Inevitably, on news like this…
UK public finances deteriorated in December, partly because the £20bn state recapitalisation of Royal Bank of Scotland swelled the government’s net cash requirement to £44.2bn.
The budget deficit for the month – tax receipts minus expenditure – totalled £11.4bn against a shortfall of £4bn a year earlier, as the deepening recession slowed tax receipts and pushed up social expenditure.
… a flurry of dire pronouncements about the state of the UK’s finances/economy will follow.
For the best of the gloom, we here at FT Alphaville always turn to Britain’s Best Selling Quality Doomsheet, The Daily Telegraph.
Ambrose “death spiral” Evans-Pritchard:
Reykjavik refused to honour the foreign debts of its buccaneering banks. It let them default… If London takes such disastrous action it will set off global panic and lead to an asset death spiral, drawing the entire world into deep depression.
What have our leaders wrought? The reckless conduct of City, the fiscal incontinence of Gordon Brown (3pc deficit at the top of the cycle), and the pitiful regulation of the UK housing boom have all combined to bring the country to the brink of disaster. England has not defaulted since the Middle Ages. There is a real risk it may do so now.
Edmund “default disaster” Conway:
So markets now reckon the UK stands a one in ten chance of defaulting on its sovereign debt over the next half decade… I have spent much of the past month or so trying to reassure my fellow colleagues and acquaintances that despite the pound’s decline, the UK is not on the brink of either insolvency or disaster. I cannot do so any longer.
Actually it’s unfair to single out the Telegraph. Even Bloomberg was at it yesterday.
And of course, if anything, it’s pundits who have underestimated the crisis, rather than those that have overestimated it, that have been made to look foolish in the past few months.
With those caveats in mind, just how much is there to be said then for a) a sovereign downgrade of the UK’s triple-A rating or b) a sovereign default?
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Here’s Moody’s, explaining some of the considerations of sovereign ratings:
…government default risk should not be confused with generic economic, political or financial risks, although they are often related. For instance, a large exchange rate depreciation may precipitate the default of one country (justifying an outright rating change), erode the shock-absorption capacity of another (justifying some downward rating pressure) or have no impact on still another government’s credit metrics.
The last phrase, which we’ve highlighted, is crucial. Moody’s continues…
Assessing default risk first relies on a cost-benefit analysis to repay the debt, and, second, requires an evaluation of the government’s resources (solvency risk), as well as its ability to mobilize resources in a timely fashion (liquidity risk). To determine whether a government will punctually face debt payment streams, it is necessary to assess the possibility and associated costs of (1) raising additional taxes or cutting spending, which both expose the sovereign to the risk of dampening growth and fueling social discontent; (2) liquidating assets, risking depletion of productive national resources; or (3) obtaining monetary financing from the central bank, with the risk of undermining the monetary authority’s credibility and fueling inflation.
The point being that some countries are more dedicated to those three processes than others. Some governments do whatever it takes to avoid defaults. Others, like that of Ecuador, do not. Or in rating agency speak:
The probability of default for a government depends on both the ability and willingness to repay. In contrast to nongovernmental economic agents that are forced to default because they no longer have the resources to repay debt, governments, by the distinctive nature of possessing sovereignty – i.e. freedom from a higher authority – can make the deliberate choice to not repay their debt.
This is what makes sovereign rating different to normal rating. And why for the UK, even with the threat of a ballooning public debt looming, Moody’s will think twice before downgrading its triple-A. The crucial point is that the UK is very unlikely to be a sovereign that “makes the deliberate choice not to repay their debt.” Indeed, the UK is among a handful of sovereign borrowers that will probably do whatever it takes to repay their own debt. Even, quite possibly, if that means a recession or depression as a result.
And indeed, the first step in any sovereign rating process is in assessing the underlying economic resiliency of the country itself. In the UK’s case, despite what you may think, this is also pretty strong. Assessing the underlying economic strength of the economy is something Moody’s does based primarily on GDP per capita and on the strength and endurance of financial and political institutions. The UK gets tip top marks in both these categories.
Take all those things together and you can see why the UK’s triple-A rating is a little bit more special – stable – than those of other triple-A nations, and why a downgrade is pretty unlikely.
Pretty unlikely, but not completely so.
This brings us rather circuitously onto question b) – the actual likelihood of sovereign default.
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First off, as the above alludes to, a large public debt to GDP alone does not necessarily mean a country can’t be triple-A.
Even if the UK nationalised RBS and Lloyds, thus vastly increasing the government’s liabilities, the chances are that Moody’s, S&P and Fitch would still maintain a triple-A rating. This is because UK Plc still has the income to finance its debt repayments happily (you think taxes are high now…) and because the rating agencies believe those debt repayment obligations will likely be honoured before other considerations – like public spending.
The threat to the UK’s rating is thus not really directly a budgetary one.
Willem Buiter in another thorough blog post today elucidates the UK’s actual problem, which is Icelandic.
The UK’s banks are mammoth compared to the UK’s GDP, just as was the case with Iceland and its banks (well, not quite as bad. UK bank liabilities are equivalent to roughly 450 per cent of GDP, whereas the ratio in Iceland was double that). While that need not immediately present a threat thanks to the size and wealth of the UK’s economy, it still raises eyebrows. And eyebrow raising in the current climate has a tendency to cause problems. Buiter:
…there is a non-negligible risk that before too long, the growing exposure of the British sovereign to the banking system (and especially to the foreign currency funding risk faced by the UK banking system), together with the 9 and 10 per cent of GDP general government fiscal deficits expected for the next couple of years, may prompt a loss of confidence by the global financial community in the British banks, currency and sovereign.
The point being that while the UK government can afford to nationalise RBS and Lloyds, it can’t really afford to nationalise them and then have them fail anyway. So it’s a kind of ‘call my bluff’: on the one hand, having the full faith and credit of the UK government behind the banks should allay lending fears. On the other hand, it ups the ante and challenges people to start fearing for the full faith and credit of the UK government itself. Or to put it another way: a run on a nationalised RBS would effectively be a run on the UK government.
Scary.
But we’re getting rather far ahead of ourselves. RBS isn’t in imminent danger of collapse. It’s in imminent danger of being nationalised, which is quite a different thing. There is no run on RBS. It – like other UK banks – can still access funding.
Unlike with Northern Rock, nationalisation is being talked about as a solution to an economic crisis, not a banking one.
So behind the talk of nationalisation, there’s no more reason to fear lenders will pull back from RBS now than there was a month ago. And indeed, given the ability of the BoE to act as a liquidity provider, there’s not too much reason to fear they will in the near future, nationalised or not.
Add to this too the recent range of supportive measures from the UK authorities (some of which are extremely supportive) and perhaps in worrying about the collapse of the UK, we really have nothing to fear but fear itself.