Dankse-Research UK 070911

8/3/2019 Dankse-Research UK 070911

http://slidepdf.com/reader/full/dankse-research-uk-070911 1/15

www.danskeresearch.com

Investment ResearchGeneral Market Conditions

The United Kingdom is a AAA-rated country with a stable outlook. Using the same

rating methodology as Standard and Poor’s, who recently downgraded the United

States, we dare to ask why?

Like S&P, we focus on five key factors that form the foundation of a sovereign credit

rating: 1) Institutional effectiveness and political risks, 2) Economic structure and

growth prospects, 3) External liquidity and international investment position, 4)

Fiscal performance and flexibility, as well as debt burden and 5) Monetary flexibility.

Instead of a “black -box" approach, we lay out all our results with full transparency.

We find that the UK’s political and economic profile is “strong”, the fourth highest

according to Standard & Poor’s. Our research shows that the UK’s flexibility and

performance profile is “moderately strong”, but close to “intermediate”. This is far

from “superior” and “extremely strong”, respectively, the highest possible in S&P’s

indicative rating table.

W ithout adjusting for “exceptional factors”, we conclude that the United Kingdom

should be given an A+ rating, i.e. four notches below the current rating. A downgrade

of the UK could in our view happen in 2012. We believe it can remain a market theme

into 2013. This prediction should however be treated cautiously as our analysis

suggests a relatively large political element in the rating process.

We disagree with the Office for Budget Responsibility’s underlying assumptions about

the debt burden projection. Real growth could in our view be substantially lower; the

GDP deflator could be somewhat lower and the deficit might be harder to reduce than

projected. Rather than peaking in 2013-14 and easing slightly towards 69% of GDP

in 2015-16, we find that the debt burden in our most likely scenario will rise

throughout our forecast horizon and reach 84% of GDP in five years’ time.

The market reaction to a UK downgrade is uncertain with interest rates at depressed

levels due to the risk of another global recession. Some investors might attach a

higher risk premium to UK assets. GBP can be negatively impacted.

Table 1: United Kingdom credit rating

our assessment based on S&P methodology

Note: Six-point numerical score from 1 (the strongest) to 6 (the weakest). See sections 1-5 for details

Source: Standard and Poors, Danske Markets

1 Political score 1.50 2.50 3.50

2 Economic score 1.60 2.60 3.60

3 External score 2.50 3.50 4.50

4 Fiscal score 2.50 3.50 4.50

5 Monetary score 1.25 2.25 3.25

A Political and economic profile 1.55 2.55 3.55

B Flexibility and performance profile 2.08 3.08 4.08

Total Sovereign indicative rating level 1.82 2.82 3.82

Total Indicative rating level AAA A+ BB+

Positive

adjustment

Main

scenario

Negative

adjustment

07 September 2011

Important disclosures and certifications are contained from page 14 of this report.

Chief Analyst

John M. Hydeskov

+44 (0)7410 8144

[email protected]

Assistant Analyst

Hugo Railing

+44 (0)777 542 2712

[email protected]

UK ResearchHow long can the UK maintain its AAA rating?



2 | 07 September 2011www.danskeresearch.com

UK Research

Stress-testing OBRs underlying assumptions about growth andpublic deficit alternative projections on the debt burden

The Office for Budget Responsibility (OBR), an entity established in 2010 to provide

“independent and authoritative analysis of the UK’s public finances”, presented its

Economic and Financial Outlook in March. Not surprisingly, the OBR concludes that the

Coalition Government is on track to meet its two medium-term fiscal target: to balance

the cyclically-adjusted current budget by the end of a rolling, five-year period; and to see

public sector net debt (PSND) falling in 2015-16. However, the OBR points out that there

is considerable uncertainty around the central forecast and will only attach “a greater than

50% probability of meeting both targets.

Chart 1: Lower UK growth alternative debt-to-GDP projections

Source: Office for Budget Responsibility, Danske Markets calculations

It is beyond the scope of this note to go into details of the OBR’s 176-page report. But

there are three assumptions that we find questionable and that could alter the projected

debt path for the UK. These are:

1) The growth outlook. 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.

2) 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%. We test how the

debt burden evolves when these scenarios are applied.

50

60

70

80

90

100

110

2009-10 2010-11 2011-12 2012-13 2013-14 2014-15 2015-16

OBR base case scenario

Lower growth, OBR's UK GDP deflator

Lower growth, US/Euroland deflator

Lower growth, japanese deflator

% of GDP




UK Research

3) The reduction of the deficit. According to the OBR, the public sector net

deficit (PSND) will decline from GBP145.9bn in 2010-11 (9.9% of GDP) to

GBP29bn in 2015-16 (1.5% of GDP). Harsh austerity measures have been

announced and the Government has so far not deviated from its ambitious plan.

