Morningstar DBRS Confirms the United Kingdom at AA, Stable Trend

DBRS Ratings Limited (Morningstar DBRS) confirmed the United Kingdom of Great Britain and Northern Ireland’s (the United Kingdom or the UK) Long-Term Foreign and Local Currency – Issuer Ratings at AA. At the same time, Morningstar DBRS confirmed the Short-Term Foreign and Local Currency – Issuer Ratings at R-1 (high). The trend on all ratings is Stable.

KEY CREDIT RATING CONSIDERATIONS
The Stable trend reflects Morningstar DBRS’ view that risks to the credit ratings are balanced. The UK economy has started to recover after a slowdown largely driven by persistent high inflation and tight financial conditions. In the near term, the recovery is expected to be tepid as financial conditions are projected to ease only gradually, with the Bank of England expected to begin cutting its policy rate later in the year. Headline inflation has fallen close to 3%, but services inflation and wage growth still point to some inflation persistence. At the same time, the fiscal deficit is forecast to narrow gradually in the coming years while the general government debt ratio is projected to decline after peaking at almost 104% of GDP in 2026, as presented in the government’s Spring Budget in March 2024. The UK debt profile remains broadly favourable, but interest costs have increased. The government remains committed to its fiscal rules of reducing the fiscal deficit and the public sector debt ratio over time, but risks to the fiscal outlook remain significant, particularly given the approaching general election due by January 2025. Financial vulnerabilities appear contained, limiting risks to financial stability.

The credit rating for the UK is supported by its large, diverse and wealthy economy, very strong governance indicators, including the rule of law and government effectiveness, its financing flexibility and its robust and credible monetary policy. The UK’s deep and liquid capital markets, alongside the reserve currency status of the pound sterling, supports the UK’s significant degree of financing flexibility. The Bank of England (BoE) oversees a reserve currency that supports the country’s substantial capacity for external adjustment. However, the country also faces credit challenges stemming from weak public sector finances – a persistent fiscal deficit and high government debt – low economic growth and external imbalances, with a recurrent current account deficit. Uncertainty over the long-term cohesion of the four-nation UK also poses some challenges.

CREDIT RATING DRIVERS
An upgrade could occur if (1) the public debt ratio returns to a sustained downward path, or (2) the UK’s growth prospects improve, with higher and sustained productivity growth. A downgrade could occur if (1) a severe economic or financial shock has a material adverse impact on the economy and fiscal accounts, damaging the UK’s financing flexibility, or (2) the likelihood of a break-up of the UK materially increases.

CREDIT RATING RATIONALE

UK Economic Growth Is Gradually Picking up While Long-term Challenges Persist

The UK economy has exited a technical recession but the recovery is expected to be relatively weak in the near term. The UK posted growth of just 0.1% in 2023, as economic activity was hit by the energy shock, high inflation, and higher interest rates. The headline inflation rate has now fallen markedly, to 3.2% in March 2024 compared with a peak of 11.1% in October 2022. But core inflation at 4.2% and services inflation at 6.0% remain relatively high and monetary policy remains tight. Inflation is expected to continue falling, boosting real incomes, but financial conditions are expected to ease only to some degree this year. With interest rates remaining high and fiscal support fading, the IMF is forecasting UK real GDP to grow by just 0.5% in 2024, followed by a stronger 1.5% in 2025 as the recovery broadens. In Morningstar DBRS' view, downside risks to the near-term economic outlook include renewed inflation, tighter-for-longer financial conditions, renewed financial market turmoil, or an intensification of global geopolitical tensions.

For years the UK economy has been struggling with persistent low growth, mostly reflecting lower productivity growth for over a decade. Brexit, the pandemic and the energy price shock have weighed on business investment in recent years. A rise in long-term sickness combined with Brexit seems to have also slowed growth in the labour force, with increased labour inactivity. The government has adopted measures to increase labour market participation, including increases to childcare support, reforms to working-age benefits, and more generous pensions tax allowances. It has also adopted measures to increase business investment, including permanent full-expensing for qualifying business investment and ongoing support for the five key growth sectors in the government’s long-term strategy – creative industries, advanced manufacturing, green industries, digital technology and artificial intelligence (AI), and life sciences. At the same time, its ‘levelling up’ agenda to address income inequality in the UK is being backed up by various initiatives including the Investment Zones programme. The measures adopted in the Spring Budget 2024, together with those of the previous two fiscal events – Autumn Statement 2023 and Spring Budget 2023 – are expected to increase potential output level by 0.7% cumulatively by 2028-29, according to the government. However, the effectiveness of these policy measures is yet to be proved.

