Scope Ratings AG has today confirmed the United Kingdom (UK)'s long-term local-currency issuer rating at AA, following the release of its revised sovereign rating methodology, and has converted its status from subscription to public. The agency has also assigned a long-term foreign-currency issuer rating of AA, along with a short-term issuer rating of S-1+ in both local and foreign currency. The sovereign’s senior unsecured debt in local and foreign currency was also rated at AA. The Outlook on the long-term issuer and senior unsecured debt ratings has been set to Negative. The Outlook on the short-term issuer ratings is Stable.

Rating drivers

The UK’s AA rating is underpinned by a wealthy, large and diversified economy, and historical institutional strengths. In addition, the UK benefits from deep capital markets, a favourable public debt maturity structure, and from sterling’s status as a global reserve currency. However, these supportive factors are balanced by significant challenges that include: uncertainties related to the range of possible outcomes surrounding negotiations for a withdrawal from the European Union (EU), a high level of public debt, and a weak external position.

The Negative Outlook reflects Scope’s assessment that the current constellation of risks is skewed to the downside. The UK’s vote to leave the EU in the June 2016 referendum has generated uncertainty over the country’s future economic relations with the EU, and damaged the UK’s attractiveness as a destination for international investment, particularly to its important financial sector. The economic and fiscal policy outlook has weakened owing to Brexit related uncertainty and consequences of this.

While Scope considers the UK's institutional strength to be high, the challenges relating to reduced policy predictability and effectiveness are material. In March, the UK government activated Article 50 of the EU’s Treaty of Lisbon, marking the start of two years of negotiations leading to Britain's exit from the EU by March 2019. Formal negotiations, started in June, have been restricted in scope to several opening contentions, including the rights of European nationals in the UK, a ‘soft’ border between Northern Ireland and the Republic of Ireland, and the size of the Brexit financial settlement. Scope expects that the resolution of these early matters may prove problematic. The possibility of delays in the early months of Brexit negotiations – compounded by the weakening of the ruling Conservative Party in the June election – would restrict the government’s room for manoeuver.

Due to the UK’s constraints and potentially significant costs of a ‘hard Brexit’ (in which the UK leaves the EU single market without a deal, possibly resulting in a reversal to World Trade Organisation trade terms), Scope’s view is that the most likely scenario remains some form of eventual ‘soft Brexit’ arrangement, maintaining full or partial access to the single market. However, to reach such an arrangement, the UK may need to compromise on important issues, including the free movement of people. Such a soft Brexit scenario could last significantly past the two year window given under Article 50, potentially requiring an extension of Article 50 negotiations (possible through a consensus decision of the EU 28 members) and/or post-Brexit transitional arrangements. The June election pushed the next scheduled parliamentary election from 2020 to 2022, allowing the government more time to extend negotiations past 2019 if needed.

With the multi-year horizons relevant to Brexit in mind, Scope notes that there’s the potential for shifts in public opinion. In July, a Survation survey found 54% of respondents in favour of Remain if another referendum were held, while 46% back Brexit. In view of the tenuous state of the public majority that initially propelled Brexit, we do not consider an eventual ‘no Brexit’ scenario (in which the country revokes Article 50, and opts to remain in the EU) to be off the table. However, given the limited foresight shown in current negotiations, an intention of the current government to seek a hard Brexit, and unlikelihood that any transitional arrangement will be concluded in the near term, concerns of a hard Brexit are likely to remain and grow if no deal pervades as the 2019 deadline approaches. This constellation of outcomes is reflected in the AA rating.

Near term growth forecasts for the UK have been revised downwards. The IMF cut its growth forecast to 1.7% from 2.0% for 2017, while holding 2018 at 1.5%. Uncertainty on the conclusion of Brexit has weighed and will continue to weigh on the UK economy; however, the effects may be more complex/gradual than initially anticipated. While investment and private consumption will be adversely affected, net exports will be an important automatic stabilising element, in Scope’s view.

Over the medium term, we assume a baseline UK trend growth rate of 1.5% to 2.0%. This compares with 2.0% average growth rates from 2010-2016. We acknowledge significant uncertainty around medium- to long-term growth estimates due to their inherent dependency on the Brexit path and the country’s overall policy framework. Owing to the government’s need to sustain public support for Brexit, potential weakening of macroeconomic policymaking vis-à-vis other significant policy areas, including long-run growth and consolidation of public finances, underscore the Negative Outlook.

The UK’s budget deficit is projected to temporarily rise in 2017-18 to 2.9% of GDP from 2.4% of GDP in 2016-17, owing partly to policy measures announced in the 2016 Autumn Statement and 2017 Spring Budget that add about 0.3% of GDP to the deficit. In the Autumn Statement, the Chancellor laid out a vision for a more gradual fiscal consolidation aiming for a 2% structural deficit and net debt to GDP falling by 2020-21, with a balanced budget by the mid-2020s. In Scope’s view, there are material risks of deviation from medium term fiscal targets. Fiscal risks are also highlighted by pressures from the opposition Labour Party against further fiscal consolidation alongside general ‘austerity fatigue’.

