DBRS Morningstar Confirms the United Kingdom at AAA, Trend Changed to Negative

DBRS Ratings GmbH (DBRS Morningstar) 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. At the same time, DBRS Morningstar confirmed the Short-Term Foreign and Local Currency – Issuer Ratings at R-1 (high). The trend on the Long-Term Foreign and Local Currency – Issuer Ratings is changed to Negative from Stable and the trend on the Short-Term Foreign and Local Currency – Issuer Ratings remains Stable.

DEVIATION FROM DBRS MORNINGSTAR’S EU CALENDAR

This is a deviation from DBRS Morningstar’s EU Sovereign, Sub-Sovereign and Supranational Calendar due to new information becoming available on the creditworthiness of the issuer related to the Coronavirus Disease (COVID-19). DBRS Morningstar believes that this new information makes it inappropriate to wait until the next scheduled review of the issuer on the June 12, 2020. The credit rating considerations and rationale are presented below.

KEY RATING CONSIDERATIONS

The Negative trend reflects DBRS Morningstar’s view that the Coronavirus Disease (COVID-19) will materially impact the U.K.’s economy and public finances in the context of an already slowing economy and expansionary fiscal policy related to Brexit. The debt-to-GDP ratio is now expected to rise from 85.4% in 2019 to 102.1% by the end of this year according to the European Commission (EC), compared with an expectation at the time of the last review of the debt ratio being on a downward trajectory. Despite low funding costs, this high debt ratio will limit the government’s fiscal flexibility should the current shock become prolonged at the same time as EU exit could yet cause economic and fiscal dislocations.

Despite the current harsh economic shock with the possibility that GDP could contract by as much as 8% this year, DBRS Morningstar maintains the view that the U.K. holds a degree of resilience with the shock-absorbing benefits of the country’s own monetary policy and flexible exchange rate. 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; and the Bank of England through its quantitative easing bond-buying programme is another key source of confidence support at present. The U.K.’s maturity structure of public debt at around 15 years is the longest average maturity in the G7; this helps reduce adverse funding impact of a temporary shock.

RATING DRIVERS

A downgrade could occur if (1) the impact of the economic shock is severe enough to materially deteriorate the medium term fiscal outlook and significantly worsen the trajectory of public debt dynamics; (2) a Brexit outcome that materially diminishes economic resilience and erodes the government’s debt financing flexibility; (3) a significant increase in the likelihood of a break-up of the United Kingdom.

The Negative trend could return to Stable if economic and fiscal outturns prove less severe than expected and the recovery phase is more sustainable and robust.

RATING RATIONALE

The Impact of COVID-19 and Still Uncertainty about the Future EU-U.K. Relationship Bring Downside Risks

The U.K. is highly negatively affected by the health crisis with 33,998 deaths thus far, the highest absolute number after the U.S. With shutdown measures affecting social life and the economy, the depth of economic contraction and the pace and extent of recovery present risks to creditworthiness. The outcome of the December 12th, 2019, U.K. general election brought a majority Conservative government to power that expedited approval of the Withdrawal Bill and exit from the European Union (EU) on January 31st, 2020, and since then has facilitated timely legislation on measures to support the economy through the coronavirus crisis. However, progress with agreeing a future EU relationship, working to a tight deadline of end-2020, is slow, and it is uncertain whether or not both sides will agree a deal by the end of the year or an extension by 1 July 2020. DBRS Morningstar considers delays in agreeing a EU-U.K. future relationship as evidence of weaker capacity to address economic challenges, resulting in a negative qualitative adjustment in DBRS Morningstar’s “Political Environment” building block.

The U.K. Economy is Materially Contracting and the Unemployment Rate Will Rise Sharply Albeit from a Very Low Base

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 until the Brexit uncertainty weighed on business investment in particular. The coronavirus fiscal response of the U.K. authorities has been timely and targeted with measures amounting to around 5.5% of GDP, that will materially increase the public sector borrowing requirement this year. The Bank of England has also responded with measures to help businesses and households, and to ensure financial markets remain functioning and liquid. These measures will cushion the blow during shutdowns and, in time, work to support a more steady recovery. That said, recent data show a weak confidence and investment background moving into the crisis that suggests even with support measures, the UK is heading for a sharp economic contraction of potentially up to 8% GDP loss this year compared with growth of 1.4% last year. Private consumption and gross fixed capital formation may be most adversely affected, while government consumption will contribute positively to growth. The net trade effect on growth is likely more negligible as both exports and imports contract.

Employment was growing before the crisis and the unemployment rate of 3.9% was amongst the lowest since 1975, but could now rise to in excess of 6.0% of the workforce. The employment rate reached a near joint record of 76.5% of all people aged from 16 to 64 years and this will likely fall despite the government’s Job Retention Scheme. In the longer term, the economic impact of the U.K.’s EU exit could adversely impact trade, investment and migration, leading to slippage of potential growth that could negatively impact long term debt dynamics, now potentially exacerbated by COVID-19-related structural factors. Given the substantial economic uncertainty presented by the coronavirus shock and the future relationship with the EU both potentially bringing risks of economic dislocation DBRS Morningstar gives a negative qualitative assessment to the “Economic Structure and Performance” building block.