The Fiscal Deficit Is Declining, But the Public Debt Ratio Is Projected to Continue Increasing For a Few More Years

The fiscal deficit is expected to narrow gradually in the coming years. In its Spring Budget 2024, the government adopted measures aimed at boosting economic growth and reducing the government debt ratio over the medium term. As the economy recovers and temporary fiscal measures expire, the deficit is forecast to decline steadily. Recent tax cuts are expected to be followed by higher taxes in later years, which includes the reform to the non-domicile regime. The Office for Budget Responsibility (OBR) is forecasting the deficit at 3.9% in FY 2024-25, followed by 3.1% in 2025-26, leading the general government debt-to-GDP ratio to increase further to 103.8% in FY 2026-27, before starting to fall gradually. Downside and upside risks to the fiscal outlook stem from the dynamics in inflation, interest rates, and economic growth. The OBR has also highlighted that changes to net migration could also affect the fiscal forecasts. The government appears committed to its fiscal rules, updated in the Autumn Statement 2022 and which require the public sector debt ratio to decline and the fiscal deficit to fall below 3% of GDP by the fifth year of the rolling forecast (2028-29). In Morningstar DBRS' view, backloading fiscal consolidation - with the debt ratio forecast to fall only by 2028-29 - increases the uncertainty over the fiscal path, as this becomes more susceptible to policy changes in view of the electoral cycle.

The debt profile remains broadly favourable, although interest costs have risen rapidly. The average maturity of debt remains very long at just above 14 years, lessening to some extent the impact from higher interest rates. However, bond yields have increased and higher inflation has driven up the cost of index-linked bonds, which account for 26% of the UK debt portfolio. Index-linked bonds meet demand from investors in the large domestic market. Debt interest spending almost doubled in FY 2022-23 compared with the previous year. The OBR is forecasting interest spending to average 3.3% of GDP between 2023-24 and 2027-28, compared with an average of 1.9% in the decade to 2021. On the investor base, major gilt holders include insurance and pension funds with almost 23% of gilts, the BoE 28% and overseas investors 31%. Despite the volatility in the gilt market in 2022, the UK enjoys a high degree of financing flexibility, given the depth of the UK debt market and sterling’s status as a reserve currency. This supports Morningstar DBRS’ Debt and Liquidity building block assessment.

Monetary Policy Remains Restrictive Weighing on Activity in the Housing Market

The UK enjoys a high degree of monetary policy credibility and flexibility. To bring inflation down, the BoE tightened policy substantially raising Bank Rate gradually from 0.10% to 5.25% between December 2021 and August 2023. Since then the policy rate has remained unchanged given the persistence in inflation, but financial markets are expecting the BoE to cut rates rate later in 2024. The BoE continues to look closely at the tightness in the labour market, wage growth in the private sector, and services inflation, as the three indicators of inflation persistence. At the same time, quantitative tightening is progressing.

Risks to financial stability appear contained. Household debt remained high at 127.2% of disposable income in 2023, which could pose a risk if unemployment rises sharply. Moreover, higher mortgage rates have increasingly affected indebted households as the term of fixed-rate mortgages expire. The extended period of high rates also had an adverse impact on the UK housing market, with mortgage approvals weakening and house prices falling moderately in 2023, with both starting to recover recently. Risks from high interest rates have weighed on Morningstar DBRS’ assessment of the Monetary and Financial Stability building block. The UK banking system, on the other hand, remains resilient to various adverse economic scenarios, according to the BoE. UK banks’ exposure to commercial real estate, which has seen a sharp fall in prices, remains limited, especially among large banks. In other parts of the UK financial system, after a rapid increase in gilt yields in September 2022 affected part of the UK pension fund market, particularly liability-driven investment funds, their shock absorption capacity has been reinforced with the adoption of new standards.

The Current Account Deficit Deteriorated as a Result of the Terms of Trade Shock

The current account is projected to remain in moderate deficit in the next years. The deficit is largely accounted for by the deficit in goods trade and in the income account, while the services balance has remained in surplus of around 6% of GDP in the past five years. In the past two years, the current account deficit deteriorated reflecting the shock in the terms of trade from high import prices of energy and food. The UK is a net importer of gas. In 2023, the current account deficit stood at 3.1% of GDP following a deficit of 3.2% in 2022. The IMF is forecasting a deficit below 3% in the coming years. The UK finances the current account deficit mainly through net financial inflows. The UK’s net external liability position has also deteriorated slightly, reaching 31% of GDP in 2023.

Politics Remain Divisive Leading to Some Degree of Policy Uncertainty

The UK political environment has turned more divisive over the past years with political tensions and crises affecting policy predictability. The Conservative party elected Prime Minister Rishi Sunak in October 2022, the fifth Conservative prime minister since 2016, following the resignations of prime ministers Liz Truss in October 2022 and Boris Johnson in July 2022. During times of political turmoil and with successive changes in leadership, economic policy uncertainty has increased, weighing on the investment environment. Political disagreements persist over how to tackle the UK’s main economic problems. Moreover, the next general election is due by January 2025, which heightens uncertainty over policies as the vote approaches.

