Threat to UK credit rating 'unjustified'
by Costas Milas
Without a dramatic weakening of its macroeconomic position the UK's AAA rating should be safe despite Moody's decision to put the country on negative outlook
Moody's decision to place the United Kingdom on negative outlook implies there is a 30 per cent chance that the country's AAA credit rating will be downgraded in the next 18 months. The agency's rationale is based on "the increased uncertainty regarding the pace of fiscal consolidation in the UK due to materially weaker growth prospects over the next few years".
But it is unlikely that the UK will lose its top credit rating unless extreme macroeconomic conditions rapidly emerge. Credit rating agencies decide on sovereign credit scores by taking into account a number of macroeconomic factors – such as gross domestic product growth, per capita GDP, governance and public finance trends – but provide very little guidance as to the relative weights assigned to each factor. Yet, a careful examination of empirical credit rating valuation models leads to the following conclusions.
First, in terms of GDP growth prospects, a sharp drop in the UK from an expansion of 0.6 per cent, which is what the International Monetary Fund predicts for 2012, to a contraction of 2.6 per cent in 2013 justifies 0.2 of a notch downgrade. Second, a rise in gross government debt from 90 per cent of GDP in 2011, based on Organisation for Economic Cooperation and Development data, to 105 per cent in 2012 justifies half a notch downgrade. And third, a rise in government deficit from 9.4 per cent of GDP in 2011, again based on OECD data, to 12.4 per cent in 2012 justifies a quarter of a notch downgrade.
Therefore, a full notch downgrade, the equivalent of UK losing its top rating to the second highest one, would be justified if a dramatic deterioration in growth prospects emerged together with a sharp increase in the budget deficit and a dramatic accumulation of gross debt. In our view, and given the current economic outlook, these are highly unlikely macroeconomic outcomes and therefore UK's credit rating should be safe. With this in mind, the threat by Moody's credit rating agency to downgrade the UK economy appears rather unjustified.
That said, a dramatic escalation in the eurozone crisis – which is obviously beyond the control of UK policymakers – might suffice to cause, at least temporarily, chaos in international markets and trigger a deep recession in the UK and everywhere else. In such a dramatic scenario, loss of the top credit rating will be the least of UK's, and everybody else's, problems.
Costas Milas is professor of finance at the University of Liverpool Management School in the UK