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Rating action

Scope Ratings GmbH (Scope) has today affirmed the United Kingdom’s AA long-term issuer and senior unsecured local- and foreign-currency ratings, along with its short-term issuer rating of S-1+ in both local and foreign currency. All Outlooks remain Stable.

Summary and Outlook

Scope’s affirmation of the United Kingdom’s AA ratings reflects its: i) large, wealthy and diversified economy, which has proved resilient during the Covid-19 pandemic; ii) strong institutions including robust financial supervisory, economic and monetary governance frameworks; and iii) a robust debt profile and strong market access.

Rating challenges include: i) the country’s high public debt; ii) a weak external position with persistent current account deficits; and iii) the prolonged uncertainties surrounding the implementation of the post-Brexit UK-EU trade agreement.

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

The ratings/Outlooks could be downgraded, individually or collectively, if: i) a significant weakening in economic and fiscal outlooks led to a rising trajectory of public debt and weakened debt sustainability; ii) Brexit resulted in more severe than anticipated attrition of the UK services sector and/or risks to the UK’s constitutional integrity materialised; and/or iii) external vulnerabilities increased or the sterling’s status as a reserve currency were challenged.

Conversely, the ratings/Outlooks could be upgraded if, individually or collectively, the United Kingdom’s: i) public finances improved, resulting in a material improvement in the fiscal outlook including a stable downward trajectory of public debt in the medium term; and/or ii) external vulnerabilities were reduced.

Rating rationale

The United Kingdom’s AA ratings are supported by the country’s large, wealthy and diversified economy, which has proved resilient following the UK’s exit from the European Union and during the Covid-19 pandemic. After one of the sharpest contractions among advanced economies during the Covid-19 crisis (-9.3%), the UK economy grew by 7.4% in 2021 on the back of a strong recovery in private demand. Economic output reached its pre-pandemic level in November 2021, ahead of the rapid spread of the Omicron Covid-19 variant. The labour market rebounded quickly, in parallel with the economic recovery, bringing the unemployment rate down to 3.7% in Q1 2022. Record high vacancies point to a tight labour market, in part owing to a lower participation rate following the Covid-19 crisis. Scope expects unemployment to stabilise at this very low level in the medium term, which should support nominal wage growth, albeit at a slower rate than inflation.

Despite its moderate direct ties to Russia and Ukraine, the UK is negatively impacted by the escalation and fallout from the war. The spike in energy and raw material prices and supply chain disruptions have intensified and are fuelling previous strong inflationary pressures. Consumer price index inflation reached a new high of 9% in April 2022, driven by higher electricity, gas and fuel prices as well as higher transport costs. Core inflation also increased markedly, up 6.2%, pointing to the broadening of price pressures across the consumer basket. A weakening sterling and tight labour markets also contributed to inflationary pressures. To contain inflation in the medium term, the Bank of England started a process of monetary tightening in the autumn of 2021, which included raising its Bank rate by a cumulated 90bps since December to 1%. In line with previous forward guidance, the Bank’s Monetary Policy Committee will also consider starting the process of selling UK government bonds held in the Asset Purchase Facility¹.

While growth remained robust in Q1 2022 (+0.8% QoQ), household consumption is likely to slow over the next few months. As the economy continues to recover from the pandemic shock, Scope expects GDP growth of 3.5% in 2022, supported by a temporary boost in business investment related to the government ‘super-deduction’ tax allowance. Growth is then expected to slow to 1.1% in 2023 before recovering somewhat towards the medium-run potential of around 1.5%. Longer-term challenges to the growth outlook relate to low productivity growth as well as continued uncertainty concerning the lasting impact of the UK-EU Trade and Co-operation Agreement.

The AA ratings are also underpinned by the country’s strong institutions including robust financial supervisory, economic and monetary governance frameworks. This includes the UK’s sophisticated financial regulatory system and strong macroprudential governance framework under the Bank of England and the Financial Conduct Authority. The independent central bank allows for flexible monetary policy, which responded appropriately to rising inflationary pressures during the second half of 2021. The institutional framework is further supported by the independent Office for Budget Responsibility (OBR), which provides forecasts and regular assessments of government budgetary plans. This includes regular assessments of whether the government is on track to meet its targets under the fiscal framework, debt sustainability analysis, evaluations of fiscal risks and assessments of tax and welfare policy costing.

Finally, the United Kingdom’s AA ratings reflect strong market access conditions and a robust debt profile with an exceptionally long average debt maturity (14.7 years as of end-2021) compared to its peers. The central bank holds around one-third of government debt, with the Bank of England being the largest single holder of outstanding gilts and treasury bills². This share is likely to fall over the coming years as the Bank is considering a gradual end to its Asset Purchase Programme.

