UK downgrade looms by 2015 amid fiscal slippage – Nomura

Matthew Turner
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Fears are growing that poor growth in the UK will result in a ratings downgrade by 2015, triggering a debate about the outlook for the gilts market.

A report by Nomura, released on September 21, has shed light on the UK’s deteriorating fiscal position, with more and more experts concerned that the UK will be downgraded by the end of this parliamentary term.

Nomura expects a 75% chance that the UK credit rating will be downgraded by May 2015 and a 25% chance in a downgrade over the coming months. This follows on from Fitch and Moody’s forecasting a negative outlook on the UK’s credit rating.

Results for this year have raised concerns about the UK’s ability to dig itself out of a recession. The UK’s economic recovery has been put on hold, after shock UK borrowing figures for July 2012 prompted a reappraisal of the government’s fiscal policy by economists, while borrowing is expected to rise to £6.2 billion in 2012/13.

From the report:

“With the latest ongoing bout of acute weakness in the economy, the situation has become more challenging for the government. A lack of activity simply deprives the exchequer of the revenues needed to stay within the budget.

“With five months of the fiscal year now (provisionally) counted, a linear extrapolation of underperformance suggests borrowing rising £6.2 billion in 2012/13. We expect nearly £10 billion of slippage relative to the OBR’s [Office for Budget Responsibility’s] March 2012 budget forecast (£92 billion).

“Of course, over half of the fiscal year still lies ahead, presenting plenty of potential for a change in trend from the current data, which could also be revised heavily. But we believe slippage of about this magnitude is likely.”

Although the UK has reduced its structural budget deficit more than any other G7 country since 2009, expectations for GDP growth remain a key concern. The UK has seen the largest downward revisions of GDP growth than in either the US or eurozone.

A report by Société Générale forecasts that the debt-to-GDP ratio will not fall by 2015/16, as required by the second part of the fiscal mandate of the debt rule, leaving the government’s planned debt-reduction targets on a negative course. The report recognizes that the chancellor of the exchequer has two options – tighten fiscal spending further or risk losing its AAA status.

From the report:

“If [George] Osborne does tighten again, then he will certainly hurt growth and there could be even more monetary easing than the extra £50 billion and 25-basis-point rate cut that we predict for November. If he does not, then the government risks losing the AAA rating for its debt.

“That could still happen eventually, even if he does tighten, because growth might continue to undershoot the OBR’s forecasts. As the 2015 election draws ever nearer, the chancellor is likely to become increasingly reluctant to inflict fresh pain on the electorate.”

Consequence of UK downgrade on gilt prices

The Nomura report predicts that a UK sovereign rating downgrade would be “more a political event than a market one”. As such, Nomura does not expect it to tarnish gilt demand significantly.

Similarly, a Deutsche Bank (fixed income) research paper also affirms support in gilt prices remaining stable: “We maintain a bearish bias for gilts, a long EUR versus USD and GBP rates, long-end steepeners in the US and a constructive view on European credit.”

However, a recent report by Capital Markets has shown that “gilt yields have edged up over the last month, as safe-haven demand has faded in response to the easing of tensions in eurozone debt markets.” 

If this continues and is followed by a UK credit rating, it is foreseeable that yields associated with UK government bonds could rise, thereby driving prices down.

Euromoney Country Risk:

ECR analysts have lowered the UK’s overall ECR score by 0.7 points since January 2012, to 74.2 in August. The sovereign’s economic assessment score was worst hit, falling by 3.2 points since Q1 2012, to 55.1 in August. This leaves the UK ranked 18 on ECR’s global rankings, only one place above France and three places behind the US.

The country’s government finances, employment and economic/GNP outlook indicators – which are the lowest among the UK’s sub-factor scores – are of most concern to ECR analysts. 


So where does this leave the UK's AAA credit rating?

A downgrade in the UK’s credit rating would undoubtedly unnerve investor sentiment and the politicians. Yet, the UK treasury’s ability to issue debt should make a default near impossible.

Julian Wiseman affirms that a UK default is de facto impossible due to parliamentary control over the currency. He explains: “Debt-ceiling legislation, under the National Loans Act 1968, issues very strict conditions before the treasury can issue debt, provided that the treasury ‘thinks fit’.

“The law allows the UK treasury to borrow in any manner it deems fit in any currency, in any jurisdiction, via any means, anyhow, provided the treasury thinks fit. In this sense, a UK default is pretty much impossible, as we can control the BoE to print the pounds. So it’s very hard to construct circumstances in which the UK can default – in this sense I believe the UK should be rated AAA.” 

Nomura adds:

“Although this uncertainty does the UK’s credit rating no favours, it does not invalidate the country’s multi-century-long track record of successfully implementing austerity. The UK’s institutions (political and monetary) are still regarded as strong on an international basis. Moreover, the gilt market’s characteristics are among the best in the world and the nation remains wealthy, even if that wealth isn’t growing much. So we think it right that the UK maintains a high credit rating, although that need not necessarily mean the highest rating.” 

This article was originally published by Euromoney Country Risk.