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Rating action

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.

Summary and Outlook

The affirmation of the UK’s AA ratings is supported by a wealthy and diversified economy and significant institutional strengths, including a strong financial supervision, economic and monetary governance framework. In addition, the UK benefits from deep capital markets, a very favourable public debt structure, enhanced financial system buffers and sterling’s reserve currency status alongside an independent monetary policy under the Bank of England. However, these supportive factors are counterbalanced by the challenges and uncertainties related to Brexit, a high public debt stock, low productivity growth and a weak external position.

The Negative Outlook reflects Scope’s assessment that uncertainty regarding the future UK-EU relationship will endure for many years, including the terms of the future relationship with the EU as well as with trading partners in the rest of the world. In Scope’s view, there is considerable distance between the UK and the EU on the terms of any future free trade agreement, such as relating to the regulation of goods and services. On this basis, Scope believes that, at some stage, segments of the UK economy will observe greater barriers to EU trade that do not exist currently. The rating implications of Brexit will hinge as such on the negotiated trading relationship and institutional end-state vis-à-vis the EU, but also on the scale of the cumulative adverse economic impact of uncertainty generated by Brexit before an end-state is concluded. Moreover, the prolonged Brexit negotiations have weighed on national sentiment and forced government policy responses, including reversals of fiscal consolidation and the easing of UK fiscal rules. This resulting decline in the predictability and quality of economic and fiscal policy setting remains a core rating concern.

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 cliff-edge scenario, with significant implications for the UK’s economic, fiscal, external sector and institutional outlooks; ii) there is evidence of additional significant weakening in the economic and/or fiscal outlooks, leading to meaningfully higher 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) the economic and/or fiscal outlooks show resilience and/or economic and fiscal policy frameworks are re-anchored, convincingly ensuring debt-to-GDP is on a sustained downward path; ii) Brexit-related economic uncertainty resolves as negotiations go in the direction of a soft exit end-state, ensuring continued single market and/or customs union memberships; and/or iii) external vulnerabilities are reduced.

Rating drivers

UK Prime Minister Boris Johnson and the Conservative Party emerged victorious in December’s general elections, capturing an outright majority of House of Commons seats. Subsequently, the new Brexit arrangement agreed with the EU on 17 October 2019 was ratified in the British and European parliaments, facilitating the UK’s exit from the European Union on 31 January 2020 “in name only”. While the first stage of Brexit has been completed, Britain will for now still trade freely with the EU and will be subject to EU laws, although the UK will no longer have a say in making the laws. In Scope’s view, upcoming negotiations around a new free trade agreement with the EU as well as finalisation of renegotiations of around 40 other free trade agreements with countries that the UK benefits from preferential trade inside the European single market and customs union will require time well past the current end-2020 date scheduled for the transition state’s conclusion, requiring extension(s) of the transition and a prolongation of the UK’s current level of access to EU markets for some time further.

The impact of Brexit uncertainty has been tangible. In 2019, the UK grew an estimated 1.3%, representing tentatively the weakest annual growth rate since 2009. Scope expects growth of 1.3% in 2020, with a quarterly growth pick-up bolstered by a momentary curtailment in economic uncertainty after a third extension of Article 50 negotiations prevented no-deal on 31 October and after December elections reduced political uncertainty, as well as supported by forthcoming fiscal stimulus. Survey data including business sentiment and purchasing manager indices as well as housing market indicators have rebounded sharply since October. Public investment plans will also raise growth potential longer-term; however, weakness in private business investment due in part to Brexit uncertainty represent continued growth bottlenecks. As of the third quarter of 2019, Scope estimates that Brexit-linked uncertainty had cost cumulative UK economic output well over 1.25% of GDP since the 2016 referendum, with this figure increasing slowly. Slower global growth moreover is impacting the export sector. However, continued growth in employment and still-robust real wage growth support household consumption. Over the medium run, Scope estimates UK trend growth of 1.5%, weighed down by low productivity growth with the former revised down from an earlier estimate of 1.5%-2.0%.

Uncertainty surrounding the UK fiscal outlook is expected to persist. The general government deficit for 2018-19 was revised up to 1.8% of GDP, from 1.1% of GDP, due to a statistical change regarding the accounting for student loans. Monthly budget figures for the 2019-20 fiscal year have modestly underperformed year-to-date to December, and Scope expects a deficit for the 2019-20 fiscal year of 1.9% of GDP. Nonetheless, this would compare favourably against revised deficits of 2.7% of GDP in 2017-18 and 10.2% of GDP in 2009-10.

