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Scope Ratings GmbH has today affirmed the United Kingdom's long-term local-currency and foreign-currency issuer ratings at AA. The agency has also affirmed the UK’s short-term issuer ratings of S-1+ in both local and foreign currency. The sovereign’s senior unsecured debt in local and foreign currency are affirmed at AA. The Outlook on the long-term issuer and senior unsecured debt ratings remains Negative. The Outlook on the short-term issuer ratings is Stable.

Rating drivers

The UK’s AA rating is supported by a wealthy (per capita income of USD 39,735 in 2017) and diversified economy, and historical institutional strengths – including the rule of law under parliamentary democracy alongside strong monetary, financial supervision and economic governance frameworks. In addition, the UK benefits from deep capital markets, a favourable public debt structure, enhanced financial system buffers and sterling’s status as a global reserve currency. However, these supportive factors are counterbalanced by the challenges and uncertainties related to the UK’s ongoing exit negotiations with the European Union, 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 exit process from the EU has generated heightened uncertainty over the country’s future economic relations with the EU and with trading partners in the rest of the world and damaged the UK’s attractiveness as a destination for international investment, particularly its crucial financial sector. The rating implications of Brexit depend not only on the negotiated trade relationship and institutional end-state with the EU, but also on the scale of the long-run economic impact stemming from uncertainty generated before an end-state is concluded. Specifically, heightened economic and financial market uncertainty before March 2019, including surrounding upcoming European Council meetings at which an exit deal will be sought, alongside anticipated prolonged uncertainty after March 2019 if negotiations are extended, may aggravate an economic slowdown. Furthermore, owing to the heavy political demands of the exit process and the government’s need to sustain public support for Brexit, the adverse effects vis-à-vis the predictability and effectiveness of other significant policy areas, including long-run growth and the consolidation of public finances, remain a significant area of concern.

Prime Minister Theresa May presented a ‘substantial evolution’ in the UK’s desired exit outcome in the Chequers statement of 6 July 2018. Mrs May’s revised proposal seeks to maintain a single market for goods and a ‘Facilitated Customs Arrangement’ with the EU but is open to greater divergence on services. However, a wide distance remains between the EU and UK’s negotiation positions on key elements including the Irish border and a common vision on a future relationship.

Scope maintains the view that the most likely long-run end-state is either an eventual ‘soft Brexit’ (Scope’s baseline) or a no-Brexit reversal scenario, rather than a ‘hard Brexit’ (the latter defined as the UK exiting the single market and customs union). In the near term, Scope considers either a transitional ‘Brexit in name only’ from the EU (with entry into a near-identical implementation period in which deeper negotiations on the future relationship would begin) or an Article 50 extension as the most probable outcomes by 29 March 2019. This view is based on the inherent complexity of exit negotiations hindering a successful hard Brexit over any short- to medium-run horizon, the significant economic, financial, political and institutional consequences of any ‘no deal’ form of hard Brexit, as well as the meaningful collective pressures from parliament, the devolved administrations, the EU, UK civil society and business for an approach that avoids the destabilisation associated with a ‘cliff-edge’ exit.

However, at the same time, given the limited foresight demonstrated in exit negotiations to date and the remaining distance between the UK and EU positions, the present government’s stated intention of achieving a hard Brexit and a new free trade arrangement with the EU (even if the government’s approach has been materially softened), as well as the very limited time left to reach a formal agreement before March 2019, concerns surrounding a hard Brexit are likely to remain central to the discourse and may escalate further in scale if no deal prevails as March 2019 approaches. The downside risk that a hard Brexit presents contributes to Scope’s Negative Outlook on the UK’s sovereign rating.

In 2017, the UK grew 1.7%, with 0.2% and 0.4% QoQ growth respectively in the first two quarters of 2018. Scope expects a continued gradual slowdown in the UK economy in 2018 compared with the 2017 rate of 1.7%, as some factors supporting UK economic resilience wane. This includes a softening of growth in private consumption, investment and exports. Over the medium term, Scope assumes a baseline UK trend growth rate of 1.5% to 2.0%. This compares with 1.9% average growth rates from 2010-2017. Scope acknowledges significant uncertainty, however, around medium- to long-term growth estimates due to their inherent dependency on the trade agreement the UK reaches with the EU and other trading partners, and the nation’s overall policy framework.

The UK’s general government deficit improved in 2017-18 to 1.9% of GDP, down from 2.3% of GDP in 2016-17 and 0.5% of GDP under the Office for Budget Responsibility’s forecast as of November 2017. Despite recent fiscal outperformance, the overall budgetary adjustment has been substantively gradualised since the EU referendum in June 2016. According to the Office for Budget Responsibility, the headline deficit should dip to 1.8% of GDP in 2018-19 – with countervailing effects from spending measures, including those from the 2017 Autumn Budget, and from an overall slower speed of consolidation.

