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Capital Economics: Why a ratings downgrade won’t hurt the UK

Speculation has grown that the UK is at greater risk of being downgraded by ratings agencies after sitting in recession for three quarters, but a leading macroeconomic consultancy argues such a move would have little impact.

The UK enjoys a AAA rating from each of the three main agencies – Moody’s Investors Service, Fitch Ratings and Standard & Poor’s – while the country is regarded among international investors as being a safe haven.

However, Moody’s and Fitch both have the UK on negative outlook, meaning a downgrade is possible in the event of the government failing to keep its debt within reasonable levels or if growth drops too severely.

Concern has grown that one or more ratings agencies could follow through with a downgrade after preliminary data from the Office for National Statistics this week showed the economy contracted by 0.7 per cent in the second quarter – making the recession deeper than economists expected.

But economic forecasting consultancy Capital Economics says the fear about the impact of a downgrade has been overdone.

UK economist Martin Beck says: “We have long been of the view that the weakness of the economy and the resulting impact on the fiscal position could well lead to a downgrade. But were this to happen, the consequences are unlikely to be significant.”

Several reasons could allow the yield on gilts to remain low even if the UK was no longer rated at AAA, he claims. One of these is the likelihood that the Bank of England will keep the base rate at 0.5 per cent for some time to come – and may take it even lower.

Slowing growth also implies more subdued inflationary pressures and could suggest that gilt yield could drop even further below their already depressed levels, the economist says. Additionally, a weaker outlook could prompt the Bank to embark on more quantitative easing that would help gilt yields low.

Nor does Beck expect the UK to lose its safe haven standing should it be downgraded: “Few investors are restricted to holding only AAA-rated securities and even if the UK was no longer rated AAA, any rules that currently limit the use of securities rated slightly lower could be loosened.”

The economist cites the example of the US’ downgrade by S&P in August last year. The country still traded like a AAA after losing this rating and yields even fell in the days after the downgrade. Today, the yield on 10-year US government bonds is almost 100 basis points lower than just before S&P’s move.

A similar story played out when Japan was stripped of its AAA rating by all three agencies in 2000 and 2001, he adds.

Beck concedes that the UK is more vulnerable than the US and Japan to adverse effects of a downgrade owing to the substantial foreign ownership of gilts. However, the Bank’s ownership of more than a quarter of the entire gilt stock and strong structural demand for gilts from UK pension funds means the country has strong financing advantages.

“Overall then, any loss of the AAA rating shouldn’t come as a major shock. And with the UK still possessing advantages not enjoyed by eurozone members, it is unlikely to lose its safe-haven status,” Beck concludes.

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