Investment Research General Market Conditions

07 September 2011

UK Research
How long can the UK maintain its AAA rating?
The United Kingdom is a AAA-rated country with a stable outlook. Using the same rating methodology as Standard and Poors, who recently downgraded the United States, we dare to ask why? Like S&P, we focus on five key factors that form the foundation of a sovereign credit rating: 1) Institutional effectiveness and political risks, 2) Economic structure and growth prospects, 3) External liquidity and international investment position, 4) Fiscal performance and flexibility, as well as debt burden and 5) Monetary flexibility. Instead of a black-box" approach, we lay out all our results with full transparency. We find that the UKs political and economic profile is strong, the fourth highest according to Standard & Poors. Our research shows that the UKs flexibility and performance profile is moderately strong, but close to intermediate. This is far from superior and extremely strong, respectively, the highest possible in S&Ps indicative rating table. Without adjusting for exceptional factors, we conclude that the United Kingdom should be given an A+ rating, i.e. four notches below the current rating. A downgrade of the UK could in our view happen in 2012. We believe it can remain a market theme into 2013. This prediction should however be treated cautiously as our analysis suggests a relatively large political element in the rating process. We disagree with the Office for Budget Responsibilitys underlying assumptions about the debt burden projection. Real growth could in our view be substantially lower; the GDP deflator could be somewhat lower and the deficit might be harder to reduce than projected. Rather than peaking in 2013-14 and easing slightly towards 69% of GDP in 2015-16, we find that the debt burden in our most likely scenario will rise throughout our forecast horizon and reach 84% of GDP in five years time. The market reaction to a UK downgrade is uncertain with interest rates at depressed levels due to the risk of another global recession. Some investors might attach a higher risk premium to UK assets. GBP can be negatively impacted.
Table 1: United Kingdom credit rating our assessment based on S&P methodology
Positive adjustment 1.50 1.60 2.50 2.50 1.25 1.55 2.08 1.82 AAA Main scenario 2.50 2.60 3.50 3.50 2.25 2.55 3.08 2.82 A+ Negative adjustment 3.50 3.60 4.50 4.50 3.25 3.55 4.08 3.82 BB+

1 2 3 4 5

Political score Economic score External score Fiscal score Monetary score

A Political and economic profile B Flexibility and performance profile Total Sovereign indicative rating level Total Indicative rating level

Chief Analyst John M. Hydeskov +44 (0)7410 8144 johy@uk.danskebank.com Assistant Analyst Hugo Railing +44 (0)777 542 2712 railinghugo@gmail.com

Note: Six-point numerical score from 1 (the strongest) to 6 (the weakest). See sections 1-5 for details Source: Standard and Poors, Danske Markets

Important disclosures and certifications are contained from page 14 of this report. www.danskeresearch.com

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Stress-testing OBRs underlying assumptions about growth and public deficit alternative projections on the debt burden
The Office for Budget Responsibility (OBR), an entity established in 2010 to provide independent and authoritative analysis of the UKs public finances, presented its Economic and Financial Outlook in March. Not surprisingly, the OBR concludes that the Coalition Government is on track to meet its two medium-term fiscal target: to balance the cyclically-adjusted current budget by the end of a rolling, five-year period; and to see public sector net debt (PSND) falling in 2015-16. However, the OBR points out that there is considerable uncertainty around the central forecast and will only attach a greater than 50% probability of meeting both targets.