It is however often easier to say that the belt should be tightened than to actually

cut down on spending. We dare to assume that the government shortfall will be

reduced, but only at half the speed assumed by the OBR.

Chart 2: Lower UK growth AND slower deficit reduction

alternative debt-to-GDP projections

Source: Office for Budget Responsibility, Danske Markets calculations

No matter what will happen, the UK debt burden will rise in the years to come

because of the still sizeable public deficit. In OBR’s base case, the debt burden will

peak at 70.9% in the fiscal year 2013-14 before easing gradually in the coming years.

Because of the underlying assumptions, we find that too optimistic though.

Assuming lower growth and keeping the OBR’s upbeat GDP deflator at 2.7%, suggests

the debt burden will peak at 75.0% in 2014-15. If instead the deflator turns out to be the

average of the US and the Eurozone, 1.95%, the debt burden will keep rising throughout

the forecast horizon and reach 78.1 in 2015-16. In the extreme scenario, in which we

apply “Japanese conditions”, debt will rise dramatically and reach 93.2%.

Assuming that the deficit will be reduced at a slower pace will obviously just make

matters worse. Even though we, in our alternative scenario, assume that the deficit will be

halved over the next five years, the debt burden rises rapidly in all scenarios.

In our view, the scenario assuming a lower growth rate, a “normal” GDP deflator

and a slower reduction of the deficit is the most likely. In this case, the debt burden

will hit 84.2% in 2015-16 and still be on the rise. That is by no means disastrous for

a country like the UK with a long duration of the debt burden and the cost of

servicing this burden will still be manageable, but it is still some 15 percentage

points higher than the OBR projects and we doubt that rating agencies will welcome

this outcome.

50

60

70

80

90

100

110

2009-10 2010-11 2011-12 2012-13 2013-14 2014-15 2015-16

OBR base case scenario

Higher deficit, lower growth, OBR's UK GDP deflator

Higher deficit, lower growth, US/Euroland deflator

Higher deficit, lower growth, japanese deflator

% of GDP




UK Research

Same rating approach as S&P but without the black box

Standard and Poor’s has attracted a lot of attention in financial markets and media

lately with its controversial downgrade of the United States from AAA to AA+ .

Japan, Spain and Italy have also been downgraded due to poor economic outlook, too

high debt burdens and no credible plans to reduce public deficits. Standard & P oor’s has been more proactive or aggressive than the two other large rating agencies, Moody’s and

Fitch. We will focus on S&P in our analysis as this company has been first-mover in

terms of sovereign downgrades in recent years.

The aim of this paper is to check whether we can justify the United Kingdom’s AAA

rating, reaffirmed by Standard and Poor’s on 26 October 2010, when the outlook was

revised from ’negative’ to ‘stable’, and further elaborated on in an unsolicited review on

21 December 2010. However, a lot has changed since end-2010 and most recently the risk

of a prolonged period with subdued growth or even a double-dip recession has risen.

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). Each score

is based on a series of quantitative factors and qualitative considerations.

As S&P does not reveal its exact scores we have not got anything concrete to relate to.

Instead we will have to make our best judgements based on a large number of statistical

sources. We have only used publicly available information in our analysis.




UK Research

1 Institutional effectiveness and political risks

According to Standard and Poor’s (2011), the political score assesses how a

government's institutions and policymaking affect a sovereign's credit fundamentals

by delivering sustainable public finances, promoting balanced economic growth, and

responding to economic or political shocks. The primary factor for determining thepolitical score is the effectiveness, stability, and predictability of the sovereign's

policymaking and political institutions. The secondary factor provides additional

information on the transparency and accountability and acts as a qualifier to the

primary factor in determining the initial political score .

The primary political factor is probably the least likely to be affected by structural

issues and we consider it relatively stable over time. The United Kingdom is generally

characterised by proactive policymaking with a strong track record in managing past

economic and financial crises and delivering economic growth. Institutions are generally

regarded strong and relatively stable, but are only ranked 17 out of 139 in World

Economic Forum’s “Global Competitiveness Report” (2010) due to a low public trust of

politicians, a high burden of government regulation and high business costs of terrorism.

According to the Wor ld Bank’s “Worldwide Governance Indicators”, the UK is in the

90th-100

thpercentile on five measures of governance, but scores low in political stability

and ends in the 50th-75

thpercentile. We notice further that the trend is declining over the

past decade. One of the cornerstones in the political score, the ability to “maintain prudent

policy-making in good times”, which according to Standard and Poor’s has deteriorated

over the past two decades, while another important factor “the willingness to ensure

sustainable public finances” has also diminished. Our best judgement is that the primary

political factor for the UK is solid. A score around 1.5 seems fair.

