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

We examine sovereign debt risk and consider the factors that have brought other European countries to their knees of late

Concerns over its budget deficit led to Greece being downgraded

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

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.

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