The UK’s new fiscal target seeks to return a budget surplus by the mid-2020s, replacing an earlier objective for a budget surplus by the end of 2019-20. This medium-term objective is complemented by three near-term goals: i) a 2% structural deficit by 2020-21; ii) a fall in net debt-to-GDP by 2020-21; and iii) a ‘welfare cap’ by 2021-22. These three complementary objectives are on track to be met, although additional spending – such as new NHS expenditure of GBP 20.5bn annually by 2023-24 – may challenge this if it is partly unfunded. In Scope’s view, there are material risks of deviation from the medium-term fiscal target for a budget surplus.

Government debt stood at 85.8% of GDP as of Q1 2018, slightly down from 86.5% of GDP a year before. The annual decline in gross government debt-to-GDP in 2017 represented the first such drop since 2001. Under an IMF baseline scenario, a very gradual decline in the debt-to-GDP ratio should continue, reaching 82.5% of GDP by 2023. In Scope’s view, the UK’s high stock of public debt remains a material credit weakness. However, the very long average maturity of the debt (of 15.2 years at end-2017, significantly longer than that of AA-rated sovereign peers), manageable levels of annual gross financing requirements, the debt’s sterling denomination and low financing rates are credit strengths. In addition, around a quarter of outstanding gilts are held by the Bank of England via the Asset Purchase Facility, meaning that a significant share of government debt is owed back to the UK public sector.

The UK’s current account deficit is undergoing a gradual correction. The IMF forecasts a current account balance of -3.7% of GDP in 2018, from a trough of -5.8% of GDP in 2016. The IMF projects that the current account balance will reach -2.9% of GDP by 2023. In the past, the current account deficit has been more than compensated for by net foreign direct investment inflows. However, these inflows may be challenged, especially in relation to the UK financial sector, which negatively affects resilience. In Scope’s view, the flexibility of the UK’s monetary and exchange rate regime and sterling’s global reserve currency status are significant credit strengths. In the highly adverse scenario that sterling’s global reserve status is threatened in the long run, Scope would consider this to be a material 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 sophisticated 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 (with an aggregate tier 1 capital ratio of 17% as of Q1 2018, considerably higher than per 2007). 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, based on the results of the Bank of England’s 2017 stress test, continued improvements in capital adequacy, and stronger asset quality.

Core Variable 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. Scope affirms the indicative rating of “aa” 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 were identified: i) market access and funding sources; ii) external debt sustainability; iii) vulnerability to short-term external shocks; and iv) banking sector oversight and governance. Relative credit weaknesses were signalled for: i) macro-economic stability and sustainability; ii) fiscal policy framework; and iii) recent events and policy decisions. 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 long-term ratings could be downgraded if, individually or collectively: i) there is an unanticipated no-deal exit from the European Union, with significant contingent implications for the UK’s economic, fiscal, external sector and institutional outlooks; ii) there is significant evidence of weakening in the economic and/or fiscal outlooks, leading to higher than anticipated public debt-to-GDP projections; and/or iii) external vulnerabilities increase and/or sterling’s reserve currency status is unexpectedly challenged.

Alternatively, the Outlook could be revised to Stable if, individually or collectively: i) Brexit-related economic uncertainty resolves as negotiations conclusively result in a soft exit end-state or a no-Brexit scenario unfolds, ensuring continued single market and customs union memberships; ii) the economic and/or fiscal outlooks show material resilience and/or economic and fiscal policy frameworks are re-bolstered, convincingly setting debt-to-GDP on a sustained downward path; and/or iii) external vulnerabilities are reduced significantly.

Rating committee

The main points discussed by the rating committee were: i) technical aspects of changes in the CVS; ii) rating drivers from the previous rating report; iii) productivity developments and systemic weaknesses of the UK economy; iv) Brexit scenarios, hard Brexit risks, Article 50 extension possibility; v) debt sustainability analysis; vi) political uncertainty; vii) QS positioning of the UK; and viii) peers comparison.

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. 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 GmbH.
Rating prepared by Dennis Shen, Associate Director
Person responsible for approval of the rating: Karlo Stefan Fuchs, Executive Director
The ratings/outlook were first assigned by Scope as a subscription rating in January 2003. The ratings/outlooks were last updated on 18.08.2017.
The senior unsecured debt ratings as well as the short-term issuer ratings were last updated by Scope on 18.08.2017.

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, Office for Budget Responsibility, Her Majesty’s Treasury, European Commission, Statistical Office of the European Union, 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 the issuance of the rating, 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
© 2018 Scope SE & Co. KGaA and all its subsidiaries including Scope Ratings GmbH, 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 GmbH at Lennéstraße 5, D-10785 Berlin.

Scope Ratings GmbH, Lennéstrasse 5, 10785 Berlin, District Court for Berlin (Charlottenburg) HRB 192993 B, Managing Director: Torsten Hinrichs.