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Investment ResearchGeneral Market Conditions
The United Kingdom is a AAA-rated country with a stable outlook. Using the same
rating methodology as Standard and Poor’s, who recently downgraded the United
States, we dare to ask why?
Like S&P, we focus on five key factors that form the foundation of a sovereign credit
rating: 1) Institutional effectiveness and political risks, 2) Economic structure and
growth prospects, 3) External liquidity and international investment position, 4)
Fiscal performance and flexibility, as well as debt burden and 5) Monetary flexibility.
Instead of a “black -box" approach, we lay out all our results with full transparency.
We find that the UK’s political and economic profile is “strong”, the fourth highest
according to Standard & Poor’s. Our research shows that the UK’s flexibility and
performance profile is “moderately strong”, but close to “intermediate”. This is far
from “superior” and “extremely strong”, respectively, the highest possible in S&P’s
indicative rating table.
W ithout adjusting for “exceptional factors”, we conclude that the United Kingdom
should be given an A+ rating, i.e. four notches below the current rating. A downgrade
of the UK could in our view happen in 2012. We believe it can remain a market theme
into 2013. This prediction should however be treated cautiously as our analysis
suggests a relatively large political element in the rating process.
We disagree with the Office for Budget Responsibility’s underlying assumptions about
the debt burden projection. Real growth could in our view be substantially lower; the
GDP deflator could be somewhat lower and the deficit might be harder to reduce than
projected. Rather than peaking in 2013-14 and easing slightly towards 69% of GDP
in 2015-16, we find that the debt burden in our most likely scenario will rise
throughout our forecast horizon and reach 84% of GDP in five years’ time.
The market reaction to a UK downgrade is uncertain with interest rates at depressed
levels due to the risk of another global recession. Some investors might attach a
higher risk premium to UK assets. GBP can be negatively impacted.
Table 1: United Kingdom credit rating
our assessment based on S&P methodology
Note: Six-point numerical score from 1 (the strongest) to 6 (the weakest). See sections 1-5 for details
Source: Standard and Poors, Danske Markets
1 Political score 1.50 2.50 3.50
2 Economic score 1.60 2.60 3.60
3 External score 2.50 3.50 4.50
4 Fiscal score 2.50 3.50 4.50
5 Monetary score 1.25 2.25 3.25
A Political and economic profile 1.55 2.55 3.55
B Flexibility and performance profile 2.08 3.08 4.08
Total Sovereign indicative rating level 1.82 2.82 3.82
Total Indicative rating level AAA A+ BB+
Positive
adjustment
Main
scenario
Negative
adjustment
07 September 2011
Important disclosures and certifications are contained from page 14 of this report.
Chief Analyst
John M. Hydeskov
+44 (0)7410 8144
johy@uk.danskebank.com
Assistant Analyst
Hugo Railing
+44 (0)777 542 2712
railinghugo@gmail.com
UK ResearchHow long can the UK maintain its AAA rating?
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Stress-testing OBRs underlying assumptions about growth andpublic deficit alternative projections on the debt burden
The Office for Budget Responsibility (OBR), an entity established in 2010 to provide
“independent and authoritative analysis of the UK’s public finances”, presented its
Economic and Financial Outlook in March. Not surprisingly, the OBR concludes that the
Coalition Government is on track to meet its two medium-term fiscal target: to balance
the cyclically-adjusted current budget by the end of a rolling, five-year period; and to see
public sector net debt (PSND) falling in 2015-16. However, the OBR points out that there
is considerable uncertainty around the central forecast and will only attach “a greater than
50% probability of meeting both targets.
Chart 1: Lower UK growth alternative debt-to-GDP projections
Source: Office for Budget Responsibility, Danske Markets calculations
It is beyond the scope of this note to go into details of the OBR’s 176-page report. But
there are three assumptions that we find questionable and that could alter the projected
debt path for the UK. These are:
1) The growth outlook. Rather optimistically, the OBR assumes that the UK
economy will grow strongly in the coming years. We are sceptical of this
buoyant growth outlook and think underlying growth will be weaker, global
growth will be slower and the pick-up in employment will be more sluggish.
