CREDIT OUTLOOK TURNS NEGATIVE OVER HIGH DEBT CONCERNS

UNCLAS SECTION 01 OF 02 LONDON 001231 SENSITIVE SIPDIS E.O. 12958: N/A TAGS: ECON EFIN ETRD EINV UK SUBJECT: CREDIT OUTLOOK TURNS NEGATIVE OVER HIGH DEBT CONCERNS LONDON 00001231 001.2 OF 002 ¶1. (U) Summary: Standard & Poor's Ratings Services (S&P) revised its outlook on the UK from stable to negative on May 21 based on its concern that government debt could approach 100 percent of GDP by 2013 and remain near that level in the medium term. If the UK does lose its Triple-A status, the government will face a higher cost of funding, a major problem given that the size of the gilt market is expected to double over the next few years. While the negative revision caused concern in the stock market and raised concomitant concern about the level of US debt, S&P told HM Treasury that a negative change to the outlook has historically only resulted in a downgrade in one in three cases. S&P warned the UK's credit rating could be downgraded after the upcoming general election (which must be held by June 2010) if the next government fails to rein in public debt. Conversely, the outlook could be revised back to stable if comprehensive measures are implemented to put public finances on a sustainable footing. Moody's and Fitch have reaffirmed Britain's Triple-A status and see the UK's outlook to be stable. End Summary. Markets React But News Not All Together Unexpected -------------- -------------- ¶2. (U) In a May 21 press release, S&P revised the UK's credit outlook to negative, stating that the UK's high government debt burden, if sustained, would be incompatible with a Triple-A sovereign credit rating. The S&P's report came just a day after the IMF called for much tougher measures to rein in state borrowing. The UK public debt at the end of April was GBP 754 billion, equivalent to 53.2% of GDP. Following the S&P announcement, the British pound fell the most in four weeks against the dollar to $1.5639 and weakened 0.7 percent against the euro to 88.07 pence. The FTSE 100 index fell 2.75 percent, the most since March 30. Credit default swaps on UK debt increased by 5.5 basis points and gilt prices fell, pushing the yield on the UK's ten-year gilt up by 13 basis points to 3.71 percent, before settling at 3.62 percent. ¶3. (U) Economists had a more measured response to the possibility of a credit rating downgrade. Ben Broadbent, chief UK economist at Goldman Sachs, speculated that the market would have had a more pronounced reaction if the S&P announcement had come as a complete surprise - instead, a lot had already been priced in, with UK sovereign credit default swap spreads already very wide. David Simmonds, head of research and strategy at RBS, agreed that the S&P announcement wasn't a huge surprise, although he said the timing caught markets unawares. Simmonds said the UK rating outlook decision is only one in a series and that the new mantra could be "AA is the new Triple-A." He reflected that the markets negotiated the actual loss of Japan's Triple-A status well. He said, however, the markets sense that S&P might be using the UK case to gauge the potentially explosive reaction for a similar announcement about the U.S. Max Watson, financial stability expert and Director of Research at John Howell and Co. Ltd. told us he expected risk premiums on borrowing to increase based on the announcement, but confirmed that announcement was largely a warning, which gave the next UK government an opportunity to reform spending. Political Reaction -------------- ¶4. (U) S&P's decision is a politically important issue because the future of the UK's credit rating is contingent on the next government's ability to tame the public purse. HMG is committed to ensuring the UK's public finances are sustainable in the medium and long term, according to the Prime Minister's spokesman. During a press briefing, he said the Chancellor's April Budget established a clear plan to halve the deficit within five years. He cautioned that during a recession, it would be dangerous to choke off the possibility of growth by reducing public spending, saying it would mean higher debt and higher deficits over the next few years. He also highlighted the success of the largest gilt auction in history, of GBP 5 billion that received bids for GBP 13 billion, which concluded shortly after the S&P announcement, as proof that there is still a significant appetite for UK sovereign debt. ¶5. (U) For the opposition parties, the announcement provided another opportunity to undermine the government's former reputation for economic competence. Shadow Chancellor, George Osborne, warned that the UK's economic reputation "is on the line at the next general election." He accused Labour of putting the UK's economic stability at risk by refusing to face up to the debt crisis they created over the last 12 years. Vince Cable, the Liberal Democrats' Treasury spokesman, echoed Osborne's accusations, saying that unless Chancellor Darling provides a viable plan for paying back the UK's debt, it is possible the UK will see a further deterioration in its rating. He added that the Chancellor has relied on implausible growth forecasts for the British economy and has failed to provide certainty to the markets. LONDON 00001231 002.2 OF 002 Fiscal Cuts Needed To Offset Long-Term Impact -------------- -------------- ¶6. (SBU) Comment: S&P's announcement is unlikely to have any significant impact in the short term. However, the announcement further calls into question Gordon Brown's reputation for economic competence, which had been partially restored after the success of the G20 London Summit. The long-term impact of S&P's negative outlook is not yet clear. Although analysts predict it will take as long as ten years to restore balance in the public finances, the next government will need to make a visible effort to quickly stabilize and then reduce the government debt burden to prevent a rating downgrade. Moreover, as investors remain highly risk averse and as the amount of borrowing needed over the next five years remains high, the willingness of investors to continue to finance the UK's debt should be monitored. LEBARON