DBRS Morningstar Confirms the United Kingdom at AA, Stable Trend

DBRS Ratings Limited (DBRS Morningstar) confirmed the United Kingdom of Great Britain and Northern Ireland’s (the United Kingdom or the UK) Long-Term Foreign and Local Currency – Issuer Ratings at AA. At the same time, DBRS Morningstar confirmed the Short-Term Foreign and Local Currency – Issuer Ratings at R-1 (high). The trend on all ratings is Stable.

KEY CREDIT RATING CONSIDERATIONS
The Stable trend reflects DBRS Morningstar’s view that risks to the credit ratings are balanced. The UK economy has slowed down largely as a result of tight financial conditions and persistent high inflation. At the same time, the fiscal deficit remains large and the government debt ratio is projected to increase further to around 107% of GDP in the coming years. Nevertheless, the monetary tightening cycle seems to have ended, with the Bank of England holding its policy rate since August. While additional impacts of higher interest rates on the economy are yet to come through and interest rates are likely to remain high for some time, inflation has now started to fall more rapidly, which is expected to ease the squeeze in real incomes. Despite higher interest rates, financial vulnerabilities appear contained, limiting risks to financial stability. Furthermore, the government remains committed to its fiscal rule of reducing the high public sector debt ratio by 2027-2028.

The credit 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 and its robust and credible monetary policy. 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. The Bank of England (BoE) oversees a reserve currency that supports the country’s substantial capacity for external adjustment. 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 UK in the long term also poses some challenges.

CREDIT RATING DRIVERS
An upgrade could occur if (1) the public debt ratio returns to a sustained downward path over the medium term, or (2) the UK’s growth prospects improve, with higher and sustained productivity growth. A downgrade could occur if (1) a severe economic or financial shock has a material adverse impact on the economy and fiscal accounts, damaging the UK’s financing flexibility, or (2) the likelihood of a break-up of the UK materially increases.

CREDIT RATING RATIONALE

UK Economic Growth Remains Weak While Long-term Challenges Persist

The UK economy is going through a slowdown and the outlook is for a weak recovery. Economic activity has been affected by the energy shock, high inflation, and higher interest rates over the past several months. After reaching a peak of 11.1% in October 2022, the annual inflation rate fell to 6.7% in September 2023 and 4.6% in October. Tighter financial conditions are expected to continue weighing on consumption and investment, though real household incomes are set to recover as inflation starts falling more rapidly. The IMF is forecasting real GDP to grow by just 0.5% in 2023, after growing by 4.1% in 2022. In 2024, it is forecasting growth of 0.6%. In DBRS Morningstar's view, downside risks to the near-term economic outlook include renewed or more persistent inflation, tighter-than-expected financial conditions, renewed financial market turmoil, and an intensification of global geopolitical tensions.

The UK economy has been struggling with chronic low growth. Potential output growth has deteriorated over the years, largely reflecting lower productivity growth for over a decade. Business investment has been, likely weighed on in recent years by Brexit, the pandemic and the energy price shock. The pandemic and Brexit seem to have also slowed growth in the labour force, with increased labour inactivity weighing on growth. At the same time, income inequality is relatively high. The Office for Budget Responsibility’s (OBR) long-term forecasts assume potential productivity about 4% lower compared to remaining in the EU as a result of Brexit alone. Uncertainty remains over the effects of new trade deals on trade, investment and migration, and ultimately on UK potential output. The OBR is projecting lower potential growth in the next years. In March 2022, the government adopted measures to increase labour market participation, including increased childcare support, reforms to working-age benefits, and more generous pensions tax allowances. Additional measures to address low growth are expected in the Autumn Statement. The effectiveness of the labour market measures and that of the temporary capital allowances on investment are yet to be proved.

The Fiscal Position Remains Weak, With the Public Debt Ratio Projected to Continue Increasing in the Coming Years

The fiscal deficit is expected to remain large this year and next. In its Spring Budget 2023, the government adopted measures aimed at further easing cost-of-living pressures on households, supporting economic growth in the medium term, and reducing the government debt ratio over the longer term. The deficit is forecast at 5.5% in FY 2023-24. As the economy recovers and temporary fiscal measures expire, the deficit is forecast to decline. The OBR is forecasting the general government debt-to-GDP ratio to increase to 105.9% in FY 2023-24 and to peak at 107.3% in 2026-27.

