UK Downgrade: The impact of ratings downgrades

15th February 2012

What does this mean?

This implies the UK has a 30% chance of losing its AAA credit rating within 18 months, compared to ‘negative watch', when there is a 50% chance of a downgrade. France and Austria have also been warned and Italy, Spain and Portugal's ratings have been lowered.

The agency said the UK faced three main risks to its top rating; slower growth and the possible impact on spending cuts, a sharp rise in borrowing costs due to inflation or a new crisis in the banking sector.

But what are sovereign credit ratings?

Like personal credit scores these ratings are an indication of how risky it is to lend money to a country. A high credit rating from the three main agencies, Moody's, Standard & Poor's and Fitch, implies that borrowing to fund public spending will be relatively cheap – just like if you have a top-notch rating when applying for a mortgage you'll have access to the best rates.

Is this a reality check, or a warning?

Treasury sources played down the significance of the ratings agency Moody's decision to place the UK's Triple A rating at risk, saying it was not "entirely unexpected".

"It was a reality check for the whole political system that Britain has to deal with its debts, that we can't waver in the path of dealing with our debts," Mr Osborne told the BBC. However, shadow chancellor Ed Balls said the Moody's statement was a warning to the UK.

BBC economics editor Stephanie Flanders said there was no suggestion that the agency would prefer the UK government to change its economic policy of austerity. However, she added the agency's warning means spending cuts may not prevent the UK losing its credit rating, if growth falls.

How has a downgrade affected other countries?

America lost their AAA rating last year and that wasn't detrimental. In fact, they are still seen as a safe haven when compared to other countries such as Greece and Spain.

While banks continue to borrow using Britain's triple-A credit rating, would it really matter if we lost this? After all, the fact Britain has its own currency means we can borrow (self-finance) and instigate further bouts of quantitive easing, whether this is wise or not.  

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 this year."

Azad Zangana, European Economist at Schroders, adds: "Note that the sovereigns that were downgraded also have a negative outlook with respect to their individual ratings. The downgrades are likely to have a marginal negative impact, even though most of the changes in Moody's ratings and outlooks were expected and follow the similar moves from rival credit rating agency Standard & Poor's.

"Moody's points to uncertainty over the prospects for the euro area's institutional reform of its fiscal and economic framework and, in particular, the resources that will be made available to deal with the crisis.

"Many will remember that European leaders decided not to increase the actual amount of money in the European Financial Stability Facility (EFSF) back in October, but instead opted to try to leverage up the funds that had remained. Since then, the plan has fallen flat as outsiders like China have declined to pay into the fund, while the scheme that was designed to insure against losses was deemed unattractive. In addition to the institutional shortcomings, Moody's cites the weak macroeconomic prospects, which puts the austerity measures of these sovereigns at risk."

What will this mean for the UK now?

Azad says: "With regards to the UK, there is no doubt that the announcement from Moody's will ignite fierce political debate across the political spectrum. The opposition has been arguing that the government should cut spending more slowly, and possibly even reverse some of the tax hikes (such as VAT) in order to stimulate growth. Even Liberal Democrats within the coalition government have been pushing for earlier implementation of planned increases in National Insurance thresholds, which would amount to tax relief.

"While Moody's primarily warns of a lack of growth in the medium term for the UK and proximity to the eurozone debt crisis being the key factors behind its change in the outlook, it also warns that one of the factors that would lead to an actual downgrade would be a ‘reduced political commitment to fiscal consolidation, including discretionary fiscal loosening or a failure to respond to a deteriorating fiscal outlook."

What would the impact of a downgrade be for investors?

Certainly, rating decisions are felt on the markets, although ratings agencies have been widely criticised for having too much clout in jittery markets during the financial crisis. They were widely attacked for failing to warn of the risks posed by certain securities, in particular mortgage-backed securities.

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. It is unlikely to encourage widespread investment in the UK's stockmarket, which is internationally diversified. Equally, i
t has had no appreciable effect on sterling. However, in the short term markets would again be rocked.

 

More from Mindful Money:

Will the pound be pummelled by long-term gloom?

The UK is no longer in the Premier League

The UK economy is stalling, but not in recession

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