Rating Action Commentary
Fitch Affirms the UK at 'AA-'; Outlook Negative
Fri 15 Jan, 2021 - 4:07 PM ET
Fitch Ratings - London - 15 Jan 2021: Fitch Ratings has affirmed the United Kingdom's Long-Term Foreign-Currency Issuer Default Rating (IDR) at 'AA-' with a Negative Outlook.
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.
The Negative Outlook reflects the impact of the coronavirus pandemic on the UK economy and the resulting material deterioration in the public finances, with Fitch estimating the fiscal deficit to have widened materially to 16.2% in 2020 and government debt set to increase to 120% of GDP over the next few years. While the UK-EU Trade and Cooperation agreement should limit disruption at borders in the short term, uncertainty remains around how the new trade arrangement will work in practice and how it will affect the UK's trade with the EU over time. Conversely, progress with vaccine rollout indicates a sustained recovery could start from 2Q21.
The expiry of the Brexit transition period on 31 December saw the UK-EU trade regime shift to a Free Trade Agreement (FTA) arrangement, ending the frictionless trade in goods and services that came with EU single market membership. A shift to trading on World Trade Organisation (WTO) terms, which would have involved the imposition of tariffs on goods trade, was narrowly avoided, but the FTA will still entail significant new non-tariff barriers.
We have raised our 2021 real GDP growth forecast to 5.0% from 4.1% following an estimated 10.3% contraction in 2020. The upward revision stems from the UK-EU FTA, which represents a positive development relative to our December GEO forecast, which had assumed a WTO or 'no-deal' outcome. It also partly reflects a stronger starting position in 2020; we have revised 2020 real GDP growth to -10.3% from -11.2% on the back of stronger than expected 3Q20 real GDP growth. However, the positive impact on GDP in 2021 will be partly offset by the imposition of a third nationwide lockdown in January 2021 in response to the renewed escalation of the health crisis. Latest monthly GDP data for November 2020 show a much smaller decline in activity than seen in the April lockdown and suggest some upside to our near-term GDP forecasts.
The new lockdown was imposed following the sharp rise in Covid-19 cases, mainly due to a new strain of the coronavirus, which UK epidemiologists estimate is up to 70% more contagious. The lockdown will last at least until mid-February but several government officials have said the measures could remain in place until March. The short-term economic outlook is therefore weak. We expect the UK economy to contract by 3% qoq in 1Q21, but we expect a stronger post lockdown recovery from 2Q21 than before due to the avoidance of no-deal disruption.
Prospects for 2H21 and 2022 have improved owing to the rollout of Covid-19 vaccines. The UK vaccination programme is currently running ahead of other European countries. The UK government aims to vaccinate the population over 70 years old and some other high-risk groups by mid-February. This could allow a very gradual removal of restrictions from March. Fitch's base case assumption is that vaccine rollout will have reached sufficient scale to allow a significant easing in social-distancing restrictions and behaviour through 2H21. Our 2022 growth forecast has been revised up accordingly, to 4.7% from 3.6%, also helped by the improvement in global prospects. Our projections point to a level of real GDP in 4Q22 that is 1.1% below pre-pandemic (4Q19) levels.
We estimate a sharp increase in the general government deficit to 16.2% of GDP in 2020 from 2.2% in 2019, well above both the peak of the deficit increase following the global financial crisis and the projected current 'AA' category median of 7.4% of GDP. The deficit increase is the result of the sharp decline in economic activity caused by the lockdowns and the operation of automatic stabilisers, as well as the government's measures to support the economy and address the health emergency. We estimate the direct cost of fiscal policy measures since March at GBP182 billion (8.2% of GDP).
We expect the deficit to fall to around 12% of GDP in 2021 and 10% of GDP in 2022. We factor in additional discretionary fiscal stimulus measures worth GBP76 billion (3.4% of GDP) this year. Expenditures are set to decline only very gradually relative to GDP as we expect rising political pressure to maintain high levels of public spending, particularly on infrastructure (eg the 'levelling-up' agenda) and public services (including healthcare and welfare). We are not factoring in fiscal consolidation measures for 2021 and 2022.