In the lead-up to the December general elections, significant increases in public spending were committed to by the Conservative Party, with a new UK budget to be formally outlined to Parliament on 11 March. The programme is expected to include an additional GBP 13.4bn (0.6% of GDP) in expenditures on public services in 2020-21 whilst easing constraints on future borrowing by up to GBP 20bn (0.9% of GDP) per year for infrastructure investment, making use of current low borrowing rates; over the medium-run, an extra GBP 7bn and GBP 34bn annually were pledged for the education and NHS budgets by 2022-23 and 2023-24 respectively. On this basis, Scope estimates that the UK’s budget deficit is at risk of increasing to above a 2.5% of GDP level over the 2020-21 and 2021-22 fiscal years, reversing some of the progress made by the UK from austerity policies after 2010, although the exact extent of an expected increase in the deficit depends on the scale of implementation of election commitments.

In addition, a revision of the UK’s fiscal framework allows for this fiscal loosening. Previous fiscal targets had become unlikely to be met and have been replaced. Two less ambitious fiscal rules have been proposed: i) the government will run a balanced current account budget no later than the third year of the forecast period and ii) borrowing for infrastructure will not exceed 3% of GDP. In Scope’s view, fiscal rules being eased undermines the resilience of the UK’s fiscal framework. The UK’s exit from the European Union also means that EU fiscal rules as defined under the Stability and Growth Pact no longer apply. This institutional effect of Brexit on the UK’s fiscal framework supports a Negative Outlook.

Government debt stood at 84.2% of GDP as of Q3 2019, slightly down on a peak of 87.1% of GDP in Q2 2015. Compared with governmental pledges to keep national debt on a falling trajectory as a share of national output in years to come, in Scope’s view, there is instead risk of debt-to-GDP remaining roughly unchanged in the coming period at around 85%, despite near all-time low funding rates. This debt trajectory could moreover resume a slight increasing slope under small economic shocks.

With regards to the external sector, the UK’s current account deficit stood at 4.7% of GDP in the year to Q3 2019, compared with the 3.5% deficit as of 2017 – owing primarily to wider deficits in the trade of goods and services. This is tied both to weak manufactured goods exports under conditions of slower global growth as well as higher UK imports (in part related to no-deal Brexit inventory stockpiling). Scope expects a more modest current account deficit of around 4.25% of GDP this year. In the past, the UK’s current account deficits have been more than compensated for by net foreign direct investment inflows. However, FDI inflows have significantly weakened since 2016, especially in relation to flows to the UK financial sector, negatively impacting resilience. This has meant the net international investment position has weakened slightly to -19% of GDP as of Q3 2019, from a balanced position at end-2016.

The UK’s AA ratings are supported by pound sterling’s status as one of the world’s leading reserve currencies. In Scope’s view, the flexibility of the UK’s independent monetary and exchange rate regime and sterling’s global reserve currency status are critical credit strengths. In the highly adverse scenario that sterling’s global reserve status is threatened in the long run – such as in an unanticipated hard Brexit scenario, Scope would consider this to be material.

Although the UK’s high stock of public debt is a credit weakness, this risk is significantly mitigated by the UK’s very long average maturity of the debt (of 15.35 years as of September 2019, significantly longer than that of AA-rated sovereign peers like France (7.5 years) and the United States (5.7 years)). Despite the UK’s elevated debt stock, the debt’s long maturity ensures manageable levels of annual gross government financing requirements (estimated at 8.5% of GDP in 2020, compared with 13.8% of GDP for France and 24.9% of GDP for the United States). Moreover, the debt’s sterling denomination and the UK borrowing in markets for 10 years at only 0.6% support debt sustainability. 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 outstanding government debt is owed back to the UK public sector.

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. Major banks are well capitalised (with an aggregate tier 1 capital ratio of 17% as of Q3 2019, more than three times levels from prior to the Global Financial Crisis). The effect of a no-deal Brexit on financial stability may be significant; however, the UK financial system is presently well positioned to deal with even a significant shock, based on the results of the Bank of England’s 2019 stress test (which found major UK banks and building societies are strong enough to carry on lending to the private sector even in a recession worse than the financial crisis), past years’ improvements at banks in capital adequacy, and relatively stable asset quality. Arrangements to provide continuity and market access to the EU for the UK financial sector would be viewed constructively by Scope.

With over GBP 1trn of high-quality liquid assets, major UK banks can meet maturing obligations without need to access wholesale funding for many months. Scope moreover views constructively the Financial Policy Committee’s decision to raise the level of the UK counter-cyclical capital buffer rate in ‘standard’ risk environments from 1% to 2% (with effect from end-2020), with the Prudential Regulation Authority reducing minimum capital requirements such that the overall loss-absorbing capacity of the banking system remains broadly unchanged. This adjustment will ensure banks hold higher-quality tier 1 capital and facilitate a greater responsiveness of capital requirements to economic conditions.

