Britain's 'star pupil' days may be over as credit rating is threatened
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David Stevenson May 29, 2009
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Britain is faced with having its top-notch credit rating downgraded for the first time. And America could be about to suffer the same fate, says David Stevenson.
What's happened to our credit score?
Thirty-three years after then Chancellor Dennis Healey had to beg the International Monetary Fund (IMF) for a bail-out loan, Britain might be on the verge of losing its top-notch, triple-A credit rating for the first time. Credit ratings agency Standard & Poor's (S&P) has cut its UK outlook from "stable" to "negative", warning there's a one in three chance it will cut Britain's rating.
But Britain isn't the only one under the microscope. Fears are growing that US government bonds, the global benchmark for long-term interest rates, could soon get the same treatment. High-profile Bond Fund Manager Bill Gross of Pimco has cautioned that America will also "eventually" lose its triple-A rating – and "the market will recognise the problem before the rating services".
What's spooked the credit agency?
In a word, debt. Both the British and American governments are trying to spend us out of recession using huge amounts of borrowed money. The UK Treasury is already forecasting annual public deficits at their largest since records began in the 1960s, leading to a £1.1trn national debt within five years. But most analysts fear even these dire predictions are far too sanguine. Indeed, April's government spending shortfall was the highest-ever and four times last year's.
Meanwhile, in the US, the fast-rising public debt mountain has now reached $11.3trn, which – even on upbeat growth forecasts – the Obama administration sees climbing by a further $1.85trn in 2009 and $1.4trn in 2010. "Just last January the 2009 deficit was estimated at 'only' $1.2trn", says John Mauldin of Investorsinsight.com. "Things have gone downhill fast." And accelerating debt raises the risk to lenders.
Will our governments be able to raise this money?
Both Britain and America depend heavily on external budget deficit funding – in other words, we borrow a lot from foreign countries. The foreign share of UK public debt has risen from 18% to 34% over the past six years, and is now a big part of some countries' overseas assets. For example, Russia's central bank held 9.7% of its reserves in sterling at the end of 2008, says Monument Securities' Marc Ostwald.
Meanwhile, China and Japan alone hold 23% of America's $6,369bn federal debt outstanding. The trouble is, both countries need to raise a lot more money, which means relying on further demand from foreigners. Even on official figures, the UK needs to flog a record £220bn of gilts this year. And the US has to raise $2trn, including $900bn by September. Growing concerns that we are already carrying too much debt have lately forced up ten-year yields on both British and American government bonds, and lower credit ratings would compel both countries to pay even higher rates on new loans.
There's another twist too. "The question is – which foreigners are holding your bonds?" asks BNP Paribas' Hans Redeker. Because of rules regarding acceptable levels of risk, some countries, including Hong Kong, would have to cut exposure to any country suffering a downgrade from triple-A.
Haven't others been here before?
Countries losing triple-A ratings in the past include Norway in 1987, Finland in 1990, Sweden in 1991, Canada in 1994 (though it eventually got it back) and this year, Spain and Ireland. Even Japan succumbed in 1998, despite being the world's top creditor with over $1.5trn of net foreign assets. "Lender abroad, it's a mega-debtor at home," says The Daily Telegraph's Ambrose Evans-Pritchard. Even then, the Japanese didn't have any trouble funding its debt, says Evans-Pritchard.
But Japan had a crucial advantage: some 95% of government debt was held by Japanese savers or big pension funds. "We're far more vulnerable", says Société Générale's Albert Edwards. "Japan had a huge current-account surplus and a strong currency. The UK's a deficit country, at risk of a sterling collapse. Years of macro-mismanagement have dragged the UK economy to the edge."
So where does this leave us?
Rising interest rates create a "debt compound trap", where you have to borrow extra just to pay the interest bills, says London School of Economics Professor Charles Goodhart. "If that happens we're in real trouble. We could be close by next year." Higher borrowing costs also curb investment spending and economic growth, meaning a lower overall tax-take – which makes deficits bigger.
Already in the US, "the yield-spike may be nearing the point where it threatens to short-circuit economic recovery", says Evans-Pritchard. It means authorities on both sides of the Atlantic need to cut spending. And as Robert Chote of the Institute of Fiscal Studies says: "a government wishing to get debt down more quickly may need to rely more on tax increases". In short, a very painful mixture.
Could the US be in worse trouble than the UK?
S&P has warned that the next UK Government has to get its act together. A downgrade will come if after the election "fiscal consolidation plans" look "unlikely to put the UK debt burden on a secure downward trajectory over the medium term". But at least that gives a prospective government the excuse to take the harsh action needed.
In the US, the newly-elected Obama administration shows no sign of cutting spending. Yet as Hayman Advisors' Kyle Bass says, if they don't do it, the consequences will be dire: "If the Americans lose control of long rates, they won't be able to arrest asset-price declines. If they print too much money, they'll debase the dollar and cause stagflation... there's no 'get out of jail free' card for anyone".
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