Losing our AAA rating will make little difference to the UK
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.
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.
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.
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.
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.
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.