Fitch Ratings-London-21 August 2008: Fitch Ratings today affirmed the United Kingdom's Long-term foreign and local currency Issuer Default Ratings (IDR) at 'AAA' with Stable Outlooks. The Country Ceiling is affirmed at 'AAA' and the Short term foreign currency IDR at 'F1+'.
"While the UK's sovereign credit fundamentals remain well within 'AAA' tolerances they are being pressured by poor fiscal performance and prospects, recent stresses in the financial sector and a more volatile economic outlook," said Brian Coulton, Managing Director in the Sovereign Group. "The continued rise in government debt ratios and new fiscal risks associated with financial sector support reinforce the need for a strong medium-term fiscal framework but we expect the government's 40% debt ceiling to be breached next year."
The ratings are supported by the UK's high income per capita and diversified economy, good track record of macroeconomic stability and growth since the early 1990s, and the flexibility of labour and product markets, which enhance the economy's resilience to shocks. Political, social and civil institutions are strong: the UK scores in the top 10% of countries worldwide in control of corruption, government effectiveness and the rule of law, according to the World Bank's Governance Indicators. The government also has an impeccable post-war debt service record and is able to fund itself in deep local capital markets at long maturities and almost entirely (99.8%) in domestic currency.
However, the last 12 months have been unusually challenging and two of the UK's traditional sovereign credit strengths - the health of its financial system and moderate levels of government debt relative to large 'AAA' peers - have been under pressure. Meanwhile, external finances have remained weak, with a current account deficit of over 4% of GDP in 2007 and a further increase in net external debt (NXD) to 50% of GDP, as both the private and public sectors became more leveraged. NXD/GDP is the highest among its 'AAA' peers, apart from Spain (which as a member of the euro area faces limited external financing risks). Inflation reached 4.4% in July - well above the 2% target - and inflation expectations have risen, but monetary policy credibility remains intact.
The global credit crunch has created significant challenges for UK banks and four of the five major banks have seen negative rating action in the past year. The deposit run at Northern Rock (NR) in September 2007 and its nationalisation in February 2008 have tarnished the UK's reputation as an international financial centre. Subsequent reform proposals include enhancing powers of regulatory intervention, creating a special resolution scheme for failing banks and strengthening deposit insurance. In addition the BOE announced a special liquidity scheme (SLS) in April 2008 to ease pressure in inter-bank and capital markets.
Fitch expects the general government deficit to widen to around 4% of GDP in 2009 from 2.7% in 2007. General government gross debt as a percentage of GDP has been rising for five years to reach 44.8% in 2007, exceeding the 'AAA' median for the first time in at least 17 years. Fitch projects general government gross debt to rise to 50% of GDP by the end of next year, its highest level since 1997, while operations to support the financial sector have added to fiscal risks. Net public sector debt (excluding NR) is predicted to rise to 40.5% by end- FY09, exceeding the ceiling under the sustainable investment rule. However, general government debt will remain significantly lower than in several 'AAA' peers including France (64.6%), Germany (62%), Austria (56.3%) Canada (60.7%) and the US (61.5%) at end-2009, illustrating the headroom that still exists before rising public debt ratios become a more serious rating concern.
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