Moody’s downgraded its outlook on Britain’s debt (currently rated Aa2) to negative from stable after the market close on Friday, saying Brexit had been a catalyst for an erosion in the country’s institutional strength, perceived “material deterioration” in UK governance, and that the country’s ability to set policy has weakened in the Brexit era along with its commitment to fiscal discipline.
The outlook cut represents a catch down to its competitors: the UK is currently rated AA by S&P and AA- at Fitch Ratings, with both companies having the UK on negative watch.
“It would be optimistic to assume that the previously cohesive, predictable approach to legislation and policymaking in the UK will return once Brexit is no longer a contentious issue, however that is achieved,” the ratings agency said adding that “the increasing inertia and, at times, paralysis that has characterized the Brexit-era policymaking process has illustrated how the capability and predictability that has traditionally distinguished the U.K.’s institutional framework has diminished.”
“The decline in institutional strength appears to Moody’s to be structural in nature and likely to survive Brexit given the deep divisions within society and the country’s political landscape,” Moody’s added.
The decision to put the UK on negative outlook even as Moody’s affirmed Britain’s Aa2 long-term issuer and senior unsecured ratings comes one month before an election that is likely to determine the future of Brexit. While the election will have a big impact on Brexit, this week has seen both sides escalate their spending pledges, drawing election battle lines with plans to end a decade of U.K. austerity.
As Bloomberg observes, there hasn’t been a U.K. downgrade by a major rating company since September 2017, when Moody’s downgraded the UK to Aa2, the country’s lowest ever rating .
Upon the announcement, the pound dipped 10 pips from 1.2784 to 1.2774.
The full Moody’s statement is below:
Moody’s changes outlook on UK’s rating to negative from stable, affirms Aa2 rating
Paris, November 08, 2019 — Moody’s Investors Service (“Moody’s”) has today changed the outlook on the Government of the United Kingdom’s Aa2 ratings to negative from stable. Concurrently, Moody’s has affirmed the Aa2 long-term issuer and senior unsecured ratings.
The outlook on the Bank of England’s Aa2 issuer and senior unsecured bond ratings and the (P)Aa2 on its senior unsecured MTN programme has also changed to negative from stable; the Aa2 and (P)Aa2 ratings have been affirmed. The short-term issuer ratings have been affirmed at Prime-1.
The change in outlook to negative from stable is driven by two factors:
1. UK institutions have weakened as they have struggled to cope with the magnitude of policy challenges that they currently face, including those that relate to fiscal policy.
2. The UK’s economic and fiscal strength are likely to be weaker going forward and more susceptible to shocks than previously assumed.
The affirmation of the UK’s Aa2 sovereign ratings balances the credit-supportive factors such as wealth, economic diversification, a sound monetary policy framework and a highly flexible labour market against constraints such as a high debt burden and weak productivity growth.
The foreign and local currency bond ceilings and the local-currency deposit ceiling remain unchanged at Aaa. The foreign-currency long-term deposit ceiling remains Aa2, and the short-term foreign-currency bond and bank deposit country ceilings remain at P-1.
RATIONALE FOR NEGATIVE OUTLOOK
FIRST DRIVER: UK INSTITUTIONAL CAPACITY AND COMMITMENT TO FISCAL DISCIPLINE HAVE WEAKENED
The increasing inertia and, at times, paralysis that has characterized the Brexit-era policymaking process has illustrated how the capability and predictability that has traditionally distinguished the UK’s institutional framework has diminished. Events in the House of Commons in recent months have revealed legislators, policymakers and administrators to be unable to arrive at the consensus needed to achieve either a broadly acceptable approach to Brexit, or the continuation of policy in other important areas, for example to address challenges relating to education, productivity, or investment in infrastructure.