Growth rates above 2.5% three years in a row will in our view be very hard to
achieve, if not impossible. We guess that the OBR desperately wanted to close
the output gap on the medium-term horizon in its economic model, a common
mistake among economists. More realistically, we assume that the economy
only will expand modestly in the coming years and that structural growth will
average 1.5%. This is actually not a negative scenario and we could easily
imagine worse outcomes.
2) The GDP deflator. An often overlooked assumption in economic forecasting is
about the GDP deflator, i.e. the measure of the level of prices of all new,
domestically produced, final goods and services. If the GDP deflator is
projected to be high in the coming years, it has the positive side effect that
nominal output will rise faster than a potential public deficit and the debt burden
will therefore decline. The UK GDP deflator has averaged 2.5% over the past 20
years, but the OBR projects that it will be even higher in the coming years,keeping the debt burden in check. In comparison, the US GDP has averaged
2.1% over the past 20 years, Eurozone 1.8% and Japan -1%. We test how the
debt burden evolves when these scenarios are applied.
50
60
70
80
90
100
110
2009-10 2010-11 2011-12 2012-13 2013-14 2014-15 2015-16
OBR base case scenario
Lower growth, OBR's UK GDP deflator
Lower growth, US/Euroland deflator
Lower growth, japanese deflator
% of GDP
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3) The reduction of the deficit. According to the OBR, the public sector net
deficit (PSND) will decline from GBP145.9bn in 2010-11 (9.9% of GDP) to
GBP29bn in 2015-16 (1.5% of GDP). Harsh austerity measures have been
announced and the Government has so far not deviated from its ambitious plan.
It is however often easier to say that the belt should be tightened than to actually
cut down on spending. We dare to assume that the government shortfall will be
reduced, but only at half the speed assumed by the OBR.
Chart 2: Lower UK growth AND slower deficit reduction
alternative debt-to-GDP projections
Source: Office for Budget Responsibility, Danske Markets calculations
No matter what will happen, the UK debt burden will rise in the years to come
because of the still sizeable public deficit. In OBR’s base case, the debt burden will
peak at 70.9% in the fiscal year 2013-14 before easing gradually in the coming years.
Because of the underlying assumptions, we find that too optimistic though.
Assuming lower growth and keeping the OBR’s upbeat GDP deflator at 2.7%, suggests
the debt burden will peak at 75.0% in 2014-15. If instead the deflator turns out to be the
average of the US and the Eurozone, 1.95%, the debt burden will keep rising throughout
the forecast horizon and reach 78.1 in 2015-16. In the extreme scenario, in which we
apply “Japanese conditions”, debt will rise dramatically and reach 93.2%.
Assuming that the deficit will be reduced at a slower pace will obviously just make
matters worse. Even though we, in our alternative scenario, assume that the deficit will be
halved over the next five years, the debt burden rises rapidly in all scenarios.
In our view, the scenario assuming a lower growth rate, a “normal” GDP deflator
and a slower reduction of the deficit is the most likely. In this case, the debt burden
will hit 84.2% in 2015-16 and still be on the rise. That is by no means disastrous for
a country like the UK with a long duration of the debt burden and the cost of
servicing this burden will still be manageable, but it is still some 15 percentage
points higher than the OBR projects and we doubt that rating agencies will welcome
this outcome.
50
60
70
80
90
100
110
2009-10 2010-11 2011-12 2012-13 2013-14 2014-15 2015-16
OBR base case scenario
Higher deficit, lower growth, OBR's UK GDP deflator
Higher deficit, lower growth, US/Euroland deflator
Higher deficit, lower growth, japanese deflator
% of GDP
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Same rating approach as S&P but without the black box
Standard and Poor’s has attracted a lot of attention in financial markets and media
lately with its controversial downgrade of the United States from AAA to AA+ .
Japan, Spain and Italy have also been downgraded due to poor economic outlook, too
high debt burdens and no credible plans to reduce public deficits. Standard & P oor’s has been more proactive or aggressive than the two other large rating agencies, Moody’s and
Fitch. We will focus on S&P in our analysis as this company has been first-mover in
terms of sovereign downgrades in recent years.
