Moody’s Downgrades the UK: Keep Calm and Carry On

If you want Aaa-rated government debt, you’ll have to go looking to Canada, or Australia, or Germany, because late last week, ratings agency Moody’s officially downgraded the United Kingdom’s government bond rating from Aaa (their highest level) to Aa1 (their second highest level). Moody’s downgrade was based on three factors: the UK’s weak medium-term growth outlook; the impact of the weak economic outlook on the government’s fiscal consolidation plan; and the high and rising public debt burden. On the last point, Moody’s expects debt to peak at over 96% of GDP in 2016.

The downgrade wasn’t really a surprise, but it did come earlier than expected. The Office of Budget Responsibility had projected that government debt would remain over 90% of GDP for at least six years – that’s inconsistent with a triple-A rating. However, the downgrade came before the official budget was announced on March 20, which is when most figured the nudge downward would have come.

Keep Calm

It’s unlikely though that the downgrade will spur any material shift in the government’s fiscal stance. The Chancellor of the Exchequer quickly responded by commenting that “Far from weakening our resolve to deliver our economic recovery plan, this decision redoubles it.”  That means an underlying fiscal tightening (at a pace of between 1% and 1.5% of GDP per annum) that extends well into the next parliament.

The downgrade probably won’t be good for sterling, as a result of outflows from overseas investors. And if the pound depreciates significantly further, raising inflationary pressures and strengthening the medium-term growth outlook, the case for further quantitative easing would be weakened. On the other hand, since this downgrade to below AAA will not force gilts to drop out of any major bond index or push foreign central banks to hold back from gilt purchases, at least the impact on the gilt market should be limited.

Carry On

In time, the two other major ratings agencies, Fitch and S&P, are likely to follow Moody’s in downgrading the UK. At that stage, significant downward pressure on sterling is likely to re-emerge because some central banks may then have no choice but to reduce or even stop their buying of British pounds. However, assuming no further meaningful deterioration in the economic outlook and no loss of political commitment to fiscal consolidation, the UK is unlikely to fall below the AA category. The wealthy, open UK economy remains flexible. Their deep and liquid domestic bond market is backed by a government with a credible and achievable plan to lower debt, which, on the negative side, is quite high. They’ve also got a relatively long average maturity on their outstanding debt – at around 15 years, it’s the longest of any high-grade sovereign. Should the UK continue to run large deficits, there will be some likely pressure on debt-reduction targets. The other big issue will continue to be contagion risk from any flare ups in the euro-area crisis.

If the world didn’t shake to its very foundations when the United States was downgraded, there shouldn’t be any surprise if it remains intact following a UK downgrade.