*What if Britain loses its triple-A rating?

*How a rating cut would hurt us all
 

From David Stevenson, across the river from the City

Britain’s in danger of losing its good reputation as a borrower.

Credit ratings agency Standard & Poor’s last week effectively threatened to take away it's AAA-credit rating. It downgraded the outlook for the UK from “stable” to “negative”, citing concerns about soaring public debt.

Now we don’t have to panic, yet. This is just a warning shot. We’re still – officially at least – in the financial premier league.

But for how much longer? And what would a downgrade actually mean for the rest of us?

Public deficit is set to be worse than the Budget forecast

Chancellor Alistair Darling is still sticking to his – already horrendous – April Budget forecasts, which predict the biggest public deficit since official records began in the 1960s.

But most independent analysts reckon these are pie-in-the-sky and that the real figures will be a lot worse. And that’s looking ever-more likely after yesterday morning’s admission from the Treasury that it had to borrow £8.5 billion last month. That’s the highest-ever April shortfall in the public purse and four times the amount the country had to find a year ago.

If you add in ‘unfunded’ public sector pensions (i.e. there’s no money set aside to pay them, so they come straight out of our taxes) as well as the debt of various public/private sector projects, then the black hole gets even bigger, as we talked about a couple of months ago: Will Britain go bankrupt?

So now credit agency S&P has warned there’s a one-in-three chance it will cut Britain’s AAA rating. (It’s a fate that’s already befallen the PIGS - Portugal, Ireland, Greece and Spain). And though neither Moody’s nor Fitch (the other big credit rating agencies) currently plans to downgrade us, one black mark alone could do plenty of damage – something you’ll know if your personal credit score has ever come a cropper, even if it happened by mistake.

What would a downgrade mean for Britain?

So what does a downgrade actually mean? Basically, it implies that the risk of lending to Britain has increased. And as we all know, the riskier an investment, the bigger the return investors demand in exchange for taking the added risk.

This wouldn’t be such a problem if Britan were like Japan, say, with a big captive market of domestic savers clamouring for it's debt. But as Ambrose Evans-Pritchard points out in The Telegraph, “the foreign share of UK public debt has risen from 18% to 34% over the past six years”.

So the danger is that the only way the UK will be able to attract the foreign investment it needs to pay its bills, will be to raise the return it pays on UK government bonds – gilts. In other words, gilt yields will have to rise, which will hike up other long-term interest rates.

That, in turn, will strangle private sector borrowing by businesses and individuals, who will have to pay more for the loans they take out. Investment spending plans will be curbed and the economy’s overall growth rate will suffer. So there will be fewer profits and incomes for the Government to tax.

The other option, of course, is to print more cash, which the Bank of England is currently doing via quantitative easing (QE). But this is no long-term answer either. Because lots of freshly-minted money being pumped into the economy without an equivalent increase in the supply of ‘real’ goods will just lead to inflation returning. Which would drive up gilt yields anyway.

Tim Price of The Price Report newsletter warned in March that he wouldn’t touch British government bonds with a 10-foot barge pole: Gilts - don't buy them. This only makes our advice to avoid gilts all the stronger.

And what does that mean for the pound?

So what about the pound? Well, interestingly, although sterling slumped as the news of the potential downgrade hit the newswires, it actually ended the day slightly up on the dollar.

The thing is, sterling has already fallen pretty hard in the past year or so. Arguably, it’s pricing in more bad news for the UK than either the euro or the dollar are reflecting for their economies.

Europe is a veritable minefield. Banks in the west are heavily exposed to the flailing Central and Eastern European economies, while question marks hang over the ability of nations such as Ireland and Spain to cope with the downturn without some sort of help from their richer compatriots.

As for the US, its fiscal situation is shockingly bad too, and there’s no sign of anyone coming up with a coherent set of policies to tackle high spending or to encourage growth.

So for now, the pound’s likely to stay weak, but it seems unlikely it will fall much further from here. Sterling’s saving grace is the prospect that an imminent election will produce a government with a plan to get us out of this hole. Indeed, S&P explicitly stated that the UK’s future credit rating depends very much on the credibility of the “next government’s fiscal consolidation plans”.

That’s a warning to the next British government – whoever leads it – that it must slash spending, and quite possibly raise taxes too.

If that happens, then it’s just possible that, in comparison to other western economies, Britain might start to look attractive. But we wouldn’t be betting on it just yet.

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Turning to the markets...

The JSE all share index closed up 0.15% yesterday. The gold mining index shed 2.23%. Resources added 0.79%. Banks and financials both rallied 0.39%. Industrials lost 0.72% and the platinum mining index fell 0.35%

London’s FTSE100 closed up 0.46%. The Dow Jones lost 0.18% and the Nasdaq grew 0.19%.

Tokyo’s Nikkei closed 0.72% down. Hong Kong’s Hang Seng gained 0.12%.

Brent crude is currently trading at $59.94 per barrel.

Spot gold’s trading at $953.50 and platinum was last quoted at $1,145.50.

And here’s how the rand is performing against the major currencies:
R/$ 8.28
R/£ 13.20
R/€ 11.58

Until next time,

David Stevenson

Associate editor, MoneyWeek UK