Moody's changes outlook on Isle Of Man's ratings to negative from stable, affirms AA1 ratings

 Moody's Investors Service has today changed the outlook on the Isle of Man's (IoM) Aa1 long-term issuer and senior unsecured debt ratings to negative from stable. Concurrently, Moody's has affirmed the IoM's Aa1 ratings. The actions follow a referendum vote in favour of the UK leaving the European Union (EU) and the recent change in the outlook of the UK's Aa1 government rating to negative from stable. 

The decision to change the outlook to negative on the IoM's Aa1 ratings is driven by the following considerations: 

1. The correlation of credit risks between the UK and the IoM in light of the close economic, institutional and financial market linkages. 

2. The island's uncertain growth outlook, given the negative impact that Moody's believes the decision to leave the EU will have on the UK's growth prospects, coupled with the potential for reduced market access to the EU's single market for some sectors of the IoM's economy as a result of the UK's exit from the EU. The manufacturing, agriculture and fishery sectors are particularly exposed, and other sectors of the economy may also be impacted in the event of a prolonged period of uncertainty following the referendum. 

The IoM's long-term and short-term foreign-currency bond and deposit ceilings remain unchanged at Aaa and P-1, respectively. IoM's long-term local-currency bond and deposit ceilings also remain unchanged at Aaa. 

RATINGS RATIONALE 

RATIONALE FOR THE NEGATIVE OUTLOOK 

FIRST DRIVER: RISK OF CONTAGION GIVEN THE CLOSE LINKAGES BETWEEN THE IOM AND THE UK 

The first key driver for the negative outlook is Moody's view of contagion risk stemming from the close linkages between the IoM and the UK as well as the rating agency's decision to change the outlook on the UK's Aa1 government rating to negative from stable following the referendum vote in favour of the UK leaving the EU. In Moody's view, institutional arrangements between the two countries, economic ties and the large presence of British banks in the IoM's banking system constrain the IoM's ratings at the level of the UK's rating. 

As a Crown Dependency, the IoM is not sovereign and relies on institutional connections with the UK in numerous areas. For instance, the country cannot enter into international treaties in its own right. Equally, the island is part of a revenue-sharing agreement with the UK that limits the island's fiscal flexibility. While the recently concluded negotiations on the Customs and Excise Agreement with the UK alleviate uncertainty around how much income will be due to the island, the rating agency highlights that income through the agreement could be weaker than expected given a weaker growth outlook for the UK. 

The IoM's financial sector, comprising insurance (contributing 15% to gross value added), banking (8%), and other financial and business services (10%), is a source of risk. A number of British banks have significant operations in the IoM, as do several banks from other countries. These banks' business models focus on the collection of deposits from overseas or from institutions such as trusts, which are often on-lent to parent banks, some of which are domiciled in the UK. Depositor confidence in the IoM could be eroded if parent banks in the UK were to experience significant financial pressures. 

Given the very large size of the banking sector, at more than 10 times GDP, buffers available to the IoM are, in Moody's view, not sufficient to absorb potential shocks emanating from the banking system. These buffers relate to (1) the island's significant wealth levels, as GDP per capita stood at more than $80,000 in 2015, and (2) fiscal reserves amounting to around 38% of GDP in the reserve fund through which fiscal deficits could be financed. 

In Moody's view, the IoM's creditworthiness is strongly linked to that of the UK, and spill-over effects on the island through economic, institutional and banking channels during a hypothetical severe crisis in the UK would likely put financial pressure on the IoM and its ability to meet its financial obligations. As a result, the credit risks and ratings of the IoM are closely aligned to those of the UK. 

SECOND DRIVER: DIRECT ECONOMIC IMPLICATIONS FOR THE IOM AS A RESULT OF THE UK EXITING THE EU 

The second rating driver relates to the island's uncertain growth outlook in the context of weaker growth in the UK over the medium term and the prospects of reduced access to the EU's single market as a result of the UK exiting the EU. The Isle of Man, as a Crown Dependency, is not a member of the EU, nor is it included within the UK's membership of the EU. The IoM's relationship with the EU is set out in Protocol 3 of the UK's treaty of accession to the EU, which would cease following the UK's exit from the EU. This creates uncertainty about future trade relations between the IoM and the EU. 