The aim of this paper is to check whether we can justify the United Kingdom’s AAA
rating, reaffirmed by Standard and Poor’s on 26 October 2010, when the outlook was
revised from ’negative’ to ‘stable’, and further elaborated on in an unsolicited review on
21 December 2010. However, a lot has changed since end-2010 and most recently the risk
of a prolonged period with subdued growth or even a double-dip recession has risen.
In order to evaluate the United Kingdom’s credit rating we will use Standard and
Poor’s’ rating methodology and assumptions for sovereigns from June 2011. This
document includes detailed information on how S&P addresses the factors that affect a
sovereign government's willingness and ability to service its debt on time and in full.
Like S&P, we will focus on five key factors that form the foundation of our analysis of
the UK:
Institutional effectiveness and political risks, reflected in the political score.
Economic structure and growth prospects, reflected in the economic score.
External liquidity and international investment position, reflected in the external
score.
Fiscal performance and flexibility, as well as debt burden, reflected in the fiscal score.
Monetary flexibility, reflected in the monetary score.
To the best of our abilities, we have assigned a score to each of the five key factors
on a six-point numerical scale from '1' (the strongest) to '6' (the weakest). Each score
is based on a series of quantitative factors and qualitative considerations.
As S&P does not reveal its exact scores we have not got anything concrete to relate to.
Instead we will have to make our best judgements based on a large number of statistical
sources. We have only used publicly available information in our analysis.
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1 Institutional effectiveness and political risks
According to Standard and Poor’s (2011), the political score assesses how a
government's institutions and policymaking affect a sovereign's credit fundamentals
by delivering sustainable public finances, promoting balanced economic growth, and
responding to economic or political shocks. The primary factor for determining thepolitical score is the effectiveness, stability, and predictability of the sovereign's
policymaking and political institutions. The secondary factor provides additional
information on the transparency and accountability and acts as a qualifier to the
primary factor in determining the initial political score .
The primary political factor is probably the least likely to be affected by structural
issues and we consider it relatively stable over time. The United Kingdom is generally
characterised by proactive policymaking with a strong track record in managing past
economic and financial crises and delivering economic growth. Institutions are generally
regarded strong and relatively stable, but are only ranked 17 out of 139 in World
Economic Forum’s “Global Competitiveness Report” (2010) due to a low public trust of
politicians, a high burden of government regulation and high business costs of terrorism.
According to the Wor ld Bank’s “Worldwide Governance Indicators”, the UK is in the
90th-100
thpercentile on five measures of governance, but scores low in political stability
and ends in the 50th-75
thpercentile. We notice further that the trend is declining over the
past decade. One of the cornerstones in the political score, the ability to “maintain prudent
policy-making in good times”, which according to Standard and Poor’s has deteriorated
over the past two decades, while another important factor “the willingness to ensure
sustainable public finances” has also diminished. Our best judgement is that the primary
political factor for the UK is solid. A score around 1.5 seems fair.
The secondary political factor can be broken down into four inputs according to
Standard and Poor’s: 1) the existence of checks and balances between institutions, 2) the
perceived level of corruption, which correlates strongly to the accountability of the
institutions, 3) the unbiased enforcement of contracts and respect for the rule of law,
which correlates closely to respect for creditors' and investors' interests and 4) the
independence of statistical offices and the media. On 1), we note that there are extensive
checks and balances between institutions in the United Kingdom and reckon that a score
of around 1.5 is appropriate. On 2), according to Transparency International’s
“Corruption Perception Index”, the UK ranks number 21 out of 178, which transforms
into a score of (1+21/((1/6)*178)) 1.7. On 3), the input factors 1.10-1.21 in World
Economic Forum’s “Global Competitiveness Report” (2010) can roughly be interpreted
as “ability to enforce contracts and respect for the rule of law”. We arrive at a relatively
bad score for the UK; only (1+30/((1/6)*139)) 2.3. The latest riots in the UK have
however not been incorporated in this score and we add 0.5 and arrive at a 2.8 score in
this component. On 4), we have to rely entirely on qualitative analysis and attach a score
of 2 due to independent statistical offices, but with frequent data revisions, and
autonomous media but sometimes with hidden agendas. The average of 1)-4) is a score of
2.0.