The government is planning to return public finances to a healthy path over time, although there are risks to the fiscal outlook. Risks to the downside and the upside stem from the dynamics in inflation, interest rates and growth. While fiscal policy has remained supportive, the policy stance is set to become more restrictive from 2024-25. The government updated its fiscal rules in the Autumn Statement 2022, which now require the public sector debt ratio to decline and the fiscal deficit to fall below 3% of GDP by the fifth year of the rolling forecast (2027-28). Fiscal consolidation was largely pushed back for later years. In DBRS Morningstar's view, backloading fiscal consolidation - with the debt ratio forecast to fall only by 2027-28 - increases the uncertainty over the fiscal path, as this becomes more susceptible to policy changes in view of the electoral cycle.

The debt profile remains broadly favourable, although interest costs have risen rapidly. The average maturity of debt remains very long at just below 14 years, lessening to some extent the impact from higher interest rates. However, bond yields have increased and higher inflation has driven up the cost of index-linked bonds, which account for 25% of the UK debt portfolio. The OBR estimated that debt interest spending almost doubled in FY 2022-23 compared with the previous year. Interest spending is projected to average 3.1% of GDP between 2023-24 and 2027-28, compared with an average of 1.8% in the decade to 2021. On the investor base, major gilt holders include insurance and pension funds with almost 25% of gilts, overseas investors 28% and the BoE 32%. Index-linked bonds meet demand from investors in the large domestic market. 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. This supports DBRS Morningstar’s qualitative assessment of the Debt and Liquidity building block.

Bank Rate Likely to Remain High for Longer Weighing on Activity in the Housing Market

The UK enjoys a high degree of monetary policy credibility and flexibility. To bring inflation down, the BoE has tightened policy substantially, raising Bank Rate gradually from 0.10% to 5.25% between December 2021 and August 2023. The BoE continues to look closely at the tightness in the labour market, wage growth in the private sector, and services inflation, as the three indications of inflation persistence. It has judged that monetary policy will need to remain restrictive for an extended period of time. Quantitative tightening is also progressing, after the BoE started the active sales of government bonds in November 2022. At the same time, the BoE has intervened to safeguard financial stability, responding more recently to the severe volatility in the gilt market in September 2022.

Risks to financial stability appear contained. Household debt remained high at 134% of disposable income in 2022, which could pose a risk if unemployment rises sharply. Moreover, higher mortgage rates are increasingly affecting more households as the term of fixed-rate mortgages expire. Higher rates have also had an adverse impact on the UK housing market, with mortgage approvals falling since September 2022 and house prices falling since May this year on an annual basis by an average of 3%. Risks from high interest rates have weighed on DBRS Morningstar’s assessment of the Monetary and Financial Stability building block. The UK banking system, on the other hand, remains resilient to various adverse economic scenarios, according to the BoE. UK banks’ exposure to commercial real estate, which has seen a sharp fall in prices, remains limited, especially among large banks. In other parts of the UK financial system, after the rapid increase in gilt yields in September 2022 affected part of the UK pension fund market, particularly liability-driven investment funds, their shock absorption has been reinforced with the adoption of new standards.

The Current Account Deficit Deteriorated As a Result of the Terms of Trade Shock

The current account is projected to remain in deficit in the next years. The deficit is largely accounted for by the deficit in goods trade and in the income account, while the services balance has remained in surplus of over 5% of GDP in the past ten years. In 2022, the current account deficit deteriorated reflecting the shock in the terms of trade from the very high import prices of energy and food. The UK is a net importer of gas. After narrowing to 1.5% of GDP in 2021, the current account deficit widened to 3.9% in 2022. The deficit is forecast to remain close to 4% in 2024-2025, according to the IMF. The UK finances the current account deficit mainly through net financial inflows. The UK’s net external liability position remains moderate below 15% of GDP.

Politics Remain Divisive Feeding into Some Degree of Policy Uncertainty

The UK political environment has become more divisive over the past years with political tensions and crises affecting policy predictability. The Conservative party elected Prime Minister Rishi Sunak in October 2022, the fifth Conservative prime minister since 2016, following the resignations of prime ministers Liz Truss in October 2022 and Boris Johnson in July 2022. During times of political crises and with successive changes in leadership, economic policy uncertainty has increased, weighing on the investment environment. Political disagreements within the Conservative party persist over how to tackle the UK’s main economic problems, including low growth. Moreover, the next general election is due by January 2025, which heightens uncertainty over policies as the vote approaches.

