How real is the threat of a UK sovereign debt downgrade?

Every FTSE finance director fears an equity analyst’s downgrade. The share price falls and borrowing costs rise as investors take fright. Now, for the first time in modern history, it is the turn of the Chancellor to fear an economic downgrade.

Pimco, the world’s largest bond trader, has stated that it believes the UK is living with the 80% chance it will lose its cherished AAA credit rating unless the government takes tougher action to tackle its ballooning fiscal deficit.

The warning doesn’t come as a surprise. Last May, Standard & Poor’s (S & P), one of the agencies on which investors rely, put its AAA rating for the UK on negative watch, while in December the ratings agency Moody’s described the UK’s position as merely “resilient” rather than “resistant”. Fitch, another ratings agency, said the UK was the AAA-rated country most at risk of losing its title.

The consequence of this would be devastating to the government’s ability to borrow money on the financial markets. As Steven Major, a strategist at HSBC says, ratings matter to debt investors because when the perceived risk of default increases, the cost of refinancing goes up.

This is already happening. Analysis from HSBC shows that spreads on credit default swaps on UK debt, those now-infamous insurance policies against default, imply the market is giving the UK a rating of AA-. This is three notches below its current level.

Jan Randolph, director of sovereign risk analysis at IHS Global Insight, says debt ratios in the UK have worsened more than all other western countries except the US. It thinks they will roughly double to as much as 90% of GDP. “Tax revenues have been heavily dependent on property and financial sector activity – the two sectors worst hit by the credit crunch and recession,” he says.

A downgrade would create a vicious circle as higher debt payments make it harder for the government to cut the deficit, raising the risk of further downgrades. In addition, says Stephen Lewis, chief economist at Monument Securities, a downgrade could inflict collateral damage on London’s status as a financial centre.

This is not an abstract idea. In January, Greece’s failure to tackle its budget deficit triggered a cut in its sovereign rating. Both Fitch and S&P cut Greece’s debt to BBB+, below the minimum quality of collateral countries can offer when going to the European Central Bank’s (ECB) lending window.

Ben May, European economist at Capital Economics, doubts the ECB will “pull the rug” from under Greece’s feet, but adds that the downgrade “underlines the need for Greece to implement tough new fiscal plans, to prove it is committed to returning the public finances to a sustainable position.”

That downgrade hit other members of the group of EU countries known as the PIGS – Portugal, Italy, Greece and Spain. Spain’s AA+ rating has been put on downgrade watch as has that of Portugal, which carries an 8% budget deficit as a share of GDP.

Frozen out
The test case, though, is Iceland – outside the safety of the eurozone and the European Union – where the financial crisis has pushed the country to the verge of bankruptcy and into the arms of the International Monetary Fund (IMF). The IMF bailed it out with a $2.1bn loan, but it remains unclear what, if anything, might restore its reputation as a bastion of financial strength and security.

However, the belief remains that Britain is still a robust economy and that its membership of the G7 puts it on a different level to the economies of, say, Iceland or Greece. But the numbers don’t reflect the sentiment. Greece’s public sector deficit is 12.7% of GDP, while the UK’s £178bn is not far off that at just over 12% of GDP.

But there are other reasons why the UK may escape a downgrade. Its economy is more diversified than property-dependent Spain or tourist-orientated Greece, for example. “The risk of government default is lower in the UK than in the fiscally hard-pressed eurozone area,” says Monument Securities’ Lewis.

In addition, the Bank of England can print more money. This is in contrast to the national central banks of the eurozone that are not able to print euros. “The UK has an escape route that is not open to its eurozone counterparts,” Lewis notes.

There are signs the warnings have hit home. Following January’s failed challenge to Gordon Brown’s leadership, Alistair Darling moved quickly to say he would impose the toughest spending cuts for 20 years. Labour pledges to cut the deficit in half by March 2014 – a target Darling calls “non-negotiable”.

The UK also has a strong long-term record. Although the scale of the deficit has a huge influence on a rating agency’s assessment of the chance of default, it is not the only one. Historic records of default and reducing deficits, the independence of the central bank and its credibility in controlling inflation all play a role. On all counts, the UK is head and shoulders above Greece and Spain. However, they also said the banks were too big to fail.