DBRS Ratings Limited (DBRS) confirmed the United Kingdom of Great Britain and Northern Ireland’s (the United Kingdom or U.K.) Long-Term Foreign and Local Currency – Issuer Ratings at AAA and Short-Term Foreign and Local Currency – Issuer Ratings at R-1 (high). The trend on all ratings is Stable.
KEY RATING CONSIDERATIONS
Risks stemming from Brexit remain significant and visibility around the U.K.’s future relationship with the EU is limited. However, a clear majority within the U.K. parliament has expressed opposition to a no-deal Brexit. The U.K.’s decision to leave the European Union (E.U.) could be postponed with the consent of European governments or unilaterally withdrawn by the U.K. Consequently, DBRS remains of the view that the likelihood of a disorderly Brexit is low. DBRS acknowledges some degree of event risk associated with such a scenario, but it expects a broadly appropriate and timely policy response from the U.K. and the E.U. to any resulting economic or financial turmoil. Thus far, key macroeconomic indicators suggest a high degree of resilience despite the uncertainty surrounding Brexit. Real GDP is expected to grow by 1.3% this year, before increasing to 1.6% in 2019. The unemployment rate is at a near historically low level of 4%. Stronger tax revenues and lower than expected spending on welfare and debt interest payments have accelerated fiscal consolidation. The public debt ratio is expected to decline to 83.7% of GDP this fiscal year and to 82.8% in 2019-20.
The U.K.’s AAA ratings reflect the size and resilience of the economy and the shock-absorbing benefits of its own monetary policy. HM Treasury and the Bank of England (BoE) oversee one of the world’s primary currencies and reserve assets. This facilitates low-cost local currency borrowing across a broad range of maturities, even during periods of investor risk aversion. Bond yields have tightened when Brexit outcomes have appeared least certain. The U.K.’s maturity structure of public debt at 15.3 years is the longest average maturity in the G7. DBRS does not expect key rating features to change, regardless of the outcome of Brexit. These factors include Central Bank independence, a sound financial supervisory structure, and statutory fiscal rules that match the discipline of (E.U.) frameworks.
The U.K.’s ratings are well placed in the AAA rating category. The ratings could come under downward pressure from one or a combination of the following factors (1) a significant increase in the likelihood of a break-up of the United Kingdom; (2) a Brexit outcome that materially diminishes economic resilience and erodes the government’s debt financing flexibility; or (3) economic and financial dislocations that undermine banking sector fundamentals or the country’s fiscal position.
As Expected, the Delivery of Brexit in the U.K. Parliament is Deeply Challenging
Current Brexit negotiations, within the U.K. parliament and with the E.U., provide limited visibility of the future U.K.- E.U relationship. DBRS views the draft withdrawal agreement made between the E.U. and the U.K. negotiators as progress. If approved, it will become the legal basis for Britain’s departure from the European Union. However, ratification by the U.K. parliament has been delayed and it is not clear that majority parliamentary approval for the bill can be secured in its current form. The part of the draft agreement that aims to circumvent a hard border between the Republic of Ireland and Northern Ireland, by requiring the U.K. to remain in a ‘customs territory’ with the E.U. until a permanent solution is found, has predictably proven to be a key obstacle to ratification.
DBRS is of the view that decisions on the customs union that potentially affect the border between the Republic of Ireland and Northern Ireland are among the most challenging in delivering Brexit. Significant uncertainty remains over different regulatory and customs regimes between Northern Ireland and the mainland, and how this might impact the U.K. Brexit could ultimately jeopardize the cohesion and resilience of the United Kingdom. The longer-term constitutional integrity of the U.K. is important to DBRS’s AAA sovereign rating.
Furthermore, DBRS does not rule out any of the possible scenarios in the days, weeks, and months ahead. These range from successful ratification of the current withdrawal agreement (soft Brexit) to unsuccessful ratification with no alternative arrangements (hard Brexit). It is possible that, if a withdrawal agreement is not ratified, the government may be forced to call a general election or to hold a second Brexit referendum. It is also possible that Article 50 could be unilaterally withdrawn or that it could be extended following agreement to do so by the EU-27. DBRS continues to monitor the U.K.’s resilience to the current stress that Brexit places on the U.K.’s political institutions and on its economy.
