UK Outlook: Brexit Drag On Sovereign Rating Eases; Risks to City, Trade Balance Remain

We have consistently argued through the Brexit period that “no deal” was the least likely outcome. In this respect, the entering into force of the Trade and Cooperation Agreement with the EU in May 2021 was a crucial development behind an improved credit outlook for the United Kingdom.

The reduction of ‘no-deal’ adverse Brexit risk has significantly curtailed contingent downside risks that affect economic, fiscal, external-sector and institutional outlooks relevant for the UK’s sovereign credit ratings.

While the important UK services sector was mostly excluded from the trade deal, the additional Memorandum of Understanding agreed by the two sides in March represents a further important step for any more substantive access rights granted to the UK financial industry medium run, contingent on equivalence rulings.

Scope revised the UK’s sovereign rating Outlook to Stable on 25 June

The rating agency I represent revised the United Kingdom’s rating Outlook to Stable from Negative, affirming the ratings at AA on 25 June. In part, this Outlook change also reflected an exhibited resilience since the referendum in sterling’s status as a reserve currency.

The diminished risk of severe no-deal complications from Brexit has coincided with comparative resilience of the British economy through both a tense phase of domestic politics and frequently fraught relations with the EU after the June 2016 referendum and the Covid-19 crisis.

Sharp contraction in UK output in 2020, but strong recovery expected over 2021-22

UK economic output contracted sharply by 9.8% in 2020 with strict sequential lockdowns and heavy disruption of the domestic economy as the government struggled to contain the SARS-CoV-2 virus.

However, supported by large-scale fiscal and monetary stimulus, we expect a strong, but uneven, economic rebound of 6.6% this year and 5.4% next. In the medium term, we anticipate the UK’s growth potential to remain around 1.5%, capped by soft estimated productivity growth of just 0.6% a year.

True, that is below our 2% potential growth estimate should the UK have stayed in the EU, but it is nonetheless still comparable to that of similarly-AA rated countries such as the US, at 1.9%, and France, at 1.4%.

Revision of UK credit Outlook does not imply Brexit risks have passed

The revision of the UK rating Outlook does not imply Brexit risk and associated economic and institutional consequences have passed. The City of London is facing permanent damage in awaiting definitive agreements with the EU on financial services. UK-based businesses may continue to relocate some activities to the continent. Domestic politics remain volatile, from the growing pressure for a second referendum on independence for Scotland and the fall-out in Northern Ireland from the new UK-EU trading arrangements.

The external sector represents one constant credit challenge. The current account deficit amounted to 3.5% of GDP in 2020, slightly up from 3.1% of GDP in 2019 although significantly below a 6.1% of GDP peak in the four quarters to Q3 2016. The UK ultimately secured an EU deal for trade in goods where it has a trading deficit with the EU, but not one as comprehensive in services where it stands to see a diminished trading surplus. This holds longer-term adverse consequences for the UK’s current account balance.

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Dennis Shen is a Director in Sovereign and Public Sector ratings at Scope Ratings GmbH. Eiko Sievert, Director at Scope Ratings, contributed to writing this commentary.