating.
The negative outlook reflects the potential of a downgrade if the government does not implement its challenging fiscal consolidation program on the scale currently planned. A slackening of that effort, in our view, could put the U.K.'s net general government debt burden on a trajectory that would be incompatible with a 'AAA' rating. Conversely, we could revise the outlook back to stable if this autumn's Spending Review is agreed in a manner consistent with the 2010 budget projections, and early success in its implementation suggests to us that the government debt burden would peak in the next three years and then begin to ease as per the budget forecasts.
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