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Rating action

Scope Ratings GmbH (Scope) has today affirmed the United Kingdom’s long-term issuer and senior unsecured debt ratings at AA in local- and foreign-currency and revised the Outlooks to Stable from Negative. The short-term issuer ratings have been affirmed at S-1+ in local- and foreign-currency, with Outlooks maintained at Stable.

Rating drivers

The revision of the Outlook assigned to the United Kingdom’s AA ratings to Stable, from Negative, reflects:

1. The entering into force of the Trade and Cooperation Agreement with the European Union in May 2021, which has mostly eliminated cliff-edge-related Brexit risk and associated significant economic, fiscal, external-sector and institutional repercussions for the UK’s credit ratings.
    
2. The resilience of the UK economy, government debt profile and reserve-currency status demonstrated amid Brexit and Covid-19 dual crises since the EU referendum of 2016.

The affirmation of the UK’s AA ratings is supported by a wealthy and diversified UK economy and significant institutional strengths, including robust financial supervisory, economic and monetary governance frameworks. In addition, the UK benefits from deep capital markets, a favourable public debt structure, enhanced financial system buffers and sterling’s reserve currency status alongside the independent monetary policy under the Bank of England. However, these supportive factors are counterbalanced by credit challenges related to the high and increasing stock of UK public debt amid a current uneven recovery from the Covid-19 economic crisis, risks relating to prolonged uncertainties surrounding the implementation of the post-Brexit UK-EU trade agreement and associated economic and institutional costs of Brexit, low productivity growth and a weak external position.

The Stable Outlook represents Scope’s view that risks to the ratings over the next 12 to 18 months are balanced.

The ratings could be downgraded or the Outlooks returned to Negative if, individually or collectively: (i) there is evidence of significant weakening in the economic outlook in addition to further significant weakening of fiscal dynamics; (ii) external vulnerabilities increase and/or sterling’s reserve currency status is unexpectedly challenged; and/or (iii) evidence that Brexit results in more severe than anticipated attrition of the UK services sector and/or challenges the UK’s constitutional integrity.

Alternatively, the ratings/Outlooks could be upgraded if, individually or collectively: (i) the economic and/or fiscal outlooks improve meaningfully; and/or (ii) external vulnerabilities are reduced significantly.

Rating rationale

The first driver for revision of the United Kingdom’s rating Outlook to Stable, from Negative, relates to the entering into force of the Trade and Cooperation Agreement with the European Union in May 2021¹, which has mostly eliminated cliff-edge-related Brexit risk. This has stemmed a worst-case scenario of widespread adoption of tariffs and quotas on goods traded between the two jurisdictions. This near elimination of ‘no-deal’ adverse Brexit risk has significantly curtailed contingent downside risks that impact economic, fiscal, external-sector and institutional outlooks affecting the United Kingdom ratings.

Furthermore, while the important UK services sector was predominantly excluded from the trade deal, a Memorandum of Understanding (MoU) was concluded² in March 2021 around regulatory cooperation in financial services sectors. Although the MoU is separate from future decisions surrounding regulatory equivalence, agreement around the MoU did represent an important step forward for any more substantive access rights granted to the UK financial industry medium run, contingent on equivalence rulings.

The second driver of the revision of the Outlook of the United Kingdom’s ratings to Stable is reflected in resilience of the UK’s economy, debt profile and reserve-currency status amid the dual crises of Brexit and the Covid-19 public-health crisis. UK economic output contracted sharply by 9.8% in 2020, as the UK became one of the most severely impacted countries globally by the SARS-CoV-2 virus with severe lockdown adopted on repeated occasions since March 2020. Supported by large-scale fiscal and monetary stimulus, Scope expects a strong, but uneven, economic rebound. Output is expected to grow by a robust 6.6% this year driven by increased consumption, particularly in the services sector, as pandemic-related restrictions are withdrawn, trailed by elevated growth of 5.4% next year. As such, the economy is seen reaching pre-pandemic levels of output by 2022, even though the Office for Budget Responsibility³ points out, nonetheless, that a degree of permanent scarring due to Covid-19 economic consequences is foreseen with output long term to remain 3% under pre-virus expectations. In the medium term, Scope expects the growth potential of the United Kingdom economy to remain around a 1.5% level (embedding soft productivity growth assumed of around 0.6% per year) – below a trend rate of growth estimate of up to 2% under scenario of the UK remaining in the European Union but nonetheless comparable to the growth potential of similarly-AA rated sovereign peers such as the United States (1.9%) and France (1.4%).