In Moody's view, the UK's decision to leave the EU will impact sectors of the Manx economy that are partially dependent on exporting goods to the EU, comprising manufacturing, agriculture and fisheries. These sectors could lose full access to the EU's single market, depending on the outcome of the negotiations between the UK and the EU. While the total contribution to the economy is limited at around 3.4% of the island's national income in 2013/2014 for manufacturing and around 1% of GVA for agriculture and fisheries, the sectors contribute to a larger extent to employment. 

Furthermore, during a prolonged period of uncertainty in which the UK negotiates a new trade agreement with the EU, which has direct implications for the IoM, Moody's expects spill-overs in the form of heightened uncertainty, diminished confidence and lower spending and investment to result in weaker growth for the Isle of Man. 

RATIONALE FOR AFFIRMING THE ISLE OF MAN's Aa1 RATINGS 

The IoM's credit strengths supporting the Aa1 ratings are (1) a wealthy and -- compared to other off-shore financial centres -- a more diverse economy; (2) strong institutions and pragmatic policy making; (3) a prudent approach to the management of government finances with a substantial level of reserves, no direct debt outstanding and manageable levels of indirect debt. 

The IoM's per-capita income is one of the highest in Moody's universe of rated sovereigns at more than $80,000 in 2015, and GDP growth has averaged 4.5% over the last 10 years. The very small size of the economy is balanced by the diversification process the economy has been undergoing, which has been supported by specific government policies and has sustained economic growth during the financial crisis. ICT and e-gaming have been the two fastest-growing sectors. The island's telecommunication and IT infrastructure has supported the development of these sectors over the past several years. 

The IoM is characterized by a strong institutional framework and has established a proactive financial services regulatory policy. The island has an established history of complying with international tax standards and is rated "compliant" by the OECD's Global Forum on Transparency and Exchange of Information for Tax Purposes. 

A prudent approach to managing government finances has resulted in a high level of overall reserves and the absence of direct general government debt. Moody's notes that the level of indirect debt -- issued on behalf of the Manx Electricity Authority (MEA) and the Isle of Man Water Authority, which merged in 2014 to form Manx Utilities -- is limited at around 6% of GDP as of 2015. 

WHAT COULD MOVE THE RATINGS UP/DOWN 

Given the negative outlook on the IoM's Aa1 long-term issuer rating, upward pressure is unlikely. In addition, the Aa1 ratings also reflects a structural shift in the international political and economic climate for offshore centres since the global financial crisis, rendering upward pressure on the ratings unlikely over the medium term. 

Downward pressure on the ratings could arise if Moody's were to observe a material deterioration in the IoM's economic or fiscal position. Equally, given the linkages between the IoM and the UK, a deterioration in the UK's creditworthiness would pose a challenge to the IoM's credit profile. 

The UK's vote to leave the EU required the publication of this credit rating action on a date that deviates from the previously scheduled release date in the sovereign release calendar, published on www.moodys.com. 

GDP per capita (PPP basis, US$): [not available] (also known as Per Capita Income) 

Real GDP growth (% change): 4.5% (2013/2014 Actual) (also known as GDP Growth) 

Inflation Rate (CPI, % change Dec/Dec): -1.6% (2015 Actual) 

Gen. Gov. Financial Balance/GDP: -0.9% (2014/2015 Actual) (also known as Fiscal Balance) 

Current Account Balance/GDP: [not available] (also known as External Balance) 

External debt/GDP: [not available] 

Level of economic development: High level of economic resilience 

Default history: No default events (on bonds or loans) have been recorded since 1983. 

On 28 June 2016, a rating committee was called to discuss the rating of the Isle of Man, Government of. The main points raised during the discussion were: The issuer's institutional strength/framework, has decreased. The systemic risk in which the issuer operates has materially increased. Other views raised included: The issuer's economic fundamentals, including its economic strength, have not materially changed. The issuer's fiscal or financial strength, including its debt profile, has not materially changed. 

The principal methodology used in these ratings was Sovereign Bond Ratings published in December 2015. Please see the Ratings Methodologies page on www.moodys.com for a copy of this methodology. 

The weighting of all rating factors is described in the methodology used in this credit rating action, if applicable.