S&P: United Kingdom Affirmed At ‘AAA/A-1+’; Outlook Stable

OVERVIEW

  • The United Kingdom has high monetary, labor, and product-market flexibility, and a wealthy and diversified economy.
  • Output and employment growth have exceeded our previous projections, but the U.K.’s fiscal position has underperformed our expectations and has yet to reflect a strengthening economy.
  • We are affirming our ‘AAA/A-1+’ long- and short-term sovereign credit ratings on the U.K.
  • The stable outlook reflects our assumptions that the U.K. fiscal position will gradually strengthen as real-wage and productivity growth improve toward pre-crisis averages, and that the government that emerges from the May 2015 general election will remain committed to fiscal consolidation.
    Our outlook also assumes the U.K.’s ongoing EU membership.

RATING ACTION

On Dec. 12, 2014, Standard & Poor’s Ratings Services affirmed its ‘AAA/A-1+’ long- and short-term unsolicited sovereign credit ratings on the United Kingdom. The outlook is stable.

We also affirmed the ‘AAA/A-1+’ long- and short-term issuer credit ratings of the Bank of England (BoE) and the ‘AAA/A-1+’ ratings on the debt program of Network Rail Infrastructure Finance PLC.

RATIONALE

The affirmation reflects our opinion that the U.K. continues to exhibit high labor- and product-market flexibility, and a wealthy and diversified economy.

We view the U.K.’s monetary flexibility as a key credit strength. It enables wages and prices to adjust rapidly, relative to trading partners. This boosts the economy’s resilience and competitiveness without generating deflationary pressures. The U.K.’s monetary authorities have drawn on the flexibility afforded by a reserve currency and this has benefited public debt sustainability, in our view.

We expect the U.K. economy to expand by more than 3.0% this year and 2.7% in 2015, as domestic demand benefits from further job creation and private-sector wage growth gradually returns. Our base case is that labor productivity growth (after adjusting for the long-term decline in North Sea output) will gradually recover as the business cycle gains traction and investment expands. Nevertheless, low interest rates and de-risking in the financial services sector (the output of which is indirectly measured via interest margins) will preclude financial-sector productivity fully returning to pre-crisis levels over the 2014-2017 forecast horizon, in our view. U.K. financial and insurance services make up roughly 9% of 2013 GDP.

Financial sector conditions also affect the U.K.’s balance of payments. The most important contributor to the deterioration in the U.K.’s current account balance–to 4.2% of GDP (2013 outcome) currently from 2.0% pre-crisis (1998-2007 average)–is the shift in the incomes component of the current account deficit. It has gone from a pre-crisis surplus (1.2% of GDP in 1998-2007) to a deficit of 0.8% of GDP in 2013.

Recent revisions to the U.K.’s national accounts indicate that the 2008-2009recession was less severe than previously thought. As a consequence, annualaverage 2008-2012 GDP growth was revised 0.5 percentage points higher,reflecting primarily upward revisions to investment. At end-September 2014, national accounts revisions also led to an upward adjustment in nominal GDP by just over 6% for 2013. This revision has led us to lower our estimate of 2014 net general government debt by 2.8 percentage points to 82% of GDP, from 85%. In accordance with ESA2010 treatment, we have included just under 2% of GDP of Network Rail debt in our estimate of general government debt. Historically, we have always classified the Treasury’s Lloyds and Royal Bank of Scotland share purchases as illiquid assets (until these are sold); hence, the introduction of ESA2010 did not affect our estimates of the Treasury’s liquid general government assets.

Weak performance of tax receipts slowed the pace of deficit reduction during the 2014 calendar year. This reflected limited real wage growth as well as tax changes that have made the personal income tax regime more progressive. Taxes on labor, mainly income tax and national insurance contributions, make up 45% of the U.K.’s tax receipts. At the same time, interest expenditure has declined to well below past budgetary assumptions (as forecast by the U.K. Office for Budget Responsibility [OBR]) as the cost of servicing indexed and non-indexed debt has benefited from low inflation and low market yields, respectively. Overall, we note that the cyclically-adjusted primary budgetary position for the current fiscal year ending March 2015 has deteriorated (by 0.3 percentage points or 13%) compared to the year ending March 30, 2014. This mirrors the OBR’s own estimates.

We believe the general government deficit will decline more slowly than the official projections, to 5.4% of GDP in calendar-year 2014 (compared to 5.8% in 2013) and toward 3.0% by 2017 compared to the government’s projection of close to 1% for the calendar year ending 2017 (for the fiscal year ending March 2018, the Treasury is targeting net public sector borrowing of 0.7% of GDP). Our projection largely reflects our view that receipts from the oil and financial services sectors will not recover to pre-crisis levels; it also reflects our expectation that recovery in real wage growth will be more protracted and potentially more concentrated compared to previous upturns. This, in our opinion, may depress tax receipts on labor, reflecting the government’s steps to further reduce the tax wedge on lower wage earners.

The government’s fiscal plans are in place through to the financial year ending March 30, 2016. In the aftermath of the May 7, 2015 elections, we expect a cross-party commitment to gradual budgetary tightening as the U.K. economy continues to expand. We expect that future consolidation may eventually look more to the revenue than the expenditure side. We also believe there is latitude, for example, to widen the base on indirect taxes as well as income taxes.

While financial services sector earnings (contributing about one-eighth of all U.K. tax receipts) have been challenged by low interest rates and several years of deleveraging and one-off fines, the U.K. still has the largest international share of cross-border financial flows. This partly reflects its role as the reporting hub for large, global banks. We expect the financial services sector will remain an important contributor to the U.K.’s economic growth and fiscal receipts by adapting to competitive and regulatory pressures, as it has done since the onset of the global financial crisis.

We view EU membership as key to longer term fiscal and growth outcomes in the U.K., given that the EU has traditionally been the destination for more than 45% of the U.K.’s net exports of financial services. We believe that, if the U.K. were to leave the EU, the U.K.’s economic prospects would weaken.

We also believe that the U.K. leaving the EU would undermine the considerable trade links between the U.K. and the EU and, more importantly, that the U.K. would likely lose a portion of its inbound direct investment. Many non-EU investors have located in the U.K. in part because of the benefits accruing from the U.K.’s EU membership. In our view, exiting the EU would have a disproportionate impact on the U.K.’s business and financial services sector. We also note that an EU exit could revive the drive for Scottish independence. This would likely heighten constitutional uncertainty and risks to the financial sector. It is our understanding that the Scottish population is more favorably inclined toward the EU than is the rest of the U.K.

OUTLOOK

The stable outlook reflects our opinion that there is a less than one-in-three probability of a downgrade over the next two years. It also reflects our view that the risks to a sustainable economic recovery have diminished, and that the financial sector is in a stronger position than it has been for several years, reflecting higher levels of capital and considerable balance sheet repair since 2009. The outlook also assumes the U.K.’s continued EU membership.

The ratings could come under pressure if we believed that the governance and institutional environment and the predictability and coherence of economic policy had weakened, for example as a reaction to polarizing political conflict over the U.K.’s role in Europe. The ratings could also come under pressure if net general government debt reached 100% of GDP (compared to our current expectation that it will peak at 83% in 2016).

source: standard & poor’s

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