The Economy has Slowed, but the U.K. Unemployment Rate is at a Near Historically Low Level
The U.K. is the fifth-largest economy in the world and is one of the most advanced, with strong economic performance in past years. However, headline growth has moderated recently, as Brexit-related uncertainty weighs on business investment and inflation has adversely affected household disposable income. The Office for Budget Responsibility (OBR) estimates economic growth at 1.3% this year, lower than its initial 1.5% forecast, but this reduction relates to the negative output impact of adverse weather conditions in the first quarter. GDP increased by 1.7% in 2017. The OBR forecasts 1.6% GDP growth in 2019 and average annual growth of 1.4% in 2020-21. Employment continues to grow and the unemployment rate at 4.0% is the lowest rate since 1975. The employment rate is at a joint record of 75.7% of all people aged from 16 to 64 years in August-October 2018, up from around 75.0% a year earlier. In the longer term, however, the economic impact of the U.K.’s exit could adversely impact trade, investment and migration leading to potential growth slippage that could negatively impact long term debt dynamics. Other economic risks come from evolving global protectionist policies.
Continued Fiscal Consolidation is Expected to Support a Slow Reduction in the Debt Ratio
The U.K.’s fiscal framework is sound and transparent, supported by flexible fiscal rules and the independent OBR publishing its economic forecasts. Since 2010, material progress was made in reducing the Maastricht treaty deficit, from 10% of GDP in 2009/10 to a revised 2.0% of GDP in 2017/18. Recently, tax revenues have surprised to the upside despite the weaker economy, reflecting stronger employment growth. In addition, lower than expected expenditures have been evident in departmental welfare spending and debt interest expenditures, where lower RPI inflation has reduced spending on inflation-linked gilts. Current official projections point to a fiscal deficit of just 1.2% in this fiscal year and 1.4% next year. These projections include near term fiscal stimulus, as well as a new multi-year settlement for the National Health Service. The settlement adds progressively larger amounts to public spending, rising from £7.4 billion in 2018-19 to £27.6 billion in 2023-24 in gross terms and from £6.3 billion to £23.4 billion adjusting for the boost to nominal GDP.
Still, the government’s interim targets are expected to be met with broadly the same fiscal headroom published by the OBR in the Spring. These targets include the fiscal mandate of achieving a structural deficit below 2% of GDP in 2020-2021 and the supplementary target of public-sector net debt as a share of GDP falling in 2020-2021.
Long Public Debt Maturity Profile Mitigates against Debt Payment Risks
After a pronounced increase in the U.K.’s public debt ratio following the global financial crisis, this ratio has stabilised; it was 85.6% of GDP in 2017/18 on the Maastricht definition basis, compared with 86.5% a year earlier. The European Commission (EC) forecasts 85.0% in 2018/19, 83.7% in 2019/20 and 82.0% in 2020-21. Nevertheless, the debt level remains high and somewhat reduces the U.K.’s scope for fiscal flexibility in times of crisis, but for comparison it is close to the Euro area average of 86.7% (2017). DBRS assesses the country’s commitment and capacity to meet its debt servicing needs as strong. Public borrowing is in British pounds sterling and the majority of gilt holders are domestic investors.
The U.K. government is considering the appropriate balance between index-linked and conventional gilts in the coming years and a government decision was made to reduce the proportion of debt to be issued as index-linked gilts. The high share of index-linked debt, which is around 27% of total debt, relates to strong structural demand from domestic pension funds. By comparison, France’s share of index-linked debt is close to 10%; U.S.A. around 8%; and Canada 6%. The expectation is that the £37.1bn ‘Brexit bill’ will have phased implementation, but should a bullet payment be required, DBRS views the U.K. to have sufficient funding flexibility.
