The UK now owes more than £1trillion, but the difference of spending above tax is falling to give Chancellor George Osborne a fighting chance of hitting deficit reduction targets.
The United Kingdom loss of its top credit rating will have many consequences for the country, but not all of them will be negative.
SO WHAT IS A TRIPLE-A RATING?
The highest possible rating assigned to the bonds of an issuer by credit rating agencies. An issuer that is rated AAA has an exceptional degree of creditworthiness and can easily meet its financial commitments. Ratings agencies such as Standard & Poor’s and Fitch Ratings use the AAA nomenclature to indicate the highest credit quality, while Moody’s uses Aaa.
As bonds that are rated AAA are perceived to have little risk of default, they offer investors the lowest yields among bonds of comparable maturity. The global credit crisis of 2008 resulted in a number of companies, including General Electric, losing their AAA rating. By the end of 2009, only four companies in the S&P 500 possessed the coveted AAA rating: Automatic , Johnson & Johnson, Microsoft and ExxonMobil.
The UK Government’s triple-A credit rating, the highest rating possible, was downgraded to Aa1 by Moody’s, one of the three major credit-rating agencies.
That was political dynamite given how much emphasis Chancellor George Osborne has placed on retaining a triple-A rating. The two other major agencies, Standard & Poor’s and Fitch, have announced that they will review their rating the month’s Budget.
It is the ratings agencies recognising that Britain is a marginally less safe place to loan cash to.
Moody’s blamed “continuing weakness in the UK’s medium-term growth outlook, with a period of sluggish growth which [it] now expects will extend into the second half of the decade”.
Last year, all three agencies put the UK on “negative outlook”, meaning they could downgrade its rating if performance deteriorates.
WAS THE DOWNGRADE EXPECTED, THEN?
Due to the “negative outlook” warning issued last year, the downgrade did not come as a surprise.
The stock market actually rose in reaction to the news, as did the price of government bonds (gilts). Investors had seen it coming.
This is not to say that Britain was unaffected. The value of the pound fell further against the dollar and the euro on Monday, spelling bad news for holidaymakers and importers.
HOW BAD IS BRITAIN’S DEBT?
Currently It stands at £1.2 Trillion and is growing fast. While Mr Osborne has successfully managed to reduce the deficit – the annual overspend – we are still a long way off having debt levels under control.
In 2011 Britain borrowed £121bn to balance the books, compared to £36bn in 2008. The last time Britain did not need to borrow money was 2001, when there was a surplus of £8.4bn.
When the OECD last measured gross debts of each country – for 2010 – and compared them to GDP – total economic output – it put the UK’s at 82pc compared to 126pc for Italy or 199pc for Japan.
However, Germany was higher, at 87pc, and so was the US, at 93pc. The difference is that the likes of Germany and the US are perceived to have more dynamic economies that will generate better tax revenues.
James Butterfill, strategist for Coutts, said that Britain’s debt would stifle the economy for some time. “The Moody’s decision is not a new development,” he said. “It is widely acknowledged that deleveraging will remain a significant drag on the UK economy for years to come. Nor is the UK alone – of the G8 major industrialised nations, only Germany and Canada have retained their triple-A rating from all three ratings agencies.”
Debt mountain: Despite the better performance in December, the level of debt as a proportion of GDP remains a daunting challenge for ministers
While the overspend is now being reduced, the UK’s debts continue to grow.
Britain owed £1003.9bn in December, a leap from £883bn a year earlier, according to the ONS [read the full release] <http://www.ons.gov.uk/ons/dcp171778_247485.pdf> and nearly double the £534.6billion figure at the end of 2007. The government needs to borrow more than £127bn in the current year, lower than the £142.7bn the previous year.
That total debt figure, as the chart shows, already equates to 64.2 per cent of GDP (the total size of all economic output), up from 59.4 per cent a year earlier. And that’s not even including bank bailouts and other ‘financial interventions’. With those included, the figures then balloon to £2,305bn or 148.1 per cent of GDP, down slightly from 150.7 per cent a year ago.
Assuming the Government claws back its bank ‘investments’, Britain’s 64 per cent debt measure is favourable compared to, say, Italy or Greece where it is nearly 150 per cent or Japan at around 200 per cent.
So no problem? Alas not. Because we’re borrowing more than most other countries, we’ll soon be climbing the total debt league tables and testing the nerve of investors. Any signs that we might struggle to repay then international markets would charge much higher rates of interest to lend, making it even harder to pay down debts. The Coalition’s plans to tackle debts have so far been well received.
The health of the economy will also be critical to reducing the debt pile. If Britain does return to recession then the deficit reduction plan will take a serious hit.
WHAT IS THE DIFFERENCE BETWEEN DEBT AND DEFICIT?
The deficit is effectively a country’s annual overspend – the difference between the revenues coming into the national purse through taxes and what is being spent on schools, hospitals, benefits and the government’s other liabilities.
In January, the deficit was actually in surplus by £11.4bn, a repayment as one-off tax payments and quantitative easing boosted the national bank account. But that was smoke and mirrors. The broader picture is that overspending will continue until 2016 with the total debt growing until then.
WHAT DOES IT MEAN FOR THE UK ECONOMY?
Some believe the downgrade could actually spell good news for the economy, as a falling pound invites further overseas business to our shores and makes our goods appear cheaper to consumers in other countries.
“The latest fall in sterling will add further stimulus over the next few months,” said Stuart Thomson, chief economist for Ignis Asset Management. “We believe that first-quarter activity will accelerate to 0.5pc and this improvement should dispel much of the pervasive gloom.”
