Moody's Changes The Outlook On The UK To Negative Affirms Aa3 Ratings

23rd October 2022

Moody's Investors Service ("Moody's") has on Friday changed the outlook on the Government of the United Kingdom's (UK) ratings to negative from stable and affirmed the domestic and foreign-currency long-term issuer and domestic-currency senior unsecured ratings at Aa3.

The outlook on the Bank of England's (BoE) ratings has also changed to negative from stable and its Aa3 long-term foreign- and domestic-currency issuer and foreign-currency senior unsecured bond ratings, as well as its (P)Aa3 foreign-currency senior unsecured MTN programme rating have been affirmed. The short-term domestic- and foreign-currency issuer ratings have also been affirmed at Prime-1. Moody's rates the BoE at the same level as the Government of the UK given it is an essential part of the government's economic policy framework and is fully owned by the government.

Saltaire Finance plc's Aa3 backed senior secured and (P)Aa3 backed senior secured MTN programme ratings have also been affirmed, based on credit substitution. The affirmation reflects the unconditional and irrevocable guarantee of scheduled principal and interest on the bonds secured under the programme provided by the UK's Secretary of State for Housing, Communities and Local Government at the Ministry of Housing, Communities and Local Government. The bonds are issued by Saltaire Finance plc in connection with the management and delivery of the Affordable Homes Guarantee Scheme.

The change in outlook to negative from stable is driven by:

1. Heightened unpredictability in policymaking amid weaker growth prospects and high inflation; and

2. Risks to the UK's debt affordability from likely higher borrowing and risk of a sustained weakening in policy credibility.

The evolution of policymaking, and the UK government's ability to engender confidence in its commitment to fiscal prudence, will be a material consideration for Moody's in resolving the negative outlook. An outlook period typically lasts 12-18 months.

The affirmation of the Aa3 rating reflects the UK's economic resilience supported by its wealthy, competitive and diversified economy. Despite the weakening in fiscal policy predictability in recent years, the country's long-standing institutional framework remains strong and will continue to support the UK's ability to respond to shocks, as seen during the pandemic. Furthermore, the structure of the UK government debt, with a very long average maturity of around 15 years, as well as a deep domestic investor base adds a degree of resilience to the credit profile in the face of shocks.

The UK's local and foreign currency country ceilings remain unchanged at Aaa. The three-notch gap between the local currency ceiling and the sovereign rating is driven by the government's relatively small footprint in the economy, a fairly robust external payments position and a diversified economy. The foreign currency ceiling at the same level as the local currency ceiling reflects a fully convertible capital account as well as reasonably effective policy management.

RATINGS RATIONALE

RATIONALE FOR THE CHANGE IN OUTLOOK TO NEGATIVE FROM STABLE

FIRST DRIVER: HEIGHTENED UNPREDICTABILITY IN POLICYMAKING AMID WEAKER GROWTH PROSPECTS AND HIGH INFLATION

The first driver of the change in outlook to negative is the increased risk to the UK's credit profile from the heightened unpredictability in policymaking amid a volatile domestic political landscape, which challenges the UK's ability to manage the shock arising from weaker growth prospects and high inflation. Moody's considers policy predictability a Governance consideration under its ESG framework.

Moody's views the 23 September fiscal statement, together with the subsequent reversal of most of the measures announced and the forthcoming change in prime minister, as a continuing reflection of the weakening predictability of fiscal policymaking seen in previous years. That policy statement outlined significant fiscal outlays without detailed policy plans and independent scrutiny from the Office for Budget Responsibility (OBR). The government's initial inability to deliver a credible policy response to address investor concerns around this unfunded stimulus further weakened the UK's policy credibility, which is unlikely to be fully restored by the subsequent decision to reverse most of the tax cuts and plans to shortly publish a medium-term fiscal strategy alongside an OBR forecast. Overall, the episode illustrates the increasing polarisation and unpredictability of the domestic political environment, which may undermine efforts to deliver on fiscal consolidation amid likely demands to further alleviate cost of living pressures.