Budget support measures in response to 2020’s recession resulted in an outsized fiscal deficit of 13.4% of GDP in 2020 and this deficit is foreseen remaining elevated in 2021 at 11.4%. In result, government debt as a percentage of GDP is projected to increase to around 106% in 2021, having adjusted sharply higher from the 85% level shortly before the pandemic. The expectation of continued budget deficits over coming years is expected to maintain public debt ratios on an increasing trajectory over the medium run – reaching 112% of GDP by 2026, posing an ongoing significant challenge to the credit ratings outlook. To eliminate the current budget deficit, the March 2021 budget did, nevertheless, table a 6pp increase of the corporation tax rate from April 2023 and freeze in income tax personal allowances from April 2022.

Despite the higher stock of UK debt, fiscal risk as associated with UK’s more-elevated debt level demonstrates resilience as the public debt profile remains anchored under prevailing low interest rate conditions and the Bank of England’s GBP 895bn Asset Purchase Facility (of which at minimum GBP 824bn has been expended thus far). Government expenditure on interest payments as a percentage of GDP is foreseen easing to an all-time low of 1.7% in 2021 (from 2.7% in 2017) despite the increased stock of debt. 10-year gilt yields of 0.8% (having increased from 2020’s all-time lows of under 0.1%) remain exceptionally low under historical standards and will support moderate levels of interest payments in the coming period.

As part of its monetary policy response to the Covid-19 crisis, the Bank of England was the most active purchaser of gilts of 2020. The Bank is forecasted to hold over 45% of UK government debt by the end of 2021, compared with 26% in 2019 – the former reflecting a higher ratio than in other advanced economies and G4 central banks: US (21% by end-2021), euro area (29%), Japan (40%). The pace of Bank of England purchases means that, despite large-scale increase in the UK debt stock amid crisis, the Scope-rated UK stock of debt owned by the private sector has decreased since 2019. As well importantly, the average maturity of the gilt portfolio, of around 15.3 years⁴, has remained long compared with that of AA-rated sovereign peers, such as the United States (5.8 years) or France (7.8 years). The UK’s long tenure with respect to public debt eases annual gross government financing needs (estimated of 14.8% of GDP on average over 2021-26, compared with that of the United States (42.3%) or France (28.7%)).

The credit strengths of the UK include flexibility of an independent monetary and exchange rate regime and sterling’s global reserve currency status – which anchor the robustness of the economy and comparatively weak external position. Sterling’s status as a reserve currency has, critically, demonstrated resilience since the 2016 referendum. 4.7% of global allocated reserves was held in sterling as of Q4 2020 – equal to the share pre-EU referendum as of Q4 2015 (based on IMF COFER data⁵). Pound’s global reserve status reduces risk of ‘sudden stop’ balance of payment crises and bolsters sterling markets including government debt during periods of external stress. Absent this status, the UK’s high external deficits would represent a significant credit challenge, with gross external financing needs as a share of current account receipts and official FX reserves among the highest in the advanced world.

The United Kingdom benefits from deep capital markets and the City of London’s position as one of the world’s leading financial centres. The soundness of the UK financial system is anchored by a sophisticated financial regulatory framework. Major banks display sturdy common equity tier 1 capital ratios of 16.2% (on aggregate) in Q4 2020 – mostly unchanged on 15.6% as of Q4 2019. Insolvencies have remained subdued to date (with a non-performing loan ratio of 1.3% as of Q4 2020), although insolvencies are a lagging indicator of corporate distress and may increase moving ahead, especially in sectors most impacted by economic closures. The UK Financial Policy Committee judged that banks, after capital increases since the global financial crisis, could incur up to GBP 120bn of credit losses before seeing severely-impaired lending, corresponding with an economic scenario of unemployment needing to increase above 15%.⁶ Nonetheless, significant increases of property prices present one longer-run financial-stability risk. The Financial Policy Committee supported the economy by releasing the regulatory countercyclical capital buffer rate to 0% in response to crisis. The Bank of England’s Monetary Policy Committee cut the policy rate to 0.1% by March 2020.⁷ The Bank is presently contending with a sharp increase in inflation to the central bank’s 2% objective (2.1% YoY in May) and Scope currently expects an unchanged base rate in 2021 but a small rate increase to 0.25% by end-2022.