Despite progress made on fiscal consolidation, public debt remains elevated at 88% of GDP as of Q1 2017. Under an IMF baseline, public debt should edge lower in 2017 and 2018 before beginning a more moderate decline to 83% by 2022. In Scope’s view, the high level of the UK’s public debt remains a material credit weakness. However, the long average maturity of the debt (of over 14 years in 2016), sterling denomination and low interest rates suggest a strong debt composition.

Brexit presents challenges to public finances. In the near term, the debate may centre on the Brexit financial settlement. A net payment in the EUR 25bn to EUR 65bn range (possibly with a large upfront payment of over EUR 100bn) would represent a 1-3 pp boost to debt-to-GDP. According to a recent study from the Office for Budget Responsibility (OBR), the greatest risk to the long term fiscal outlook relates to an economic shock, including impacts of Brexit on long-run growth. In OBR’s stress scenario (akin to the global financial crisis), public sector net debt ended the forecast horizon (2021-22) at 114% of GDP, compared with 80% by 2021-22 in a baseline scenario. Scope believes this demonstrates the vulnerabilities of the UK’s fiscal position to shocks of either domestic or external origin.

The UK’s current account deficit has begun a process of correction: the European Commission forecasts a current account balance of -3.9% of GDP for 2017 and -3.2% in 2018, from -4.4% in 2016. In the past, the current account deficit has been more than compensated for by net FDI inflows. However, there may be material challenges to these flows, which negatively affect resilience. In Scope’s view, the flexibility of the UK’s monetary and exchange rate regime and sterling’s global reserve currency status are major credit strengths. Any adverse scenario in which sterling’s reserve currency status is challenged would be considered a significant credit negative development.

The United Kingdom benefits from deep capital markets and its position as one of the world’s leading financial centres. The soundness of the UK’s financial system is supported by the nation’s robust financial regulation framework – including the Bank of England, its Financial Policy Committee, the Prudential Regulation Authority and the Financial Conduct Authority. Major banks are well capitalised (aggregate Tier 1 capital ratio of 15.7% as of March, higher than the Bank of England’s view on steady state capital requirements of around 11%). The effect of Brexit on financial stability may be significant; however, the UK financial system is presently well positioned to deal with a potential shock, in Scope’s view, on the basis of results of the Bank of England’s 2016 stress test, continued improvements in capital adequacy, and stronger asset quality.

Sovereign rating scorecard (CVS) and Qualitative Scorecard (QS)

Scope’s Core Variable Scorecard (CVS), which is based on relative rankings of key sovereign credit fundamentals, signals an indicative “AA” (“aa”) rating range for the United Kingdom. This indicative rating range can be adjusted by the Qualitative Scorecard (QS) by up to three notches depending on the size of relative credit strengths or weaknesses versus peers based on qualitative analysis. For the United Kingdom, the following relative credit strengths have been identified: 1) market access and funding sources, 2) low vulnerability to short-term shocks, 3) financial sector performance and 4) financial sector oversight and governance. Relative credit weaknesses are: 1) growth potential of the economy, 2) fiscal performance, 3) recent events and policy decisions and 4) macro-financial vulnerabilities and fragility. The combined relative credit strengths and weaknesses indicate a sovereign rating of AA for the UK. A rating committee has discussed and confirmed these results.

For further details, please see Appendix 2 of the rating report.

Outlook and rating-change drivers

The Negative Outlook reflects Scope’s view that risks to the ratings are tilted to the downside over the next 12 to 18 months.

The ratings could be downgraded if: i) there were an unanticipated increase in the probability for a hard Brexit; ii) there’s further evidence of weakening in the economic and/or fiscal outlook; iii) a deterioration in public finances leads to higher than anticipated public debt to GDP projections; and/or iv) sterling’s reserve currency status comes under challenge long term. The outlook could be upgraded if: i) a soft Brexit outcome were to materialise, ensuring continued full access to the single market and materially reducing Brexit uncertainties; ii) a no Brexit scenario unfolds; and/or iii) there’s an improvement in the policy environment, enhancing debt sustainability.

For the detailed research report, please click HERE.

Rating committee

The main points discussed by the rating committee were: (1) latest political developments and negotiations regarding Brexit, (2) economic growth potential and outlook, (3) public finance performance and outlook, (4) external economic position and developments linked to Brexit, (5) financial and banking sector performance and regulatory framework, (6) Brexit potential scenarios analysis and impact on rating outcome, (7) peers consideration.