At the same time, the economic outlook has worsened as high inflation, weaker external demand, and the rising cost of borrowing - exacerbated by volatile financial market conditions in the aftermath of the government's September fiscal announcement - weigh on consumption, investment and economic activity. The recently announced energy price cap means inflation will peak lower than initially forecast, providing some support, although Moody's expects real disposable incomes will materially decline over the coming year particularly as the energy price cap likely becomes more targeted from April 2023. Real GDP growth has been slowing since the beginning of 2022 and will continue to soften in the coming quarters, with Moody's forecasting growth will average just 0.3% over 2023-2024 and not return to its potential level of 1.5% until 2026.

Moreover, Moody's expects the Bank of England will significantly further tighten monetary policy in light of the risk of more persistent inflation over the medium term and to ensure long-term inflation expectations remain anchored amid the heightened volatility in financial markets. The tighter monetary policy in turn will weigh on economic growth.

Furthermore, medium-term economic growth will face headwinds from Brexit and lower labour participation following the pandemic as well as longstanding constraints to productivity growth. Even under the Trade and Cooperation Agreement reached with the European Union (EU, Aaa stable) at the end of 2020, Brexit will continue to weigh on trade, investment and the labour market, reducing long-term productivity by around 4%. Weaker medium-term growth will further exacerbate the already-evident tensions around fiscal policy settings.

SECOND DRIVER: RISKS TO THE UK'S DEBT AFFORDABILITY FROM LIKELY HIGHER BORROWING AND RISK OF A SUSTAINED WEAKENING IN POLICY CREDIBILITY

The second driver of the decision to change the outlook to negative is the heightened risks to the UK's debt affordability from likely higher borrowing and the risk of more persistent inflation. A sustained erosion of the UK's policy credibility could also lead to higher borrowing costs in the medium term.

The combination of a weaker growth outlook and a likely wider budget deficit than Moody's previously forecasted will keep general government debt consistently above 100% of GDP in the coming years and elevate risks to the debt trajectory. Notwithstanding the reversal of most aspects of the September fiscal announcement, Moody's expects the budget balance to deteriorate given likely demands to further alleviate cost of living pressures, which will challenge efforts to deliver on fiscal consolidation in the absence of any credible fiscal anchor. The government faces very acute spending pressures as high inflation increases the interest paid on inflation-linked debt and erodes the real-term increases in departmental budgets that were set in nominal terms in October 2021. Furthermore, significant cuts to public spending are likely to prove politically difficult ahead of the next general election due before January 2025.

The prospect of higher borrowing, more persistent inflation, and a more significant tightening in monetary policy leading to higher funding costs has increased risks to the UK's debt affordability over the medium term. Weakening debt affordability would be of heightened significance for the UK's fiscal strength given sterling's status as a reserve currency.

The current high levels of inflation - Moody's expects inflation to peak close to 11% within the next six months - will add to interest costs in the near term given that close to a quarter of the UK's government debt has its cost linked to inflation. Moody's forecasts interest payments on government debt will rise by around £40 billion in 2022 before moderating as the very high levels of inflation gradually recede over the coming years. That said, Moody's expects interest payments would still absorb around 7.5% of UK government revenue in 2025, a larger share than before the pandemic, with inflation forecast to remain above the 2% target until 2026.

Moreover, while Moody's ratings tend to look through short-term market volatility, the recent rise in government bond yields is in part a reflection of wider market concerns around the credibility of UK policymaking, adding to the risk that the UK's cost of funding remains higher in the medium term. Despite recent gilt purchases, the planned gradual unwinding by the central bank of its large government debt holdings will also likely keep pressure on funding costs and shift debt towards more risk-sensitive private-sector holders over the medium term.

RATIONALE FOR AFFIRMING THE Aa3 RATINGS

The affirmation of the Aa3 ratings reflects the UK's economic resilience supported by its wealthy, competitive and diversified economy even though the challenges posed by Brexit and the pandemic have weakened medium-term growth.