Against these supportive areas, the UK ratings remain constrained by not only an elevated and increasing government debt level, longer-term economic scarring as associated with an uneven post-Covid recovery and low productivity growth, but also ongoing costs and contingencies associated with Brexit, the weakening of the UK fiscal framework of past years, and a weak external position.

While avoiding the severe implications of a hard Brexit is a core driver of the revision of the UK Outlook to Stable, this does not imply Brexit risks and associated economic and institutional consequences have passed. The City of London is facing permanent damage in awaiting definitive agreement around financial services in this current period during which select UK financial services have lost the right of “passporting”. Future and existing equivalence arrangements between the UK and EU are, moreover, likely to reflect a “dynamic” structuring – with equivalence retractable should standards diverge. UK-based businesses may continue relocation of some activities to the continent – ensuring a steadily increasing cost of a “slow-burn” Brexit. Temporary equivalence granted to UK central counterparties until June 2022 presents associated contingencies by next year.

In addition, the Scottish National Party’s success during May 2021 Scottish parliamentary elections risks future constitutional confrontation with respect to desire to structure a second independence referendum. The institutional consequences of Brexit are, in addition, illustrated via UK unilateral action alongside formal requests made for extension of grace periods on the requirement for checks on certain goods crossing from Great Britain to Northern Ireland, with current legal contentions around delays surrounding implementation of the Northern Ireland Protocol. Against this, UK progress with trading negotiations with other global trading partners, including negotiations around acceding to the Trans-Pacific Partnership, could advance financial and professional services’ access to fresh markets.

Reversals of fiscal consolidation and easing of UK fiscal rules resulted from taxing Brexit negotiations of past years. Two less ambitious fiscal rules have been adopted since the last UK elections: i) the government will run a balanced current account budget no later than the third year of the government’s forecast period (2022-23); and ii) borrowing for infrastructure will not exceed 3% of GDP. In Scope’s opinion, fiscal rules being progressively watered down undermines the resilience of the UK fiscal framework. The UK’s exit from the European Union also means EU fiscal rules as defined under the Stability and Growth Pact no longer apply.

The external sector represents a credit challenge. The current account deficit amounted to 3.5% of GDP in 2020, slightly up from 3.1% of GDP in 2019 but nonetheless well below a 6.1% of GDP peak in the four quarters to Q3 2016. As associated with Brexit – the UK ultimately secured a deal for trade in goods where it has a trading deficit with the EU, but not one as comprehensive in services where it stands to see losses to a trading surplus. This holds longer-term adverse consequences for the UK’s current account balance. Since the start of 2021, exports of goods have started to pick up while services sector exports have stayed stable. This resulted in the lowest share of services sector exports in the twelve months to April since mid-2015.

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

Scope’s Core Variable Scorecard (CVS), which is based on the relative rankings of key sovereign credit fundamentals, provides a first indicative rating of ‘aa-’ for the United Kingdom. United Kingdom receives a one-notch uplift to this indicative rating via the reserve currency adjustment under the methodology. As such, under the methodology, ‘aa’ final indicative ratings 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) monetary policy framework; ii) debt profile and market access; and iii) banking sector oversight. Relative credit weaknesses were signalled for: i) fiscal policy framework; ii) current account resilience; and iii) external debt structure. The combined relative credit strengths and weaknesses in the QS generates zero net adjustment notches and indicates a sovereign credit rating of AA for the United Kingdom.

A rating committee has discussed and confirmed these results.