Chart 1: Lower UK growth alternative debt-to-GDP projections

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% of GDP OBR base case scenario Lower growth, OBR's UK GDP deflator Lower growth, US/Euroland deflator Lower growth, japanese deflator

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70 60 50 2009-10 2010-11 2011-12 2012-13 2013-14 2014-15 2015-16

Source: Office for Budget Responsibility, Danske Markets calculations

It is beyond the scope of this note to go into details of the OBRs 176-page report. But there are three assumptions that we find questionable and that could alter the projected debt path for the UK. These are: 1) The growth outlook. Rather optimistically, the OBR assumes that the UK economy will grow strongly in the coming years. We are sceptical of this buoyant growth outlook and think underlying growth will be weaker, global growth will be slower and the pick-up in employment will be more sluggish. Growth rates above 2.5% three years in a row will in our view be very hard to achieve, if not impossible. We guess that the OBR desperately wanted to close the output gap on the medium-term horizon in its economic model, a common mistake among economists. More realistically, we assume that the economy only will expand modestly in the coming years and that structural growth will average 1.5%. This is actually not a negative scenario and we could easily imagine worse outcomes. The GDP deflator. An often overlooked assumption in economic forecasting is about the GDP deflator, i.e. the measure of the level of prices of all new, domestically produced, final goods and services. If the GDP deflator is projected to be high in the coming years, it has the positive side effect that nominal output will rise faster than a potential public deficit and the debt burden will therefore decline. The UK GDP deflator has averaged 2.5% over the past 20 years, but the OBR projects that it will be even higher in the coming years, keeping the debt burden in check. In comparison, the US GDP has averaged 2.1% over the past 20 years, Eurozone 1.8% and Japan -1%. We test how the debt burden evolves when these scenarios are applied.

2)

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3)

The reduction of the deficit. According to the OBR, the public sector net deficit (PSND) will decline from GBP145.9bn in 2010-11 (9.9% of GDP) to GBP29bn in 2015-16 (1.5% of GDP). Harsh austerity measures have been announced and the Government has so far not deviated from its ambitious plan. It is however often easier to say that the belt should be tightened than to actually cut down on spending. We dare to assume that the government shortfall will be reduced, but only at half the speed assumed by the OBR.

Chart 2: Lower UK growth AND slower deficit reduction alternative debt-to-GDP projections
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90
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% of GDP OBR base case scenario Higher deficit, lower growth, OBR's UK GDP deflator Higher deficit, lower growth, US/Euroland deflator Higher deficit, lower growth, japanese deflator

70 60 50 2009-10 2010-11 2011-12 2012-13 2013-14 2014-15 2015-16

Source: Office for Budget Responsibility, Danske Markets calculations

No matter what will happen, the UK debt burden will rise in the years to come because of the still sizeable public deficit. In OBRs base case, the debt burden will peak at 70.9% in the fiscal year 2013-14 before easing gradually in the coming years. Because of the underlying assumptions, we find that too optimistic though. Assuming lower growth and keeping the OBRs upbeat GDP deflator at 2.7%, suggests the debt burden will peak at 75.0% in 2014-15. If instead the deflator turns out to be the average of the US and the Eurozone, 1.95%, the debt burden will keep rising throughout the forecast horizon and reach 78.1 in 2015-16. In the extreme scenario, in which we apply Japanese conditions, debt will rise dramatically and reach 93.2%. Assuming that the deficit will be reduced at a slower pace will obviously just make matters worse. Even though we, in our alternative scenario, assume that the deficit will be halved over the next five years, the debt burden rises rapidly in all scenarios. In our view, the scenario assuming a lower growth rate, a normal GDP deflator and a slower reduction of the deficit is the most likely. In this case, the debt burden will hit 84.2% in 2015-16 and still be on the rise. That is by no means disastrous for a country like the UK with a long duration of the debt burden and the cost of servicing this burden will still be manageable, but it is still some 15 percentage points higher than the OBR projects and we doubt that rating agencies will welcome this outcome.

