Is the stage set for a UK Downgrade?

18th May 2012

Some economists and fund managers are predicting that 2013 will be the year for the UK to finally be taken down a notch. Earlier this year, in March, a second ratings agency put the UK on negative watch for a downgrade with Fitch agreeing with Moody's that the UK needed to stick its neck out to preserve its AAA rating. But since then, this status has been retained, despite ongoing shocks to the financial system and expectations of an explosion in the Eurozone. 

The question is – Why is it taking so long?

Back in January the Eurozone's second-largest economy, France, lost its AAA rating. Eight other single-currency members were also downgraded, while others appeared on thin ice. Yet somehow, the UK managed to keep a grip on its status because of the quantative easing – or 'printing money' – approach to tackling debt. Meanwhile, the government put "austerity" at centre stage, and bought Britain some time before it too is downgraded.

When Standard and Poor's slashed the credit rating of France and several other European countries, there was an outcry – both at the decision, and the fact that the UK was not affected. One German politician even argued that, "If the agency downgrades France, it should also downgrade Britain in order to be consistent".

But the deficit, or the amount the government spends compared to the sum the economy generates in revenue, remains stubbornly high – and the mask the UK has hidden behind while other countries have been downgraded must at some stage be whipped off. 

In an interview with the BBC's World at One earlier this year, Dave Riley, the head of global sovereign ratings at Fitch said: "There's really very little room for manoeuvre if there was an adverse shock."

"That bad news could come from Europe, but there's also an uncertainly about the overhang of personal and banking debt in the UK and whether that might mean a prolonged period of economic stagnation."

However, will a rating downgrade matter? 

In theory, it simply determines a country's borrowing costs.

There are many reasons to think that credit ratings aren't worth the paper they're printed on. Ratings agencies completely failed to warn of the subprime crisis for example. And credit spreads on sovereign debt are better at predicting default than ratings themselves.

Matthew Partridge said in Money Week back when there was threat of a downgrade earlier this year: "Certainly, the market isn't phased by the downgrade threat…

"However, because of the political sensitivity as much as anything else, decisions to downgrade are not taken lightly. So, while Moody's warning doesn't mean much for the price of gilts, it's a reminder that Britain's economy faces some serious problems." 

And indeed it does, now that we're in a double dip recession and the light at the end of the tunnel is growing dimmer. Partridge added: "A recession would hit the tax base, while more people out of work means more benefit spending. Lower growth also means that the UK government will have to work harder to cut the debt-to-GDP ratio. This would, "put into question the government's ability to place the debt burden on a downward trajectory by fiscal year 2015-16".

But experts stress that a downgrade shouldn't prompt a large amount of fear. 

Simon Ward, Henderson's chief economist and Mindful Money blogger, says: "Sovereign credit ratings are pretty meaningless – at least for countries borrowing in their own currency with their own central bank. Such countries will always print money rather than "default".

"…The impact (of a downgrade) would probably be minimal – as it was in the case of S&P's US downgrade."

However, investors will find that rating decisions are felt on the markets, as the real impact is in sentiment – which is a prime market driver. 

Losing your rating or being downgraded can, in some cases, have a fatal effect on your country's ability to borrow money on the markets. But this depends on which country we're talking about. Here Wikipedia explains and details which country has which rating.

In the short-term it is likely to make little difference for investors. However, it is unlikely to encourage widespread investment in the UK's stockmarket, which is internationally diversified. Equally, it has had no appreciable effect on sterling. However, in the short term markets would again be rocked

 

More on Mindful Money:

The Age of 'Austerity' – But what is it, and does it work?

Private security: A recession-proof industry

Moody's: Spain plagued by Greek-style economic crisis

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