On 14th February this year, Moody’s put the UK’s AAA credit rating on negative outlook. This means that the agency says there is a 30% chance of the UK being downgraded within the next 18 months (i.e. by mid 2013). A month later, Fitch moved the UK’s AAA rating to negative too – for them this means a slightly greater than 50% chance that there is a downgrade within the next two years. At the time Moody’s said that “any further abrupt economic or fiscal deterioration would put into question the government’s ability to place the debt burden on a downward trajectory for fiscal year 2015-16”.
Since that Moody’s action, we have seen deterioration, both in economic growth and on the fiscal side. Q4 2011 GDP was revised down from -0.2% to -0.3%, and now today to -0.4%, and an official recession is now occurring with 2012 Q1 GDP growth coming in at -0.3%. Whilst the latest survey of economic forecasts has a median Q2 GDP growth of +0.1%, the impact of the extra bank holiday on economic activity has 35% of forecasters expecting a third consecutive negative quarter. At the same time, and as a direct result of that weak growth performance, government borrowing is overshooting. In May the UK borrowed £18 billion, compared with an expectation of £14.5 billion. This is £3 billion more than in May 2011 and was driven both by weakness in tax receipts (-7% year on year) and higher government spending (+8% year on year).
The government then came out and announced a freeze in petrol duty, postponing a planned 3p rise in the rate due to take place in August. The cost of this, whilst “only” £550 million, appears to be unfunded – there was talk of departmental underspends, although the monthly borrowing numbers don’t seem to reflect such savings yet. As Treasury minister Chloe Smith said in “that” Newsnight interview, “it is not possible to give you a full breakdown (of the underspends)…because the figure is evolving somewhat”. Whilst as a good Keynesian I’m all in favour of fiscal stimulus helping to support the existing monetary stimulus in the UK, this is not the implicit deal that Chancellor George Osborne made with the rating agencies – that being that he would deliver both growth and austerity together and thus get the UK’s debt/GBP ratios down in coming years. Failing to both get government spending down, and to grow the economy means that that debt/GDP ratio will continue to grow, and it becomes increasingly likely that the UK will lose its prized AAA ratings. Whether this matters is a different question – our sovereign CDS spreads are lower than AAA Germany’s (70 bps vs 103 bps), our bond yields are as low as they’ve ever been, and whilst the Eurozone crisis continues the UK remains a safe haven for capital. And as we know, when S&P downgraded the US last year its bond yields subsequently fell. It’s also unlikely that gilts will sell off, as UK rates are pinned at 0.5% (or lower) for the foreseeable future, and more Quantitative Easing is on its way. A downgrade might therefore just be an embarrassment for the Chancellor, rather than the starting gun for a race out of UK bond markets.