In addition to the political divisions, a constitutional debate over the long-term cohesion of the four-nation UK re-surfaced after the UK referendum on EU membership in 2016. A majority in Scotland and Northern Ireland (NI) voted to remain in the EU, while a majority England and Wales voted for Brexit. Regional elections in Northern Ireland in 2022, in which the nationalist Sinn Féin party won the most seats in the NI Assembly, and in Scotland in 2021, in which the pro-independence Scottish National Party remained the largest party in the Scottish parliament, added to the uncertainty over the UK constitutional integrity in the long term. The risk of a break-up of the UK decreased after the UK Supreme Court ruled in November 2022 that the Scottish government does not have the power to legislate for a referendum on Scottish independence, but the issue seems unlikely to fade completely. In Northern Ireland, a political stalemate remains unsolved as the Democratic Unionist Party continues to refuse to form a government given its disapproval of the NI protocol and Windsor Framework. Nevertheless, the Windsor Framework agreed between the UK and the EU in February 2023 clarifies the applicability of EU laws in NI and should smooth the flow of trade within the UK.

The UK still benefits from solid political institutions, with strong governance indicators including the rule of law, lessening some of the risks from domestic political tensions and regional divisions. Yet, regional political divisions and the associated political uncertainties continue to weigh on DBRS Morningstar’s assessment of the Political Environment building block.

ENVIRONMENTAL, SOCIAL, GOVERNANCE CONSIDERATIONS

Environmental (E) Factors
There were no Environmental factors that had a relevant or significant effect on the credit analysis.

Social (S) Factors
There were no Social factors that had a relevant or significant effect on the credit analysis.

Governance (G) Factors
There were no Governance factors that had a relevant or significant effect on the credit analysis.

A description of how DBRS Morningstar considers ESG factors within the DBRS Morningstar analytical framework can be found in the DBRS Morningstar Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings (04 July 2023) https://www.dbrsmorningstar.com/research/416784/dbrs-morningstar-criteria:-approach-to-environmental,-social,-and-governance-risk-factors-in-credit-ratings

For more information on the Rating Committee decision, please see the Scorecard Indicators and Building Block Assessments. https://www.dbrsmorningstar.com/research/423544.

Notes:
All figures are in Pound Sterling unless otherwise noted. Public finance statistics reported on a general government basis unless specified.

The principal methodology is the Global Methodology for Rating Sovereign Governments (06 October 2023) https://www.dbrsmorningstar.com/research/421590/global-methodology-for-rating-sovereign-governments. In addition DBRS Morningstar uses the DBRS Morningstar Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings https://www.dbrsmorningstar.com/research/416784/dbrs-morningstar-criteria:-approach-to-environmental,-social,-and-governance-risk-factors-in-credit-ratings in its consideration of ESG factors.

The credit rating methodologies used in the analysis of this transaction can be found at: https://www.dbrsmorningstar.com/about/methodologies.

The sources of information used for these credit ratings include HM Treasury (Spring Budget 2023), Office of Budget Responsibility (Fiscal Risks and Sustainability Report July 2023, Economic and Fiscal Outlook March 2023), HM Government (The Windsor Framework February 2023, Powering Up Britain March 2023, British Energy Security Strategy April 2022, UK Net Zero Strategy October 2021), Bank of England (Monetary Policy Report November 2023, Financial Stability Report July 2023), UK Debt Management Office (Quarterly Review April-June 2023, 2022-2023 Annual Review), Office for National Statistics, Halifax, IMF, OECD, BIS, World Bank, Our World in Data, Haver Analytics. DBRS Morningstar considers the information available to it for the purposes of providing these credit ratings to be of satisfactory quality.

With respect to FCA and ESMA regulations in the United Kingdom and European Union, respectively, these are unsolicited credit ratings. These credit ratings were not initiated at the request of the issuer.

With Rated Entity or Related Third Party Participation: YES
With Access to Internal Documents: NO
With Access to Management: YES

DBRS Morningstar does not audit the information it receives in connection with the rating process, and it does not and cannot independently verify that information in every instance.

The conditions that lead to the assignment of a Negative or Positive trend are generally resolved within a 12-month period. DBRS Morningstar’s outlooks and ratings are under regular surveillance.

For further information on DBRS Morningstar historical default rates published by the European Securities and Markets Authority (ESMA) in a central repository, see: https://registers.esma.europa.eu/cerep-publication. For further information on DBRS Morningstar historical default rates published by the Financial Conduct Authority (FCA) in a central repository, see https://data.fca.org.uk/#/ceres/craStats.

The sensitivity analysis of the relevant key credit rating assumptions can be found at https://www.dbrsmorningstar.com/research/423542.

These credit ratings are endorsed by DBRS Ratings GmbH for use in the European Union.

Lead Analyst: Adriana Alvarado, Senior Vice President, Credit Ratings, Global Sovereign Ratings
Rating Committee Chair: Thomas Torgerson, Managing Director, Co-Head of Sovereign Ratings, Global Sovereign Ratings
Initial Rating Date: July 19, 2010
Last Rating Date: May 19, 2023

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