24th February 2013
The two other globally significant agencies S&P and Fitch have the UK on watch. But Moody’s as the first mover will grab the headlines. Its reasoning is quite straight forward – “subdued growth” and a “high and rising debt burden”. Labour’s Shadow Chancellor Ed Balls has described it as a “humiliating blow” though Osborne says he is determined to press ahead with the deficit reduction programme, otherwise known as plan A.
So what does this all mean economically? Well one view is that it doesn’t matter all that much. AA1 is still a strong rating. A downgrade for the US has not had a significant or material effect on the status of treasuries as a safe haven investment. Nor did it have an immediate impact on France which also saw a downgrade recently. However in the case of the US, the dollar is the globe’s reserve currency and so it is very much a special case. France’s economy has continued very much in the doldrums. It is certainly no longer regarded as a core Eurozone country, but is almost counted amongst the periphery these days. Kames Capital’s head of international rates John McNeill says: “Moody’s announced a downgrade of the U.K. sovereign credit rating from AAA to Aa1 on Friday evening. The main reason for the action was the weakness of growth and the challenge this poses to the government’s fiscal consolidation programme. We would agree that the U.K. debt and deficit trajectory are not consistent with a AAA rating and Moody’s action may be followed in time by S&P and Fitch, where the rating is currently on review for downgrade.
“We do not take comfort from the fact that the downgrade of other major sovereign issuers, for example the U.S. and France, did not lead to a sell off in these markets. The U.S. enjoys the benefits of being the global reserve currency, and major euro-zone issuers are to some extent seen as substitutable on the view that they will enjoy mutual support. The U.K. gilt market and sterling currency have already weakened significantly year-to-date. We believe that this can continue in the short-term. A more major risk to GBP assets would come from any political fall-out. A major deviation from the current fiscal plans or any fracturing in the coalition would be taken badly.”
As McNeill says the pound is neither the world’s reserve currency nor is it part of the euro. Sterling has fallen to a 31-month low against the dollar and a 16 month low against the euro as the BBC reports with more falls expected.
The depreciation in sterling is worrying because it comes at a time of stubbornly mid range inflation. It could put more pressure on prices for example in dollar denominated energy. It could see the cost of Government borrowing rise, though that has not always happened to other downgraded developed markets, so perhaps we have to wait for the market verdict on that. The fact that the Bank of England has been the major purchaser of bonds suggests it will not have a hugely significant immediate impact.
If markets don’t react too badly and sterling avoids a mini crisis – though it is difficult to know how that is defined – then perhaps the biggest impact will be political. There may be significant coalition tensions, coinciding with the Eastleigh by-election. After all deficit reduction has been the Coalition’s raison d’être.It means that dissenting voices among economists and politicians who disagree with the current strategy may get more of a hearing. Maybe more voters, who polls suggest more or less agree with the deficit strategy, will begin to question the approach too. Politics and economics have always been intimately entwined, but it is probably more the case now than at any time arguably since the 1930s. As we say, the pressure’s on the Chancellor. The markets will give their verdict next, and then, maybe the voters.