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Losing our AAA rating will make little difference to the UK

Ed Bowsher
by Lovemoney Staff Ed Bowsher on 14 December 2012  |  Comments 10 comments

One of the ratings agencies has put the UK on `negative outlook' and may cut the country's AAA rating at some point over the next two years.

Losing our AAA rating will make little difference to the UK

It sounds scary when you hear that S&P, one of the three main credit rating agencies, says it may cut the UK’s AAA rating. But really it’s not bad.

Before I explain why that’s the case, let’s just take a quick look at what credit ratings are.

What is a credit rating?

Governments and large companies often raise money by issuing bonds that are effectively IOUs made out to bondholders.

These bonds are traded on the financial markets and their prices change all the time. Prices move for all sorts of reasons, but one important factor is whether there’s any chance that the borrower will fail to repay its debts when the bond matures. (Read more about government bonds in Why gilts matter.)

All these big borrowers are given credit ratings by the ratings agencies. These ratings are estimates of how likely it is that a particular borrower will default on its debts.

The three main agencies are S&P, Moody’s and Fitch, and they all give ‘AAA’ ratings to the very best borrowers – the ones who are almost certain to repay their debts. You can see all the different ratings here.

News

This week S&P said there was a one-in-three chance that it might downgrade the UK’s rating from AAA to AA during the next two years. It has also put the UK on ‘negative outlook’ – another way of saying that the rating might be cut in the reasonably near future.

This follows a similar announcement from Moody’s back in February.

Impact

So will a credit rating downgrade make much difference?

Well, the textbook view is that it a downgrade could create problems for the Government. That’s because some investors might be spooked by a downgrade and might decide to sell UK government bonds (gilts). These sales would push down the price of gilts and increase the yield.

Then if the Government needed to issue more gilts – to raise extra cash – it would probably have to pay a higher yield to find buyers. The Government would effectively have to pay a higher interest rate.

That would mean less money to spend on schools, hospitals and so on, or higher taxes.

Individuals might also face higher interest rates. This would be especially likely for new fixed rate mortgages.

The worst case scenario is that bond markets might refuse to buy any more gilts and we would find ourselves in a Greece-style financial meltdown.

As I say, that’s the traditional textbook view of what might happen. But, in reality, I think a debt downgrade would make very little difference. Here’s why:

Credit ratings agencies are discredited

The main credit ratings agencies had a rotten financial crisis. Back in the boom years they had been far too positive about a wide range of borrowers and then got egg on their face when some of those borrowers defaulted.

If the UK was downgraded, few investors would modify their investment strategy and so little would change.

The news is out there

The financial markets already know that George Osborne is going to miss his original targets for cutting the UK’s national debt, but our long-term interest rates are still very low. The bond markets haven’t been scared by Osborne’s deficit reduction plan going off course.

The UK will never default

What’s more, the markets appear to be confident that the UK won’t default on its debts. There are two reasons for this:

a) The majority of the UK Government’s debt is long-term, so the UK doesn’t have to repay onerous levels of debt in the next five years.

b) The UK has its own currency. That means the Bank of England can always ‘print’ more money to pay off debts. Or it can encourage inflation which reduces the real value of our debt.

S&P has already downgraded France and the US

S&P has already cut its ratings for France and the US to AA and not much has happened. The US government has  no difficulty selling government bonds and long-term interest rates remain very low.

Global shortage of low-risk assets

Thanks to the growth of emerging markets, there’s still a shortage of low-risk assets to buy around the world. I’m convinced that many investors will still be happy to buy gilts even if the rating is cut to AA.

The Bank of England

And we shouldn’t forget that the Bank of England may decide to create more new money as part of the QE programme, and the Bank will probably use that money to buy gilts. That will keep long-term interest rates nice and low.

Don’t panic

So if you hear news of a debt downgrade next year, don’t panic. Not much will change.

That said, our economy is not healthy and it will be a long time before there’s a full recovery. I just think that ratings from credit agencies will make very little difference to how long we’ll have to wait.

