UK: Osborne loses his cherished AAA
Moody’s decision to downgrade the UK’s government bond rating to Aa1 should not come as a big surprise to investors. That said, the lower rating is a huge blow to Mr. Osborne’s credibility since his austerity plan was partly based on maintaining the prized AAA-rating of the UK.
Figure 1: UK's recovery has been very sluggish
Source: Reuters EcoWin, Rabobank
Last Friday, Moody’s decided to downgrade the UK’s government bond rating from Aaa to Aa1 with a stable outlook (Fitch and S&P still have a triple-A rating for the UK but with a negative outlook). According to the press release “[t]he main driver underpinning Moody’s decision to downgrade the UK’s government bond rating is the increasing clarity that…the UK’s economic growth will remain sluggish over the next few years due to the anticipated slow growth of the global economy and the drag on the UK economy from the ongoing domestic public- and private-sector deleveraging process”. The rating agency goes on to say that “the country’s current economic recovery has already proven to be significantly slower compared with the recovery observed after previous recessions, such as those of the 1970s, early 1980s and early 1990s” (figure 1). In fact, we have been saying for some time now that the aggressive austerity drive of the UK is choking the nascent recovery (see our Special Report 10/11). Unfortunately, just over a third of the government’s planned austerity measures have taken place so far. Most of the spending cuts are yet to come (figure 2). The weak economic backdrop combined with years of painful deleveraging process by the private and public sector has given Moody’s enough reason to justify a rating downgrade.
Will the decision spook market participants?
If we were to look at Moody’s Aaa monitor (figure 3), it seems that the UK was not very close to the Aa-space. The country did not even enter the debt reversibility band, which is the grey area between an AAA and an Aa rating. Therefore, the decision could come as a surprise to some market participants. However, most investors look at a broad array of indicators to get a sense of UK’s fiscal fundamentals. For this reason, we have considered 10 indicators in order to measure the relative fiscal strength of Britain (in an unbiased manner). Table 1 shows the list of indicators for a group of advanced countries (Luxembourg and Norway were excluded due to data availability). Our simple fiscal risk heatmap has been turned into a ‘traffic light’ system to increase clarity. When the designated indicator is in the bottom 33rd percentile of the sample, we assign it a colour green (i.e. low risk). If the indicator is between the 33rd percentile and 66th percentile, the colour turns to yellow (i.e. medium risk). Once the indicator rises above the 66th percentile the cell colour will turn red (i.e. high risk).
Table 1: Fiscal risk heatmap
Source: OECD, IMF, BIS, World Bank, Federal Reserve, Reuters EcoWin, Rabobank
When glancing through the table, we see that the UK’s fiscal metrics is amongst the weakest when compared to other Aaa-rated countries (only US and Canada have more indicators in the ‘red’ zone). This is thanks to the country’s large twin deficits (budget and current account balance), weak economic growth and massive external debt-to-GDP ratio. Indeed, Britain does not even score too much better than countries with a lower rating. Against this backdrop, it would be difficult to assume that bond investors were ignorant about UK’s weak fiscal fundamentals prior to Moody’s rating downgrade. This means the new decision should have a negligible impact in the financial markets. Most importantly, government bond yields are unlikely to rise when (i) growth continues to stay sluggish and (ii) the Bank of England maintains its loose policy. Besides, the experience of countries that were stripped-off their triple-A rating in the recent past by at least one of the major rating agencies (e.g. France and the US) suggests that interest rates do not always respond to rating downgrades.
What are the political implications?
Although we do not expect any economic ramifications, Moody’s decision to cut UK’s much-cherished AAA rating for the first time since the 1970s is a huge blow to the government, in specific George Osborne, the chancellor of the exchequer. Mr. Osborne has said on numerous occasions that the government’s quick deficit reduction plan is “to safeguard Britain’s credit rating”. He maintained course amid strong economic headwinds because he believed that abandoning the austerity plan “would definitely lead to a downgrade of the credit rating”. One would think that the new development would give the chancellor a second thought. But he has recently mentioned, “[f]ar from weakening our resolve to deliver our economic recovery plan, [Moody’s] decision redoubles it”. Therefore, it seems Mr. Osborne is still not convinced that opting for plan B – a slower pace of deficit reduction – is the better fiscal medicine given UK’s current economic woes.