When the credit ratings agency Standard & Poor’s put the UK long-term rating on its sovereign debt on a negative outlook, most expected the UK’s critics to come out in droves and say “I told you so.”
Instead, it seems the critics have been slamming Standard & Poor’s, and in the process a right can of worms has been opened.
You may recall that when legendary investor Jim Rogers said “Britain was finished”, he found himself on the receiving end of much flak. Then Howard Schultz, Chairman of Starbucks, said in an interview on US television: “The place that concerns us the most is western Europe, and specifically the UK … the UK is in a spiral.” But on that same TV programme, no less a supporter of the UK than Peter Mandelson was scheduled to appear. Mandy was fuming and responded: “Why should I have this guy running down the country? Who the **** is he? How the hell are they [Starbucks] doing?”
Strangely, sterling actually rose in the weeks that followed, leaving the predictions of the UK’s arch critics look about as meaningful as the latest astrological readings in the tabloids.
But then last week it was Standard & Poor’s turn. It didn’t actually reduce the UK’s credit rating from Triple-A, but warned that it might, suggesting there was roughly a one-in-three chance of a downgrade.
At first glance Standard & Poor’s pessimism seems to be well-founded. “In truth it’s a bit of a surprise that people were surprised,” said Michael Riddell from the M&G Fixed Income team.
But then over the bank holiday weekend, the UK’s cohorts came out to the rescue.
One of many who was not at all impressed with the Standard & Poor’s decision was OECD Secretary-General Angel Gurria, who said: “To me, it’s inexplicable they want to cut the UK rating and that people are now talking about them cutting the rating of the US. Credit rating companies are evaluating governments’ policies rather than a country’s ability to pay.”
Mr Gurria slammed into the recent downgrade of Spain’s credit rating too, calling it “senseless”. He added: “The United States, England, Greece, Spain and Ireland need to give a bit of help to the ratings agencies to see if they recover their prestige and credibility, to see what the rating agencies are worried about.”
Meanwhile, Peter Spencer, Chief Economist to the Ernst and Young ITEM Club said: “They completely missed the financial crisis and are trying to regain some credibility. But at the end of the day, when the next problem occurs, they’ll be asleep at the wheel again.”
Even, Michael Riddell, the M&G man referred to above, qualified his comments by saying: “What do the credit rating agencies know anyway … Moody’s rated Iceland AAA until May 2008.”
Others are saying so what. When Japan had its credit rating downgraded its ability to raise money was unaffected.
But then again, Japan was in the happy position of seeing most of the funding for its fiscal deficit coming internally. According to Ambrose Evans-Pritchard, writing in The Telegraph: “The foreign share of UK public debt has risen from 18 per cent to 34 per cent over the past six years.”
But the key really does boil down to this. For as long as inflation is modest, the UK can always resort to the printing press – the Bank of England can always buy government debt with money it has created from thin air.
And for as long as inflation remains modest, and there is little prospect of a change, then the interest rate on debt will be sufficiently modest to make the cost of servicing debt modest.
The danger lies in what happens should that change. This column has long argued that for the time being at least, the threat of inflation will be muted. But who knows what the future may bring.
The UK’s big vulnerability lies in future interest rates. Should interest rates rise in say 2014, or 2015, either because so much money was printed the Bank of England has to slam on the inflation brake, or simply because foreigners are less willing to lend to the UK unless the return on their money is much higher, then suddenly the size of the UK’s debt burden will be overwhelming.
The clincher might be what happens when the baby boomers retire. At that point, the UK’s capacity relative to demand will start falling, and that will bring a new threat of inflation. This danger will be especially pronounced if house prices start to rise again and baby boomers rely on wealth tied up in their home to fund their retirement.
It seems the UK has found itself with a ticking bomb. Before the recession began it suffered from the twin problems of too much personal and corporate debt. Now government debt has been added to the pile of woes. As long as interest rates are low, this debt is affordable. If the debt is repaid now, while the cost of servicing is quite modest, then a crisis down the line can be avoided.
But should debt remain high, and then at some later stage interest rates return to the levels seen a couple of years ago, we will be in big trouble. Another crucial point might be what happens when the Bank of England decides the time is right to reverse quantitative easing.
No one denies this may be necessary in a few years’ time. Even the great prophet of deflation, Roger Bootle, says that at some point the Bank of England will have to hoover up some of the money it has created. This could in turn create a new credit crisis, and this time the only possible solution may be higher interest rates.
© Investment & Business News 2013