U.K.’s Euro Zone Reliance Increases Downgrade Chances

With the triple-A rating of U.K. gilts now on warning from Moody’s, the U.K. has now been sucked into the euro zone problem despite not being part of the currency bloc.


The safe-haven status of U.K. government debt has been thrown into doubt by a leading rating agency’s warning that gilts could lose their top-notch ranking.

The news shows the highly contagious nature of the euro zone debt crisis, which now threatens to claim as victim a country not even in the currency bloc.

Moody’s cautioned that “the high risk of further shocks (economic, financial, or political) within the currency union are [sic] exerting negative pressure on the U.K.’s triple-A rating given the country’s trade and financial links with the euro area.” Historically, warnings by Moody’s of a “negative outlook” have been followed by downgrades in 30 percent of cases.

The news, announced late on Monday, prompted frenetic debate among analysts about the future safety of both the £1,175bn ($1.8 trillion) British government bond market and British assets in general.

The decision by Moody’s reflects the already parlous state of U.K. government finances, as well as the pressures that could make them even worse.


Credit Suisse said in a research note, “It is not a surprise that the U.K. finds itself under such scrutiny.” It explained: “The U.K.’s general government debt ratio is set to peak just below 100 percent of GDP, a level at which agencies tend to place triple-A ratings under greater scrutiny. And this year the U.K.’s deficit is set to be larger than that of Greece.” The European economy regards Greece — among a long and highly competitive list of invalids — as the ultimate sick man of Europe.

Credit Suisse forecasts the U.K.’s fiscal deficit at about 7.5 percent of GDP this year, compared with about 7 percent for Greece and only 1 percent for Germany.

The rating agency’s argument that the U.K.’s creditworthiness is closely entwined with the euro zone’s fortunes reflects its economic dependence on the bloc. About half of U.K. exports are sold to countries within the region.

But despite the gloomy prognosis by Moody’s, yields on the benchmark 10-year gilt fell six basis points to 2.07 percent on Tuesday – only 11bp above December’s record low of 1.96 percent.

One explanation for the amazing resilience of gilt prices is that other countries’ public finances are in an even worse state. Several euro zone nations, such as Italy, have lower deficits but higher overall debt burdens relative to GDP and considerably worse prospects to run down debt by engineering economic growth.

“The U.K. has benefited from safe-haven status, and it remains well placed to do so,” said Philip Rush, U.K. economist at Nomura in London. “Indeed, the downgrades of euro area sovereigns alongside this announcement are a timely reminder that there are bigger problems elsewhere.”

Moody’s also assigned negative outlooks to triple-A rated France and Austria and downgraded six euro zone countries.

Those who think that U.K. gilts’ safe-as-houses reputation will be unaffected by the Moody’s decision can point to the example of the U.S.; in August Standard & Poor’s, the leading rival to Moody’s, downgraded it from triple-A for the first time in the country’s history. Yields fell, however, because investors could see no sovereign debt market of similar size and liquidity that was any less dangerous.

Other analysts think that gilt yields are at risk of rising appreciably in the future — but only if a major rating agency takes the next step beyond placing the U.K. on negative outlook, by actually downgrading it.

The loss of the U.K.’s triple-A rating could raise yields by 50bp, according to research by Bank of America Merrill Lynch, based on looking at average yield spreads between triple-A and double-A U.K. corporate bonds.

But Credit Suisse points to a third possibility, “It may well be that markets should regard this as a downgrade risk for sterling rather than gilts.”

Its argument rests on an analysis of how euro zone debt contagion could, in practical terms, hit countries that do not use the euro.

In the second half of last year, fears about government insolvency in Greece and then in Italy prompted higher yields across most of the euro zone. They continued rising because the European Central Bank made clear that it had neither the inclination nor the legal authority to force yields back down by printing euros in order to buy unlimited amounts of euro zone members’ debt.

In contrast, bond traders know that the Bank of England is able to buy unlimited amounts of gilts if necessary, funding this by printing unlimited amounts of sterling. This knowledge has forestalled any run on U.K. government bonds, despite the U.K.’s poor fiscal position.

A dramatic expansion of the sterling money supply, however, would reduce the value of sterling to a correspondingly dramatic degree.

Credit Suisse’s theory, so far, has been supported by market reaction. Although gilt yields fell on Tuesday, in U.S. afternoon trading the pound was down 0.7 percent on the day against the dollar at $1.566.

HSBC made a gloomy assessment of all nine countries on Moody’s Monday danger list, saying: “Solvency depends on economic growth. And there is precious little sign that any of these debt-ridden European economies are heading back to growth.”