But the downgrade does put pressure on Mr Osborne less than a month before the Budget. Economists are calling for him to use the downgrade as a catalyst to announce pro-growth measures.
Schroders European economist Azad Zangana said: “The Chancellor should take advantage of near-record low borrowing costs to fund long-term infrastructure projects, but at the same time should focus on structural reforms to boost productivity, which has plummeted in recent years.”
WHAT DOES IT MEAN FOR THE FTSE 100?
Britain’s largest 100 companies derive 27pc of their revenue from emerging markets, and a further 40pc from Europe and the US.
A weaker currency therefore not only makes UK exports more competitive, but because of the London stock market’s large exposure to emerging markets – greater than the eurozone markets or the US – the boost is magnified. However, Mr Butterfill said that smaller companies with domestic focus would suffer as UK consumers’ disposable incomes get squeezed by rising costs of essentials like petrol.
“While nearly a third of FTSE 100 revenues come from growth markets, this drops to 13pc for the FTSE 250 index of mid-cap companies, which has a whopping 55pc exposure to the UK,” he said.
Adrian Lowcock of Hargreaves Lansdown agreed, saying a weaker currency could be a double-edged sword, good for the blue-chips but bad for consumers.
“On the one hand it is good for economic growth as it will make UK exports cheaper and the country more competitive, while on the other it may drive up inflation as the costs of imported goods such as energy and food rise,” he said.
WHAT DOES IT MEAN FOR BONDS?
The price of gilts – loans that investors make to the Treasury – may have initially risen, bizarrely, on the news that the UK had been downgraded, but long term it could spell bad news for government bonds.
Jim Leaviss, bond specialist at M & G Investments, said:
“We do believe gilts could come under increasing pressure due to the UK’s poor fundamentals. With the full impact of austerity still to take effect, it is difficult to see where future growth will come from. With its safe-haven status in potential jeopardy, we might begin to see a reversal of the significant foreign inflows.”
Corporate bond funds are potentially problematic too, since most of those available to UK private investors focus on sterling-denominated issues or are currency hedged back into sterling.
Jason Hollands of Bestinvest said that this means even funds owning non-UK bonds won’t benefit from a weakening pound.
Our total debt problem
There’s also the not-so-small issue of Britain’s household consumer debt problem which, in relative terms, is the second worst in the developed world.
See these charts on The Economist website for a quick comparison of our debt problem vs others. The OECD also carries figures for public debt for euro zone countries
Also, this ‘ring of fire’ chart published in 2010 by bond fund giant PIMCO perfectly captures the problem. Basically, you want to be in the top left corner. Being far to the right shows too much total debt and being too low down shows too much annual borrowing (debts growing too fast).
More recently, a report by McKinsey Global Institute painted a startling picture of Britain’s debt problem.
Published last week, the report suggested the UK has the highest level of combined personal, national and business debt among the major economies bar Japan.
Over the past three years, the 60-page report claimed, debt has risen to more than 500 per cent of national output.
The UK’s debt level is second only to that of Japan among major economies, including the U.S. and Spain. The figures here are calculated on total debt liability which includes the future cost of pensions
The alarming rise since the height of the financial crisis has been fuelled by debt in the financial sector as people seek to borrow their way out of the economic slump.
Even at current trends it will take until 2020 for the UK to return to pre-2003 debt levels, when total debt was at 300 per cent of the total economy.
Increased borrowing by financial firms pushed Britain’s debt up from 487 per cent of GDP in 2008 to 507 per cent by the middle of last year.
‘While the largest component of U.S. debt is household borrowing and the largest share of Japanese debt is government debt, the financial sector accounts for the largest share of debt in the UK,’ the report says.
‘Although UK banks have significantly improved their capital ratios, non-bank financial companies have increased debt issuance since the crisis.’
Consumer debts keep growing
So it’s our troubled financial sector doing much of the borrowing in recent years.
But there’s also a misconception about consumer debt. There’s much talk of businesses and households ‘deleveraging’ – paying off debts.
But in reality, Britons are not paying off what they owe. There were hopeful signs of this happening when mortgage rates fell sharply in 2008 and 2009 – some borrowers used the opportunity to pay extra off their mortgages. But consumers soon returned to form and began borrowing again to spend.
Even the falls there have been are due to banks writing off debts, according to the campaign group Save Our Savers (SOS). It points out that total consumer debt stood at £1,461billion in November 2008 and £1,452 billion in November 2011. But banks wrote off £26.7billion of consumer debt. So excluding the bank write-offs debt actually rose by £18.4billion.
Credit card debt continues to ‘run rampant’, says SOS, rising from £53.3billion to £56.5 billion over that time even thought an ‘extraordinary’ £13billion has been written off. Total credit card debt when write-offs have been stripped out has exploded by £16.1billion.
So the clear picture is that debts are not only still rising, by bad consumer debts are also just shifting across to become financial sector company debt which, if recent history is anything to go by, could one day become state debt.
And the projection, is that UK debt is set for another explosion. According to the Office of Budget Responsibility, personal debt will grow by nearly 50 per cent from £1.5trillion today to £2.12trillion by 2015.
Do what we expect in the course of the year for the UK – This is summarised by Tim Drayson according to the following video:
Tim Drayson – Economist, reviews the global economic outlook based on what’s happened in the last month. You may find this information useful when considering where you’d like to invest your stocks and shares – ISA.
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