UK latest Country Risk outlook

The biggest country risk factor the UK has had to face and the one that could still jeopardize its AAA Sovereign rating has been its fiscal situation. Concerns have also been voiced regarding policy commitment and ability to pass through controversial legislation aimed at tackling government finances given a hung parliament. Although the emergency budget passed by the new coalition government would reduce expected cumulative debt from the previously forecast 90% of GDP by March 2014, it is still likely to rise to well over 80% from the current level of just over 60% - and this is providing resulting fiscal tightening will not endanger economic recovery. The major culprit for the debt escalation has been the cost of the recent financial bailout and subsequent stimulus package, but the situation has certainly not been helped by the previous Labour government’s policy of running spending fuelled deficits over a period of economic growth that should have yielded budget surpluses.

Signs of recent economic recovery have largely been attributed to both monetary and fiscal stimulus packages, as well as unprecedented sums expended to support the country’s financial system. There are concerns that once these measures are withdrawn, future growth will suffer. Indeed, current plans to cut public spending and reduce taxes could seriously undermine economic recovery and would have certainly risked a double dip recession and a compound debt spiral were it not for a continuation of extremely loose monetary policy (a combination of near zero base rates and monetary easing)

In an extreme situation, a fiscal crisis could lead to some domestic capital flight, severe pound weakness and a sell-off in UK government bonds. The Bank of England would in such an instance be forced to hike rates to shore up confidence in monetary police and stabilize the currency. Under the scenario, yields of 10-year UK gilts could increase by 150 basis points which would raise borrowing costs to well over 5%, further increasing the cost to the taxpayer. This would greatly complicate the task of funding Britain’s budget deficit. Furthermore, a downgrading of the country’s AAA rating would also greatly increase financing costs.

On a more positive note, the existence of a grand coalition government is likely to take the sting out of the unpopular measures that may need to be undertaken. The burdens of some decisions could for instance be shouldered by the government’s junior partner (the Liberal Democrats). Historically, the UK has also a good record of fiscal consolidation. Public debt far exceeded current levels especially following wars (156% GDP in 1784 and 238% following the Second World War). It must also be noted that the average maturity of UK government debt is longer than elsewhere in Europe – about 14 years compared with 7 in Greece, consequently immanent dangers of default are far less likely.