For the updated report accompanying this review, click here.

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) strong institutions including robust financial supervisory, economic and monetary governance frameworks; ii) large, wealthy and diversified economy, which has proved resilient during the Covid-19 pandemic; and iii) robust debt profile with long average maturities and strong market access.

Rating challenges include: i) the country’s weakening fiscal and economic outlooks; 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.

Following the significant political turmoil in recent months, the UK’s institutional strengths have been instrumental in ensuring a smooth transition of power and to ease tensions in financial markets. The new government’s commitment to budgetary discipline, the appropriate policy response of the Bank of England and a more orthodox approach to economic policymaking has helped to reverse the rapid and unfunded fiscal expansion of the ‘mini-budget’ announced by the previous government in September.

The new government’s Autumn Statement introduced a mixture of direct and indirect tax increases and sharp reductions in public spending, returning the UK on a path to fiscal discipline. While spending cuts have been largely backloaded to after 2025, tax increases will start to take effect more immediately. Following the unsustainable mini-budget, the latest plans demonstrate a long-term strategy to balance the public finances. Given the unusually challenging economic backdrop, the government has announced amendments to the fiscal framework which could weaken future fiscal discipline. This underlines the importance of a period of political stability to ensure that the government can credibly implement on its policy plans.

Overall, the UK’s economic outlook is set to worsen as high inflation, weaker external demand, and tighter financial conditions weigh adversely on economic activity. After robust growth in 2022 of around 4.4%, we expect the UK’s economy to contract by 0.6% in 2023 and only rebound gradually towards its medium-term growth potential of around 1.5%.

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 if, individually or collectively: i) a significant, further weakening in economic and fiscal outlooks led to a rising trajectory of public debt and weakened debt sustainability in the medium term beyond the Autumn Statement’s projections; ii) Brexit resulted in more severe than anticipated weakening of UK-EU trade, attrition of the UK’s services sector and/or if risks to the country’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 UK’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 robust institutions and renewed commitment to fiscal discipline. This was demonstrated by a series of fiscal U-turns on the previous government’s fiscally expansive mini-budget and the appointment of a new prime minister, Rishi Sunak.

The large fiscal loosening put forward by the previous Truss government in September has been replaced by a significant fiscal tightening announced in the Autumn Statement with a mixture of direct and indirect tax increases and sharp reductions in public spending amounting to about GBP 55bn (approximately 2.5% of GDP) needed for the government to meet its budgetary targets. The fiscal tightening announced is backloaded with a significant part of the spending cuts taking effect only from 2025. According to forecasts published by the Office for Budget Responsibility (OBR), debt-to-GDP is expected to increase in the medium term, peaking at 97.6% in 2025-26 and subsequently declining to 97.3% in 2027-28, leaving much of the future debt consolidation to the next government given the next general election is likely to take place in 2024. However, increases in taxation are being implemented earlier as the tax burden is expected to peak at 37.5% of GDP in 2024-25.

The announced significant fiscal tightening has eased tensions in the bond markets, returning 10-year gilt yields to similar levels as before the sharp market reaction. Scope expects a period of relative political stability which will be crucial to solidify the country’s fiscal credibility and to provide a more stable environment to support business investment.

The fiscal framework has been amended with the introduction of two new less restrictive fiscal rules to be met under the OBR's projections: i) net debt as a share of GDP is set to fall by the fifth year of the rolling five-year forecast horizon rather than the previously targeted third year; and ii) public sector net borrowing is targeted at less than 3% of GDP over the same period. Since the targets within the fiscal framework are rolling targets, it offers a high degree of flexibility to adjust plans in future years. This makes it relatively easy for any ruling government to loosen fiscal policy to support the economy in the future if needed.

Further institutional support comes from the UK’s financial supervisory, economic, and monetary governance frameworks. As part of this, the independent Bank of England reacted promptly to the September bond market volatility concerning pension funds following liability-driven investment strategies and previously to the Covid-19 crisis. The new government has reiterated its commitment to the central bank’s independence. In an effort to support growth, provisions under the Financial Services and Markets Bill would introduce secondary competitiveness and growth objectives for the Prudential Regulation Authority and the Financial Conduct Authority.

The AA ratings are also underpinned by the UK’s large, wealthy and diversified economy which has proved broadly resilient to the Covid-19 shock, with output edging close to pre-pandemic level by late 2021. While the economic outlook has weakened materially in recent months, comparatively high wealth levels and a very diversified economic base remain significant resilience factors. A resilient and flexible labour market, a well-capitalised banking sector and sterling’s role as a reserve currency also contribute to the country’s ability to withstand economic shocks.

