The AAA threat to UK credit rating

Vanessa Rossi

For the last year, pundits everywhere have enjoyed putting the UK economy and pound at the bottom of the economic heap - indeed the UK itself, far from fighting this, seems to have quite happily taken on the role of punch bag. Whatever international organisation you looked at, forecasters were keen to point to the UK being the worst impacted by the crisis amongst the major economies. The table below illustrates the IMF’s track record but the forecasts from the OECD and Brussels were very similar. Admittedly the forecasts were generally very poor (one could argue that the UK projection was simply less wrong than others) but few, if any, objections were raised to the relative rankings - in spite of the fact that it was unlikely that the UK would be the hardest hit economy. No doubt the UK taking this role suited those countries which did not want to accept that their economies had even more severe problems, although statistics suggested otherwise before as well as after the outbreak of financial mayhem last September.

Epitomising the saga of "UK bashing" has been the position of the pound: as it slid to near parity with the euro at the start of 2009, headlines enthusiastically quoted "experts" who were suggesting that it would fall even further - and they notably fell silent when the pound actually picked up again.


Downgrades in IMF growth estimates: UK moves from worst hit to middle-of-the-road
 
IMF Oct 08
IMF Jan 09
IMF Apr 09
Own estimates
US
0.1
-1.6
-2.8
-3 to -4
Euro area
0.2
-2.0
-4.2
-4 to -6
Germany
--
-2.5
-5.6
-6 to -7
UK 
-0.1
-2.8
-4.0
-3.5 to -4.5
Japan
0.5
-2.6
-6.2
-7 to -8
China
9.3
6.7
6.5
6 to 7
Middle East
5.9
3.9
2.5
0 to 1
Latin America
3.2
1.1
-1.5
-2 to -4.5
Sources: IMF, own estimates of alternative risk scenario

By now, with dire results coming not only from Japan but also Germany and other parts of Europe, forecasts have had to change and the UK is no longer at the bottom of the league tables. But this is only being whispered, with talk of the UK perhaps being "first out" of recession masking forecasters’ previous errors. And far from such revision leading to a relatively positive view of UK prospects, the doom-mongers are instead turning their attention to the rise in the UK's budget deficit and debt - and hence the risk to the UK's AAA status in financial markets. True the "small print" suggests looming questions over other countries as well - the UK may not "win" the race to reach a debt/GDP ratio of 100% - but it is nevertheless the UK that has been first in the ratings hot spot. Why?

Chatham House

The UK's complacency about persistently incorrect relative assessments has been foolish - such perceptions need to be challenged as they will persist and have damaging consequences. The threat to the AAA credit rating means that the UK has been served a rude awakening over the risks posed by wallowing in its economic problems and not fighting back regarding its relative strengths. While other countries have carefully have protected their image - often with little justification in the economic data or even in terms of financial sector strength and stability - UK PLC has seemed bent on shooting itself down. But the costs of this, if they do get built into a loss in the UK’s credit rating, will be significant.

It is true - and honest - that we can be under no illusions about the depth of this recession and the serious issues facing the financial sector and public sector finances as well. The UK economy has been hit hard and will remain under significant pressure. But it is far from alone - and probably far from the worst - in this regard. Relatively, the UK’s economic losses may turn out middle-of-the-road. And the debt position may be similar.

The UK went into this disastrous recession, with lower levels of government debt (about 50% of GDP) than most other major economies - less than the US (over 60%) and key EU partners such as Germany and France (in the 65-70% of GDP range) and of course much less than Japan (which has a debt to GDP ratio of around 170% gross and 100% net). Arguably, the UK government could have reduced its annual budget deficit in the years just before the crisis, rather than going into recession with an already deficit already close to 3% of GDP (2007), but total government debt was quite modest at the time. This year, the UK, like the US, is expected to see a public sector deficit of 10-15% of GDP, sharply bumping up debt. But other countries are also posting larger deficits, with the EU average possibly around 5%, which means the UK's debt/GDP ratio will remain lower than its peers in 2009. As long as this year’s deficit is an exceptional, recession-induced dip, then there is no reason to expect the UK’s debt position to be worse than others over the longer run.

There are two issues to address here: the general risk from rising OECD government debt and the specific question of the UK’s relative position and ability to control debt over the coming years.

Firstly, given the unusual nature of this recession, some leeway must be granted for all countries to adapt and recover before credit ratings can be reassessed in a meaningful way. At this point in the recession/recovery process, longer term debt risks are not at all clear. In particular, most countries expect to see substantial improvements in both economic performance and government finances over the next two years, and the UK is no exception. While there is rightly general unease about the present deterioration in conditions, there can be little confidence in early attempts to differentiate these new risks across countries – indeed, the very poor quality of economic forecasts, in both absolute and relative terms, over the last year provides ample evidence of how dramatically unreliable current assessments may be. This is no time to implement substantial changes in ratings, certainly based on erratic forecasts and the dubious distinctions being drawn across the major economies.

Secondly, in favour of the UK, there are good reasons to expect big improvements in public sector finances by 2010-2011. Previous experience of recessions such as the early 1990s, points to the probability that the UK has particularly strong cyclical impacts on tax revenues (compared with its peers) and thus its budget deficit may also see larger short-term swings (possibly from large deficit in recession to near surplus in recovery). From a peak of around 8% of GDP in early 1993, it took until 1996 for the budget deficit to fall below 5% but by the end of 1998 there was a small surplus. This recession will have an even more exaggerated impact on debt, partly because of its depth (1990-92 was relatively shallow), but also due to the cost of bank bails outs, some of which could be recouped at a later date. In addition, the government should be in a better position to tackle budget management after the next general election, which has to be held within the coming year. While it would be foolish to argue that the UK economy and finances are in a strong position today in absolute terms, given the global nature of this unprecedented recession and prospective slow recovery, it is more reasonable to judge the UK in relative terms - and on this basis the UK's outlook both for GDP growth and public finances is almost certainly not as bad as many seem to think and better than many of its competitors.

As we began by remarking, this matters: the UK needs to pay more attention to its relative ranking in the league table of major economies. Although credit rating agencies have seen their reputations tarnished by the rating follies of recent years, justifying scepticism about their analysis and ratings, the AAA status (especially the relative status) still makes a difference to the financial sector and to the rest of the broad economy. It can impact on the cost of capital for companies, on pubic sector debt costs and even on household mortgages, as well as affecting the potential to transact profitable financial business and grow the financial sector. Financiers fight over every basis point of interest rates for good reason.

So, the AAA rating must be worth fighting for. The UK should start by presenting itself better and instilling more sense into estimates of its economic and financial position relative to the rest of the world. Others will be only too happy to gain an advantage if the current, unbalanced, view is not addressed.

Vanessa Rossi is a Senior Research Fellow in International Economics at The Royal Institute of International Affairs, Chatham House

For more information, please visit:
t: +44 (0)20 7957 5700
f: +44 (0)20 7957 5710
w: www.chathamhouse.org.uk