The secondary political factor can be broken down into four inputs according to

Standard and Poor’s: 1) the existence of checks and balances between institutions, 2) the

perceived level of corruption, which correlates strongly to the accountability of the

institutions, 3) the unbiased enforcement of contracts and respect for the rule of law,

which correlates closely to respect for creditors' and investors' interests and 4) the

independence of statistical offices and the media. On 1), we note that there are extensive

checks and balances between institutions in the United Kingdom and reckon that a score

of around 1.5 is appropriate. On 2), according to Transparency International’s

“Corruption Perception Index”, the UK ranks number 21 out of 178, which transforms

into a score of (1+21/((1/6)*178)) 1.7. On 3), the input factors 1.10-1.21 in World

Economic Forum’s “Global Competitiveness Report” (2010) can roughly be interpreted

as “ability to enforce contracts and respect for the rule of law”. We arrive at a relatively

bad score for the UK; only (1+30/((1/6)*139)) 2.3. The latest riots in the UK have

however not been incorporated in this score and we add 0.5 and arrive at a 2.8 score in

this component. On 4), we have to rely entirely on qualitative analysis and attach a score

of 2 due to independent statistical offices, but with frequent data revisions, and

autonomous media but sometimes with hidden agendas. The average of 1)-4) is a score of

2.0.

Standard and Poor’s notes that there are two potential adjustments to the political

score. The first relates to the debt payment culture: regardless of the fact that the IMF had

to bail the UK out in 1976, we reckon that it has a very good debt payment culture.

Incentive to default is almost non-existing and it would in our view be rather stupid even

to consider a default as close to 10% of the economy is the financial sector, which

probably would be shut in the case of a default. The second potential adjustment relates togeopolitical and external security risks: We judge that the UK is at moderate risk due to

recent participation in wars in Iraq and Afghanistan and involvement in various conflicts

around the world. A terrorist attack hit London in 2005 and more attacks cannot be

excluded.




UK Research

The European debt crisis poses a major threat to the UK. Although not directly

affected by, for example, higher interest rates or costs or guarantees to bail-out funds, the

UK can be sucked into the crisis because of its exposure to the peripheral Euroland

countries and because of the heavy British banking sector. Bank of England notes in its

latest Minutes that “The greatest risk to the downside stemmed from the euro area.

Concerns about the euro area were likely already to be affecting the economic outlook

through their impact on asset prices, bank funding costs and the level of household and

business confidence. Reflecting that, the Committee’s projections were conditioned on

relatively slow growth in the euro area. There were, however, additional risks relating to

a significant further intensification of concerns. These could affect the United Kingdom

through a number of channels, including: the impact a further slowing in euro-area

activity would have on UK exports; financial and banking sector interlinkages; and

possibly, and perhaps most significantly, through a disruption to the functioning of the

international financial system more generally – hitting global asset prices, wholesale

funding markets, and business and household confidence”.

Summarily, we judge that the primary political factor for the United Kingdom isaround 1.5. The secondary factor is according to inputs 1)-4) ((1.5+1.7+2.8+2.0)/4=)

2.0. Average for those is 1.75. Adjusting for the good debt payment culture, -0.25,

higher external security risks, +0.4, and the European debt crisis, +0.6, leads us to a

final political score of 2.5.

2 Economic structure and growth prospects

The history of sovereign defaults suggests that a wealthy, diversified, resilient,

market-oriented, and adaptable economic structure, coupled with a track record of

sustained economic growth, provides a sovereign government with a strong revenue

base, enhances its fiscal and monetary policy flexibility, and ultimately boosts itsdebt-bearing capacity. Standard and Poor’s observes that market-oriented economies

tend to produce higher wealth levels because these economies enable more efficient

allocation of resources to promote sustainable, long-term economic growth. We can only

agree with that.

GDP per capita is S&P's most prominent measure of income levels. With higher GDP

per capita, a country has a broader potential tax and funding base upon which to draw, a

factor that generally supports creditworthiness. The determination of the economic score

uses the latest GDP per capita from national statistics, converted to US dollars.

Standard and Poor’s uses a rating system in determining the economic score, a 1 is given

to countries whose GDP per capita is over USD35,000, a score of 2 if the GDP per capitais between USD25,000 and 35,000. The UK has an average GDP per capita of

USD35,616 (using the mean GDP of the CIA World Factbook, the Bank of England and

the Office of National Statistics, divided by the current population). Initially ranked 1 in

Standard and Poor’s scoring system; this has been altered to 1.9 due to the closeness of

the USD35,000 boundary and the fact that many more countries have a higher GDP per

capita (the UK is ranked 22nd

in IMF’s global ranking).