Standard and Poor’s notes that there are two potential adjustments to the political
score. The first relates to the debt payment culture: regardless of the fact that the IMF had
to bail the UK out in 1976, we reckon that it has a very good debt payment culture.
Incentive to default is almost non-existing and it would in our view be rather stupid even
to consider a default as close to 10% of the economy is the financial sector, which
probably would be shut in the case of a default. The second potential adjustment relates togeopolitical and external security risks: We judge that the UK is at moderate risk due to
recent participation in wars in Iraq and Afghanistan and involvement in various conflicts
around the world. A terrorist attack hit London in 2005 and more attacks cannot be
excluded.
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The European debt crisis poses a major threat to the UK. Although not directly
affected by, for example, higher interest rates or costs or guarantees to bail-out funds, the
UK can be sucked into the crisis because of its exposure to the peripheral Euroland
countries and because of the heavy British banking sector. Bank of England notes in its
latest Minutes that “The greatest risk to the downside stemmed from the euro area.
Concerns about the euro area were likely already to be affecting the economic outlook
through their impact on asset prices, bank funding costs and the level of household and
business confidence. Reflecting that, the Committee’s projections were conditioned on
relatively slow growth in the euro area. There were, however, additional risks relating to
a significant further intensification of concerns. These could affect the United Kingdom
through a number of channels, including: the impact a further slowing in euro-area
activity would have on UK exports; financial and banking sector interlinkages; and
possibly, and perhaps most significantly, through a disruption to the functioning of the
international financial system more generally – hitting global asset prices, wholesale
funding markets, and business and household confidence”.
Summarily, we judge that the primary political factor for the United Kingdom isaround 1.5. The secondary factor is according to inputs 1)-4) ((1.5+1.7+2.8+2.0)/4=)
2.0. Average for those is 1.75. Adjusting for the good debt payment culture, -0.25,
higher external security risks, +0.4, and the European debt crisis, +0.6, leads us to a
final political score of 2.5.
2 Economic structure and growth prospects
The history of sovereign defaults suggests that a wealthy, diversified, resilient,
market-oriented, and adaptable economic structure, coupled with a track record of
sustained economic growth, provides a sovereign government with a strong revenue
base, enhances its fiscal and monetary policy flexibility, and ultimately boosts itsdebt-bearing capacity. Standard and Poor’s observes that market-oriented economies
tend to produce higher wealth levels because these economies enable more efficient
allocation of resources to promote sustainable, long-term economic growth. We can only
agree with that.
GDP per capita is S&P's most prominent measure of income levels. With higher GDP
per capita, a country has a broader potential tax and funding base upon which to draw, a
factor that generally supports creditworthiness. The determination of the economic score
uses the latest GDP per capita from national statistics, converted to US dollars.
Standard and Poor’s uses a rating system in determining the economic score, a 1 is given
to countries whose GDP per capita is over USD35,000, a score of 2 if the GDP per capitais between USD25,000 and 35,000. The UK has an average GDP per capita of
USD35,616 (using the mean GDP of the CIA World Factbook, the Bank of England and
the Office of National Statistics, divided by the current population). Initially ranked 1 in
Standard and Poor’s scoring system; this has been altered to 1.9 due to the closeness of
the USD35,000 boundary and the fact that many more countries have a higher GDP per
capita (the UK is ranked 22nd
in IMF’s global ranking).
According to Standard & Poor’s, an undervalued currency suggests that the GDP
per capita understates prosperity. Applying Purchasing Power Parity (PPP) analysis,
Sterling is some 15% undervalued, the highest among G10 currencies. Our previous
research suggests however, that sterling might be less undervalued than generally
perceived as UK fundamentals have weakened during the financial and economic crisis,
please see “Sterling’s fall from grace” and “New regime, new forecast”. We subtract 0.3
index points from the initial score, improving the economic score to 1.6.
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Below-average economic growth compared with peers, as measured by real GDP
trend growth, drags down the economic score according to the rating methodology.