However, rising inflationary pressures and interest rates will strain finances and increase households’ vulnerability to future shocks. Average mortgage rates on five-year fixed contracts with a loan-to-value ratio of 75% have increased more than fourfold from 1.3% in October 2021 to 5.6% in October 2022. Since around 85% of mortgage balances are on fixed rates, the sharp rise in interest rates will only gradually impact average mortgage costs. Small and medium-sized businesses will be impacted significantly faster as most of their loans tend to be on variable rates. There remains a considerable degree of uncertainty about the expected price correction in the housing market which will depend on how much further the Bank of England raises policy rates.

The labour market remains tight, with a high employment rate of 75.5% as of Q3 2022 and an unemployment rate near all-time lows of 3.6% amid a low participation level due to rising long-term sickness. Labour shortages still constitute a significant challenge as 83% of firms reported hiring difficulties in October, although there has been a slight decline in the total number of unfilled vacancies in recent months, signalling some easing in labour demand. The tightness in the labour market has supported robust nominal wage growth (up to +6% YoY in September), though it has so far remained below CPI inflation, causing a drop in real incomes. Wage growth developments will be an important factor for the Bank of England in future policy rate decisions.

Finally, the UK’s AA ratings reflect strong market access, with an exceptionally long average debt maturity (14.8 years as of June 2022) compared to its peers. The Bank of England is the largest holder of gilt and treasury bills (around a third of total), though quantitative tightening is expected to reduce this share over the coming years.

Similarly to peers, funding costs have been increasing steadily since H2 2021 in a context of rising inflation and tightening monetary policy. Approximately 30% of the government’s total outstanding debt will have to be re-financed over the next five years. As illustrated by the September market turmoil, investor confidence in the UK’s fiscal sustainability will remain key to support continued debt issuance as part of the fiscal consolidation plans. After experiencing a sharp jump in September, yields have moderated in recent weeks on expectations of a reversal of fiscal policy.

Despite these credit strengths, the UK faces several challenges.

Firstly, the country faces a high level of public debt and a worsening fiscal and economic outlook. The UK’s debt-to-GDP ratio peaked at 103% of GDP during the pandemic in 2020 and is set to return to similar levels over the coming years. While this was well above AAA-rated economies such as Germany (71%) and the Netherlands (55%), it remained below AA-rated peers such as France (115%) and Belgium (113%). The relaxation of the fiscal framework could reduce fiscal discipline in future. Current budget proposals would have missed the original targets and the extended five-year horizon provides only a narrow margin of around GBP 9bn in 2027-28 according to the OBR. Since the targets within the fiscal framework are rolling targets, it offers a high degree of flexibility to adjust plans in future years. This aligns the UK’s framework more closely to France (AA/Stable) than those of higher, AAA-rated countries in Europe. These tend to have more binding targets such as Germany’s constitutionally anchored debt brake or Sweden’s debt anchor which keeps debt levels close to 35% of GDP.

The sharp increase in interest rates is leading to weaker debt sustainability. After declining to 95.3% in 2021, Scope expects the UK’s debt-to-GDP ratio to rise above 100% of GDP by 2025. In addition to facing an increase in government bond yields since the escalation of the Russia-Ukraine war, the country has also been a big issuer of inflation-linked bonds in recent years. These make up around 25% of outstanding government debt, higher than other major European economies such as Germany (4%) and France (11%). The OBR estimates that the combination of higher interest rates and inflation will push up debt interest spending as a percent of revenues to its highest level since the 1950s, at 12% in 2022-23 (or 4.8% of GDP). OBR data indicates that this would make spending on debt interest the second highest budget expenditure item after the National Health Service. With inflation expected to fall back in 2023, debt interest spending as a share of GDP is expected to decrease somewhat to levels seen during the 1980s and 1990s.

Besides the weaker fiscal outlook, the economic outlook has also deteriorated significantly over the past months. The rise in inflation is eroding households’ disposable income which is expected to decline by more than 7% between 2022 and 2024 according to the OBR. This would mark the steepest drop in disposable income since at least the 1950s. While tax rises announced in the Autumn Statement are largely progressive, they are expected to raise the overall tax burden which is expected to peak at 37.5% of GDP in 2024-25, its highest level since the end of World War II. Lower household purchasing power is the main driver for lower economic growth over the next year. After robust growth in 2022 of around 4.4%, we expect the UK’s economy to contract by 0.6% in 2023 and only rebound gradually towards its medium term growth potential of around 1.5%.