According to Standard & Poor’s, an undervalued currency suggests that the GDP

per capita understates prosperity. Applying Purchasing Power Parity (PPP) analysis,

Sterling is some 15% undervalued, the highest among G10 currencies. Our previous

research suggests however, that sterling might be less undervalued than generally

perceived as UK fundamentals have weakened during the financial and economic crisis,

please see “Sterling’s fall from grace” and “New regime, new forecast”. We subtract 0.3

index points from the initial score, improving the economic score to 1.6.

http://danskeanalyse.danskebank.dk/abo/FXStrategyGBP09062011/$file/FX_Strategy_GBP_09062011.pdf



http://danskeanalyse.danskebank.dk/abo/FXGBPNewForecast170811/$file/FX_GBP_NewForecast_170811.pdf








UK Research

Below-average economic growth compared with peers, as measured by real GDP

trend growth, drags down the economic score according to the rating methodology.

We believe that trend growth in the UK has slowed after the financial and economic

crises. Unemployment has settled at an uncomfortably high level and risks becoming

structural if not actively reduced in the near term. The UK has been running a trade

deficit for more than a decade and even a significant currency-led improvement of the

terms-of-trade has not been able to turn this around. The financial sector ’s contribution to

GDP might be considerably smaller than in the decade up to the crisis. It is difficult to say

whether trend growth has deteriorated more in the UK than in the peer group and it is

hard to see who the peer group should be. On growth rates, the UK is ranked poorly in the

CIA World Factbook, only 163rd

out of 215. According to our best judgement, we find

that the economic score should be raised 0.5 index points to 2.1.

Finally, a sovereign exposed to significant economic concentration and volatility

compared with its peers receives an economic score that is one category worse than

the initial score. More precisely, a sovereign's economic score would be one category

worse if it carried significant exposure to a single cyclical industry (typically accountingfor more than about 20% of GDP), or if its economic activity was vulnerable due to

constant exposure to natural disasters or adverse weather conditions. Economic

concentration and volatility are important because a narrowly based economic structure

tends to be correlated with greater variation in growth than is typical of a more diversified

economy.

The UK service sector accounts for 77.5% of all industry in the UK, compared to the

world average of 63.2%. The service sector, the sixth largest service sector in the world,

is in other words crucial for the UK where, for example, exports are of less importance.

The financial sector accounts for 9.4%, i.e. lower than Standard and Poor’s threshold. We

dare however, interpret the term “significant economic concentration” less strictly as the

government already has a sizeable ownership in the financial sector with its controlling

stake of 84% in the RBS Group and its minority stake of 43% in Lloyds Banking Group.

In conclusion, our initial economic score was 1.9. Taking into account the

undervaluation of Sterling -0.3, the slow growth rates +0.5 and the reliance of the

financial sector +0.5 leaves the final economic score at 2.6.

3 External liquidity and international investment position

The external score reflects a country's ability to generate receipts from abroad

necessary to meet its public- and private-sector obligations to non-residents. It refers

to the transactions and positions of all residents (public- and private-sector entities)versus those of non-residents because it is the totality of these transactions that

affects the exchange rates of a country's currency.

Three factors drive a country's external score according to Standard and Poor’s: 1) the

status of a sovereign's currency in international transactions, 2) the country's external

liquidity, which provides an indication of the economy's ability to generate the foreign

exchange necessary to meet its public- and private-sector obligations to non-residents and

3) the country's external indebtedness, which shows residents' assets and liabilities (in

both foreign and local currency) relative to the rest of the world.

From IMF's report "Currency Composition of Official Foreign Exchange Reserves", we

find that Sterling qualifies as a reserve currency as it accounts for more than 3% of theworld's total allocated foreign exchange reserves. According to S&P’s definition, this

gives the UK the best starting point for the external score.

Unfortunately, the UK is highly indebted: narrow net external debt of over 400% is just

about as bad as it can be. According to McKinsey, the UK is the world’s most indebted




UK Research

country, adding private and public debt together. Due to the massive debt burden, the UK

falls in the lowest category, and following S&P’s adjustment rubric, the UK falls in the

negative adjustment section. The initial external score is a clear 3.

There are a few adjustment factors though – and both on the negative front:

1) Standard and Poor ’s stipulates that countries running persistent current account deficits

should count as a negative adjustment factor. The UK has been running a sizeable current

account deficit for the past 25 years, on average -2% of GDP. There are no signs of a

large improvement of the current account deficit.

2) We observe sudden shifts in foreign direct investment for the UK. With a 10 year

average of GBP54bn, highs of close to GBP100bn and lows of close to GBP10bn, FDI is

very uneven and unpredictable. The UK holds the third highest stock of FDI, but with

such variation over time, future inflow is less accountable. It is possible that the natural

FDI has diminished due to lower structural growth as foreign investors find the UK less

attractive.