We believe that trend growth in the UK has slowed after the financial and economic
crises. Unemployment has settled at an uncomfortably high level and risks becoming
structural if not actively reduced in the near term. The UK has been running a trade
deficit for more than a decade and even a significant currency-led improvement of the
terms-of-trade has not been able to turn this around. The financial sector ’s contribution to
GDP might be considerably smaller than in the decade up to the crisis. It is difficult to say
whether trend growth has deteriorated more in the UK than in the peer group and it is
hard to see who the peer group should be. On growth rates, the UK is ranked poorly in the
CIA World Factbook, only 163rd
out of 215. According to our best judgement, we find
that the economic score should be raised 0.5 index points to 2.1.
Finally, a sovereign exposed to significant economic concentration and volatility
compared with its peers receives an economic score that is one category worse than
the initial score. More precisely, a sovereign's economic score would be one category
worse if it carried significant exposure to a single cyclical industry (typically accountingfor more than about 20% of GDP), or if its economic activity was vulnerable due to
constant exposure to natural disasters or adverse weather conditions. Economic
concentration and volatility are important because a narrowly based economic structure
tends to be correlated with greater variation in growth than is typical of a more diversified
economy.
The UK service sector accounts for 77.5% of all industry in the UK, compared to the
world average of 63.2%. The service sector, the sixth largest service sector in the world,
is in other words crucial for the UK where, for example, exports are of less importance.
The financial sector accounts for 9.4%, i.e. lower than Standard and Poor’s threshold. We
dare however, interpret the term “significant economic concentration” less strictly as the
government already has a sizeable ownership in the financial sector with its controlling
stake of 84% in the RBS Group and its minority stake of 43% in Lloyds Banking Group.
In conclusion, our initial economic score was 1.9. Taking into account the
undervaluation of Sterling -0.3, the slow growth rates +0.5 and the reliance of the
financial sector +0.5 leaves the final economic score at 2.6.
3 External liquidity and international investment position
The external score reflects a country's ability to generate receipts from abroad
necessary to meet its public- and private-sector obligations to non-residents. It refers
to the transactions and positions of all residents (public- and private-sector entities)versus those of non-residents because it is the totality of these transactions that
affects the exchange rates of a country's currency.
Three factors drive a country's external score according to Standard and Poor’s: 1) the
status of a sovereign's currency in international transactions, 2) the country's external
liquidity, which provides an indication of the economy's ability to generate the foreign
exchange necessary to meet its public- and private-sector obligations to non-residents and
3) the country's external indebtedness, which shows residents' assets and liabilities (in
both foreign and local currency) relative to the rest of the world.
From IMF's report "Currency Composition of Official Foreign Exchange Reserves", we
find that Sterling qualifies as a reserve currency as it accounts for more than 3% of theworld's total allocated foreign exchange reserves. According to S&P’s definition, this
gives the UK the best starting point for the external score.
Unfortunately, the UK is highly indebted: narrow net external debt of over 400% is just
about as bad as it can be. According to McKinsey, the UK is the world’s most indebted
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country, adding private and public debt together. Due to the massive debt burden, the UK
falls in the lowest category, and following S&P’s adjustment rubric, the UK falls in the
negative adjustment section. The initial external score is a clear 3.
There are a few adjustment factors though – and both on the negative front:
1) Standard and Poor ’s stipulates that countries running persistent current account deficits
should count as a negative adjustment factor. The UK has been running a sizeable current
account deficit for the past 25 years, on average -2% of GDP. There are no signs of a
large improvement of the current account deficit.
2) We observe sudden shifts in foreign direct investment for the UK. With a 10 year
average of GBP54bn, highs of close to GBP100bn and lows of close to GBP10bn, FDI is
very uneven and unpredictable. The UK holds the third highest stock of FDI, but with
such variation over time, future inflow is less accountable. It is possible that the natural
FDI has diminished due to lower structural growth as foreign investors find the UK less
attractive.
The initial external score was 3.0 but is raised 0.5 points to 3.5 due to the UK’s
persistent current account deficit and the volatility and uncertainty surrounding the
future flow situation. A higher, i.e. worse, score could in our view have been justified
and we cannot exclude that this will be adjusted higher in the future if the net external
debt does not decline. Unfortunately there are no signs of this.