Our deficit projections imply an increase in the gross general government debt (GGGD) to GDP ratio to 107% of GDP in 2020 (AA current median forecast: 43.3%) and to 113% in 2021. We expect public debt to reach a peak of around 120% of GDP over the medium term. The risks from higher government debt are mitigated by extremely favourable financing terms. The average maturity of debt at 15 years is among the longest in Fitch's rated portfolio, limiting the risk from potentially higher interest rates. The average effective interest rate on debt is set to fall to 1.7% by 2022 from 2.6% in 2019. The quantitative easing programme by the Bank of England and sterling's reserve currency status will continue to underpin the sovereign's financing flexibility.
There is a high degree of uncertainty around the fiscal projections. The Chancellor Rishi Sunak had said that the government would put public finances 'back on a sustainable footing' but the renewed coronavirus-related restrictions mean that fiscal policy is set to reman accommodative for some time, adjusting to the evolving health situation and focusing on job and income protection. Once the health crisis abates, the absence of a credible medium-term fiscal consolidation plan would increase the level of downward pressure on the ratings.
The Coronavirus Job Retention Scheme (CJRS) has been important in mitigating the impact of the crisis on the labour market. The unemployment rate rose to 4.9% in the three months to October 2020 from 3.8% a year earlier. Following the sharp rise in coronavirus cases and the imposition of further restrictions, the scheme has been extended to the end of April 2021. Fitch's research suggests that unemployment would have surged to 13%-14% in the absence of the CJRS. We expect a substantial increase in unemployment as the support scheme is gradually withdrawn, with the unemployment rate peaking at 7.3% in 1Q21 and the annual average for the whole of 2021 to rise to 6.7% from 4.7% in 2020.
We expect impaired loans in the banking sector to increase in 2021 as some vulnerable sectors of the economy recover more slowly from the crisis and the unemployment rate rises. We believe that the UK banks were proactive in front-loading expected credit losses in 1H20, which should moderate the implications of rising impaired loans on 2021 profitability. The UK banking sector scores 'a' on Fitch's banking system indicator, which indicates 'high fundamental credit quality'. The majority of UK banks entered the crisis from a position of strength, with well performing assets, sound capitalisation, good funding and liquidity profiles and adequate underlying profitability.
The UK-EU trade agreement includes general provisions to support cross-border trade in services but the benefits are likely to be limited as they are subject to many exceptions that vary by service sector and country. As a result, the UK is bound to lose some market access for trade in financial services as there will be restrictions on whether UK service providers can service EU clients. The UK and EU have committed to establishing a Memorandum of Understanding by March 2021 to agree a framework for regulatory cooperation on the financial services' sector. The services' sector accounted for more than 40% of UK exports to the EU and for about 80% of UK's gross value added in 2019.
The Scottish First Minister Nicola Sturgeon has announced plans to publish draft legislation to hold a second referendum on Scottish Independence ahead of next May's Scottish Parliament elections. Although we think it is highly unlikely the UK government would agree toa second referendum, recent opinion polls suggest a majority of Scottish voters would back independence in a second referendum. A vote for independence would be negative for the UK's credit profile as it would likely lead to a rise in the gross government debt/GDP, increase the size of the UK's external balance sheet and potentially generate uncertainty in the banking system.
ESG - Governance: The UK has an ESG Relevance Score (RS) of 5 for both Political Stability and Rights and for the Rule of Law, Institutional and Regulatory Quality and Control of Corruption, as is the case for all sovereigns. These scores reflect the high weight that the World Bank Governance Indicators (WBGI) have in our proprietary Sovereign Rating Model. The UK has a WBGI ranking at the 87th percentile, reflecting strong institutional capacity and effective rule of law.
RATING SENSITIVITIES
The main factors that could, individually or collectively, lead to negative rating action:
- Public Finances: Evidence that the government's fiscal strategy will fail to arrest the increase in the government debt/GDP ratio over time.
- Macro: Evidence that the new trading arrangements with the EU from 1 January 2021 will undermine the UK's economic performance over time.
- Structural: Political developments that lead to a deterioration in governance indicators and/or undermine the territorial integrity of the UK.
The main factors that could, individually or collectively, lead to positive rating action:
- Public Finances: Greater confidence that the government debt to GDP ratio will stabilise over time once the Covid-19 crisis has subsided.