Similarly to other advanced economies, financing costs have increased in recent months on the back of heightened inflation expectations and tightening monetary policy. The 10-year government bond yield reached about 1.6% on average in May 2022, up from 0.8% the year before. Around a fifth of government debt is indexed to retail-price inflation, which should lead to significant increases in interest payments in the medium run. Market access will remain strong for the UK, partially thanks to the pound sterling’s status as a reserve currency, which largely shields the country from external short-term shocks. The share of global reserves held in GBP has moderately increased in recent decades, from 2.8% in 2000 to 4.8% in 2021, supporting Scope’s view that it will retain its status in the foreseeable future.

Despite these considerable credit strengths, the United Kingdom faces several challenges.

Firstly, the country has a high level of public debt. The recovery in economic output and fiscal performance allowed for a 7.3pp reduction in the debt-to-GDP ratio in 2021 to 95.3%. However, this remains well above the 2019 level of 83.9% and significantly higher than the peer country average of 61.2%. The government deficit increased to 12.8% of GDP in 2020 to finance large-scale support measures during the pandemic but receded at a faster rate than anticipated to 8% in 2021 thanks to a stronger-than-expected recovery in tax receipts.

The government announced several fiscal measures aimed at cushioning the impact of rising inflation on households, including a reduction of the basic rate of income tax and targeted support for lower income households. The total fiscal support announced to date amounts to approximately GBP 37bn over the fiscal year 2022/23 (1.7% of GDP in 2021) and further support is likely to be required in the next years if some inflationary pressures persist. However, these measures are partially counterbalanced by policies announced in 2021, which reflects the government’s efforts to bring public finances onto a more stable path in the medium-to-long run. These include a revamp of the higher education funding system and an increase in the overall tax burden to 36.3% of GDP by fiscal year 2026/27, which would be its highest level since the 1940s.

Revised fiscal targets came into force in January 2022 and include a reduction of public sector net debt as a percentage of GDP by the third year of the OBR’s rolling forecast, a balanced current budget by the third year of the forecast, public sector net investment not in excess of 3% of GDP per year on average, and contained spending on welfare within a pre-determined cap set by the Treasury³. In its March review, the OBR expected the government to meet its targets under the fiscal framework⁴. While the headroom against these targets is broadly in line with that of previous Chancellors of the Exchequer, it remains modest and would be eroded by a 1.3 pp shortfall in GDP growth or a 1.3 pp increase in effective interest rates in the fiscal year 2024-25. The OBR has previously⁵ noted the frequent changes in the UK’s fiscal framework and that changes have been made to the rules in response to the fiscal outlook, rather than amending policies to meet the rules.

Scope expects a gradual decline of debt levels in the coming years, falling below the pre-pandemic level by the end of the agency’s forecast horizon to 82.3% in 2027. Downside risk to the debt trajectory is associated with significant contingent liabilities related to pension and healthcare costs, with the net present value of additional pension and health care expenditure estimated at 74.7% of GDP over 2021-50 according to the IMF⁶. In light of the worsening cost of living crisis, Scope also expects further government support measures over the coming year, resulting in a continued headline budget deficit.

Secondly, the UK has a relatively weak external position, with persistent current account deficits for several decades. The deficit averaged 3.4% over 2017-19, significantly larger than the peer country average. It receded somewhat during the pandemic, to 2.6% in 2021, on the back of lower nominal energy imports and strong services and pharmaceutical exports. Scope expects the current account deficit to widen significantly in the medium term, primarily due to the spike in global energy prices, which will weigh on the trade balance, before gradually converging to its pre-crisis level. In the longer term, the UK’s departure from the EU will have an ambiguous effect on the current account deficit as it will reduce both import and export intensity. Since the Brexit vote in 2016, the UK has run a continued deficit in goods trade while the services balance has remained in surplus above 5%. The full impact will only become evident once the UK-EU agreement is fully implemented, pandemic-related trade disruptions dissipate and businesses have adjusted to the new norm.

Finally, the UK continues to face prolonged uncertainties surrounding the implementation of the post-Brexit UK-EU trade agreement. The OBR⁷ has estimated a reduction in long-run productivity of 4% from Brexit due to the increase in non-tariff barriers on EU-UK trade. This is expected to result in both exports and imports being 15% lower in the long run as new trade deals with non-EU countries are not expected to materially offset the expected decline in trade with European partners. Exports have not recovered since the onset of the pandemic and remain around 20% below 2019 levels.