While fiscal policy predictability has been weakening for a number of years, Moody's expects the country's strong long-standing institutional framework, including its rule of law, central bank, professional civil service and the OBR, will continue to support the UK's ability to respond to shocks, as seen during the pandemic.

Despite the elevated risks, Moody's expects the government debt-to-GDP ratio will still remain broadly in line with advanced economy peers such as France (Aa2 stable, 109% of GDP) and Belgium (Aa3 stable, 105% of GDP) in 2023.

Furthermore, the very long average maturity of UK government debt, which, at around 15 years, compares favourably to the median of Aa-rated peers of around 9 years, will keep gross borrowing requirements low relative to other highly rated and indebted sovereigns, supporting a higher capacity to carry a large debt burden and slowing the pass-through from rising funding costs to debt affordability.

In addition, the UK's deep domestic investor base has, in Moody's view, sufficient capacity to absorb new government debt, which will help to mitigate the credit impact of a loss in foreign investor confidence.

ENVIRONMENTAL, SOCIAL AND GOVERNANCE CONSIDERATIONS

The UK's ESG Credit Impact Score is neutral to low (CIS-2), reflecting low exposure to environmental and social risks and, like many other advanced economies, a strong governance profile and in general capacity to respond to shocks.

Its overall E issuer profile score is neutral to low (E-2), reflecting low exposure to environmental risks across most categories.

We assess its S issuer profile score as neutral to low (S-2), reflecting low exposure to social risks over most categories. The only category that entails moderately negative risk is demographics: demographic change in the form of relatively fast ageing of the population poses long-term fiscal sustainability challenges to the UK, while Brexit will likely lead to lower immigration over the medium term. Health care in particular will become an increasingly important source of fiscal risk in the absence of reforms. The UK's labour and income score reflects the country's very flexible labour market as well as rising income and wealth inequalities, which have had political and policy ramifications.

The UK's G issuer profile score (G-1) is supported by its strong institutions and governance profile. Although policy predictability has been weakening for a number of years, the UK's institutions continue to score highly on international surveys, reflecting high-quality legislative and executive institutions, and a strong civil society. Coupled with high wealth levels and moderate government financial strength, this supports a high degree of resilience.

GDP per capita (PPP basis, US$): 50,523 (2021) (also known as Per Capita Income)

Real GDP growth (% change): 7.5% (2021) (also known as GDP Growth)

Inflation Rate (CPI, % change Dec/Dec): 5.4% (2021)

Gen. Gov. Financial Balance/GDP: -8% (2021) (also known as Fiscal Balance)

Current Account Balance/GDP: -2.6% (2021) (also known as External Balance)

External debt/GDP: 303.5% (2021)

Economic resiliency: a1

Default history: No default events (on bonds or loans) have been recorded since 1983.

On 18 October 2022, a rating committee was called to discuss the rating of the Government of the United Kingdom. The main points raised during the discussion were: The issuer's economic fundamentals, including its economic strength, have not materially changed. The issuer's institutions and governance strength, have decreased. The issuer's fiscal or financial strength, including its debt profile, has not materially changed. The issuer's susceptibility to event risks has not materially changed.

FACTORS THAT COULD LEAD TO AN UPGRADE OR DOWNGRADE OF THE RATINGS

WHAT COULD MOVE THE RATINGS UP

The negative outlook indicates that an upgrade is unlikely. Moody's could return the outlook to stable if the heightened risks to the UK's economic and fiscal prospects were to moderate. In particular, evidence that the UK authorities are able to deliver on a credible medium-term fiscal strategy, that reduces the risks of a deterioration in the UK's fiscal strength and helps avoids a more sustained weakening in the government's policy credibility, could lead to a stabilization of the outlook. Continued confidence in the UK's long-standing institutions to help navigate the current heightened uncertainty without detriment to the UK's economic and fiscal strength would be a prerequisite for a stabilization in the outlook.

