Why is Britain still AAA? | FT Alphaville

Why is Britain still AAA?

Viewers of European CNBC early on Thursday morning will probably have seen Danske Bank making their case for cutting the UK’s credit rating by no fewer than four notches, from AAA to A+.

(Which is about where Italy is at the moment.)

It’s an eye-catching call, especially just ahead of another Bank of England monetary policy decision… but actually Danske Bank analysts John Hydeskov and Hugo Railing have constructed the argument in an ironic fashion. They’ve done it like a rating agency would:

In order to evaluate the United Kingdom’s credit rating we will use Standard and Poor’s 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)…

S&P themselves continue to keep the UK on a stable outlook of course and there’s no sign that this is changing. It’s an arresting conceit anyway. Although deep down this is really about Danske making another reality check on UK economic growth over the coming years. Tim Morgan of Tullett Prebon has previously said that trend growth to 2016 is going to be more like 1.4 per cent, compared to the Office for Budget Responsibility’s benchmark 2.5 per cent forecast… and that’s what Danske Bank think too:

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%.

Danske Bank also forecast that UK austerity policies in practice will turn out to have around half the impact on the deficit than has been advertised. (And look – even Bill Gross is arguing for a ‘mid-course correction’ these says. What about the nitroglycerine, Bill?)

Which brings us to this chart:

You can see that under some scenarios, UK debt to GDP doesn’t peak at 70 per cent in 2014 (which is the OBR forecast) but will carry on increasing past 2016. In fact under a “Japanese-style” scenario of serious deflation it’s close to 100 per cent by 2016.

Although, to close, Japan is the twist in the tale here. Danske say Britain doesn’t deserve an AAA rating any more but naturally they also add that it’s not the same as arguing that rates on gilts will explode. Four notches will not mean much in the grander, deflationary scheme of things.

It’s partly because sterling might continue to be one of the cleaner shirts in the dirty basket in the next few years (note the talk this week that sterling assets may become a replacement safe haven following the Swiss National Bank’s currency depreciation.) And partly because gilts have already become a big deflation and QE trade — meaning there’s nothing stopping gilts going through the looking glass — hence the historic low rates recently. It’s always worth remembering that Japan got its first rating downgrades just as short-term JGB yields approached the zero bound and the Bank of Japan launched QE proper in 2001. It would be nice if the BoE was at least considering creative monetary policy.

History repeating itself? Considering that gilt yields are as low now as UK consol yields during the Long Depression of the late 1800s, it increasingly seems we have a pick of history to choose from. None of it reassuring.

Full note in the usual place.

Related link:
Coalition rejects early end to 50p tax rate – FT