Factoring of Environment, Social and Governance (ESG)

Scope explicitly factors in ESG sustainability issues during the ratings process via the sovereign methodology’s stand-alone ESG sovereign risk pillar, with a 20% weighting under the quantitative model (CVS) as well as in the qualitative overlay (QS). Under governance-related factors in the CVS, the UK’s performance is strong and in line with that of sovereign peers, as assessed by the World Bank’s Worldwide Governance Indicators (WGI). However, the UK marks have noticeably declined after the 2016 EU referendum as institutional strengths attenuated, illustrated especially in declining scores under the WGI’s “Government Effectiveness”, “Regulatory Quality” and “Rule of Law” categories of assessment. Cliff-edge Brexit negotiation deadlines of past years weighed on UK institutional strengths – with acts such as the prorogation of Parliament and passage of the Internal Market Bill contravening international law observed over difficult negotiations – weakening the rule of law and UK parliamentary norm. With the UK’s exit from the single market and customs union, such governance risk due to Brexit has, however, moderated. For the UK, governance-related assessments are also reflected in Scope’s QS evaluation of ‘neutral’ on ‘institutional and political risks’ as compared with a ‘aa’ sovereign peer group.

Socially related credit factors are similarly captured under Scope’s CVS quantitative model and QS qualitative overlay. In the CVS model, the United Kingdom scores well on the basis of moderate levels of income inequality (as measured through the ratio of the share of the 20% of persons with the highest household incomes to the 20% of persons with the lowest household income) and high labour force participation (79% of the active labour force as of March 2021), while facing challenges as related to an ageing society, with the UK’s old-age dependency dynamics scoring poorly under an international comparison although favourably compared with those of EU member countries. The UK labour market has been resilient over this crisis. Furlough schemes are being phased out, but any rise in unemployment ought to be contained as most furloughed workers are likely to remain in employment. Scope projects the UK unemployment rate to average 4.6% in 2021 before 4.0% in 2022, after 4.6% in 2020 and 3.9% pre-crisis (in 2019). The UK has been one of the most severely impacted countries by the Covid-19 crisis with more than 4.6m confirmed cases and 128,000 deaths – although the vaccination programme has been advanced at faster pace than that in most peer nations. The UK ranked, nonetheless, as the second most prepared nation globally (of 195) for health crises under the 2019 Global Health Security Index. With the Build Back Better growth programme⁸, the UK aims for substantive investment into infrastructure, skills and innovation, and to pursue growth that levels up every part of the economy. On the QS assessment, the ‘social risks’ of the UK are evaluated as ‘neutral’ compared with that within the sovereign peer group.

In respect to environment risk – the UK scores comparatively well under the CVS on carbon emissions per unit of GDP and its exposure and vulnerability to natural disaster risk metrics but is evaluated more in a middling categorisation on ecological footprint of consumption compared with the available biocapacity within the UK’s borders. The UK was the first major nation to announce a commitment to reach net zero carbon emissions by 2050. Over the past two decades, the UK has made good progress in reducing carbon emissions as a percentage of GDP, cutting greenhouse gas emissions by 21% between 2005-2018 according to the European Commission. Further investments will be needed, however, over the next years to reduce transport-sector emissions, electrify the railway system and improve the energy efficiency of the UK housing stock. The UK does remain vulnerable to effects of climate change including risk of flooding and water-supply shortages, as well as pronounced risk to health due to high temperatures. According to the UK Committee on Climate Change, carbon emissions were 41% under 1990 levels in 2019. The Committee has previously warned that the UK is on track to meet the third (2018-22) carbon budget, but not on track to meet the fourth budget, which covers the period of 2023-27. The UK’s post-Covid growth scheme seeks to enable the transition to net zero, with 78% reductions aimed for by 2035.⁹ On the QS, Scope evaluates the UK’s strong performance on environmental sustainability as ‘neutral’ on the ‘environmental risks’ assessment category compared with performance within the nation’s strong ‘aa’ sovereign peer group.