- Macro: Greater confidence and evidence that the UK's growth prospects will prove resilient to the consequences of the Covid-19 crisis and the new trade arrangement with the EU.
SOVEREIGN RATING MODEL (SRM) AND QUALITATIVE OVERLAY (QO)
Fitch's proprietary SRM assigns the UK a score equivalent to a rating of 'A+' on the LTFC IDR scale.
Fitch's sovereign rating committee adjusted the output from the SRM to arrive at the final LT FC IDR by applying its QO, relative to peers, as follows:
- Macroeconomic performance, policies and prospects: +1 notch to offset the deterioration in the SRM output driven by volatility from the pandemic shock, including on GDP growth. The deterioration of the GDP growth and volatility variables reflects a very substantial and unprecedented exogenous shock that has hit the vast majority of sovereigns, and Fitch believes that the UK has the capacity to absorb it without lasting effects on its long-term macroeconomic stability.
Fitch's SRM is the agency's proprietary multiple regression rating model that employs 18 variables based on three-year centred averages, including one year of forecasts, to produce a score equivalent to a LTFC IDR. Fitch's QO is a forward-looking qualitative framework designed to allow for adjustment to the SRM output to assign the final rating, reflecting factors within our criteria that are not fully quantifiable and/or not fully reflected in the SRM.
BEST/WORST CASE RATING SCENARIO
International scale credit ratings of Sovereigns, Public Finance and Infrastructure issuers have a best-case rating upgrade scenario (defined as the 99th percentile of rating transitions, measured in a positive direction) of three notches over a three-year rating horizon; and a worst-case rating downgrade scenario (defined as the 99th percentile of rating transitions, measured in a negative direction) of three notches over three years. The complete span of best- and worst-case scenario credit ratings for all rating categories ranges from 'AAA' to 'D'. Best- and worst-case scenario credit ratings are based on historical performance. For more information about the methodology used to determine sector-specific best- and worst-case scenario credit ratings, visit [https://www.fitchratings.com/site/re/10111579].
KEY ASSUMPTIONS
The global economy performs broadly in line with Fitch's latest Global Economic Outlook published on 7 December 2020.
REFERENCES FOR SUBSTANTIALLY MATERIAL SOURCE CITED AS KEY DRIVER OF RATING
The principal sources of information used in the analysis are described in the Applicable Criteria.
ESG CONSIDERATIONS
The UK has an ESG Relevance Score of 5 for Political Stability and Rights as World Bank Governance Indicators have the highest weight in Fitch's Sovereign Rating Model and is therefore highly relevant to the rating and a key rating driver with a high weight.
The UK has an ESG Relevance Score of 5 for Rule of Law, Institutional and Regulatory Quality and Control of Corruption as World Bank Governance Indicators have the highest weight in the Sovereign Rating Model and are therefore highly relevant to the rating and a key rating driver with a high weight.
The UK has an ESG Relevance Score of 4 for Human Rights and Political Freedoms as the Voice and Accountability pillar of the World Bank Governance Indicators is relevant to the rating and a rating driver.
The UK has an ESG Relevance Score of 4 for Creditor rights as willingness to service and repay debt is relevant to the rating and is a rating driver, as for all sovereigns
Except for the matters discussed above, the highest level of ESG credit relevance, if present, is a score of 3. This means ESG issues are credit-neutral or have only a minimal credit impact on the entity(ies), either due to their nature or to the way in which they are being managed by the entity(ies). For more information on Fitch's ESG Relevance Scores, visit www.fitchratings.com/esg.
Additional information is available on www.fitchratings.com
Applicable Criteria
APPLICABLE MODELS
Numbers in parentheses accompanying applicable model(s) contain hyperlinks to criteria providing description of model(s).
- Country Ceiling Model, v1.7.1 (1)
- Debt Dynamics Model, v1.2.1 (1)
- Macro-Prudential Indicator Model, v1.5.0 (1)
- Sovereign Rating Model, v3.12.1 (1)
Additional Disclosures
ENDORSEMENT STATUS
| United Kingdom | UK Issued, EU Endorsed |
ADDITIONAL DISCLOSURES FOR UNSOLICITED CREDIT RATINGS
United Kingdom (Unsolicited)
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