It was largely inevitable given the UK’s poor medium-term growth prospects and rising levels of government debt. With debt-to-GDP levels pushing 90 per cent, the UK does not meet the criteria required of a AAA-rated sovereign.
The early announcement of the decision provides an opportunity for chancellor George Osborne to adopt more pro-growth policies in the coming budget.
The UK’s AAA rating was viewed as something of a white elephant – a prized but burdensome possession. Maintaining the country’s credit rating has been one of the key aims of the government’s austerity drive. Freed of this burden, the chancellor has a chance to pursue some much-needed fiscal stimulus.
The impact on the gilt market has been relatively muted so far. A downgrade in itself need not translate to significantly higher borrowing costs, as evidenced by the aftermath of the US and French downgrades where bond yields actually fell in spite of the announcement.
However, gilts could come under increasing pressure due to the UK’s poor fundamentals. With the full impact of austerity still to take effect, it is difficult to see where future growth will come from. With its safe haven status in potential jeopardy, we might begin to see a reversal of the significant foreign inflows.
On the other hand, a rout is unlikely as the Bank of England always has the ability to undertake further monetary stimulus, which should help suppress bond yields. With a limited capacity for growth amid continuing austerity, policymakers are instead looking to inflate their way out of debt.
‘Central Bank regime change’ is a term used to describe an unspoken shift in policy away from delivering price stability and towards stimulating employment and growth. This policy sees interest rates set below the level of inflation.
The UK has had predominantly negative real interest rates since the financial crisis, and this approach was successfully applied post-World War II when the UK had to reduce its highly inflated public debt burden.
The ratings downgrade could be a catalyst for further weakness in sterling. The currency is fundamentally overvalued based on the UK’s persistent current account deficit. This is not economically sustainable and such large deficits have historically preceded a sterling crash.
Furthermore, the improving situation in the eurozone, where the risk of a single currency breakup has receded, may entice investor flows away from sterling and back to the euro.
A depreciation of sterling would be a positive development for the UK economy, which should help stimulate exports and address the trade imbalance.
Jim Leaviss is head of retail fixed interest at M&G Investments
