Reserve Currency, Independent Monetary Policy and Deep Capital Markets…
As an economy holding a global reserve currency and bearer of one of the world’s oldest central banks in the Bank of England, the UK Treasury can live beyond its means for longer than most sovereigns. There are limits, nevertheless, as demonstrated during the brief tenure of the Liz Truss government. But generally speaking, this greater debt tolerance means the UK can sustain higher levels of government debt without suffering the same disciplining responses levied by the capital markets on most other advanced economies.
A comparatively-lower vulnerability to financial-market sell-off also supports the UK’s credit ratings and reduces downside ratings pressure. Our ratings acknowledge the UK’s meaningful institutional strengths including an independent monetary policy, which is an element euro-area sovereigns, as an example, do not benefit from and which proved crucial during the rapid resolution of the 2022 UK budget crisis.
Specifically, our agency’s AA assessment of the UK reflects a one-notch positive adjustment acknowledging the reserve-currency strengths of sterling and further upward adjustments for the independent monetary policy framework and excellent debt profile and market access. This reflects the very-long average debt maturity, excellent capital-market access and a significant amount of government debt still held by the Bank of England, resulting in government partly owing the debt to itself.
… Could Lower Incentives for the UK to Consolidate Public Finances
Yet in spite of material credit strengths, the UK’s status as an AA-rated, reserve-currency sovereign could also of itself present vulnerabilities in the long run if this results in moral hazard and an inadequate fiscal framework unable to incentivise fiscal prudence.
The general government deficit is projected to stay above 3% of GDP during each year of our forecast horizon to 2029. Leaving aside markets and rating agencies, UK fiscal rules are not strongly binding as the commitment to achieve net borrowing of not more than 3% of GDP and net debt declining on a one-year basis by the fifth year of a given forecasting period means that the year the government has committed to curtailing debt never in fact arrives and shifts forward one year each year. So, reducing debt is perpetually a promise for the future rather than the highest priority of the present.
Only three Chancellors of the Exchequer have been in office for five years or longer, which weakens any commitment to reduce debt by the fifth year of the forecast horizon. Moreover, the fact that UK fiscal rules have been changed on six separate occasions since 2011 after prevailing objectives became inconvenient does not bolster confidence. The UK leaving the European Union in 2020 removed the straight-jacket of more-binding EU Maastricht rules overseen externally, but a core driver of Brexit was also precisely that: returning sovereignty.
The polls strongly suggest that the general elections by January 2025 will result in a shift to a Labour government, in line with the Labour Party’s decisive local-election victory earlier this month. Nevertheless, Labour is committing to fiscal rules like the current ones, although presenting greater space for investment. We do not expect a Labour government to represent a significantly tighter fiscal policy than the existing one – even if taxes were to rise.
The UK spent more than GBP 120bn on debt interest payments in fiscal year 2022-23, more than for any other public commitment except for health and social care. The estimated net interest payments of 2.3% of GDP (or 5.8% of general-government revenue) for this year are high compared to the interest service of similarly rated sovereigns (Figure 1).
Given our assumption of higher rates for longer (even after rate cuts start and ultimately conclude), we expect net interest payments to rise to 2.9% of GDP by 2029 (7.2% of revenue) – in line with rises in most advanced economies. The 26% of UK gilts that are index-linked has seen greater vulnerability during the recent phase of high inflation.
Higher interest payments reduce the capacity to cut budget deficits unless fiscal trade-offs are found elsewhere in the public accounts. According to the Office for Budget Responsibility, a primary budget surplus of around 1.3% of GDP is needed to stabilise debt medium run, compared against an estimated primary deficit of 1.2% as of fiscal year 2023-24.
The fact that the UK has not achieved a primary surplus since 2001 despite a near-constant objective of achieving one demonstrates the challenge of realising a sustainable fiscal trajectory. This is particularly the case within the current ecosystem of comparatively high interest rates and outstanding military, social and climate spending requirements.
Figure 1: Net interest spending rising internationally
Net interest payments, % of GDP
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