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Same rating approach as S&P but without the black box

Standard and Poors has attracted a lot of attention in financial markets and media lately with its controversial downgrade of the United States from AAA to AA+. Japan, Spain and Italy have also been downgraded due to poor economic outlook, too high debt burdens and no credible plans to reduce public deficits. Standard & Poors has been more proactive or aggressive than the two other large rating agencies, Moodys and Fitch. We will focus on S&P in our analysis as this company has been first-mover in terms of sovereign downgrades in recent years. The aim of this paper is to check whether we can justify the United Kingdoms AAA rating, reaffirmed by Standard and Poors on 26 October 2010, when the outlook was revised from negative to stable, and further elaborated on in an unsolicited review on 21 December 2010. However, a lot has changed since end-2010 and most recently the risk of a prolonged period with subdued growth or even a double-dip recession has risen. In order to evaluate the United Kingdoms credit rating we will use Standard and Poors rating methodology and assumptions for sovereigns from June 2011. This document includes detailed information on how S&P addresses the factors that affect a sovereign government's willingness and ability to service its debt on time and in full. Like S&P, we will focus on five key factors that form the foundation of our analysis of the UK: Institutional effectiveness and political risks, reflected in the political score. Economic structure and growth prospects, reflected in the economic score. External liquidity and international investment position, reflected in the external score. Fiscal performance and flexibility, as well as debt burden, reflected in the fiscal score. Monetary flexibility, reflected in the monetary score. To the best of our abilities, we have assigned a score to each of the five key factors on a six-point numerical scale from '1' (the strongest) to '6' (the weakest). Each score is based on a series of quantitative factors and qualitative considerations. As S&P does not reveal its exact scores we have not got anything concrete to relate to. Instead we will have to make our best judgements based on a large number of statistical sources. We have only used publicly available information in our analysis.

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1 Institutional effectiveness and political risks

According to Standard and Poors (2011), the political score assesses how a government's institutions and policymaking affect a sovereign's credit fundamentals by delivering sustainable public finances, promoting balanced economic growth, and responding to economic or political shocks. The primary factor for determining the political score is the effectiveness, stability, and predictability of the sovereign's policymaking and political institutions. The secondary factor provides additional information on the transparency and accountability and acts as a qualifier to the primary factor in determining the initial political score. The primary political factor is probably the least likely to be affected by structural issues and we consider it relatively stable over time. The United Kingdom is generally characterised by proactive policymaking with a strong track record in managing past economic and financial crises and delivering economic growth. Institutions are generally regarded strong and relatively stable, but are only ranked 17 out of 139 in World Economic Forums Global Competitiveness Report (2010) due to a low public trust of politicians, a high burden of government regulation and high business costs of terrorism. According to the World Banks Worldwide Governance Indicators, the UK is in the 90th-100th percentile on five measures of governance, but scores low in political stability and ends in the 50th-75th percentile. We notice further that the trend is declining over the past decade. One of the cornerstones in the political score, the ability to maintain prudent policy-making in good times, which according to Standard and Poors has deteriorated over the past two decades, while another important factor the willingness to ensure sustainable public finances has also diminished. Our best judgement is that the primary political factor for the UK is solid. A score around 1.5 seems fair. The secondary political factor can be broken down into four inputs according to Standard and Poors: 1) the existence of checks and balances between institutions, 2) the perceived level of corruption, which correlates strongly to the accountability of the institutions, 3) the unbiased enforcement of contracts and respect for the rule of law, which correlates closely to respect for creditors' and investors' interests and 4) the independence of statistical offices and the media. On 1), we note that there are extensive checks and balances between institutions in the United Kingdom and reckon that a score of around 1.5 is appropriate. On 2), according to Transparency Internationals Corruption Perception Index, the UK ranks number 21 out of 178, which transforms into a score of (1+21/((1/6)*178)) 1.7. On 3), the input factors 1.10-1.21 in World Economic Forums Global Competitiveness Report (2010) can roughly be interpreted as ability to enforce contracts and respect for the rule of law. We arrive at a relatively bad score for the UK; only (1+30/((1/6)*139)) 2.3. The latest riots in the UK have however not been incorporated in this score and we add 0.5 and arrive at a 2.8 score in this component. On 4), we have to rely entirely on qualitative analysis and attach a score of 2 due to independent statistical offices, but with frequent data revisions, and autonomous media but sometimes with hidden agendas. The average of 1)-4) is a score of 2.0. Standard and Poors notes that there are two potential adjustments to the political score. The first relates to the debt payment culture: regardless of the fact that the IMF had to bail the UK out in 1976, we reckon that it has a very good debt payment culture. Incentive to default is almost non-existing and it would in our view be rather stupid even to consider a default as close to 10% of the economy is the financial sector, which probably would be shut in the case of a default. The second potential adjustment relates to geopolitical and external security risks: We judge that the UK is at moderate risk due to recent participation in wars in Iraq and Afghanistan and involvement in various conflicts around the world. A terrorist attack hit London in 2005 and more attacks cannot be excluded.
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The European debt crisis poses a major threat to the UK. Although not directly affected by, for example, higher interest rates or costs or guarantees to bail-out funds, the UK can be sucked into the crisis because of its exposure to the peripheral Euroland countries and because of the heavy British banking sector. Bank of England notes in its latest Minutes that The greatest risk to the downside stemmed from the euro area. Concerns about the euro area were likely already to be affecting the economic outlook through their impact on asset prices, bank funding costs and the level of household and business confidence. Reflecting that, the Committees projections were conditioned on relatively slow growth in the euro area. There were, however, additional risks relating to a significant further intensification of concerns. These could affect the United Kingdom through a number of channels, including: the impact a further slowing in euro-area activity would have on UK exports; financial and banking sector interlinkages; and possibly, and perhaps most significantly, through a disruption to the functioning of the international financial system more generally hitting global asset prices, wholesale funding markets, and business and household confidence. Summarily, we judge that the primary political factor for the United Kingdom is around 1.5. The secondary factor is according to inputs 1)-4) ((1.5+1.7+2.8+2.0)/4=) 2.0. Average for those is 1.75. Adjusting for the good debt payment culture, -0.25, higher external security risks, +0.4, and the European debt crisis, +0.6, leads us to a final political score of 2.5.