DBRS Expects an Appropriate Monetary Policy Response to Economic and Inflation Conditions
The U.K. enjoys a high degree of monetary policy flexibility, owing to a responsive central bank and sterling’s status as a reserve currency. The Bank of England (BoE) took important measures to address financial volatility that occurred in the aftermath of the U.K. vote to leave the EU and, in August 2016, reduced Bank Rate to 0.25%. It has conducted a loose monetary policy for many years, only returning the Bank Rate to the pre-August 2016 level of 0.5% in November 2017 and again increasing the rate to 0.75% in August 2018, given the strong labour market and credit growth. Inflation peaked at 3.1% in November 2017 and is currently 2.4% (October 2018), close to the two percent target. Financial stability risks include high household debt at 88.3% of GDP and 133.3% of household disposable income (end-2017), as well as housing price growth, although this has recently decelerated. The process of leaving the E.U. poses another key risk to financial stability should there be an adverse outcome. However, the U.K.’s banking system has improved its results, albeit still carrying some risks from consumer lending. DBRS assesses the BoE stress test as highlighting the improved resilience of the U.K. banking system with overall better performance than in the 2017 test. https://www.dbrs.com/research/336898/dbrs-the-2018-stress-test-of-uk-banks-good-progress-over-the-last-year)
External Balances Are Improving
The current account deficit has been shrinking. It was down to 3.7% of GDP in 2017 from 5.2% in 2016. The EC forecast is further improvement to 3.3% this year and 3.2% next year, limiting this source of external vulnerability. The recent improvement is related to a narrowing in the trade deficit and the primary income deficit. In detail, this relates to a widening in the financial services surplus and a narrowing in the travel services deficit, on the one hand, and the improvement in net foreign direct investment income, on the other. Despite the current account deficit, the United Kingdom’s net external liability position has been moderate at just 11.8% of GDP in June 2018. In the longer term, the impact of the U.K.’s exit from the EU on the external accounts is highly uncertain.
RATING COMMITTEE SUMMARY
The DBRS Sovereign Scorecard generates a result in the AAA – AA range. The main points discussed during the Rating Committee include GDP performance, fiscal consolidation and potential Brexit impact.
Fiscal Balance (% GDP): -2.0 (2017); -1.2 (2018E); -1.4 (2019F)
Gross Debt (% GDP): 85.6 (2017); 83.7 (2018E); 82.8 (2019F)
Nominal GDP (GBP billions): 2,044 (2017); 2,111 (2018E); 2,171 (2019F)
GDP per Capita (GBP): 30,958 (2017); 31,764 (2018E); 32,465 (2019F)
Real GDP growth (%): 1.7 (2017); 1.3 (2018E); 1.6 (2019F)
Consumer Price Inflation (%): 2.7 (2017); 2.6 (2018E); 2.0 (2019F)
Domestic Credit (% GDP): 183.9 (2017); 185.8 (Jun-2018)
Current Account (% GDP): -3.7 (2017); -3.3 (2018E); -3.2 (2019F)
International Investment Position (% GDP): -8.6 (2017); -11.8 (Jun-2018)
Gross External Debt (% GDP): 312.1 (2017); 307.5 (Jun-2018)
Governance Indicator (percentile rank): 90.9 (2017)
Human Development Index: 0.92 (2017)
All figures are in GBP unless otherwise noted. Public finance statistics reported on a general government basis unless specified. General government gross debt is calculated on a Maastricht basis. Fiscal figures as at end of fiscal year. Governance indicator represents an average percentile rank (0-100) from Rule of Law, Voice and Accountability and Government Effectiveness indicators (all World Bank). Human Development Index (UNDP) ranges from 0-1, with 1 representing a very high level of human development.
The principal applicable methodology is Rating Sovereign Governments, which can be found on the DBRS website www.dbrs.com at http://www.dbrs.com/about/methodologies. The principal applicable rating policies are Commercial Paper and Short-Term Debt, and Short-Term and Long-Term Rating Relationships, which can be found on our website at http://www.dbrs.com/ratingPolicies/list/name/rating+scales.
The sources of information used for this rating include UK Office for National Statistics, the Office of Budget Responsibility, HM Treasury, Debt Management Office, the Bank of England, International Monetary Fund, European Commission, Organization for Economic Co-operation and Development, United Nations Development Programme (UNDP), World Bank, Bloomberg L.P, Haver Analytics. DBRS considers the information available to it for the purposes of providing this rating to be of satisfactory quality.
This is an unsolicited rating. This credit rating was not initiated at the request of the issuer.
This rating included participation by the rated entity or any related third party. DBRS had no access to relevant internal documents for the rated entity or a related third party.
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Generally, the conditions that lead to the assignment of a Negative or Positive Trend are resolved within a twelve-month period. DBRS’s outlooks and ratings are under regular surveillance.
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Lead Analyst: Nichola James, Senior Vice President, Co-Head of Sovereign Ratings, Global Sovereign Ratings
Rating Committee Chair: Roger Lister, Managing Director, Chief Credit Officer, Global Financial Institutions Group and Sovereign Ratings
Initial Rating Date: July 19, 2010
Last Rating Date: June 15, 2018
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