UK Current Conditions

8/4/2019 UK Current Conditions

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CURRENT UK FISCAL SCENARIO

In recent months, concerns have mounted over the possibility that UK government debt will bedowngraded from its AAA rating. At the very outset and with a blunt stare, though one cannot completelyrule out the risk of a downgrade, I believe it is unlikely in the SHORT TERM (at least, say, for theforthcoming few years)

The following pages outline the UKs current fiscal and ec onomic status and examine the prospects for UKgovernment debt.

The Impact on Gilts of Concerns over the UKs Debt Rating

UK government debt has always been rated AAA by the three main rating agencies: Standard & Poors,Moodys and Fitch. However, the rating agencies outlook for the UK has taken a negative turn recentlybecause of the UKs significant fiscal deficit and its ongoing economic difficulties. While all three agencieshave voiced their concerns, S&P took its first action in May 2009 when it placed a negative outlook on theUK, based on concerns that government debt would be difficult to rein in, particularly in the uncertainpolicy environment in the run up to the general election.

S&Ps negative outlook contributed to the rise in gilts yields t owards the end of May 2009 as well as to arise in the cost of insuring against a default by the UK government; the cost of this insurance was reflectedin the increasing value of the five-year credit default swap (CDS) contract.

Chart 1: UK Five-year Credit Default Swaps (basis points)


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By the end of October 2009, the CDS spread had fallen back to lower levels of around 45 basis points, asinvestors became more optimistic about the prospects for the UK and the global economy. Yet, six monthslater, concerns over sovereign risk have re-emerged as the market questions the sustainability of such largefiscal deficits. The recent jumps in the Sovereign Debt Concerns have forced the UK CDS to shoot up to

what could be alarming levels yet again. And I am for one, sure, that the Tories do not want an Athens inthe making!!!

The Problem of Growing UK Debt

Nearly 70-75% percent of the UKs GDP is derived from the services sector, of which financial services is asignificant part. As such, the UK is more likely to be exposed than most nations to global financialrestructuring and to the impact of any downturn in the global recovery. With six quarters of falling outputbetween the second quarter of 2008 and the third quarter of 2009 unprecedented in post-war history the evidence that the UK has been particularly hard hit by the global downturn is compelling.

Since 2007, as a result of several factors, the UK recorded the fastest rise in the government debt ratioamong AAA rated sovereigns. First , the Labor government has spent excessively creating a deficit evenbefore the credit crisis began. Second , bank bailouts have cost the government approx 69 billion, whichequates to 4.9% of GDP for 2009. Third , the government has implemented a number of other measures tosupport the economy such as its car scrappage scheme and VAT reductions. Finally , increased governmentspending has coincided with an obvious (but more than estimated) declining tax revenues resulting fromthe economic downturn.

The UK recession officially ended during the fourth quarter of 2009, when GDP showed a small increase of 0.3%. While this figure is better than the initial estimate, it is still minimal, suggesting that there is a realrisk that UK growth forecasts have been too optimistic and adding to concerns over the countrys fiscalcrisis.

Chart 2: GDP Growth


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The Debt-to-GDP Menace

UKs debt -to-GDP ratio and interest costs on the debt have risen in the past four decades. It also showshow these figures are forecast to only rise further . The UK is not the only major developed country

experiencing such fiscal problems. US, Greece, Ireland and Spain all have similar fiscal deficits as the UK.

But, with the exception of the US, none of these nations are triple-A rated by all three rating agencies. Anddespite its large deficit, the US is in a stronger position than the UK because of its position as the largesteconomy in the world, and the fact that the US dollar is the worlds main reserve currency.

Despite its difficult fiscal situation, overall the UK economy is still arguably viewed somewhat favorably bythe rating agencies. They point out that it is a large, wealthy, diversified economy. It has a high degree of fiscal and monetary policy flexibility, as well as relatively flexible product and labor markets.

The catch lies here. The agencies also note, however, that whether the UK maintains its AAA rating relies

on the assumption that the fiscal deficit will decline. S&P has forecast that the UK government debt-to-GDPratio could approach 100% by 2013 and remain near that level thereafter. Unless fiscal consolidation is putin place to reduce this forecast, a longer-term debt-to-GDP ratio of near 100% is incompatible with a ratingof AAA. But with a Hung Parliament, will fiscal consolidation be an easy path for the New Govie??