More on the economy:

Autumn Statement 2012: what it means for you

When should you get financial advice?

How to transform your finances in 2013

City bonuses slashed

ING shouldn't be allowed to sell to Barclays

Libor gets better but still isn't perfect

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Comments (10)

  • Arblaster
    Love rating 43
    Arblaster said

    No, Ed. This is serious. And people have every reason to be scared.

    One of the UK's biggest invisible export industry is its finance industry. The British government has been trying for years to protect the City of London from losing its number one status to other European finance centres, such as Frankfurt. At the moment, Gilts are one of the few high-quality government bonds where they are guaranteed a positive coupon. There are several countries where you will get negative interests on some of their short term bonds. Last I heard there were, I think, seven countries. The only two that come to mind are Denmark and Germany. I have forgotten the others, but I think Sweden and Finland are in there.

    You say:

    And we shouldn’t forget that the Bank of England may decide to create more new money as part of the QE programme, and the Bank will probably use that money to buy gilts. That will keep long-term interest rates nice and low.

    It would keep the interest rates low, but not nice. The low interest rates are having an effect throughout the country. You will have noticed that the interest rates you can get on the high street on your bank accounts and non-marketable bonds have nosedived. Now you can't get much more than 3 percent. And that is the result of quantitative easing and the so-called 'flight to safety.' This will gradually get worse, as the European Central Bank starts to jerrymander the bond yields of countries like Greece and Spain, instead of leaving them to market forces.

    You also say:

    THE UK WILL NEVER DEFAULT

    What’s more, the markets appear to be confident that the UK won’t default on its debts. There are two reasons for this:

    a) The majority of the UK Government’s debt is long-term, so the UK doesn’t have to repay onerous levels of debt in the next five years.

    b) The UK has its own currency. That means the Bank of England can always ‘print’ more money to pay off debts. Or it can encourage inflation which reduces the real value of our debt.

    As I have written before to you on this subject. It can default in two ways: it can refuse to pay part or all bond coupons and even principals on maturity; or it can pay coupons and principals with inflated currency. In the latter case, the bondholder will get his money, but the money won't be worth anything. And inflation, which you think so highly of, means that you will not be able to afford anything in the shops, or to fill your car to get to work.

    You may know that the bond markets are in for an almighty crash, which is one reason why I am not holding any marketable bonds at the moment. WHEN the markets do, the interest rates are on their way to Jupiter - NICE and high.

    Report on 17 December 2012  |  Love thisLove  1 love
  • PDB11
    Love rating 75
    PDB11 said

    Ed, Arblaster, I think there's another thing you've both missed.

    Pension funds - and maybe other funds - have rules about what proportion of their investment they can keep in pots of a given credit rating. There's a minimum proportion for A rated investments, and so on.

    I don't actually know if there's a set minimum for AAA, but if there is:

    When a country is downgraded, a lot of these funds find that they no longer meet their investment criteria, and they have a set time to put this right. So they sell the downgraded stock and buy other things.

    Not only does this mean a massive upheaval in our pensions, it means that just as the country's government is in trouble, people start selling its stock all over the place. So it's not just the credit rating, it's the market that will make it harder for the Government to borrow.

    Incidentally, "The UK will never default". Well, it was before we had a UK, but England did default, back in the 14th century, I think. The repercussions were felt across Europe. Several big Italian banks collapsed. I don't think the Italians have forgiven us, even now. "Never" is a sweeping generalisation to use in these troubled times!

    (OK, the relative strengths of the British and Italian economies are now the other way around. But what does this mean for us if Greece or somewhere does go under?)

    Report on 17 December 2012  |  Love thisLove  1 love
  • Ed Bowsher
    Love rating 80
    Ed Bowsher said

    Hi all,

    I stand by my view that a downgrade per se will make little difference.

    Fine, on an historic basis, bonds look very expensive. We may see some falls in prices. But will a downgrade contribute to that? I suspect that contribution will be very small.