2 Economic structure and growth prospects

The history of sovereign defaults suggests that a wealthy, diversified, resilient, market-oriented, and adaptable economic structure, coupled with a track record of sustained economic growth, provides a sovereign government with a strong revenue base, enhances its fiscal and monetary policy flexibility, and ultimately boosts its debt-bearing capacity. Standard and Poors observes that market-oriented economies tend to produce higher wealth levels because these economies enable more efficient allocation of resources to promote sustainable, long-term economic growth. We can only agree with that. GDP per capita is S&P's most prominent measure of income levels. With higher GDP per capita, a country has a broader potential tax and funding base upon which to draw, a factor that generally supports creditworthiness. The determination of the economic score uses the latest GDP per capita from national statistics, converted to US dollars. Standard and Poors uses a rating system in determining the economic score, a 1 is given to countries whose GDP per capita is over USD35,000, a score of 2 if the GDP per capita is between USD25,000 and 35,000. The UK has an average GDP per capita of USD35,616 (using the mean GDP of the CIA World Factbook, the Bank of England and the Office of National Statistics, divided by the current population). Initially ranked 1 in Standard and Poors scoring system; this has been altered to 1.9 due to the closeness of the USD35,000 boundary and the fact that many more countries have a higher GDP per capita (the UK is ranked 22nd in IMFs global ranking). According to Standard & Poors, an undervalued currency suggests that the GDP per capita understates prosperity. Applying Purchasing Power Parity (PPP) analysis, Sterling is some 15% undervalued, the highest among G10 currencies. Our previous research suggests however, that sterling might be less undervalued than generally perceived as UK fundamentals have weakened during the financial and economic crisis, please see Sterlings fall from grace and New regime, new forecast. We subtract 0.3 index points from the initial score, improving the economic score to 1.6.

