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Fitch Downgrades UK Credit Rating To AA- After Sterling’s Best Week Since 1985 Plaza Accord

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Via Zerohedge

The Pound Sterling soared a stunning 7.1% this week – its greatest weekly gains since 1985 and the beginning of the Plaza Accord – but apparently that strengthening currency was not enough for Fitch who downgraded The United Kingdom’s credit rating to AA-.

The downgrade of the UK’s IDRs reflects the following key rating drivers and their relative weights:

HIGH

The downgrade reflects a significant weakening of the UK’s public finances caused by the impact of the COVID-19 outbreak and a fiscal loosening stance that was instigated before the scale of the crisis became apparent. The downgrade also reflects the deep near-term damage to the UK economy caused by the coronavirus outbreak and the lingering uncertainty regarding the post-Brexit UK-EU trade relationship. The commensurate and necessary policy response to contain the COVID-19 outbreak will result in a sharp rise in general government deficit and debt ratios, leading to an acceleration in the deterioration of public finance metrics over the medium term.

The Negative Outlook reflects our view that reversing the deterioration in the fiscal metrics beyond 2020 will not be a political priority for the UK government. Moreover, uncertainty around the future trade relationship with the EU could constrain the strength of the post-crisis economic recovery.

The coronavirus outbreak has inflicted an unprecedented shock on financial markets and economic activity, with policymakers struggling to avert a longer-lasting downturn. In common with other advanced countries, the UK has shut down parts of its economy to slow the spread of the disease, which will cause a deep contraction centred on 2Q20. On 23 March, Prime Minister Johnson announced more drastic measures to contain the spread of COVID-19, including closure of all non-essential shops and a ban of public gatherings of more than two people.

Under our much-revised baseline forecast that reflects the lockdown measures across the UK, we now estimate that GDP could fall by close to 4% in 2020. In the baseline, we assume that containment measures can be unwound in 2H20, allowing for recovery in sequential growth and the broader economy, leading to a sharp recovery in growth to around 3% in 2021. However, with so much depending on the extent and duration of the coronavirus outbreak, there is material downside risk to these economic forecasts. A plausible downside case, including a second wave of infections and a longer lockdown period, would see an even larger decline in output in 2020 and a weaker recovery in 2021. The strength of the recovery is subject to lingering Brexit uncertainty, as the final shape of any future trade deal with the EU remains unknown and the risk of the transition period ending without a deal persists.

The UK’s public finances were already set to weaken following the stimulus measures announced in the budget on 11 March, and they are now set to deteriorate more rapidly. The government has announced substantive fiscal policy easing to mitigate the impact of the lockdown measures on the economy. There is some uncertainty around the fiscal impact, which will depend on the severity and length of the lockdown and the sustainability of any progress in coronavirus containment. Under our baseline, we estimate that the general government deficit will increase to around 9% in 2021 from 2.1% of GDP in 2019. Within this forecast, we estimate that the Coronavirus Job Retention scheme will cost 1.3% of GDP, assuming that 4.7 million employees will be supported over the three month duration of the scheme. We estimate that the whole COVID-19 response fiscal package will cost 4.4% of GDP in 2020.

For 2021 we do not include any further discretionary fiscal easing but we expect upward pressures on spending to persist. The expected recovery in GDP growth should support a rebound in revenue growth. Under these assumptions, we expect the deficit to narrow in 2021. General government debt will rise to 94% and 98% in 2020 and 2021, respectively, from 84.5% in 2019. Over the medium term, we expect public debt to peak at well above 100% of GDP beyond 2025 assuming a gradual reduction in fiscal deficits and trend GDP growth of 1.6%.

We fully recognise that timely and targeted policies can help reduce the risk of a more sustained loss of economic output. The likelihood that temporary stimulus measures are unwound will reflect policy choices and political developments. However, in our view, given the direction of public finances reflected in the March 2020 budget, it is unlikely that reducing public deficit and debt levels will be a priority for the UK government. Excluding GBP12 billion of COVID-19 related measures, the budget was targeting a rise in the fiscal deficit by GBP30 billion (1.4% of GDP) by 2024-25 and an increase in net debt of GBP125 billion (5.8% of GDP) relative to the pre-budget baseline.

Additionally, Fitch writes that The UK’s IDRs also reflect the following key rating drivers:

The UK’s ratings balance a high income, diversified and advanced economy against high and rising public sector indebtedness. Sterling’s reserve currency status, deep capital market and strong governance indicators support the ratings. The very long average maturity of public debt (15 years) is among the highest of all Fitch-rated sovereigns and mitigates refinancing and interest rate risks. Public debt is exclusively in sterling, so a weaker exchange rate will not lead to deterioration in debt dynamics.

The Bank of England (BoE) has responded swiftly to the health crisis by cutting the base rate by 65bp to 0.1% and restarting quantitative easing with GBP200 billion of asset purchases, which will include gilts and corporate sector bonds. The response also includes a new Term Funding Scheme for SMEs, increased contingent access for banks to liquidity via a new contingent term repo facility in addition to the BoE’s regular sterling market operations; and the COVID-19 Corporate Financing Facility to provide funding to business through the purchase of corporate commercial paper of up to one year maturity. The Financial Policy Committee (FPC) and the Prudential Regulation Authority (PRA) have adopted measures to support credit supply, including the reduction of the countercyclical capital buffer to 0% with immediate effect. This was set at 1% and was due to rise to 2% in December 2020. The cut is expected to support up to GBP190 billion of bank lending for businesses.

In Fitch’s view, the swift and coordinated macroeconomic policy response by the UK Treasury and the Bank of England should limit the second-round effects of the initial shock and should help growth to recover, assuming that the immediate health crisis subsides. In particular, the combined liquidity support measures which include GBP330 billion (15% of UK GDP) of loans and guarantees from the Treasury and the Bank of England are an important component of an effective near-term policy response, providing support to the ratings.

Another component of the budget not related to COVID-19 was the announced increase in investment spending to 3% of national income, which would be its highest level for 65 years. Whether higher investment spending improves UK productivity and medium-term growth prospects would depend on how effectively such measures as large infrastructure projects are targeted. At this stage, we are not assuming any large impact on trend GDP growth from public infrastructure investment.

The uncertainty around the future UK-EU trade relationship and its effect on the UK’s economy and public finances weighs on the rating. Negotiations on a trade deal have started but the two sides’ initial positions appear far apart. While the UK is seeking a deep free trade agreement (FTA) that allows it to diverge from EU rules, the EU’s starting position is to have the UK adopt EU rules as “reference points” and follow the evolution of those rules.

Given the divergent positions, little time available to strike a deal (December 2020) and the outbreak of the COVID-19 crisis that will take priority, other scenarios are possible, including a trade “cliff-edge” with the UK exiting the transition period at end-2020 and reverting to WTO terms, which would be negative for long-term economic growth compared with an FTA. Alternatively, the transition period could be extended, but in our view this would not be straightforward. The government has ruled out any extension to the transition period and legislated for a commitment not to agree to any extension in the Withdrawal Agreement Act. The government is only able to reverse that provision through new legislation.

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We suspect the Queen and the sick PM will not be amused…

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