4 Fiscal performance and flexibility
The fiscal score reflects the sustainability of a sovereign's deficits and debt burden.
This measure considers fiscal flexibility, long term fiscal trends and vulnerabilities,
debt structure and funding access, and potential risks arising from contingent
liabilities. Given the many dimensions that this score captures, the analysis is divided
into two segments, "fiscal performance and flexibility" and "debt burden" which are
scored separately. The overall score for this rating factor is the average from the two
segments.
According to Standard and Poor’s, the key measure of a government's fiscal
performance is the change in general government debt stock during the year
expressed as a percentage of GDP in that year. Fiscal flexibility provides governments
with the "room to manoeuvre" to mitigate the effect of economic downturns or other
shocks and to restore its fiscal balance. Conversely, government finances can also be
subject to vulnerabilities or long-term fiscal challenges and trends that are likely to hurt
their fiscal performance. The assessment of a sovereign's revenue and expenditureflexibility, vulnerabilities and long-term trends is primarily qualitative.
The UK has experienced a greater than 6% change of government debt between 2010-
2011, higher than S&P’s upper thr eshold; this results in a high initial score of 6.0 (the
worst possible) following the Standard and Poor’s rating system. The government debt
has practically doubled in the last three years, a consequence of the recession.
Luckily, the UK has a fairly robust and well established taxation system with the ability
to easily raise finance relatively quickly. Due to this factor, we subtract half a point from
the initial score. As the UK has a stable asset income, ranked 24th
out of 167 in CIA’s
World Factbook, we subtract another half point and arrive at a fiscal performance and
flexibility score of 5.0.
The rating methodology suggests that the debt burden score reflects the
sustainability of a sovereign's prospective debt level. Factors underpinning a
sovereign's debt burden score are: its debt level; the cost of debt relative to revenue
growth; and debt structure and funding access. This score also reflects risks arising
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from contingent liabilities with the potential to become government debt if they were to
materialize. The calculation of net general government debt is generally more restrictive
than national measures of net general government debt, as it deducts from the general
government debt only the most liquid assets.
The UK debt burden stands at 61.4 % of GDP, according to the Office of NationalStatistics. The cost of servicing the debt burden is relatively low though, only around 3%
of GDP per year due to the long duration of the UK debt portfolio. This gives the UK an
initial debt score of 3.0 in accordance to the Standar d and Poor’s rating system. UK debt
auctions are usually well-bid and Gilts are generally considered as safe-haven assets. If a
severe crisis occurred, the Bank of England could relatively easily print out money or buy
more government debt. Because of these extenuating circumstances, we lower the score
to 2.0.
Contingent liabilities refer to obligations that have the potential to become
government debt or more broadly affect a government's credit standing, if they were
to materialize. Some of these liabilities may be difficult to identify and measure, but they
can generally be grouped in three broad categories: Contingent liabilities related to the
financial sector (public and private bank and non-bank financial institutions); Contingent
liabilities related to non-financial public sector enterprises (NFPEs); and guarantees and
other off-budget and contingent liabilities.
The UK has a financial recapitalisation cost of GBP133.2bn, while non-financial public
sector enterprise liabilities costs amount to GBP148.4bn, totalling GBP281.6bn. This
accounts for over 10% of the UK’s total GDP (GBP2.246trn) which is well below the
30% threshold (the UK would need a combined total liability of GBP674bn); this is
classed as limited in Standard and Poor’s rating system. This means that UK obligations
are of a lower risk to become problematic and turn into debt. We assign a score of 2.0.
The fiscal score was worked out in two parts; first the fiscal performance and
flexibility’s initial score was 6, due to the high percentage changes in government debt,
but lowered to 5 because of the UK’s stable asset income. Secondly, the debt margin
and contingent liabilities; the debt margin had an initial score of 3 due to the high
percentage of debt to GDP but was lowered to 2 due to low costs of servicing the debt.
In total, we have a fiscal score of 5+(2+2)/2=3.5.