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 fell somewhat during the pandemic to 2.5% and 2.6% of GDP in 2020 and 2021 respectively on the back of robust services exports. However, the deficit widened during the first half of 2022 due to a record high deficit in the trade of goods balance as a result of rising nominal imports in light of very high global energy and raw material prices. Scope expects the external balance to remain near pre-pandemic levels, in line with IMF forecasts, which estimate the current account deficit to average 4.0% of GDP over 2022-27.

Finally, the UK continues to face prolonged uncertainties surrounding the implementation of the post-Brexit UK-EU trade agreement. The OBR notes that Brexit had a clear adverse impact on UK trade by reducing trade volumes as well as lowering the number of trade relationships with EU firms. This is expected to result in the trade intensity being 15% lower in the long run than if the UK had remained in the EU as new trade deals with non-EU countries are not expected to materially offset the expected decline in trade with European partners.

The aftermath of the Brexit vote continues to cause political divisions. There has been no functioning government in Northern Ireland following the election in May 2022 as the Democratic Unionist Party refuses to restore power-sharing if the Northern Ireland protocol is not resolved. At the same time, the pro-independence Scottish National Party, which remained the biggest force in Scotland following the 2021 election, will continue to call for a referendum. However, a vote is highly unlikely in the near future as it 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. 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, an ‘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) current account resilience; ii) external debt structure; and iii) social risks.

The combined relative credit strengths and weaknesses identified in the QS result in no 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 ratings process via the sovereign methodology’s standalone ESG sovereign risk pillar, with a 25% weighting under the quantitative model (CVS) and in the qualitative overlay (QS).

The UK receives a strong CVS score with regards to environmental risks, primarily reflecting lower levels of greenhouse gas (GHG) emissions per unit of GDP as well as per capita relative to rating peers. Furthermore, the country receives average marks regarding the ecological footprint of consumption compared with available biocapacity. Finally, similarly to peers, the country achieves a high score for its resilience to natural disaster risks. Scope assesses the UK’s QS adjustment for environmental risks as ‘neutral’. Similar to other highly-rated sovereigns, the government has adopted ambitious climate goals – aiming to cover nearly all of its electricity consumption from zero-carbon sources by 2035 as well as to reach carbon neutrality by 2050. While significant progress was made from 2010-2020 as the share of primary energy generated from low carbon sources more than doubled from 10.1% to 21.5%, increased efforts will be needed to achieve the ambitious targets. Some recent policy announcements should help, including a package of measures included in the November Autumn Statement aimed at levelling up energy efficiency in the country. At the same time, the UK trails European peers on some key policy areas, including its carbon emissions taxation system, which ranks 14th in Europe according to the Tax Foundation, regarding the level of its tax rate as well as the share of GHG emissions it covers.

Regarding social risks, the UK receives average scores in the CVS, with high labour force participation and average levels of income equality balancing a low score on old-age dependency – though the latter remains favourable relative to rating peers. Scope expects the worsening economic outlook, with falling real wages and rising mortgage rates, to aggravate the current cost of living crisis, in turn raising risks of social exclusion and increasing the need for government support for households.

Under governance-related factors captured in the CVS, the UK enjoys good average scores on six World Bank Worldwide Governance Indicators (WGIs), in line with main sovereign peers. The UK benefits from the high quality of its institutions under its parliamentary democracy, which has helped to steer the country through volatile domestic political changes since the vote to leave the EU in 2016. At the same time, four of the six WGI scores have weakened since the EU referendum; 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; ii) public finance risks, including fiscal framework and debt dynamics; iii) external risks; iv) financial stability risks, including housing market and private sector debt; v) ESG considerations; and vi) peer developments.

Methodology
The methodology used for these Credit Ratings and/or Outlooks, (Sovereign Rating Methodology, 27 September 2022), 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: public domain, the rated entiry.
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 Outlooks and the principal grounds on which the Credit Ratings and 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: Eiko Sievert, Director
Person responsible for approval of the Credit Ratings: Dr. Giacomo Barisone, Managing Director
The ratings/outlook were first assigned by Scope in January 2003. The Credit Ratings/Outlooks were last updated on 3 June 2022.

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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