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Below-average economic growth compared with peers, as measured by real GDP trend growth, drags down the economic score according to the rating methodology. We believe that trend growth in the UK has slowed after the financial and economic crises. Unemployment has settled at an uncomfortably high level and risks becoming structural if not actively reduced in the near term. The UK has been running a trade deficit for more than a decade and even a significant currency-led improvement of the terms-of-trade has not been able to turn this around. The financial sectors contribution to GDP might be considerably smaller than in the decade up to the crisis. It is difficult to say whether trend growth has deteriorated more in the UK than in the peer group and it is hard to see who the peer group should be. On growth rates, the UK is ranked poorly in the CIA World Factbook, only 163rd out of 215. According to our best judgement, we find that the economic score should be raised 0.5 index points to 2.1. Finally, a sovereign exposed to significant economic concentration and volatility compared with its peers receives an economic score that is one category worse than the initial score. More precisely, a sovereign's economic score would be one category worse if it carried significant exposure to a single cyclical industry (typically accounting for more than about 20% of GDP), or if its economic activity was vulnerable due to constant exposure to natural disasters or adverse weather conditions. Economic concentration and volatility are important because a narrowly based economic structure tends to be correlated with greater variation in growth than is typical of a more diversified economy. The UK service sector accounts for 77.5% of all industry in the UK, compared to the world average of 63.2%. The service sector, the sixth largest service sector in the world, is in other words crucial for the UK where, for example, exports are of less importance. The financial sector accounts for 9.4%, i.e. lower than Standard and Poors threshold. We dare however, interpret the term significant economic concentration less strictly as the government already has a sizeable ownership in the financial sector with its controlling stake of 84% in the RBS Group and its minority stake of 43% in Lloyds Banking Group. In conclusion, our initial economic score was 1.9. Taking into account the undervaluation of Sterling -0.3, the slow growth rates +0.5 and the reliance of the financial sector +0.5 leaves the final economic score at 2.6.

3 External liquidity and international investment position

The external score reflects a country's ability to generate receipts from abroad necessary to meet its public- and private-sector obligations to non-residents. It refers to the transactions and positions of all residents (public- and private-sector entities) versus those of non-residents because it is the totality of these transactions that affects the exchange rates of a country's currency. Three factors drive a country's external score according to Standard and Poors: 1) the status of a sovereign's currency in international transactions, 2) the country's external liquidity, which provides an indication of the economy's ability to generate the foreign exchange necessary to meet its public- and private-sector obligations to non-residents and 3) the country's external indebtedness, which shows residents' assets and liabilities (in both foreign and local currency) relative to the rest of the world. From IMF's report "Currency Composition of Official Foreign Exchange Reserves", we find that Sterling qualifies as a reserve currency as it accounts for more than 3% of the world's total allocated foreign exchange reserves. According to S&Ps definition, this gives the UK the best starting point for the external score. Unfortunately, the UK is highly indebted: narrow net external debt of over 400% is just about as bad as it can be. According to McKinsey, the UK is the worlds most indebted
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country, adding private and public debt together. Due to the massive debt burden, the UK falls in the lowest category, and following S&Ps adjustment rubric, the UK falls in the negative adjustment section. The initial external score is a clear 3. There are a few adjustment factors though and both on the negative front: 1) Standard and Poors stipulates that countries running persistent current account deficits should count as a negative adjustment factor. The UK has been running a sizeable current account deficit for the past 25 years, on average -2% of GDP. There are no signs of a large improvement of the current account deficit. 2) We observe sudden shifts in foreign direct investment for the UK. With a 10 year average of GBP54bn, highs of close to GBP100bn and lows of close to GBP10bn, FDI is very uneven and unpredictable. The UK holds the third highest stock of FDI, but with such variation over time, future inflow is less accountable. It is possible that the natural FDI has diminished due to lower structural growth as foreign investors find the UK less attractive. The initial external score was 3.0 but is raised 0.5 points to 3.5 due to the UKs persistent current account deficit and the volatility and uncertainty surrounding the future flow situation. A higher, i.e. worse, score could in our view have been justified and we cannot exclude that this will be adjusted higher in the future if the net external debt does not decline. Unfortunately there are no signs of this.