5 Monetary flexibility
A sovereign's monetary score reflects the extent to which its monetary authority can
support sustainable economic growth and attenuate major economic or financial
shocks, thereby supporting sovereign creditworthiness. Monetary policy is a
particularly important stabilization tool for sovereigns facing economic and
financial shocks. Accordingly, it could be a significant factor in slowing or
preventing a deterioration of sovereign creditworthiness in times of stress.
According to Standard and Poor’s, a sovereign's monetary score results from the analysis
of the following elements: 1) the sovereign's ability to use monetary policy to address
domestic economic stresses particularly through its control of money supply and domestic
liquidity conditions, 2) the credibility of monetary policy, as measured by inflation trends
and 3) the effectiveness of mechanisms for transmitting the effect of monetary policy
decisions to the real economy, largely a function of the depth and diversification of the
domestic financial system and capital markets.
The United Kingdom has a free-floating currency that qualifies for the highest possible
exchange rate regime score according to Standard and Poor’s. We dare to argue that the
world might be more complex than that, but accept that it gives the highest degree of
flexibility as opposed to, for example, a currency board.
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The second element, “credibility”, cannot be objectively measured, as noted by Standard
and Poor’s. The Bank of England’s credibility was probably higher prior to the financial
and economic crises. Trustworthiness probably peaked in 2006, when the Bank could
celebrate ‘the great moderation’ with lower volatility in output and inflation. It proved
however, to be more ‘good luck’ than ‘good policy’; the 2008-09 recession was the worst
since the 1930s and the economy has not recovered yet. Consumer price inflation has
been very volatile over the past three years and the Bank of England has not been able to
anchor inflation and inflation expectations. A BoE/GfK survey from Q2 2011 found that
the extent of satisfaction with the Bank of England had fallen since mid-2010, see Bank
of England Quarterly Bulletin, “Public attitudes to monetary policy and satisfaction with
the Bank”.
The third element, effectiveness of monetary policy, has in our view diminished lately as
it has become clear that the Governor does not have a magic wand, which he publicly
admitted in July (honestly, we never thought differently). The MPC however, still enjoys
support from the financial markets and the public even though some have hinted that the
Bank is running out of ammunition. The extensive use of quantitative easing – asset purchases worth GBP200bn – early on in the crisis has not had the desired effect, even
though interest rates have been substantially below historical averages at all maturities.
More Gilt purchases will probably not have much impact and can furthermore have
adverse effects. The UK financial system is in dire straits, funding is a problem and the
transmission mechanism to households is broken.
Summing up , we believe that United Kingdom’s monetary flexibility has worsened but
from a good starting point. Our best judgement is that a total score around 2.25 is
appropriate. A score below 2 would in our view indicate that the BoE has plenty of
room to manoeuvre, which is not the case, while a score above 2.5 would imply that no
ammunition was left. Neither is true. The monetary score is in our view the ‘fluffiest’ in
the S&P framework and relies mainly on outdated inputs.
An indicative rating level for the United Kingdom
Standard and Poor’s issued a statement in October last year in which it revised the
UK’s credit outlook to ‘stable’ and affirmed the AAA-rating. S&P wrote:
“ In our opinion, the decisions reached by the United Kingdom coalition government in
its 2010 Spending Review reduce risks to the government's implementation of its June
2010 fiscal consolidation program. Moreover, the coalition parties have shown a high
degree of cohesion in putting the U.K.'s public finances onto what we view to be a more
sustainable footing.”
However, our analysis of the United Kingdom’s institutional effectiveness and
political risks, economic structure and growth prospects, external liquidity and
international investment position, fiscal performance and flexibility and monetary
flexibility questions that conclusion.
Using S&P’s own sovereign rating framework in which the political and economic score
form a “political and economic profile” and the external score, the fiscal score and the
monetary score form a “flexibility and performance profile”, we can calculate an
indicative rating level for the United Kingdom.
Standard and Poor’s is so kind to provide a table to determine this level, see table 2. We
find this table quite intuitive and easy to interpret. The table shows that a AAA-ratedcountry cannot have a “flexibility and performance profile” with a higher score than 2.7
or a “political and economic profile” higher than 2.5 ( please note that a number close to 1
is good while a number close to 6 is bad).
