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FITCH downgrades the United Kingdom to AA ; outlook negative

Fitch Ratings has downgraded the United Kingdom's Long-Term Foreign and Local Currency Issuer Default Ratings (IDR) to 'AA' from 'AA+'. The Outlooks are Negative. The issue ratings on the UK's senior unsecured Foreign and Local Currency bonds have also been downgraded to 'AA' from 'AA+'. The Country Ceiling has been affirmed at 'AAA' and the Short-Term Foreign Currency IDR at 'F1+'.

Under EU credit rating agency (CRA) regulation, the publication of sovereign reviews is subject to restrictions and must take place according to a published schedule, except where it is necessary for CRAs to deviate from this in order to comply with their legal obligations. Fitch interprets this provision as allowing us to publish a rating review in situations where there is a material change in the creditworthiness of the issuer that we believe makes it inappropriate for us to wait until the next scheduled review date to update the rating or Outlook/Watch status. The next scheduled review date for Fitch's sovereign rating on the UK is 9 December 2016, but Fitch believes that developments in the country warrant such a deviation from the calendar and our rationale for this is laid out below.

KEY RATING DRIVERS

The downgrade of the UK's IDRs and Negative Outlook reflects the following key rating drivers and their relative weights:

HIGH

The UK vote to leave the European Union in the referendum on 23 June will have a negative impact on the UK economy, public finances and political continuity.

Fitch believes that uncertainty following the referendum outcome will induce an abrupt slowdown in short-term GDP growth, as businesses defer investment and consider changes to the legal and regulatory environment. While recognising the uncertainty of the extent of the negative shock, Fitch has revised down its forecast for real GDP growth to 1.6% in 2016 (from 1.9%), 0.9% in 2017 and 0.9% in 2018 (both from 2.0% respectively), leaving the level of real GDP a cumulative 2.3% lower in 2018 than in its prior 'Remain' base case.

Medium-term growth will also likely be weaker due to less favourable terms for exports to the EU, lower immigration and a reduction in foreign direct investment. An adjustment in the value of sterling and changes in the business environment could also affect growth.

The extent of the medium-term economic shock will mainly depend on the nature of any future trade agreement with the EU, by far the UK's largest export market. Statements by UK and EU leaders will provide some guidance on the UK government's policy objectives, the likelihood of achieving them and the timeframe for negotiation. However, Prime Minister David Cameron has indicated that negotiations with the EU will not begin in earnest until 4Q16, and the final position may well not be known for several years.

Weaker economic growth will adversely affect tax revenue and the budget deficit and require the government to implement additional fiscal consolidation measures to prevent it missing its fiscal targets. We expect the general government deficit to average 3.6% of GDP over the next three years, compared with 2.8% in our prior 'Remain' base case. This implies that the general government debt ratio will continue rising over the forecast horizon, reaching 91% of GDP in 2017, compared with the debt ratio stabilising previously. Public sector indebtedness remains among the highest of 'AA' and 'AAA' range sovereigns. At the same time, the long average maturity of public debt almost exclusively GBP-denominated and low interest service burden imply a higher level of debt tolerance than many high-rated peers.

The outcome of the referendum has precipitated political upheaval, including the announced resignation of the Prime Minister, contributing to heightened uncertainty over government economic policies and diminished scope for policy implementation at the current conjuncture.

Furthermore, the fact that a majority of voters in Scotland opted for 'Remain' makes a second referendum on Scottish independence more probable in the short to medium term. The Scottish First Minister Nicola Sturgeon has indicated that a second referendum on Scottish independence is "highly likely". A vote for independence would be negative for the UK's rating, as it would lead to a rise in the ratio of government debt/GDP, increase the size of the UK's external balance sheet and potentially generate uncertainty in the banking system, for example in the event of uncertainty over Scotland's currency arrangement.

The UK's 'AA' IDRs also reflect the following key rating drivers:

The UK's ratings benefit from a high-income, diversified and flexible economy. A credible macroeconomic policy framework and sterling's international reserve currency status further support the ratings.

The current account remained high in 2015, at 5.2% of GDP, almost unchanged from the previous year. In addition to a structurally negative trade balance, the income balance has turned negative, recording deficits of almost 2% of GDP in the past two years. There is the risk that the financing of the current account may become more expensive. At the same time, we are confident of the ability of UK banks to fund themselves in foreign currency.

Banks are liquid and were well prepared to withstand market volatility that could limit their access to funding for a period of time. Central bank funding provides them with a further line of defence in case of more protracted market closure. Banks have an aggregate Tier 1 capital ratio of 13.8%, higher than the Bank of England's view on steady state capital requirements of around 11%.

SOVEREIGN RATING MODEL (SRM) and QUALITATIVE OVERLAY (QO)

Fitch's proprietary SRM assigns the UK a score equivalent to a rating of 'AA' on the Long-Term FC IDR scale. Fitch's sovereign rating committee did not adjust the output from the SRM to arrive at the final LT FC IDR.

Fitch's SRM is the agency's proprietary multiple regression rating model that employs 18 variables based on three year centred averages, including one year of forecasts, to produce a score equivalent to a LT FC IDR. Fitch's QO is a forward-looking qualitative framework designed to allow for adjustment to the SRM output to assign the final rating, reflecting factors within our criteria that are not fully quantifiable and/or not fully reflected in the SRM.

RATING SENSITIVITIES

Future developments that could result, individually or collectively, in a downgrade are:

Evidence that Brexit is having a more harmful impact on the UK economy

Worsening public finance developments leading to a continued rise in the government debt to GDP ratio

A more extended period of political uncertainty that undermines the economic policy framework, impedes a clear determination of the UK's future relationship with the EU, or leads to a break-up of the UK.

Future developments that could individually, or collectively, result in the Outlook being revised to Stable include:

 

  • Evidence that the UK's short and medium-term growth prospects prove resilient to the shock of Brexit
  • Further reductions in the budget deficit, leading to a stabilisation in the government debt to GDP ratio.

 

  • Market Data
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