4 Fiscal performance and flexibility

The fiscal score reflects the sustainability of a sovereign's deficits and debt burden. This measure considers fiscal flexibility, long term fiscal trends and vulnerabilities, debt structure and funding access, and potential risks arising from contingent liabilities. Given the many dimensions that this score captures, the analysis is divided into two segments, "fiscal performance and flexibility" and "debt burden" which are scored separately. The overall score for this rating factor is the average from the two segments. According to Standard and Poors, the key measure of a government's fiscal performance is the change in general government debt stock during the year expressed as a percentage of GDP in that year. Fiscal flexibility provides governments with the "room to manoeuvre" to mitigate the effect of economic downturns or other shocks and to restore its fiscal balance. Conversely, government finances can also be subject to vulnerabilities or long-term fiscal challenges and trends that are likely to hurt their fiscal performance. The assessment of a sovereign's revenue and expenditure flexibility, vulnerabilities and long-term trends is primarily qualitative. The UK has experienced a greater than 6% change of government debt between 20102011, higher than S&Ps upper threshold; this results in a high initial score of 6.0 (the worst possible) following the Standard and Poors rating system. The government debt has practically doubled in the last three years, a consequence of the recession. Luckily, the UK has a fairly robust and well established taxation system with the ability to easily raise finance relatively quickly. Due to this factor, we subtract half a point from the initial score. As the UK has a stable asset income, ranked 24th out of 167 in CIAs World Factbook, we subtract another half point and arrive at a fiscal performance and flexibility score of 5.0. The rating methodology suggests that the debt burden score reflects the sustainability of a sovereign's prospective debt level. Factors underpinning a sovereign's debt burden score are: its debt level; the cost of debt relative to revenue growth; and debt structure and funding access. This score also reflects risks arising
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from contingent liabilities with the potential to become government debt if they were to materialize. The calculation of net general government debt is generally more restrictive than national measures of net general government debt, as it deducts from the general government debt only the most liquid assets. The UK debt burden stands at 61.4 % of GDP, according to the Office of National Statistics. The cost of servicing the debt burden is relatively low though, only around 3% of GDP per year due to the long duration of the UK debt portfolio. This gives the UK an initial debt score of 3.0 in accordance to the Standard and Poors rating system. UK debt auctions are usually well-bid and Gilts are generally considered as safe-haven assets. If a severe crisis occurred, the Bank of England could relatively easily print out money or buy more government debt. Because of these extenuating circumstances, we lower the score to 2.0. Contingent liabilities refer to obligations that have the potential to become government debt or more broadly affect a government's credit standing, if they were to materialize. Some of these liabilities may be difficult to identify and measure, but they can generally be grouped in three broad categories: Contingent liabilities related to the financial sector (public and private bank and non-bank financial institutions); Contingent liabilities related to non-financial public sector enterprises (NFPEs); and guarantees and other off-budget and contingent liabilities. The UK has a financial recapitalisation cost of GBP133.2bn, while non-financial public sector enterprise liabilities costs amount to GBP148.4bn, totalling GBP281.6bn. This accounts for over 10% of the UKs total GDP (GBP2.246trn) which is well below the 30% threshold (the UK would need a combined total liability of GBP674bn); this is classed as limited in Standard and Poors rating system. This means that UK obligations are of a lower risk to become problematic and turn into debt. We assign a score of 2.0. The fiscal score was worked out in two parts; first the fiscal performance and flexibilitys initial score was 6, due to the high percentage changes in government debt, but lowered to 5 because of the UKs stable asset income. Secondly, the debt margin and contingent liabilities; the debt margin had an initial score of 3 due to the high percentage of debt to GDP but was lowered to 2 due to low costs of servicing the debt. In total, we have a fiscal score of 5+(2+2)/2=3.5.