The initial external score was 3.0 but is raised 0.5 points to 3.5 due to the UK’s

persistent current account deficit and the volatility and uncertainty surrounding the

future flow situation. A higher, i.e. worse, score could in our view have been justified

and we cannot exclude that this will be adjusted higher in the future if the net external

debt does not decline. Unfortunately there are no signs of this.

4 Fiscal performance and flexibility

The fiscal score reflects the sustainability of a sovereign's deficits and debt burden.

This measure considers fiscal flexibility, long term fiscal trends and vulnerabilities,

debt structure and funding access, and potential risks arising from contingent

liabilities. Given the many dimensions that this score captures, the analysis is divided

into two segments, "fiscal performance and flexibility" and "debt burden" which are

scored separately. The overall score for this rating factor is the average from the two

segments.

According to Standard and Poor’s, the key measure of a government's fiscal

performance is the change in general government debt stock during the year

expressed as a percentage of GDP in that year. Fiscal flexibility provides governments

with the "room to manoeuvre" to mitigate the effect of economic downturns or other

shocks and to restore its fiscal balance. Conversely, government finances can also be

subject to vulnerabilities or long-term fiscal challenges and trends that are likely to hurt

their fiscal performance. The assessment of a sovereign's revenue and expenditureflexibility, vulnerabilities and long-term trends is primarily qualitative.

The UK has experienced a greater than 6% change of government debt between 2010-

2011, higher than S&P’s upper thr eshold; this results in a high initial score of 6.0 (the

worst possible) following the Standard and Poor’s rating system. The government debt

has practically doubled in the last three years, a consequence of the recession.

Luckily, the UK has a fairly robust and well established taxation system with the ability

to easily raise finance relatively quickly. Due to this factor, we subtract half a point from

the initial score. As the UK has a stable asset income, ranked 24th

out of 167 in CIA’s

World Factbook, we subtract another half point and arrive at a fiscal performance and

flexibility score of 5.0.

The rating methodology suggests that the debt burden score reflects the

sustainability of a sovereign's prospective debt level. Factors underpinning a

sovereign's debt burden score are: its debt level; the cost of debt relative to revenue

growth; and debt structure and funding access. This score also reflects risks arising




UK Research

from contingent liabilities with the potential to become government debt if they were to

materialize. The calculation of net general government debt is generally more restrictive

than national measures of net general government debt, as it deducts from the general

government debt only the most liquid assets.

The UK debt burden stands at 61.4 % of GDP, according to the Office of NationalStatistics. The cost of servicing the debt burden is relatively low though, only around 3%

of GDP per year due to the long duration of the UK debt portfolio. This gives the UK an

initial debt score of 3.0 in accordance to the Standar d and Poor’s rating system. UK debt

auctions are usually well-bid and Gilts are generally considered as safe-haven assets. If a

severe crisis occurred, the Bank of England could relatively easily print out money or buy

more government debt. Because of these extenuating circumstances, we lower the score

to 2.0.

Contingent liabilities refer to obligations that have the potential to become

government debt or more broadly affect a government's credit standing, if they were

to materialize. Some of these liabilities may be difficult to identify and measure, but they

can generally be grouped in three broad categories: Contingent liabilities related to the

financial sector (public and private bank and non-bank financial institutions); Contingent

liabilities related to non-financial public sector enterprises (NFPEs); and guarantees and

other off-budget and contingent liabilities.

The UK has a financial recapitalisation cost of GBP133.2bn, while non-financial public

sector enterprise liabilities costs amount to GBP148.4bn, totalling GBP281.6bn. This

accounts for over 10% of the UK’s total GDP (GBP2.246trn) which is well below the

30% threshold (the UK would need a combined total liability of GBP674bn); this is

classed as limited in Standard and Poor’s rating system. This means that UK obligations

are of a lower risk to become problematic and turn into debt. We assign a score of 2.0.

The fiscal score was worked out in two parts; first the fiscal performance and

flexibility’s initial score was 6, due to the high percentage changes in government debt,

but lowered to 5 because of the UK’s stable asset income. Secondly, the debt margin

and contingent liabilities; the debt margin had an initial score of 3 due to the high

percentage of debt to GDP but was lowered to 2 due to low costs of servicing the debt.

In total, we have a fiscal score of 5+(2+2)/2=3.5.

5 Monetary flexibility

A sovereign's monetary score reflects the extent to which its monetary authority can

support sustainable economic growth and attenuate major economic or financial

shocks, thereby supporting sovereign creditworthiness. Monetary policy is a

particularly important stabilization tool for sovereigns facing economic and

financial shocks. Accordingly, it could be a significant factor in slowing or

preventing a deterioration of sovereign creditworthiness in times of stress.