Rating Committee
The main points discussed by the rating committee were: i) ratification of the UK-EU Brexit agreement and financial services cooperation MoU; ii) consequences of Brexit and facets of resilience; iii) Covid-19 crisis, vaccination and long-term economic scarring; iv) debt trajectory and debt profile; v) growth potential and recovery programme; vi) banking system dynamics and financial stability; vii) monetary policy and inflation outlook; and viii) sovereign peers considerations.

Rating driver references
1. UK government, Agreements reached between the United Kingdom of Great Britain and Northern Ireland and the European Union
2. UK government, Technical negotiations concluded on UK – EU Memorandum of Understanding 
3. Office for Budget Responsibility, Economic and fiscal outlook, March 2021 
4. UK Debt Management Office, Quarterly Review, January - March 2021 
5. IMF, Currency Composition of Official Foreign Exchange Reserves (COFER) 
6. Bank of England, Financial Policy Summary and Record of the Financial Policy Committee Meeting on 8 December 2020 
7. Bank of England: including Monetary Policy Report and Financial Stability Report 
8. HM Treasury: Budget 2021 and the ‘Build Back Better’ plan for growth 
9. UK government, UK enshrines new target in law to slash emissions by 78% by 2035

Methodology
The methodology used for these Credit Ratings and/or Outlooks, (Rating Methodology: Sovereign Ratings, 9 October 2020) is available on https://www.scoperatings.com/#!methodology/list.
Scope Ratings GmbH and Scope Ratings UK Limited apply the same methodologies/models and key rating assumptions for their credit rating services, while Scope Hamburg GmbH’s methodologies/models and key rating assumptions are different from those of Scope Ratings GmbH and Scope Ratings UK Limited.
Information on the meaning of each Credit Rating category, including definitions of default, recoveries, Outlooks and Under Review, can be viewed in ‘Rating Definitions – Credit Ratings, Ancillary and Other Services’, published on https://www.scoperatings.com/#!governance-and-policies/rating-scale. Historical default rates of the entities rated by Scope Ratings can be viewed in the Credit Rating performance report at https://www.scoperatings.com/#governance-and-policies/regulatory-ESMA. 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 Ratings’ definitions of default and Credit Rating notations can be found at https://www.scoperatings.com/#governance-and-policies/rating-scale. Guidance and information on how environmental, social or governance factors (ESG factors) are incorporated into the Credit Rating can be found in the respective sections of the methodologies or guidance documents provided on https://www.scoperatings.com/#!methodology/list.
The Outlook indicates the most likely direction of the Credit Ratings if the Credit Ratings were to change within the next 12 to 18 months.
 
Solicitation, key sources and quality of information
The Credit Ratings were not requested by the Rated Entity or its Related Third Parties. The Credit Rating process was conducted:
With Rated Entity or Related Third Party Participation  YES
With Access to Internal Documents                               NO
With Access to Management                                         NO
The following substantially material sources of information were used to prepare the Credit Ratings: public domain and the Rated Entity.
Scope Ratings considers the quality of information available to Scope Ratings on the Rated Entity or instrument to be satisfactory. The information and data supporting these Credit Ratings originate from sources Scope Ratings considers to be reliable and accurate. Scope Ratings does not, however, independently verify the reliability and accuracy of the information and data.
Prior to the issuance of the Credit Rating action, the Rated Entity was given the opportunity to review the Credit Ratings and/or Outlooks and the principal grounds on which the Credit Ratings and/or Outlooks are based. Following that review, the Credit Ratings were not amended before being issued.

Regulatory disclosures
These Credit Ratings and/or Outlooks are issued by Scope Ratings GmbH, Lennéstraße 5, D-10785 Berlin, Tel +49 30 27891-0. The Credit Ratings and/or Outlooks are UK-endorsed.
Lead analyst: Dennis Shen, Director
Person responsible for approval of the Credit Ratings: Dr. Giacomo Barisone, Managing Director
The Credit Ratings/Outlooks were first released by Scope Ratings on January 2003. The Credit Ratings/Outlooks were last updated on 7 February 2020.

Potential conflicts
See www.scoperatings.com under Governance & Policies/EU Regulation/Disclosures for a list of potential conflicts of interest related to the issuance of Credit Ratings.
 
Conditions of use / exclusion of liability
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