5 Monetary flexibility
A sovereign's monetary score reflects the extent to which its monetary authority can support sustainable economic growth and attenuate major economic or financial shocks, thereby supporting sovereign creditworthiness. Monetary policy is a particularly important stabilization tool for sovereigns facing economic and financial shocks. Accordingly, it could be a significant factor in slowing or preventing a deterioration of sovereign creditworthiness in times of stress. According to Standard and Poors, a sovereign's monetary score results from the analysis of the following elements: 1) the sovereign's ability to use monetary policy to address domestic economic stresses particularly through its control of money supply and domestic liquidity conditions, 2) the credibility of monetary policy, as measured by inflation trends and 3) the effectiveness of mechanisms for transmitting the effect of monetary policy decisions to the real economy, largely a function of the depth and diversification of the domestic financial system and capital markets. The United Kingdom has a free-floating currency that qualifies for the highest possible exchange rate regime score according to Standard and Poors. We dare to argue that the world might be more complex than that, but accept that it gives the highest degree of flexibility as opposed to, for example, a currency board.
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The second element, credibility, cannot be objectively measured, as noted by Standard and Poors. The Bank of Englands credibility was probably higher prior to the financial and economic crises. Trustworthiness probably peaked in 2006, when the Bank could celebrate the great moderation with lower volatility in output and inflation. It proved however, to be more good luck than good policy; the 2008-09 recession was the worst since the 1930s and the economy has not recovered yet. Consumer price inflation has been very volatile over the past three years and the Bank of England has not been able to anchor inflation and inflation expectations. A BoE/GfK survey from Q2 2011 found that the extent of satisfaction with the Bank of England had fallen since mid-2010, see Bank of England Quarterly Bulletin, Public attitudes to monetary policy and satisfaction with the Bank. The third element, effectiveness of monetary policy, has in our view diminished lately as it has become clear that the Governor does not have a magic wand, which he publicly admitted in July (honestly, we never thought differently). The MPC however, still enjoys support from the financial markets and the public even though some have hinted that the Bank is running out of ammunition. The extensive use of quantitative easing asset purchases worth GBP200bn early on in the crisis has not had the desired effect, even though interest rates have been substantially below historical averages at all maturities. More Gilt purchases will probably not have much impact and can furthermore have adverse effects. The UK financial system is in dire straits, funding is a problem and the transmission mechanism to households is broken. Summing up, we believe that United Kingdoms monetary flexibility has worsened but from a good starting point. Our best judgement is that a total score around 2.25 is appropriate. A score below 2 would in our view indicate that the BoE has plenty of room to manoeuvre, which is not the case, while a score above 2.5 would imply that no ammunition was left. Neither is true. The monetary score is in our view the fluffiest in the S&P framework and relies mainly on outdated inputs.

An indicative rating level for the United Kingdom

Standard and Poors issued a statement in October last year in which it revised the UKs credit outlook to stable and affirmed the AAA-rating. S&P wrote: In our opinion, the decisions reached by the United Kingdom coalition government in its 2010 Spending Review reduce risks to the government's implementation of its June 2010 fiscal consolidation program. Moreover, the coalition parties have shown a high degree of cohesion in putting the U.K.'s public finances onto what we view to be a more sustainable footing. However, our analysis of the United Kingdoms institutional effectiveness and political risks, economic structure and growth prospects, external liquidity and international investment position, fiscal performance and flexibility and monetary flexibility questions that conclusion. Using S&Ps own sovereign rating framework in which the political and economic score form a political and economic profile and the external score, the fiscal score and the monetary score form a flexibility and performance profile, we can calculate an indicative rating level for the United Kingdom. Standard and Poors is so kind to provide a table to determine this level, see table 2. We find this table quite intuitive and easy to interpret. The table shows that a AAA-rated country cannot have a flexibility and performance profile with a higher score than 2.7 or a political and economic profile higher than 2.5 (please note that a number close to 1 is good while a number close to 6 is bad).