In addition to the political divisions, a constitutional debate over the long-term cohesion of the four-nation UK re-surfaced after the UK referendum on EU membership in 2016. A majority in Scotland and Northern Ireland (NI) voted to remain in the EU, while a majority England and Wales voted for Brexit. Regional elections in Northern Ireland in 2022, in which the nationalist Sinn Féin party won the most seats in the NI Assembly, and in Scotland in 2021, in which the pro-independence Scottish National Party remained the largest party in the Scottish parliament, added to the uncertainty over the UK constitutional integrity in the long term. The risk of a break-up of the UK decreased after the UK Supreme Court ruled in November 2022 that the Scottish government does not have the power to legislate for a referendum on Scottish independence, but the issue seems unlikely to fade completely. In Northern Ireland, after a two-year political stalemate driven by the Democratic Unionist Party’s disapproval of post-Brexit trade arrangements, a government was formed in February 2024.

The UK still benefits from solid political institutions, with strong governance indicators including the rule of law, lessening some of the risks from domestic political tensions and regional divisions. Yet, regional political divisions and the associated political uncertainties continue to weigh on Morningstar DBRS’ assessment of the Political Environment building block.

ENVIRONMENTAL, SOCIAL, AND GOVERNANCE CONSIDERATIONS

Environmental (E) Factors
There were no Environmental factor(s) that had a relevant or significant effect on the credit analysis.

Social (S) Factors
There were no Social factor(s) that had a relevant or significant effect on the credit analysis.

Governance (G) Factors
There were no Governance factor(s) that had a relevant or significant effect on the credit analysis.

A description of how Morningstar DBRS considers ESG factors within the Morningstar DBRS analytical framework can be found in the Morningstar DBRS Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings (23 January 2024) https://dbrs.morningstar.com/research/427030/morningstar-dbrs-criteria:-approach-to-environmental,-social,-and-governance-risk-factors-in-credit-ratings.

For more information on the Rating Committee decision, please see the Scorecard Indicators and Building Block Assessments. https://www.dbrsmorningstar.com/research/432898.

Notes:
All figures are in pound sterling unless otherwise noted. Public finance statistics reported on a general government basis unless specified.

The principal methodology is the Global Methodology for Rating Sovereign Governments (06 October 2023) https://dbrs.morningstar.com/research/421590/global-methodology-for-rating-sovereign-governments. In addition Morningstar DBRS uses the Morningstar DBRS Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings https://dbrs.morningstar.com/research/427030/morningstar-dbrs-criteria:-approach-to-environmental,-social,-and-governance-risk-factors-in-credit-ratings in its consideration of ESG factors.

The credit rating methodologies used in the analysis of this transaction can be found at: https://dbrs.morningstar.com/about/methodologies.

The sources of information used for these credit ratings include HM Treasury (Spring Budget 2024), Office of Budget Responsibility (Economic and Fiscal Outlook March 2024, Fiscal Risks and Sustainability Report July 2023), UK Debt Management Office (Quarterly Review October-December 2023), HM Government (Powering Up Britain March 2023, British Energy Security Strategy April 2022, UK Net Zero Strategy October 2021), Bank of England (Monetary Policy Report May 2024, Financial Stability Report December 2023), Office for National Statistics, Department for Energy Security and Net Zero, IMF, OECD, BIS, World Bank, Haver Analytics. Morningstar DBRS considers the information available to it for the purposes of providing these credit ratings to be of satisfactory quality.

With respect to FCA and ESMA regulations in the United Kingdom and European Union, respectively, these are unsolicited credit ratings. These credit ratings were not initiated at the request of the issuer.

With Rated Entity or Related Third Party Participation: YES
With Access to Internal Documents: NO
With Access to Management: YES

Morningstar DBRS does not audit the information it receives in connection with the rating process, and it does not and cannot independently verify that information in every instance.

The conditions that lead to the assignment of a Negative or Positive trend are generally resolved within a 12-month period. Morningstar DBRS’ outlooks and ratings are under regular surveillance.

For further information on Morningstar DBRS historical default rates published by the European Securities and Markets Authority (ESMA) in a central repository, see: https://registers.esma.europa.eu/cerep-publication. For further information on Morningstar DBRS historical default rates published by the Financial Conduct Authority (FCA) in a central repository, see https://data.fca.org.uk/#/ceres/craStats.

The sensitivity analysis of the relevant key credit rating assumptions can be found at: https://www.dbrsmorningstar.com/research/432897.

These credit ratings are endorsed by DBRS Ratings GmbH for use in the European Union.

Lead Analyst: Adriana Alvarado, Senior Vice President, Sector Lead, Global Sovereign Ratings
Rating Committee Chair: Thomas R. Torgerson, Managing Director, Global Sovereign Ratings
Initial Rating Date: July 19, 2010
Last Rating Date: November 17, 2023

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