    If there is a global shift away from bonds - ie the 'flight to safety' reverses - then gilt yields will rise. But I don't think a debt downgrade will make much difference to that. And anyway, I suspect that any global shift will be fairly modest. We probably won't see a full bond market crash in the next couple of years.

    I don't 'love' inflation. I'm well aware of the damage it can cause. But, unlike many, I don't see it as a serious worry for the next few years.

    Re default: you can argue about what the word means. Fine, you could argue that a period of hyperinflation is an effective default. But I don't see hyperinflation coming. I'm happy to use the word 'never' for the definition of just not paying up. 'Unlikely' for hyperinflation.

    Re savings: yes, I'm well aware that many savers and pensioners have suffered thanks to low interest rates. It's also been good news for debtors - including mortgage borrowers and the government.

    The important point is that I don't think a debt downgrade will make much difference either way.

    To be clear, we have serious economic problems. I just don't think that a downgrade to AA will make much difference either way.

    Ed

    Report on 17 December 2012  |  Love thisLove  0 loves
  • Arblaster
    Love rating 43
    Arblaster said

    Hi Ed, PDB 11

    @PDB11, you say:

    Ed, Arblaster, I think there's another thing you've both missed.

    Pension funds - and maybe other funds - have rules about what proportion of their investment they can keep in pots of a given credit rating. There's a minimum proportion for A rated investments, and so on.

    In fact as far back as June 11, I posted on Love Money:

    I have been told that a certain portion of a "proper" pension plan has to be in government bonds. Right at this moment government bonds are a huge bubble in search of a pin.Most people don't even know they own government bonds. When the bubble pops, anyone with a pension plan is in for a right royal haircut.

    I think I am correct in saying that gilts have never been so high before. It is obvious that there is going to be one huge collapse. It is no secret: several publications, such as the Fleet Street Letter - Moneyweek, I think, too - have predicted it.

    I have also posted on Love Money that each private pensionholder is in for a triple whammy in regards to bonds:

    (I) Because the price is so high, the number of units your premium will buy is low;

    (II) The interest any new units are generating will be lower than at any time in living memory;

    (iii) Depending on what your fund manager does, you will lose money WHEN the bond market tanks. Either the manager will sell your bonds to buy in at new prices, or he will leave the bonds to maturity date, where you will lose money anyway, because your bonds were bought at a premium.

    The government should really change the rules right at this moment, so that fund managers could be allowed to sell gilts and move clients' money to somewhere safer. But I think we know that the government are not going to do that.

    @Ed

    The UK is not only producing its own inflation, it is importing it from the USA too. This is very, very serious. And, no, I do not believe that the jerrymandered CPI and RPI are accurate measures of inflation.

    You may be right that the bond markets will not collapse in the next two years. The only certainty is that they WILL collapse.

    And if the three major rating agencies downgrade the UK and leave Germany with three As, then that will put more business Frankfurt's way, and leave a huge dent in the turnover and credibility of the City.

    Report on 17 December 2012  |  Love thisLove  0 loves
  • nickpike
    Love rating 308
    nickpike said

    Ed said,

    "Re savings: yes, I'm well aware that many savers and pensioners have suffered thanks to low interest rates. It's also been good news for debtors - including mortgage borrowers and the government."

    What an attitude, Lets manage the economy the wrong way round shall we. Lets help debtors and screw savers. Even the Victorians realised this was wrong and had debtors jails to deter debt.This is an unsustainable system and is bound to collapse.

    And lets keep interest rates low. Now the laws of consequence kick-in. Mortgages may be kept low, but house prices are kept artificially high and too much wealth gets locked into a house and not allowed to flow around the system. But what you save on mortgages, you lose on ever increasing food and fuel prices.

    Have you not walked down the high street lately. How many more shops have to close before you notice something is going on? Do you know that Comet has shut shop today with a loss of 6,600 jobs?

    All you evidence points one way. NOTHING IS GETTING ANY BETTER.

    This whole article is tinged with the idea that buying property is still a good idea. I fail to see why so many people think it's OK to pay far too much for a house. When interest rates rise, millions will be repossessed. Credit crunch 2 is fermenting as we speak.