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Table 2: Indicative rating level from the combination of 1) The Political and Economic Profile and 2) The Flexibility and Performance Profile

Source: Standard and Poors

Our analysis shows that the UKs AAA-rating is questionable. To the best of our ability we have used Standard and Poors methodology and find that the UK should not be given more than an A+ rating, i.e. four notches below todays level. Standard and Poors gives itself full flexibility by allowing for exceptional adjustment factors. We think this just blurs the true outcome and we believe we already have included the important factors that should form the foundation of a credit rating. Accordingly, we do not make further adjustments to our credit rating of the UK. Adding 1 index point to all scores changes the picture, though. Then the AAA-rating can be justified, but we cannot see where this positive adjustment should come from and can only see that such an alteration could be done due to political reasons. Subtracting 1 index point from all scores just makes matters worse of course; the indicative rating deteriorates massively to BB+, i.e. 10 notches below todays level. We cannot justify such an alteration either and stick to our well-authenticated analysis above.

Conclusion: What would happen if the UK got downgraded?

The short and perhaps somewhat disappointing answer is: probably not much. It would of course create a lot of public furore and cause UK politicians to criticise rating agencies, but it would not lead to a huge Gilt sell-off and we believe that there would still be plenty of demand for British debt even if the UK got downgraded to A+, the same as Italy and Slovakia at present. Some investors would probably attach a higher risk premium to UK assets, but we doubt that this would dominate other factors. Yields would most likely stay low because of a poor economic outlook and Sterling would not face a confidence crisis on the back of a lower rating. A downgrade of the UK could in our view happen in 2012 and we believe it can remain a market theme into 2013. This prediction should however be treated cautiously, as our analysis suggests a relatively large political element in the rating process.

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References
Bank of England Minutes (August 2011) http://www.bankofengland.co.uk/publications/minutes/mpc/pdf/2011/mpc1108.pdf Bank of England Quarterly Bulletin Public attitudes to monetary policy and satisfaction with the Bank (Q2 2011) http://www.bankofengland.co.uk/publications/quarterlybulletin/qb110203.pdf Office for National Statistics Public Sector Finances (July 2011) http://www.statistics.gov.uk/pdfdir/psf0811.pdf Standard and Poors (2011) Sovereign Government Rating Methodology and Assumptions http://www.standardandpoors.com/prot/ratings/articles/en/us/?assetID=1245315323295 Standard and Poors (2010) United Kingdom http://www.standardandpoors.com/ratingsdirect Standard and Poors (2010) United Kingdom Outlook Revised To Stable; 'AAA' Ratings Affirmed http://www.standardandpoors.com/prot/ratings/articles/en/us/?assetID=1245231048727 World Banks Doing business (2011) http://www.doingbusiness.org/data/exploreeconomies/united-kingdom/ World Banks Worldwide Governance Indicators (2009) http://info.worldbank.org/governance/wgi/sc_chart.asp World Economic Forums Global Competitiveness Report (2010) http://www3.weforum.org/docs/WEF_GlobalCompetitivenessReport_2010-11.pdf

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New regime, new forecast (17 August) UK Q2 GDP poor as expected Bank of England to keep rates low for most of 2012 (27 July) Sterlings fall from grace (09 June) An augmented Taylor rule for the United Kingdom (01 June) King is right UK inflation will hit 4.9% in September (13 May) Ten good reasons why BoE will keep rates unchanged in 2011 (11 May) UK Gilt handbook (09 May) UK Fact Book rain on your wedding day (28 April) UK avoids new recession but underlying growth is weak (27 April) Hesitant King to drive GBP weaker (13 April) The Bank of Englands dilemmas (05 April)

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