According to Standard and Poor’s, a sovereign's monetary score results from the analysis

of the following elements: 1) the sovereign's ability to use monetary policy to address

domestic economic stresses particularly through its control of money supply and domestic

liquidity conditions, 2) the credibility of monetary policy, as measured by inflation trends

and 3) the effectiveness of mechanisms for transmitting the effect of monetary policy

decisions to the real economy, largely a function of the depth and diversification of the

domestic financial system and capital markets.

The United Kingdom has a free-floating currency that qualifies for the highest possible

exchange rate regime score according to Standard and Poor’s. We dare to argue that the

world might be more complex than that, but accept that it gives the highest degree of

flexibility as opposed to, for example, a currency board.




UK Research

The second element, “credibility”, cannot be objectively measured, as noted by Standard

and Poor’s. The Bank of England’s credibility was probably higher prior to the financial

and economic crises. Trustworthiness probably peaked in 2006, when the Bank could

celebrate ‘the great moderation’ with lower volatility in output and inflation. It proved

however, to be more ‘good luck’ than ‘good policy’; the 2008-09 recession was the worst

since the 1930s and the economy has not recovered yet. Consumer price inflation has

been very volatile over the past three years and the Bank of England has not been able to

anchor inflation and inflation expectations. A BoE/GfK survey from Q2 2011 found that

the extent of satisfaction with the Bank of England had fallen since mid-2010, see Bank

of England Quarterly Bulletin, “Public attitudes to monetary policy and satisfaction with

the Bank”.

The third element, effectiveness of monetary policy, has in our view diminished lately as

it has become clear that the Governor does not have a magic wand, which he publicly

admitted in July (honestly, we never thought differently). The MPC however, still enjoys

support from the financial markets and the public even though some have hinted that the

Bank is running out of ammunition. The extensive use of quantitative easing – asset purchases worth GBP200bn – early on in the crisis has not had the desired effect, even

though interest rates have been substantially below historical averages at all maturities.

More Gilt purchases will probably not have much impact and can furthermore have

adverse effects. The UK financial system is in dire straits, funding is a problem and the

transmission mechanism to households is broken.

Summing up , we believe that United Kingdom’s monetary flexibility has worsened but

from a good starting point. Our best judgement is that a total score around 2.25 is

appropriate. A score below 2 would in our view indicate that the BoE has plenty of

room to manoeuvre, which is not the case, while a score above 2.5 would imply that no

ammunition was left. Neither is true. The monetary score is in our view the ‘fluffiest’ in

the S&P framework and relies mainly on outdated inputs.

An indicative rating level for the United Kingdom

Standard and Poor’s issued a statement in October last year in which it revised the

UK’s credit outlook to ‘stable’ and affirmed the AAA-rating. S&P wrote:

“ In our opinion, the decisions reached by the United Kingdom coalition government in

its 2010 Spending Review reduce risks to the government's implementation of its June

2010 fiscal consolidation program. Moreover, the coalition parties have shown a high

degree of cohesion in putting the U.K.'s public finances onto what we view to be a more

sustainable footing.”

However, our analysis of the United Kingdom’s institutional effectiveness and

political risks, economic structure and growth prospects, external liquidity and

international investment position, fiscal performance and flexibility and monetary

flexibility questions that conclusion.

Using S&P’s own sovereign rating framework in which the political and economic score

form a “political and economic profile” and the external score, the fiscal score and the

monetary score form a “flexibility and performance profile”, we can calculate an

indicative rating level for the United Kingdom.

Standard and Poor’s is so kind to provide a table to determine this level, see table 2. We

find this table quite intuitive and easy to interpret. The table shows that a AAA-ratedcountry cannot have a “flexibility and performance profile” with a higher score than 2.7

or a “political and economic profile” higher than 2.5 ( please note that a number close to 1

is good while a number close to 6 is bad).




UK Research

Table 2: Indicative rating level from the combination of 1) The Political and Economic

Profile and 2) The Flexibility and Performance Profile

Source: Standard and Poors

Our analysis shows that the UK’s AAA-rating is questionable. To the best of our ability

we have used Standard and Poor’s methodology and find that the UK should not be given

more than an A+ rating, i.e. four notches below today’s level.

Standard and Poor’s gives itself full flexibility by allowing for “exceptional adjustment

factors”. We think this just blurs the true outcome and we believe we already have

included the important factors that should form the foundation of a credit rating.

Accordingly, we do not make further adjustments to our credit rating of the UK.