    What a country. We have become greedy and irresponsible.

    I'm sorry, but I prefer to believe Max Keiser. He suggests we will have a

    bond collapse in the next 3 to 4 months, and his evidence is far more compelling than yours. He even moved his studio to London to get a ring side seat.

    The economic situation is so broken, it has to collapse, and house prices will do the same. Why should prices drop 50-70% in Ireland, the USA and Spain and not here. Having the pound has merely postponed the inevitable.

    BTW, Ed, how big is you portfolio?

    Report on 17 December 2012  |  Love thisLove  0 loves
  • MK22
    Love rating 169
    MK22 said

    The saddest thing about credit reference agencies is that they actually don't have a clue, but nobody in the finance industry realizes. The UK's financial problems have been caused by selling off our (manufacturing) industry to foreigners and relying on the financial boys to bail us out. Where as anyone who actually understood economics would have been doing the opposite. But Thatcher only had a second in Chemistry......

    Report on 17 December 2012  |  Love thisLove  1 love
  • Arblaster
    Love rating 43
    Arblaster said

    I'm sorry, but I prefer to believe Max Keiser. He suggests we will have a

    bond collapse in the next 3 to 4 months, and his evidence is far more compelling than yours. He even moved his studio to London to get a ring side seat.

    Yes, I love Max and Stacey too...and Faber, Schiff, Celente and the late, lamented Bob Chapman.

    Meanwhile in good old Blighty, we had that trader who appeared on the BBC about a year ago and told everybody what the economy was really like. What happened? They did their best to bury the news, even insinuating that this guy was a fake. (He wasn't.)

    Things have reached a pretty pass when we have to go to Russia Today and Alex Jones's Infowars to find out the truth.

    Report on 18 December 2012  |  Love thisLove  0 loves
  • Ed Bowsher
    Love rating 80
    Ed Bowsher said

    There are so many points here, I can’t answer them all.

    But I’ll just say a few things and then disappear. This will be my last comment on the thread.

    Just to emphasise – the article is about why any downgrade will make little difference. I stand by that – look at what has happened in the US since its downgrade.

    MK22 said: “The saddest thing about credit reference agencies is that they actually don’t have a clue, but nobody in the finance industry realises.”

    I disagree. If you’re talking about Moody’s and S&P, I think there are many folk in the City and elsewhere who attach very little value to what they say.

    Re the bond collapse: Personally I doubt we’ll have a bond collapse in the next three or four months, but I can’t rule it out completely. (I’d define a ‘collapse’ as a fall in bond prices of at least 15%.) But if we do get such a collapse, I’m sure that a UK downgrade will have had very little to do with it.

    That said, I wouldn’t be surprised if bond prices do fall gradually over the next few years. I certainly don’t see gilts as a good investment right now. I don’t own any.

    Moving on, I’d be delighted if UK house prices fell some more. Especially in London (where they haven’t fallen.) I’m not a property fanatic.

    I also agree that pension funds are forced by regulators to invest too much in gilts. I’ve written that before on this site. But, sadly, those regulations probably won’t change.

    I also agree that the economy is in a mess and won’t recover fully for a long time.

    Where I differ from most of the commenters is that I’m not losing sleep over inflation. I don’t think inflation is about to take off. It’s not our primary economic problem. Our problem is lack of growth.

    I know the current low interest rates are hard for savers. But it would be completely mad to push up interest rates at the moment. The economy would nosedive and everyone would suffer – including savers.

    Report on 18 December 2012  |  Love thisLove  0 loves
  • Tanni
    Love rating 92
    Tanni said

    Considering the company known as the UK has been bust since 1914; it don't matter if we have 5 star AAAAA rating.

    Report on 31 December 2012  |  Love thisLove  0 loves
  • Tanni
    Love rating 92
    Tanni said

    Agree with realistic Max Kieser

    Report on 31 December 2012  |  Love thisLove  0 loves

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