Results from regional elections in Scotland in 2021 and Northern Ireland in May 2022 have added to political divisions and continue to fuel debates around votes for independence within the UK. The pro-independence Scottish National Party remained the biggest force in the Scottish parliament in the 2021 elections. While calls for a new independence referendum will continue, such a vote would have to be authorised by the UK government, which considers the question of independence to have been settled by the previous vote in 2014. The election results in Northern Ireland in 2022, in which the nationalist Sinn Féin party won most of the seats, have reignited disputes on the implementation of the UK-EU trade agreement, which currently results in a customs border within the UK through the Irish sea. Scope expects negotiations between the UK and EU to remain tense, but to ultimately result in compromises to help implement the previously agreed Northern Ireland Protocol.

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 an indicative rating of ‘aa+’ for the United Kingdom, including an adjustment for reserve currency under Scope’s methodology. As such, under Scope’s methodology, a ‘aa+’ indicative rating can be adjusted by the Qualitative Scorecard (QS) by up to three notches depending on the size of relative qualitative credit strengths or weaknesses compared to a peer group of countries.

For the United Kingdom, the following relative credit strengths via the QS have been identified: i) monetary policy framework; and ii) banking sector oversight. Conversely, the following relative credit weaknesses have been identified: i) fiscal policy framework; ii) current account resilience; iii) external debt structure; and iv) social risks.

The combined relative credit strengths and weaknesses identified in the QS result in a one-notch negative adjustment for the United Kingdom. This 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 its rating 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 methodology’s qualitative overlay (QS).

With respect to environmental risks, the United Kingdom receives a high CVS score for having low carbon emissions per GDP. Compared with peers, the United Kingdom achieves average scores for natural disaster risk and below-average scores regarding the ecological footprint of consumption compared with available biocapacity. Scope assesses the United Kingdom’s QS adjustment for environmental risks as ‘neutral’. While the government has adopted ambitious climate goals in line with peer countries to achieve carbon neutrality by 2050, increased efforts will be needed to achieve these goals, including the renewal of the UK housing stock and increased electrification of the railway network.

Regarding social risks, the United Kingdom scores slightly above average in the CVS for its still relatively high labour force participation and low old-age dependency ratio compared with peer countries. However, it has the second lowest score among peers for the high level of income inequality. Scope expects the worsening cost of living crisis to aggravate income inequality levels due to a drop in real incomes, thereby raising the risk of social exclusion and increasing the need for government support to households.

The United Kingdom benefits from the high quality of its institutions under its parliamentary democracy, which has helped to steer the country through volatile domestic political changes following the vote to leave the EU in 2016. While the country continues to rank highly on the World Bank’s Worldwide Governance Indicators⁸, four of the six scores have weakened since the EU referendum. In particular, scores for voice and accountability, governance effectiveness, regulatory quality and the rule of law are either at or near all-time lows since the rankings began in 1996. The exit from the EU has particularly increased uncertainty around future regulatory policies. Political gains by the nationalist Sinn Féin party in the Northern Ireland elections in 2022 and by the pro-independence Scottish National Party in 2021 continue to fuel debates on independence referendums over the medium term.

Rating Committee

The main points discussed by the rating committee were: i) domestic economic risk, including growth potential and resilience; ii) public finance risks, including fiscal framework and debt dynamics; iii) external risks; iv) financial stability risks, including housing market and household debt; v) ESG considerations; and vi) peer developments.

Rating driver references
1. Bank of England, Monetary Policy Report, May 2022
2. UK Debt Management Office, Quarterly Review October – December 2021
3. House of Commons Library, The UK’s fiscal targets, 25 February 2022
4. Office for Budget Responsibility, Economic and fiscal outlook, March 2022
5. Office for Budget Responsibility, Fiscal risks report, Fiscal policy over the past 10 years and potential risks, July 2019
6. IMF Fiscal Monitor April 2022
7. Office for Budget Responsibility, Brexit analysis, February 2022
8. World Bank, Worldwide Governance Indicators

Methodology
The methodology used for these Credit Ratings and/or Outlooks, (Rating Methodology: Sovereign Ratings, 8 October 2021), is available on https://scoperatings.com/governance-and-policies/rating-governance/methodologies.
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-governance/definitions-and-scales. Historical default rates of the entities rated by Scope Ratings can be viewed in the Credit Rating performance report at https://scoperatings.com/governance-and-policies/regulatory/eu-regulation. 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-governance/definitions-and-scales. 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://scoperatings.com/governance-and-policies/rating-governance/methodologies.
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                                        YES
The following substantially material sources of information were used to prepare the Credit Ratings: the rated entity, public domain.
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 is/are UK-endorsed.
Lead analyst: Eiko Sievert, 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 18 August 2017. The Credit Ratings/Outlooks were last updated on 25 June 2021.

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
© 2022 Scope SE & Co. KGaA and all its subsidiaries including Scope Ratings GmbH, Scope Ratings UK Limited, Scope Analysis GmbH, Scope Investor Services GmbH, and Scope ESG Analysis 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.