WHAT COULD MOVE THE RATINGS DOWN

A sustained deterioration in the UK's debt affordability, including from higher government borrowing and persistently high inflation and/or persistent concerns around the credibility of UK policymaking, which leads to a sustained rise in the UK's cost of funding and materially weakens Moody's assessment of fiscal strength, would exert downward pressure on the rating. A sharp and sustained rise in government debt relative to peers would also be negative for the rating.

While unlikely, concerns around the UK's funding of its current account deficit, indicating concerns that could ultimately lead to lower demand for sterling as a reserve currency and therefore persistently higher borrowing costs, would exert downward pressure on the rating. Finally, a significant weakening in the UK's economic fundamentals including its medium-term growth prospects would also undermine the UK's credit profile.

The principal methodology used in these ratings was Sovereign Ratings Methodology published in November 2019 and available at https://ratings.moodys.com/api/rmc-documents/63168. Alternatively, please see the Rating Methodologies page on https://ratings.moodys.com for a cpy of this methodology.

The weighting of all rating factors is described in the methodology used in this credit rating action, if applicable.

REGULATORY DISCLOSURES

The List of Affected Credit Ratings announced here are a mix of solicited and unsolicited credit ratings. For additional information, please refer to Moody's Policy for Designating and Assigning Unsolicited Credit Ratings available on its website https://ratings.moodys.com. Additionally, the List of Affected Credit Ratings includes additional disclosures that vary with regard to some of the ratings. Please click on this link https://www.moodys.com/viewresearchdoc.aspx?docid=PBC_ARFTL469291 for the List of Affected Credit Ratings. This list is an integral part of this Press Release and provides, for each of the credit ratings covered, Moody's disclosures on the following items:

• EU Endorsement Status

• UK Endorsement Status

• Rating Solicitation

• Issuer Participation

• Participation: Access to Management

• Participation: Access to Internal Documents

• Lead Analyst

• Releasing Office

For further specification of Moody's key rating assumptions and sensitivity analysis, see the sections Methodology Assumptions and Sensitivity to Assumptions in the disclosure form. Moody's Rating Symbols and Definitions can be found on https://ratings.moodys.com/rating-definitions.

For ratings issued on a program, series, category/class of debt or security this announcement provides certain regulatory disclosures in relation to each rating of a subsequently issued bond or note of the same series, category/class of debt, security or pursuant to a program for which the ratings are derived exclusively from existing ratings in accordance with Moody's rating practices. For ratings issued on a support provider, this announcement provides certain regulatory disclosures in relation to the credit rating action on the support provider and in relation to each particular credit rating action for securities that derive their credit ratings from the support provider's credit rating. For provisional ratings, this announcement provides certain regulatory disclosures in relation to the provisional rating assigned, and in relation to a definitive rating that may be assigned subsequent to the final issuance of the debt, in each case where the transaction structure and terms have not changed prior to the assignment of the definitive rating in a manner that would have affected the rating. For further information please see the issuer/deal page for the respective issuer on https://ratings.moodys.com.

For any affected securities or rated entities receiving direct credit support from the primary entity(ies) of this credit rating action, and whose ratings may change as a result of this credit rating action, the associated regulatory disclosures will be those of the guarantor entity. Exceptions to this approach exist for the following disclosures, if applicable to jurisdiction: Ancillary Services, Disclosure to rated entity, Disclosure from rated entity.

The ratings have been disclosed to the rated entity or its designated agent(s) and issued with no amendment resulting from that disclosure.

Regulatory disclosures contained in this press release apply to the credit rating and, if applicable, the related rating outlook or rating review.

Moody's general principles for assessing environmental, social and governance (ESG) risks in our credit analysis can be found at https://ratings.moodys.com/documents/PBC_1288235.

At least one ESG consideration was material to the credit rating action(s) announced and described above.

Please see https://ratings.moodys.com for any updates on changes to the lead rating analyst and to the Moody's legal entity that has issued the rating.

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