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Dennis Shen
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Scope Ratings says the heavy impact of Covid-19 and Brexit is testing the resilience of the UK’s economy and public finances, although the UK (rated AA/Negative by Scope) retains important, counterbalancing fiscal strengths.

“Prime Minister Boris Johnson’s government faces a delicate balancing act of gradually re-opening the economy and easing physical distancing while avoiding a significant second wave of infection, as is the case for many other governments around the world,” says Dennis Shen, lead sovereign analyst for the UK.

The UK has experienced a disproportionately heavy toll from the pandemic due in significant part to government mismanagement in the crisis, accounting for near 10% of global Covid-19 confirmed fatalities (according to Johns Hopkins University data) with 0.9% of the world’s population. “The economy and health trade-off in this crisis is not such an obvious trade-off in the final analysis – as long as the virus is not brought under control, there cannot be a true normalisation of economic conditions,” says Shen.

Brexit represents a second potential risk

The UK faces a second potential crisis: the looming end-June deadline in the Brexit process on whether to extend the standstill implementation period in the EU’s single market and customs union beyond 2020 – a deadline that UK negotiators are likely to let pass by.

“If so, the UK would technically lose its option under the 2019 Withdrawal Agreement to avoid a disruptive no deal exit on 1 January 2021,” says Shen. “However, even if the deadline is ignored, we expect an agreement late in 2020 to extend the transition state and avoid hard Brexit. Such an extension would mean that the UK continues payments to the EU budget for the EU’s 2021-27 financial period.”

“Beneath the rhetoric and Brexit posturing, we believe there is little real appetite from general publics for a no-deal exit on either side of the Channel in the middle of a severe health and economic crisis,” says Shen. “UK proposals for a temporary light-touch customs regime, in the case no trade deal is struck, are also unrealistic – as stated by the EU.”


Deep recession alongside fiscal deterioration

The UK economy is expected to be in a very deep recession in 2020. “A significant weakening of the UK’s public finances is foreseen with the budget deficit set to increase to above 10% of GDP in 2020 with public debt to climb above 100% of GDP from 85% in 2019,” says Shen. “Potential no-deal Brexit contingency planning late in 2020 is expected to add additional budget costs – as it did in 2019. Economic uncertainties tied to Brexit will damage investment and impede the recovery later in 2020 as well as in future years.”

Public debt will likely continue to rise over the medium run toward 115% by 2024, as the UK economy recovers with the support of accommodative fiscal and monetary policies but deficits remain high as the Conservative government seeks to avoid a fresh round of austerity cuts, in line with a potentially more lax fiscal consolidation response globally after this crisis compared with after 2008-09. “This also links to a weakened UK fiscal framework after attrition from the Brexit process.”

“With Labour gaining on the Conservatives in opinion polls, the government will want to provide fiscal support for households and business – likely forgoing significant tax increases and spending reductions for the foreseeable future,” he says. “The government has discussed treating debt accrued in 2020 as ‘war debt’, justifying a higher public debt ratio. Central bank QE has moreover granted governments greater fiscal space. Unfortunately, debts accrued during this crisis will, nonetheless, have to be repaid one day,” says Shen.

However, the UK maintains economic and fiscal strengths

However, the UK has counterbalancing economic and fiscal strengths. As one of three economies with a “Big Four” central bank alongside an independent monetary policy – the others being the United States and Japan – the UK can issue gilts and raise borrowing with limited immediate concern regarding debt sustainability. UK yields are near historic lows: at or under 0% on the short to medium end and only 0.2% to borrow for 10 years (compared with near 5% at 2008 crisis heights). Similarly, UK interest payments are at their lowest since World War II, with debt interest to revenues of around 3.5%, well under a new fiscal rule set in case this ratio were to rise above 6%.

The 2020 public debt ratio remains well below that of similarly rated sovereigns such as France (AA/Stable) (at around 115% of GDP at end-2020) and the US (AA/Stable) (135-140%) despite the increase in the UK government’s debt stock. Government annual gross financing needs are also significantly below those of such sovereigns, with the UK’s long average maturity of public debt of 15.2 years contrasting with 7.8 years in the case of France, 5.8 years for the US, and a weighted average of 7 years for G7 countries.

“Moreover, the Bank of England has been buying gilts in the secondary market,” says Shen. “With the expansion of QE to GBP 645bn as announced in March, the central bank should at minimum approach holding 30% of outstanding UK debt securities in 2020, up from 24% at end-2019, with the significant possibility that QE is further enlarged. Even if purchases represent only the momentary transfer of UK debt to the central bank, this goes some way in curtailing the 2020 increase in UK government debt owed to the private sector – the segment of sovereign debt rated by Scope.”

For a look at all of today’s economic events, check out our economic calendar.

Dennis Shen is a Director in Public Finance at Scope Ratings GmbH.

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