Chart 3: UK Debt as a % of GDP

The returning of the debt burden to normally acceptable levels would take considerable time and this is

coupled with a high risk of Policy Error in such unprecedented times. To put the situation in perspective,cumulative net debt is forecast to rise sharply to 90% of GDP by 03/14 from the current 62%.


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Chart 4: UK Govie Deficit as a %age of GDP

In the calendar year 2009 the UK recorded a general government deficit of 159.2 billion, which wasequivalent to 11.4 per cent of gross domestic product (GDP). At the end of December 2009 generalgovernment debt was 950.4 billion, equivalent to 68.1 per cent of GDP. The Maastricht Treaty's ExcessiveDeficit Procedure sets deficit and debt targets of 3 per cent and 60 per cent respectively for all EUcountries.

Fiscal austerities are, therefore, a key determinant of the UKs rating outlook. The measures announced byChancellor Alistair Darling in his pre-budget report in December 2009 were met with a lukewarm responsefrom the market. The projections on growth were deemed too optimistic, and the proposed actions to

tackle the deficit lacked details and clarity. As a result, gilt yields rose and CDS spreads widened.

Uncertainty surrounding the UKs fiscal position has somewhat increased with the outcome of the generalelections being a Hung Parliament the first since 1974. Though the Conservatives have promised moresevere fiscal consolidation than Labor, and that too, sooner rather than late; I believe as Britain goes theIndia way (coalition Government), alliances are difficult to keep up with. There definitely needs to be abalance . Consolidation that is too aggressive could lead to a double dip scenario for economic growth,which would in turn precipitate a further deterioration in public finances.

Coming back to our discussion on Budget Deficits and Government Debt, we must note that, in a historicalcontext, high public sector debts are not uncommon. The ratio was some 156% of GDP in 1784 followingwars. The Second World War resulted in the ratio reaching as high as 238% of GDP. It finally fell to 25% by1992 owing to numerous factors, viz., rising inflation, string economic growth, reduction in obligations,privatizations.

The major difference this time is that now governments have used national debt to not only finance warsbut also to fund public services and mitigate economic troubles . Estimates reveal that such financialinterventions have caused about 39% increase in Net Public debt over the past three years. Thegovernment has excluded these interventions on its forward-looking projections naming them astemporary. However, given their contingent nature of recovery (Bank Bailouts) the cost might furtherincrease instead of a recovery on the taken-over financial institutions assets.


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Another important point to be concerned about is that financial services, real estate and constructioncomprise a large portion of the UK economy, and are not expected to recover to their pre-recession levelsanytime soon. This implies an increase in the structural deficit that might not be rectified directly through areturn to growth.

It is often assumed that indebted governments would inflate their way out of debt but inflation thatbecomes persistent would be priced into Bonds. This would force the government to pay more to raisemore debt, thereby increasing the dangers. Inflation can easily get out of control and the cost of reducing itmay turn out to be very high. As such, consolidation is the more preferred option currently available (thepros and cons of which have already been discussed) unless the economy starts explaining and the mostpreferred Tax Receipts methodology can be successfully adopted.

On the rates front, the downside risk for yields is of interest rates rising more rapidly than expected. Asthings are panning out, this could occur (sadly though) if the government loses control of the deficit. In such

scenarios, we could witness capital flight and a collapse of the Proud Pound currency, which would increaseimport prices substantially as well as have significant disruptive effects on the economy. From what itseems, a moderate decline in sterling that has recently happened shows that some Government leeway inits finances has already been factored into.

Chart 5: GBP/USD Currency Flow since the Credit Crisis 2007/08


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Below are attached some charts that give an overview of some important economic sectors since theadvent of the ongoing crisis:


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Latest Figures from the Bloomberg:

TABLE SHOWING CDS Values as on May 10, 2010Data Source CBIL CMAN

Issuer 5Yr 5Yr

Brazil 130.95 151.72China 68 86.06Denmark 42.99 50.57Dubai 459.91 464.79France 62.64 77.9Germany 49.17 57.3Greece 576.25 938.69Hungary 293.93 287.2Iceland N.A 342.7Italy 145.83 229.59Japan 79.08 89.39Kazakhstan 195.27 242.4Portugal 260 440.16Qatar 91.64 103.16Romania 270 310.59Spain 160.58 251.16Switzerland 54.8 61.5USA 41.61 42.61United Kingdom 80.54 99.75Vietnam 246.67 270.93

Conclusion:

Overall, the case for a severe ratings downgrade is one that could take some time and would be more of aprocess rather than a simple announcement as has been for many European counterparts.

Documents

UK Current Conditions