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Table 2: Indicative rating level from the combination of 1) The Political and Economic
Profile and 2) The Flexibility and Performance Profile
Source: Standard and Poors
Our analysis shows that the UK’s AAA-rating is questionable. To the best of our ability
we have used Standard and Poor’s methodology and find that the UK should not be given
more than an A+ rating, i.e. four notches below today’s level.
Standard and Poor’s gives itself full flexibility by allowing for “exceptional adjustment
factors”. We think this just blurs the true outcome and we believe we already have
included the important factors that should form the foundation of a credit rating.
Accordingly, we do not make further adjustments to our credit rating of the UK.
Adding 1 index point to all scores changes the picture, though. Then the AAA-rating can
be justified, but we cannot see where this positive adjustment should come from and can
only see that such an alteration could be done due to political reasons.
Subtracting 1 index point from all scores just makes matters worse of course; the
indicative rating deteriorates massively to BB+, i.e. 10 notches below today’s level. We
cannot justify such an alteration either and stick to our well-authenticated analysis above.
Conclusion: What would happen if the UK got downgraded?
The short and perhaps somewhat disappointing answer is: probably not much. It
would of course create a lot of public furore and cause UK politicians to criticise rating
agencies, but it would not lead to a huge Gilt sell-off and we believe that there would still
be plenty of demand for British debt – even if the UK got downgraded to A+, the same as
Italy and Slovakia at present. Some investors would probably attach a higher risk
premium to UK assets, but we doubt that this would dominate other factors. Yields would
most likely stay low because of a poor economic outlook and Sterling would not face a
confidence crisis on the back of a lower rating. A downgrade of the UK could in our view
happen in 2012 and we believe it can remain a market theme into 2013. This prediction
should however be treated cautiously, as our analysis suggests a relatively large politicalelement in the rating process.
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References
Bank of England Minutes (August 2011)
http://www.bankofengland.co.uk/publications/minutes/mpc/pdf/2011/mpc1108.pdf
Bank of England Quarterly Bulletin “Public attitudes to monetary policy and satisfaction
with the Bank” (Q2 2011)
http://www.bankofengland.co.uk/publications/quarterlybulletin/qb110203.pdf
Office for National Statistics “Public Sector Finances” (July 2011)
http://www.statistics.gov.uk/pdfdir/psf0811.pdf
Standard and Poor’s (2011) “Sovereign Government Rating Methodology and
Assumptions”
http://www.standardandpoors.com/prot/ratings/articles/en/us/?assetID=1245315323295
Standard and Poor’s (2010) “United Kingdom”
http://www.standardandpoors.com/ratingsdirect
Standard and Poor’s (2010) “United Kingdom Outlook Revised To Stable; 'AAA' Ratings
Affirmed”
http://www.standardandpoors.com/prot/ratings/articles/en/us/?assetID=1245231048727
World Bank’s “Doing business” (2011)
http://www.doingbusiness.org/data/exploreeconomies/united-kingdom/
World Bank’s “Worldwide Governance Indicators” (2009)
http://info.worldbank.org/governance/wgi/sc_chart.asp
World Economic Forum’s “Global Competitiveness Report” (2010)
http://www3.weforum.org/docs/WEF_GlobalCompetitivenessReport_2010-11.pdf
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See more UK Research here:
New regime, new forecast (17 August)
UK Q2 GDP poor as expected – Bank of England to keep rates low for most of 2012 (27
July)
Sterling’s fall from grace (09 June)
An augmented Taylor rule for the United Kingdom (01 June)
King is right – UK inflation will hit 4.9% in September (13 May)
Ten good reasons why BoE will keep rates unchanged in 2011 (11 May)
UK Gilt handbook (09 May)
UK Fact Book – rain on your wedding day (28 April)
UK avoids new recession – but underlying growth is weak (27 April)
Hesitant King to drive GBP weaker (13 April)
The Bank of England’s dilemmas (05 April)
Please visit Bloomberg DMGB <GO> for live tradable GBP swaps
Please visit Bloomberg DRIM <GO> for more Danske Bank research
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