The UK is no longer rated AA (high) by DBRS Morningstar because of a lack of predictability.
In a statement, Morningstar’s credit arm DBRS announced it had downgraded long-term foreign and local currency to AA, citing divisive politics compounded by economic challenges.
As a result, the United Kingdom of Great Britain and Northern Ireland is “no longer compatible with a AA (high) rating”, it said.
The move comes after DBRS placed UK government debt “Under Review with Negative Implications” in October last year, following the turmoil of the Truss government and its “mini-Budget”, and marks the conclusion of that review process.
However, DBRS noted that the UK’s short-term foreign and local currency retains a rating of R-1 (high). The trend on all ratings is Stable.
In its statement, the agency said unexpected hasty changes in policies led initially to significant economic uncertainty, market turmoil and tighter financial conditions. However, some of the concerns later receded with the reversal of the mini-budget measures.
“Although the high degree of uncertainty has receded, the swift changes in economic policies in recent months have affected the predictability of UK policy, in DBRS Morningstar’s view. The rating downgrade reflects the deterioration in the Political Environment building block,” it said.
DBRS maintains the risks to the ratings are now broadly balanced and maintain a stable outlook. The new government appears committed to a prudent strategy over the medium to long term, with “more coherent measures and tighter fiscal policy”, aiming to reverse fiscal deterioration.
“Public debt is expected to increase in the near term, but the government is aiming to reduce the public sector debt ratio by 2027-2028. At the same time, despite higher interest rates, financial vulnerabilities appear contained, limiting risks to financial stability and the economy.”
The Challenges Ahead
The rating for the UK is supported by its large, diverse and wealthy economy, very strong governance indicators, including the rule of law and government effectiveness, its financing flexibility (this week is governance week at Morningstar, and you can read more on the topic here) and its robust and credible monetary policy.
DBRS believes the UK’s deep and liquid capital markets, alongside the reserve currency status of the pound sterling, supports the UK’s significant degree of financing flexibility.
However, the country also faces credit challenges stemming from weakened public sector finances – a large fiscal deficit and high government debt – low growth, and external imbalances, with a persistent current account deficit. Uncertainty over the cohesion of the four-nation archipelago also poses some challenges.
Moreover, the UK has a “chronic low growth problem”, DBRS added, which has been further exacerbated by the cost-of-living crisis and tighter financial conditions. Potential output growth has deteriorated over the past years, and is now estimated just below 2%, largely reflecting lower productivity growth driven by other factors like Brexit, the pandemic and energy prices. Inflationary pressures also intensified with the Russian invasion of Ukraine and sterling depreciation.
Despite this, DBRS maintains that the debt profile remains broadly favourable.
“The average maturity of debt remains very long at over 14 years, lessening the impact from higher interest rates,” it said.
“However, bond yields spiked in September 2022 amid a sell-off of UK assets, while higher inflation has also driven up the cost of index-linked bonds, which account for 26% of the UK debt portfolio.
“Despite the volatility in the gilt market last year, the UK still enjoys a high degree of financing flexibility, given the depth of the UK debt market and sterling’s status as a reserve currency. However, DBRS Morningstar notes that a dysfunction in the gilt market could pose a risk to the UK’s financial stability. The efficient functioning of the gilt market remains crucial.”
DBRS’ Rating Drivers
In order for DBRS to issue an upgrade, it looks at whether two things are happening: if public debt ratio returns to a sustained downward path over the medium term; or if the UK’s growth prospects are improving, with higher and sustained productivity growth.
A further downgrade could occur if the likelihood of a break-up of the UK materially increases; or a severe economic or financial shock has a material adverse impact on the economy and fiscal accounts, damaging the UK’s financing flexibility.
DBRS Morningstar is the world’s fourth-largest credit ratings agency. It was acquired by Morningstar in 2019. The full decision is available here.
