Last month the UK says goodbye to the EU. A referendum induced socio-political metamorphosis dawned on the UK, a grey and gloomy sky of uncertainty prevails over the economic landscape of the UK. In an overnight move, Moody’s downgraded UK’s credit rating outlook to negative from stable. Moritz Kramer, chief ratings officer for S&P, said on the same morning that the UK’s AAA rating was “untenable under the circumstances”. Subsequently, S&P and Fitch both downgraded sovereign credit rating of the UK to AA+ from AAA.
Since 1909 there are mainly three major credit rating agencies. Their historic reputation and sourcing of major credit data make them key players. However, following Credit Rating Reform Act 2006, a number of minor rating agencies across the USA and globe were formed. All three major credit rating agencies, i.e. Standard and Poor’s (S&P), Moody’s and Fitch work on same principles—provide a measured assessment of the probability that a country will default on its debts.
In principle, they offer an outlook for the borrowing cost for the countries and financial institutions. Although the process of rating is often subjective, but significant for the countries’ financial services. The IMF finds that rating used by the agencies are reasonably good indicators of sovereign-default risk. The methodologies adopted by the credit agencies are broadly consistent with the corporate credit rating methods.
Although the recent downgrade is marginal but the ramification is wide reaching in light of recent uncertainty induced by Brexit. The market will be affected, leading to weak share price of banks. Banks take support from the government and the current political climate is shrouded by uncertainty, thus risk-return variance will have a tail-risk. Therefore, the banks and financial institution will turn risk-averse and the public finance will be affected by the GDP squeeze. That, in turn will widen fiscal deficit. The entire process has a domino effect. Therefore, a short-term fix is nearly implausible and it’s unlikely that Britain will be upgraded soon. Most importantly the reversal process will be sluggish and would take considerable time, say more than 2 years for an upward swing. Interestingly, unlike Greece, UK have far fewer friends to show solidarity and goodwill. Therefore, any bailout for the UK would appear as a grave and horrid sin.
So, what happens next.
- The uncertainty reigns and the market volatility soars. Thus, a higher borrowing rate will trigger leading to more and more—liquidity contraction. Among others, the fiscal savings earned over last few years as a result of financial austerity will be eroded, if not fully but certainly partly. The budget deficit will widen and the measures to maintain the forward looking macro-economic model will be hampered.
- A full separation following Article 50 invoked, might take more than 2 years to complete the UK’s exit from the EU. Although prime minister David Cameron promised no immediate changes, but the UK market will experience a medium term retraction from the other member states of the EU. This, in effect will influence the material prospect of growth and the renegotiation process of UK with other EU trading partners. This will make public finance to suffer and welfare outputs to be limited.
- Since several policy-making changes are to be developed afresh, the institutional stability of the UK will be challenged. Once the institutional framework is in question, the related measures to continue with the growth and investment will be on hold. Moody concurrent with the rating action on the sovereign, and has also changed the outlook to negative for the Aa1 rating of the Bank of England from stable.
- With a more constrained financial condition, the risk premia will rise as the cost of financing will increase. Therefore, Moody expects the real GDP growth will go down half a percent in 2016 contrary to the agency’s previous forecast of 1.8%.
- With less financial consolidation and falling pound sterling, the public will face a pinch with their savings, pensions, house prices, social benefits, holidays and travel with higher borrowing cost.