Viewpoint: Moody’s threat to downgrade UK’s top credit rating is not justified

Costas Milas, Professor of Finance, University of Liverpool Management School.

“Moody’s threat to downgrade UK’s top credit rating appears unjustified and should not happen. Moody’s threat is based on ‘the increased uncertainty regarding the pace of fiscal consolidation in the UK due to materially weaker growth prospects over the next few years’. In our view, it is highly unlikely that the UK will lose its top credit rating unless extreme macroeconomic conditions rapidly emerge.

“Indeed, we note that credit rating agencies base their decisions on a number of factors such as GDP growth rate prospects and public finance trends. Empirical credit rating valuation models (tested on sovereign credit rating decisions over the last 20 years) reach the following conclusions:

1. In terms of growth prospects, a sharp drop in UK GDP growth from 0.6% (which is what the IMF predicts for 2012) to -2.6% in 2013 justifies 0.2 of a notch downgrade.

2. A rise in gross government debt from 90% of GDP in 2011 (based on OECD data) to 105% of GDP in 2012 justifies half a notch downgrade.

3. A rise in government deficit from 9.4% of GDP in 2011 (based on OECD data) to 12.4% in 2012 justifies a quarter of a notch downgrade.

“Therefore, a full notch downgrade would be justified if (i) a very sharp deterioration in UK economic growth emerges, (ii) gross government debt climbs to 105% of GDP in 2012, and (iii) government deficit climbs to 12.4% of GDP in 2012. This is what credit rating valuation models suggest. Unless all of the above highly unlikely macroeconomic outcomes emerge, UK’s credit rating should be safe. With this in mind, this week’s threat by Moody’s credit rating agency to downgrade the UK economy appears unjustified.”

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