Adding 1 index point to all scores changes the picture, though. Then the AAA-rating can

be justified, but we cannot see where this positive adjustment should come from and can

only see that such an alteration could be done due to political reasons.

Subtracting 1 index point from all scores just makes matters worse of course; the

indicative rating deteriorates massively to BB+, i.e. 10 notches below today’s level. We

cannot justify such an alteration either and stick to our well-authenticated analysis above.

Conclusion: What would happen if the UK got downgraded?

The short and perhaps somewhat disappointing answer is: probably not much. It

would of course create a lot of public furore and cause UK politicians to criticise rating

agencies, but it would not lead to a huge Gilt sell-off and we believe that there would still

be plenty of demand for British debt – even if the UK got downgraded to A+, the same as

Italy and Slovakia at present. Some investors would probably attach a higher risk

premium to UK assets, but we doubt that this would dominate other factors. Yields would

most likely stay low because of a poor economic outlook and Sterling would not face a

confidence crisis on the back of a lower rating. A downgrade of the UK could in our view

happen in 2012 and we believe it can remain a market theme into 2013. This prediction

should however be treated cautiously, as our analysis suggests a relatively large politicalelement in the rating process.




UK Research

References

Bank of England Minutes (August 2011)

http://www.bankofengland.co.uk/publications/minutes/mpc/pdf/2011/mpc1108.pdf

Bank of England Quarterly Bulletin “Public attitudes to monetary policy and satisfaction

with the Bank” (Q2 2011)

http://www.bankofengland.co.uk/publications/quarterlybulletin/qb110203.pdf

Office for National Statistics “Public Sector Finances” (July 2011)

http://www.statistics.gov.uk/pdfdir/psf0811.pdf

Standard and Poor’s (2011) “Sovereign Government Rating Methodology and

Assumptions”

http://www.standardandpoors.com/prot/ratings/articles/en/us/?assetID=1245315323295

Standard and Poor’s (2010) “United Kingdom”

http://www.standardandpoors.com/ratingsdirect

Standard and Poor’s (2010) “United Kingdom Outlook Revised To Stable; 'AAA' Ratings

Affirmed”

http://www.standardandpoors.com/prot/ratings/articles/en/us/?assetID=1245231048727

World Bank’s “Doing business” (2011)

http://www.doingbusiness.org/data/exploreeconomies/united-kingdom/

World Bank’s “Worldwide Governance Indicators” (2009)

http://info.worldbank.org/governance/wgi/sc_chart.asp

World Economic Forum’s “Global Competitiveness Report” (2010)

http://www3.weforum.org/docs/WEF_GlobalCompetitivenessReport_2010-11.pdf













UK Research

See more UK Research here:

New regime, new forecast (17 August)

UK Q2 GDP poor as expected – Bank of England to keep rates low for most of 2012 (27

July)

Sterling’s fall from grace (09 June)

An augmented Taylor rule for the United Kingdom (01 June)

King is right – UK inflation will hit 4.9% in September (13 May)

Ten good reasons why BoE will keep rates unchanged in 2011 (11 May)

UK Gilt handbook (09 May)

UK Fact Book – rain on your wedding day (28 April)

UK avoids new recession – but underlying growth is weak (27 April)

Hesitant King to drive GBP weaker (13 April)

The Bank of England’s dilemmas (05 April)

Please visit Bloomberg DMGB <GO> for live tradable GBP swaps

Please visit Bloomberg DRIM <GO> for more Danske Bank research



http://danskeanalyse.danskebank.dk/abo/FlashCommentGDP260711/$file/FlashComment_GDP_260711.pdf






http://danskeanalyse.danskebank.dk/abo/UKResearchAugmentedTaylor010611/$file/UKResearch_Augmented_Taylor_010611.pdf


http://danskeanalyse.danskebank.dk/abo/ResearchUKCPI130511/$file/Research_UK_CPI_130511.pdf




http://danskeanalyse.danskebank.dk/abo/UKResearch10goodreasons100511/$file/UKResearch_10goodreasons_100511.pdf


http://danskeanalyse.danskebank.dk/abo/UKGiltHandbook220411/$file/UKGiltHandbook_220411.pdf


http://danskeanalyse.danskebank.dk/abo/FactBookUK280411/$file/FactBook_UK_280411.pdf




http://danskeanalyse.danskebank.dk/abo/FlashCommentUKGDPQ1270411/$file/FlashComment_UK_GDPQ1_270411.pdf




http://danskeanalyse.danskebank.dk/abo/FXC130411/$file/FXC_130411.pdf


http://danskeanalyse.danskebank.dk/abo/UKBoE050411/$file/UK_BoE_050411.pdf
















UK Research

DisclosureThis research report has been prepared by Danske Research, a division of Danske Bank A/S ("Danske Bank").

