Q&A: Should we worry about the UK losing its AAA credit rating?

 
Jake Cordell
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The Bank of England is expected to cut rates this summer following the UK's vote to leave the European Union
The Bank of England is expected to cut rates this summer following the UK's vote to leave the European Union (Source: Getty)

The UK suffered the embarrassment of a downgrade to its credit rating from not just one, but two of the leading agencies yesterday.

Standard and Poor's (S&P) stripped the UK government of its gold standard triple-A rating, while Fitch also knocked a notch from its rating. Treasury debt is now graded as double-A, the third rung of the ladder, but still one of the safest ratings dished out.

Why has the UK been downgraded?

Credit ratings are a signal to investors about how safe a certain kind of debt is. A higher credit rating implies a lower risk that the borrower of that debt will be unable to pay it back.

The ratings agencies believe the outcome of the EU referendum will place considerable pressure on the UK economy and could lead to a political crisis. In such circumstances, they do not believe the UK deserves to have its top rating, which implies de facto risk-free lending.

S&P said: "In our opinion, this outcome is a seminal event, and will lead to a less predictable, stable and effective policy framework in the UK.

Fitch added: "The UK vote to leave the EU ... will have a negative impact on the UK economy, public finances and political continuity."

Both maintained their "negative outlook", meaning further cuts could be on the way if the agencies believe the ability of the UK to pay its debts deteriorates further.

Is UK government debt still safe?

The downgrade should be put in context. There are more than 20 grades of rating the agencies can apply to debt. The UK now has the third highest. S&P says the difference between AAA and AA ratings "differ ... only to a small degree," adding: "The obligor's capacity to meet its financial commitment ... is very strong."

AA rated debt is still ranked "investment grade" and seen by investors as some of the safest in the world.

Despite the fact a lower rating implies a higher risk of default, Neil Williams, chief economist at Hermes Investment said: "With the UK's government debt being local-currency denominated and the Bank of England waiting in the wings, default risk in reality looks next to zero."

Will borrowing get more expensive?

Not at the moment. In isolation, a lower credit score implies investors should demand a higher rate of return since they are taking on more risk. But, there are so many other forces pulling on the economy that UK government debt is the cheapest it has ever been.

The yield on a 10-year bond is currently 0.97 per cent, down from 1.43 per cent just one month ago.

There are two reasons, even as the UK's credit rating has been downgraded, debt is still cheap: the risk of a recession and the path of monetary policy.

Thursday's vote led to a number of forecasters slashing their outlook for UK growth. Some are predicting a recession, others do not believe the economy will grow any more than one per cent next year. With growth so low, and the stock market expected to be very bumpy, UK investors are fleeing riskier assets like equities and finding ways to keep their cash safe.

Markets are also fully pricing in the Bank of England to cut interest rates before the end of the year. Lower central bank rates mean lower government borrowing costs.

Should we worry?

There is virtually no chance the UK will default on its debt. The fact that bond yields are at their lowest yet shows investors are shrugging off the ratings downgrades and looking at the other fundamentals of the UK economy.

It is, however, a symbolic gesture: Another slap in the face for a chancellor who fought so hard to protect the UK's credit rating - to a degree of success - during the financial crisis.

The "negative outlook", however, could be a concern. If the rating continues to fall, then UK government debt may no longer be eligible to be included in the super-safe bits of big investment portfolios. This would reduce demand and push borrowing costs higher.

Moreover, if the downgrade to government debt is the first stage in potential cuts to the ratings of debt issued by UK firms, then it could turn out to be a little more than symbolic.

Analysts and investors have previously warned about rising "spreads" in the aftermath of Brexit due to wider economic uncertainty. That means even as government borrowing - or the Bank of England's base rate - goes down - the costs of loans for companies and on mortgages could rise.

In short

Cheaper borrowing for governments because of economic concerns. Ratings downgrades and, potentially, more expensive borrowing for everybody else because of economic concerns.

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