Brexit has been the catalyst for this erosion in institutional strength, which can also be seen in, among other things, the small but significant weakening of Worldwide Governance Indicators for Government Effectiveness and Rule of Law. It is likely to remain so for some time to come given the inevitably contentious nature of the negotiations regarding a permanent set of trading arrangements with the EU. And it would be optimistic to assume that the previously cohesive, predictable approach to legislation and policymaking in the UK will return once Brexit is no longer a contentious issue, however that is achieved. The decline in institutional strength appears to Moody’s to be structural in nature and likely to survive Brexit given the deep divisions within society and the country’s political landscape.
This broad erosion in the predictability and cohesion of policymaking is mirrored in areas of policy that are significant from a credit perspective. Most importantly, the UK’s broad fiscal framework, characterized by features such as multi-year budget plans and more detailed revenue and spending decisions announced for the outer years of the planning period, has weakened. Following the significant fiscal consolidation that took place between 2010 and 2015, more recent years have seen an increasing willingness to move the goalposts, with changes to the longer-term fiscal anchor and the definition of fiscal targets and a revealed preference to shift the fiscal tightening to outer years of a five-year horizon. Successive governments have announced large, permanent increases in public expenditures, most notably a large increase in spending on the National Health Service (NHS), outside the normal calendar for fiscal policy changes and without detailed policy plans.
Over the longer term, institutional weakening may also impact the UK’s economic strength, through its effect on the investment climate and on the UK’s attractiveness to skilled and unskilled foreign labour. In recent years, we have already seen the negative impact this can have, and Moody’s expects this negative influence will likely endure as the exit process continues and uncertainties persist during the subsequent phase of trade negotiations with the EU and with other nations.
This deterioration in the quality of institutions has made policy planning more opaque and unpredictable. The independent Office for Budget Responsibility (OBR) has noted that policy risks to the public finances are now significant and are greater than they were two years ago. Going forward, no matter what the outcome is of the general election Moody’s sees widespread political pressures for higher expenditures with no clear plan to increase revenues to finance this spending. In Moody’s view, the commitment to maintaining a predictable, prudent fiscal framework and associated policy settings that has characterized the UK’s credit profile until now is weakening in a way that will transcend electoral cycles as pressures from the electorate for improved public services continue to rise.
SECOND DRIVER: A LIKELY DETERIORATION IN FISCAL AND ECONOMIC STRENGTH
The weakening of the fiscal policy environment is evident in the data. Even after years of fiscal consolidation, the country remains highly indebted, with gross general government debt being only marginally below its 2015 peak of 86.9% of GDP, and unlikely to fall significantly over the medium term. In Moody’s baseline projections, the UK’s general government debt is set to stay broadly unchanged at around 85% of GDP over the next 3-4 years, absent any unexpected economic shocks. While that is a lower level than assumed when Moody’s downgraded the UK’s rating to Aa2 in September 2017, the trajectory has changed. Then, Moody’s expected a gradual decline in the debt burden over the longer term. Now, Moody’s sees little appetite or opportunity for that to happen.
Indeed, the risks are that debt will begin to rise. In the current political climate, Moody’s sees no meaningful pressure for debt-reducing fiscal policies. In fact, there is rising pressure for spending increases with little apparent clarity as yet on how they might be financed through additional revenues and little scope for politically acceptable expenditure cuts. While greater public investment could be growth-enhancing, there is no appetite to address important areas of rigidity in public expenditure, particularly health and social care, which will be key sources of future financial pressure. In June 2018, the government pledged real annual increases on average of 3.4% for the NHS for the next five years. Even that expenditure increase may not be sufficient to achieve the longer-term objective of improving standards. In recent years, the government has consistently had to accommodate higher spending by the NHS, and the OBR projects that health spending will nearly double as a proportion of GDP over the coming decades.
The large and sticky debt burden is a key source of fragility for the UK’s credit profile, particularly at the current juncture, when external threats to growth are rising and internal growth momentum is slowing.