Core Variable Scorecard (CVS) and Qualitative Scorecard (QS)

The rating committee reviewed Scope’s Core Variable Scorecard (CVS), which is based on the relative rankings of key sovereign credit fundamentals and assigned 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 analysts’ 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) economic policy framework; ii) macro-economic stability and sustainability; iii) fiscal policy framework; iv) current account vulnerability; and v) 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.

Factoring of Environment, Social and Governance (ESG)

Scope considers ESG sustainability issues during the rating process as reflected in the sovereign methodology. Governance-related factors are explicitly captured in Scope’s assessment of ‘Institutional and Political Risk’ in its methodology, within which the UK retains strong CVS scores within Scope’s rated sovereign universe on a composite index of six World Bank Worldwide Governance Indicators. However, after the 2016 EU referendum, institutional strengths have weakened, shown especially in declining scores for “Political Stability”, “Government Effectiveness” and “Rule of Law”. Qualitative governance-related assessments reflect Scope’s QS evaluations of ‘inadequate’ on ‘recent events and policy decisions’ (reflecting the impact of the UK’s exit from the European Union on the quality of economic governance) and ‘neutral’ on ‘geo-political risk’ compared with the UK’s ‘aa’ sovereign peer group.

Social factors are captured in Scope’s CVS in the UK’s high GDP per capita (of an estimated USD 41,030 in 2019), low level of risk associated with the national unemployment rate (of 3.8% in the three-months to November – at its lowest since the mid-1970s), and high level of risk from a rising old-age dependency ratio. The UK’s Gini coefficient after taxes and transfers – designating income inequality – is moderate in a cross-country comparison. In the 2020 budget, the government plans to invest in “levelling up” public expenditure, helping raise spending especially for slow-growing regions of the economy. Social considerations and impacts of social factors on the economy are reflected in Scope’s QS evaluation of ‘neutral’ on the UK’s ‘growth potential of the economy’, ‘poor’ on ‘economic policy framework’ and ‘poor’ on ‘macro-economic stability and sustainability’ compared with ‘aa’-indicative sovereign peers.

The UK has maintained a strong record on environmental sustainability and recorded the sixth highest score (out of 180 countries) in the 2018 Environmental Performance Index – an index developed by Yale University. Yet, according to the OECD, the UK “could still improve its ranking… with respect to a number of indicators of environmental pressure intensity. Today, priority environmental issues include diffuse pollution, waste management, soil and water management, landscape and biodiversity conservation, and climate protection”. According to the UK’s Committee on Climate Change, carbon emissions were 44% under 1990 levels as of 2018; the UK is on track to meet the third (2018-22) carbon budget, but not on track to meet the fourth, the latter which covers 2023-27. Meeting an ambitious new government target to reduce net greenhouse gas emissions to zero by 2050 (the UK became the first major nation to propose an objective of this ambition) will require, however, a significant step-up in actions across sectors. In the Spending Round for 2020-21 outlined last September, decarbonisation, air quality and biodiversity received a pledged funding boost of GDP 90mn, alongside an additional GBP 250mn allocated to international climate and environment funds. Environmental factors are considered during the rating process, but did not play a direct role in this rating action.

Rating committee
The main points discussed by the rating committee were: i) Brexit process developments; ii) economic risks in a hard Brexit; iii) growth potential; iv) fiscal framework; v) budget and debt sustainability; vi) external sector and net international investment position; vii) country peer comparisons.

Methodology
The methodology used for this rating and/or rating outlook, ‘Public Finance Sovereign Ratings’, is available on www.scoperatings.com.
Historical default rates of the entities rated 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 as well as 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.

Solicitation, key sources and quality of information
The rating was not requested by the rated entity or its agents. The rated entity and/or its agents did not participate in the rating process. Scope had no access to accounts, management and/or other relevant internal documents for the rated entity or related third party. The following substantially material sources of information were used to prepare the credit rating: public domain. Key sources of information for the rating include: (UK) Office for National Statistics, the Bank of England, the Office for Budget Responsibility, Her Majesty’s Treasury, European Commission, Eurostat, 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 or outlook action, 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.

Regulatory disclosures
This credit rating and/or rating outlook is issued by Scope Ratings GmbH.
Rating prepared by Dennis Shen, Director
Person responsible for approval of the rating: Dr Giacomo Barisone, Managing Director, Public Finance
The ratings/outlook were first assigned by Scope in January 2003. The ratings/outlooks were last updated on 10 August 2018.

Potential conflicts
Please see www.scoperatings.com for a list of potential conflicts of interest related to the issuance of credit ratings.

Conditions of use / exclusion of liability
© 2020 Scope SE & Co. KGaA and all its subsidiaries including Scope Ratings GmbH, Scope Analysis GmbH, Scope Investor Services GmbH and Scope Risk Solutions 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 does not, 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 other 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 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.

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