Analyst certification

Each research analyst responsible for the content of this research report certifies that the views expressed in the

research report accurately reflect the research analyst’s personal view about the financial instruments and issuers

covered by the research report. Each responsible research analyst further certifies that no part of the compensation

of the research analyst was, is or will be, directly or indirectly, related to the specific recommendations expressed

in the research report.

Regulation

Danske Bank is authorized and subject to regulation by the Danish Financial Supervisory Authority and is subject

to the rules and regulation of the relevant regulators in all other jurisdictions where it conducts business. Danske

Bank is subject to limited regulation by the Financial Services Authority (UK). Details on the extent of the

regulation by the Financial Services Authority are available from Danske Bank upon request.

The research reports of Danske Bank are prepared in accordance with the Danish Society of Financial An alysts’

rules of ethics and the recommendations of the Danish Securities Dealers Association.

Conflicts of interest

Danske Bank has established procedures to prevent conflicts of interest and to ensure the provision of high

quality research based on research objectivity and independence. These procedures are documented in the

research policies of Danske Bank. Employees within the Danske Bank Research Departments have been

instructed that any request that might impair the objectivity and independence of research shall be referred to the

Research Management and the Compliance Department. Danske Bank Research Departments are organised

independently from and do not report to other business areas within Danske Bank.

Research analysts are remunerated in part based on the over-all profitability of Danske Bank, which includes

investment banking revenues, but do not receive bonuses or other remuneration linked to specific corporate

finance or debt capital transactions.

Financial models and/or methodology used in this research report

Calculations and presentations in this research report are based on standard econometric tools and methodology

as well as publicly available statistics for each individual security, issuer and/or country. Documentation can beobtained from the authors upon request.

Risk warning

Major risks connected with recommendations or opinions in this research report, including as sensitivity analysis

of relevant assumptions, are stated throughout the text.

First date of publication

Please see the front page of this research report for the first date of publication. Price-related data is calculated

using the closing price from the day before publication.

General disclaimerThis research has been prepared by Danske Markets (a division of Danske Bank A/S). It is provided for

informational purposes only. It does not constitute or form part of, and shall under no circumstances be

considered as, an offer to sell or a solicitation of an offer to purchase or sell any relevant financial

instruments (i.e. financial instruments mentioned herein or other financial instruments of any issuer

mentioned herein and/or options, warrants, rights or other interests with respect to any such financial

instruments) ("Relevant Financial Instruments").

The research report has been prepared independently and solely on the basis of publicly available

information which Danske Bank considers to be reliable. Whilst reasonable care has been taken to

ensure that its contents are not untrue or misleading, no representation is made as to its accuracy or

completeness, and Danske Bank, its affiliates and subsidiaries accept no liability whatsoever for any

direct or consequential loss, including without limitation any loss of profits, arising from reliance on this

research report.

The opinions expressed herein are the opinions of the research analysts responsible for the research

report and reflect their judgment as of the date hereof. These opinions are subject to change, and

Danske Bank does not undertake to notify any recipient of this research report of any such change nor of

any other changes related to the information provided in the research report.

This research report is not intended for retail customers in the United Kingdom or the United States.



UK Research

This research report is protected by copyright and is intended solely for the designated addressee. It

may not be reproduced or distributed, in whole or in part, by any recipient for any purpose without

Danske Banks prior written consent.

Disclaimer related to distribution in the United StatesThis research report is distributed in the United States by Danske Markets Inc., a U.S. regi stered broker-

dealer and subsidiary of Danske Bank, pursuant to SEC Rule 15a-6 and related interpretations issued by

the U.S. Securities and Exchange Commission. The research report is intended for distribution in the

United States solely to "U.S. institutional investors" as defined in SEC Rule 15a-6. Danske Markets Inc.

accepts responsibility for this research report in connection with distribution in the United States solely

to U.S. institutional investors.

Danske Bank is not subject to U.S. rules with regard to the preparation of research reports and the

independence of research analysts. In addition, the research analysts of Danske Bank who have

prepared this research report are not registered or qualified as research analysts with the NYSE or

FINRA, but satisfy the applicable requirements of a non-U.S. jurisdiction.

Any U.S. investor recipient of this research report who wishes to purchase or sell any Relevant Financial

Instrument may do so only by contacting Danske Markets Inc. directly and should be aware that investing in non-

U.S. financial instruments may entail certain risks. Financial instruments of non-U.S. issuers may not be

registered with the U.S. Securities and Exchange Commission and may not be subject to the reporting and

auditing standards of the U.S. Securities and Exchange Commission.

Dankse-Research UK 070911

Documents

Transcript of Dankse-Research UK 070911