The Fiscal Position is Set to Materially Deteriorate as the Government-Imposed Shutdown Persists

The U.K.’s fiscal framework is 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 1.8% of GDP in 2018/19. Current European Commission (EC) projections point to a fiscal deficit of 10.5% this calendar year compared with 2.1% in the previous fiscal year. Tax measures include, like other countries, additional funding for the health service, measures to support businesses including property tax holidays, direct grants for small firms and firms in the most affected sectors and increasing payments under the Universal Credit Scheme. In addition, the government has launched three separate loan schemes to support business access to credit including with the British Business Bank the Coronavirus Business Interruption Scheme to support SMEs, the Coronavirus Large Business Interruption Loans Scheme to support larger firms and the Bounce Back loan scheme for SMEs, that include government guarantees. Given the size of government guarantees, potentially up to 15% of GDP, and that additional fiscal measures will likely be required, DBRS Morningstar has given a negative qualitative assessment to the “Fiscal Management and Policy” building block.

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 declined to 85.4% of GDP at the end of 2019. The debt-GDP ratio is now expected to rise from 85.4% at the end of 2019 to 102.1% by the end of this year according to the European Commission, compared with an expectation at the time of the last review of a debt ratio decline. Nonetheless, DBRS Morningstar assesses the U.K’s commitment and capacity to meet its debt servicing needs favourably. Public borrowing is in British pounds sterling and the majority of gilt holders are domestic investors now receiving extra confidence from the Bank of England’s (BoE) renewed debt purchasing scheme. DBRS Morningstar considers liquidity strength given sterling’s status as a reserve currency, the breadth and depth of the debt market, and the long maturity structure, warrants a positive qualitative adjustment in DBRS Morningstar’s “Debt and Liquidity” building block. Given the current risks to the debt and economic outlook, the positive assessment is currently offset by a negative assessment related to future debt sustainability.

DBRS Morningstar 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 in August 2016 and has taken proactive measures in the current crisis. These measures include reducing bank rate by 65 basis points to 0.1%; expanding the central bank’s holdings of U.K. government bonds and non-financial corporate bonds by £200 billion; introducing a new Term Funding Scheme; launching the joint HM Treasury—Bank of England COVID Corporate Financing Facility which, together with the Coronavirus Business Loans Interruption Scheme, makes £330bn of loans and guarantees available to businesses (15% of GDP); and other measures. Financial stability risks include high household debt at 87.5% of GDP and 130.6% of household disposable income in 2019 that could present financial challenges should higher levels of unemployment become endemic. The end of the transition period with the EU poses another key risk to financial stability should there yet be a hard Brexit. For DBRS Morningstar’s view on UK banks see “UK Banks’ 2019 Results hit by Charges: 2020 outlook affected by COVID 19 and Brexit” at https://www.dbrsmorningstar.com/research/357763.

External Balance To Marginally Deteriorate

The current account deficit has been shrinking. It was down to 3.8% of GDP in 2019 from 5.2% in 2016. The EC forecasts 4.1% this year and 4.3% next year. The U.K. finances the current account deficit mainly through portfolio investment, and the net external liability position is moderate, at just 25.5% of GDP in 2019. In the longer term, the impact of the current crisis as well as the U.K.’s full exit from the EU on the external accounts is highly uncertain.

ESG CONSIDERATIONS

A description of how DBRS Morningstar considers ESG factors within the DBRS Morningstar analytical framework and its methodologies can be found at: https://www.dbrsmorningstar.com/research/357792.

For more information on the Rating Committee decision, please see the Scorecard Indicators and Building Block Assessments: https://www.dbrsmorningstar.com/research/361075.

Notes:

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.

The principal methodology is the Global Methodology for Rating Sovereign Governments (17, September 2019): https://www.dbrsmorningstar.com/research/350410.

For more information regarding rating methodologies and Coronavirus Disease (COVID-19), please see the following DBRS Morningstar press release: https://www.dbrsmorningstar.com/research/357883.

The sources of information used for this rating include: UK Office for National Statistics, the Office of Budget Responsibility – The OBR’s Coronavirus Analysis April 2020 and Economic and Fiscal Outlook March 2020, HM Treasury, Debt Management Office, the Bank of England, International Monetary Fund, International Financial Statistics (IFS), HM Land Registry, BIS, European Commission – European Economic Forecast Spring 2020, Organization for Economic Co-operation and Development, United Nations Development Programme (UNDP), World Bank, Bloomberg L.P, Haver Analytics. DBRS Morningstar 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.

With Rated Entity or Related Third Party Participation: YES
With Access to Internal Documents: NO
With Access to Management: YES

DBRS Morningstar does not audit the information it receives in connection with the rating process, and it does not and cannot independently verify that information in every instance.

Generally, the conditions that lead to the assignment of a Negative or Positive trend are resolved within a 12-month period. DBRS Morningstar’s outlooks and ratings are under regular surveillance.

For further information on DBRS Morningstar historical default rates published by the European Securities and Markets Authority (ESMA) in a central repository, see:
http://cerep.esma.europa.eu/cerep-web/statistics/defaults.xhtml.

The sensitivity analysis of the relevant key rating assumptions can be found at: https://www.dbrsmorningstar.com/research/361074.

Ratings assigned by DBRS Ratings GmbH are subject to EU and US regulations only.

Lead Analyst: Nichola James, Managing Director, Co-Head of Sovereign Ratings, Global Sovereign Ratings
Rating Committee Chair: Roger Lister, Managing Director, Chief Credit Officer, Global FIG and Sovereign Ratings

Initial Rating Date: July 19, 2010
Last Rating Date: December 13, 2019

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