The magnitude of the fiscal challenge may well be amplified by weaker-than-expected growth. Since the EU referendum, UK business investment (which accounts for more than half of gross fixed capital formation) has contracted by more than 1% in real terms, in contrast to the growth that Moody’s has observed in other advanced economies. This shortfall does not just affect current growth rates. The persistent weakness of business investment, combined with firms’ bias towards hiring as a more flexible way to increase capacity, has resulted in limited capital deepening–a trend that will further intensify the UK’s existing productivity challenges over the longer term. The UK economy has already experienced low productivity growth since the global financial crisis, compared to previous cycles and also other advanced economies.
This weakness in investment has taken place despite broadly favourable credit conditions and limited spare capacity. It is unlikely to reverse quickly; Brexit-related uncertainty as to future policy settings and the UK’s relationship with trading partners is unlikely to diminish much even in the event that a deal is struck, given the significant challenges it is now clear will be inherent in agreeing any sort of longer-term trade agreement with the EU. Even if the UK leaves the EU under the terms of a revised Withdrawal Agreement, the two sides will still have to go through difficult and lengthy negotiations around the terms of their future relationship. Negotiations with other key trading partners are unlikely to be any more straightforward.
These trends leave the UK more vulnerable to shocks, and the debt burden is sensitive to both growth and fiscal shocks. A deterioration in growth and the fiscal performance as well as a rise in interest rates or inflation would cause the debt burden to rise not fall. In Moody’s view, adverse fiscal outcomes would have the most impact, followed by a reduction in growth.
RATIONALE FOR AFFIRMATION OF Aa2 RATINGS
The factors supporting the affirmation of the UK’s Aa2 sovereign rating include economy’s significant strength, which is a function of its large size, diversification, and flexibility. The government also enjoys very low financing risks and a very high average debt maturity. While the UK’s institutions have weakened, in part due to the serious challenges raised by Brexit, they remain strong in comparison to global peers and the monetary policy framework and central banking arrangements continue to be excellent.
ENVIRONMENTAL, SOCIAL, GOVERNANCE CONSIDERATIONS
Moody’s takes account of the impact of environmental (E), social (S), and governance (G) factors when assessing sovereign issuers’ economic, institutional and fiscal strength and their susceptibility to event risk. In the case of the UK, the materiality of ESG to the credit profile is as follows.
Environmental considerations are not currently material to the rating.
Social factors are taken into account in determining the UK’s credit profile. The most relevant social factors relate to spending pressures on healthcare and pensions due to an ageing population. Over the longer term, demographic pressures will (as in many peers) negatively influence potential growth in the absence of increases in productivity, in participation rates or in immigration.
Governance factors are a material driver of the rating. On a global basis, the UK’s governance institutions are strong, supporting the Aa2 rating for now. However, the deterioration observed in recent years is a key driver for the negative outlook.
WHAT COULD CHANGE THE RATING UP/DOWN
The UK’s rating would likely be downgraded if we were to conclude that policymakers’ capacity and appetite to develop a credible medium-term debt-reduction strategy was low. This would be particularly negative for the UK’s credit quality if, in our view, that reflected a continued overall erosion in the coherence and predictability of UK policymaking. Structurally weaker economic fundamentals would also undermine the UK’s credit profile. In that context, departure from the EU without a deal would be strongly negative for the rating. However, even if some form of withdrawal agreement were to be signed, indications that the UK would not be able to replace the very favourable trading arrangements embedded in EU membership with similarly advantageous agreements with key trading partners in Europe and elsewhere would also be negative for the rating.
Given the negative outlook on the UK’s rating, an upgrade is unlikely in the short to medium term. However, indications that the apparent erosion in institutional strength is in fact reversible and that the coming years will see a reversion to the capability and predictability that has traditionally characterized the UK’s institutional framework would support the rating at its current level. Such an outcome would most likely be characterised by the development of a credible strategy to achieve medium-term fiscal objectives that put the debt burden on a downward trajectory. Passage of economic policies that could sustainably boost growth potential would also be credit positive.