Methodology

The methodology applicable for this rating and/or rating outlook ‘Public Finance Sovereign Ratings’ is available on www.scoperatings.com.
The historical default rates used by Scope Ratings can be viewed in the rating performance report on https://www.scoperatings.com/governance-and-policies/regulatory/esma-registration. Please also refer to the central platform (CEREP) of the European Securities and Markets Authority (ESMA): http://cerep.esma.europa.eu/cerep-web/statistics/defaults.xhtml. A comprehensive clarification of Scope’s definition of default and definitions of rating notations can be found in Scope’s public credit rating methodologies at www.scoperatings.com.
The rating outlook indicates the most likely direction in which a rating may change within the next 12 to 18 months. A rating change is, however, not automatically a certainty.

Regulatory disclosures

This credit rating and/or rating outlook is issued by Scope Ratings AG.

Rating prepared by Dennis Shen, Lead Analyst

Person responsible for approval of the rating: Dr Stefan Bund, Chief Analytical Officer

The ratings/outlook were first assigned by Scope as a subscription rating in January 2003. The subscription ratings/outlooks were last updated on 05.05.2017.

The senior unsecured debt ratings as well as the short term issuer ratings were assigned by Scope for the first time.

As a "sovereign rating" (as defined in EU CRA Regulation 1060/2009 "EU CRA Regulation"), the ratings on the United Kingdom are subject to certain publication restrictions set out in Art 8a of the EU CRA Regulation, including publication in accordance with a pre-established calendar (see "Sovereign Ratings Calendar of 2017" published on 21.07.2017 on www.scoperatings.com). Under the EU CRA Regulation, deviations from the announced calendar are allowed only in limited circumstances and must be accompanied by a detailed explanation of the reasons for the deviation. In this case, the deviation was due to the recent revision of Scope’s Sovereign Rating Methodology and the subsequent placement of the ratings under review, in order to conclude the review and disclose ratings in a timely manner, as required by Article 10(1) of the CRA Regulation.

Solicitation, key sources and quality of information

The rating was initiated by Scope and was not requested by the rated entity or its agents. The rated entity and/or its agents did not participate in the ratings process. Scope had no access to accounts, management and/or other relevant internal documents for the rated entity or related third party.

The following material sources of information were used to prepare the credit rating: public domain and third parties. Key sources of information for the rating include: (UK) Office for National Statistics, Bank of England, European Commission, Statistical Office of the European Communities, IMF, OECD, and Haver Analytics.

Scope considers the quality of information available to Scope on the rated entity or instrument to be satisfactory. The information and data supporting Scope’s ratings originate from sources Scope considers to be reliable and accurate. Scope does not, however, independently verify the reliability and accuracy of the information and data.

Prior to publication, the rated entity was given the opportunity to review the rating and/or outlook and the principal grounds upon which the credit rating and/or outlook is based. Following that review, the rating was not amended before being issued.

Conditions of use / exclusion of liability

© 2017 Scope SE & Co. KGaA and all its subsidiaries including Scope Ratings AG, Scope Analysis, Scope Investor Services GmbH (collectively, Scope). All rights reserved. The information and data supporting Scope’s ratings, rating reports, rating opinions and related research and credit opinions originate from sources Scope considers to be reliable and accurate. Scope cannot, however, independently verify the reliability and accuracy of the information and data. Scope’s ratings, rating reports, rating opinions, or related research and credit opinions are provided “as is” without any representation or warranty of any kind. In no circumstance shall Scope or its directors, officers, employees and other representatives be liable to any party for any direct, indirect, incidental or otherwise damages, expenses of any kind, or losses arising from any use of Scope’s ratings, rating reports, rating opinions, related research or credit opinions. Ratings and other related credit opinions issued by Scope are, and have to be viewed by any party, as opinions on relative credit risk and not as a statement of fact or recommendation to purchase, hold or sell securities. Past performance does not necessarily predict future results. Any report issued by Scope is not a prospectus or similar document related to a debt security or issuing entity. Scope issues credit ratings and related research and opinions with the understanding and expectation that parties using them will assess independently the suitability of each security for investment or transaction purposes. Scope’s credit ratings address relative credit risk, they do not address other risks such as market, liquidity, legal, or volatility. The information and data included herein is protected by copyright and other laws. To reproduce, transmit, transfer, disseminate, translate, resell, or store for subsequent use for any such purpose the information and data contained herein, contact Scope Ratings AG at Lennéstraße 5, D-10785 Berlin.

Scope Ratings AG, Lennéstrasse 5, 10785 Berlin, District Court for Berlin (Charlottenburg) HRB 161306, Executive Board: Torsten Hinrichs (CEO), Dr. Stefan Bund; Chair of the supervisory board: Dr. Martha Boeckenfeld.