A country’s credit rating matters – a downgrade means a state has to pay more interest on its borrowing. Costas Milas explains why Britain’s ratings could be cut if we vote to leave the EU.
There have been a couple of notable signals about the upcoming EU referendum lately. A public opinion poll showed a clear majority lead for Brexit, then a Financial Times poll of more than 100 leading economists concluded that a vote to leave would damage UK growth. But while the arguments for and against are still shaping up, everyone appears to be ignoring how the credit-ratings agencies would respond to Brexit.
This is surprising. Only recently, credit-rating agency Standard & Poor’s fired a warning shot, saying that the UK would be downgraded one notch on leaving, and this could double if relations with Brussels soured. And unlike Standard & Poor’s, the other two main credit-ratings agencies, Moody’s and Fitch, have already stripped Britain of its precious AAA rating – the highest possible. If all three downgraded Britain after a Brexit, the road back to AAA status would be even harder.
Whether or not one agrees with these decisions, they do matter. Sovereign credit ratings estimate the probability that a country will default on its debts. They set the tone for the borrowing costs in international markets both for the country and the financial institutions operating there. Increasing the interest rates that the country pays to borrow means less money to spend on schools, hospitals and so forth. Downgrades also weaken the share prices of banks that are expected to receive stronger support from their governments – particularly in advanced economies.
How sovereign ratings work
The three agencies cite a number of factors that come into their sovereign ratings, including GDP growth rate developments and public finance trends. They provide little guidance as to how they weight each factor, but academics fortunately have studied the agencies’ models extensively and reached the following conclusions:
- An increase in annual GDP growth by one percentage point improves a country’s rating by about one-tenth of a notch.
- An annual drop in general government gross debt by one percentage point of GDP justifies about one-tenth of a notch upgrade.
- An annual drop in government deficit by one percentage point of GDP justifies about one-tenth of a notch upgrade.
- EU membership enjoys a “premium” of as much as two notches. It improves a country’s financial credibility, since its economic policy is restricted and monitored by other member states; and it provides enormous economic benefits as it offers free trade access to a population of around 503m.
- Last but not least, Moody’s matters more than Standard & Poor’s because investors value more of its decisions (Fitch was not examined).
What do these mean in the case of the UK? According to the latest estimates of the UK’s Office for Budgetary Responsibility, the country’s economy is expected to have grown at a rate of 2.4% per annum in 2015 and is expected to achieve the same rate in 2016. Thanks to the government’s cuts, general government gross debt is expected to drop by some 0.4 percentage points of GDP (from 87.5% in 2014-15 to 87.1% in 2015-16). The deficit is also projected to drop by 1.2 percentage points of GDP (from 5.1% in 2014-15 to 3.9% in 2015-16).
My feeling is that we will avoid Brexit as such a decision would be a “jump into the unknown”. Nevertheless, I have hopefully shown that the government’s cuts will prove powerless in counteracting a post-Brexit downgrade. And since Brexit looks possible based on the latest polls, the authorities may want to be ready to respond. For instance the Bank of England should be prepared to defend the government from rising borrowing costs by authorising additional quantitative easing in the event of a Brexit. Government officials would also want to use all diplomacy at their disposal to avoid additional tensions with our EU partners that are bound to emerge. We need to start planning for this now. Waiting until the day after the EU referendum would be far too late.
This post was originally published at The Conversation. It represents the views of the author and not those of the BrexitVote blog, nor the LSE.
Costas Milas is Professor of Finance at the University of Liverpool.
Be real for a second. The Bank of England sets the interest rate in the UK. What you are saying is that inflation will skyrocket, forcing the Bank of England to raise interest rates. However, with inflation as low as it currently is, why would you believe that a UK exit would result in some dramatic rise in expected inflation?
Why would we want to raise interest rates to make our exports less competitive? If the Pound lost just 10% against the Euro it would gain a massive competitive edge against the Eurozone as tariffs wouldn’t have an impact on exports. If it lost 20 or 30% exports would soar the world over so at the end of the day it is just swings and roundabouts!
I’m all for leaving the EU – Costs would fall but sadly a 10% depreciation of the pound against the Euro would not necessarily generate a 10% reduction in production costs – some production costs such as labour will fall but other costs such as raw materials which are likely to be priced in US dollars will remain the same (assuming no currency movement between the dollar and Euro).
On the issue of interest rates in my opinion risks would increase if the UK decided to leaves the EU – however I’m betting that the risks of complete EU fracture would be far greater – the UK may well be seen as a safe haven and therefore comparatively attractive which would keep interest rates down.
It is most interesting that those who posture with the greatest fervour for Britain to stay in the EU are rarely native born British.
They are like the Janissaries.
However, this coming referendum will surely see a hard fought campaign, which if we who want to leave Europe win the referendum – then Britain will leave the EU – but if we do not win – we will one day get another referendum.
We only need to win a referendum once.