What does a cut in the UK’s credit rating outlook really mean?
A country’s credit ratings can have several important functions including influencing the cost of its national debt and acting as a long-term indicator for investors. Here we look at what happened recently in the UK and what the impact may be in the global markets.
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In the wake of September 2022’s calamitous mini-budget, two major credit rating agencies downgraded the UK’s credit rating outlook to negative, citing political instability as well as continued high inflation. While this was humiliating – and the subsequent Chancellor Jeremy Hunt has had to work hard to restore the UK’s standing - do these credit ratings matter? Can they impact the UK’s standing on the global stage, influencing its currency or bond markets?
How do credit ratings work?
Credit ratings for individual countries are assigned by rating agencies. The three largest are Standard & Poor’s, Moody’s and Fitch and they will exert the most power over policymakers. Each has a proprietary scale to grade countries on their creditworthiness: Standard & Poor’s goes from AAA to D; Moody’s from Aaa to C; and Fitch from AAA to D with a + or – to indicate the relative probability of default on their government debt. These ratings are designed to give an indication of the financial strength of an individual country.
The agencies bring in a range of factors to decide a country’s credit rating. They will look at the overall wealth of a country through metrics such as per capita income. They will also look at the growth trends in a country: is GDP growing or shrinking? What is the inflation rate for a country? The agencies will also look at a country’s debt levels relative to its overall economy. They will assess a country’s willingness to pay back their debts: do they have a history of defaults? A poor history of defaulting on debt has made it difficult for some countries to borrow in international capital markets – Argentina is one example.
Returning to the UK’s credit rating, the borrowing proposed in the mini-budget was not outside international norms. However, it showed a lack of fiscal discipline that made the rating agencies question the UK’s high rating. Moody’s said the change had been driven by: “heightened unpredictability in policymaking amid weaker growth prospects and higher inflation” plus “risks to the UK’s debt affordability from likely higher borrowing and risk of sustained weakening in policy credibility.”
There is some debate around how much a country’s credit ratings matter
In theory, credit ratings are important in allowing countries to borrow money in international capital markets. Most countries run an annual and structural deficit. In the UK, the annual shortfall between tax revenues and spending commitments was approximately £44bn in Q2 2022. There was also a structural deficit – debt built up over time – of £2.44 trillion as at Q2 2022. The majority of this is funded by capital markets – large institutional investors buying UK government debt. Governments have to maintain credibility with those international investors and a good credit rating is part of that.
In reality, there is some debate as to the extent to which a country’s credit ratings influence the price of debt in the market. In the mini-budget debacle, the yields on UK government bonds moved a long way before the credit ratings agencies changed their views, suggesting that the market decides before the rating agencies. However, countries need a credit rating. This is the equivalent of having an independent person ‘mark their homework’ – a country shows it is willing to open up its financial information to scrutiny.
Credit ratings downgrades tend to matter more at the lower end of the scale. When the US sovereign bond rating was downgraded in the wake of the global financial crisis of 2007/8, it had relatively little impact on its borrowing costs. However, for emerging markets, downgrades can be significant. They inflate the cost of their debt and these countries generally have less capacity to absorb higher repayments. They can also affect a country’s currency.
Credit ratings can play several important roles
There is an important distinction between investment grade and ‘junk’ bonds. If a country moves from investment grade to junk status, it will affect who can buy its debt and the price. Standard & Poor’s considers any country with a BBB- rating or higher to be investment grade, with the rest considered to be speculative debt. Among the investment grade names are Canada, Germany and the Netherlands. The UK is AA-. Major countries with weaker credit ratings include Brazil (BB-) or Pakistan (B-). In general, the rating agencies will form similar conclusions about the creditworthiness of individual countries, but there will be differences at the margin.
Credit ratings can be a useful tool for investors. While they aren’t helpful in short-term decision-making because it takes time for rating agencies to change their judgement on a country, they will often provide detailed analysis of a country’s prospects and can help with longer-term positioning. They can be particularly useful in judging whether to invest in emerging market debt and currencies. They will influence international investment flows at the margin.
The Autumn Budget in November 2022 brought a new round of tax rises and spending cuts as the UK appeared to be emerging from its flirtation with fiscal irresponsibility. Policymakers will be hoping that the rating agencies will revise their view and restore its rating. Along with many developed markets, it has a large debt burden and changes to the cost of that debt burden are important to its long-term financial strength.
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