OREANDA-NEWS. Fitch Ratings has affirmed the UK's Long-term foreign and local currency Issuer Default Ratings (IDRs) at 'AA+'. The Outlooks are Stable. The issue ratings on the UK's senior unsecured foreign and local currency bonds have also been affirmed at 'AA+'. The Country Ceiling has been affirmed at 'AAA' and the Short-term foreign currency IDR at 'F1+'. 

KEY RATING DRIVERS
The UK's ratings benefit from a high-income, diversified and flexible economy. Strong civil and policy institutions and a high degree of transparency enhance the predictability of the business and economic policy environment that compares favourably with peers in the 'AA' category. The credible monetary policy framework and sterling's international reserve currency status afford the UK a high degree of financial and economic policy flexibility.

Public debt remains among the highest of 'AA' and 'AAA' rated sovereigns. Fitch expects gross general government debt (GGGD), using the EU Treaty definition to peak at 90% of GDP in 2015-16 and practically remain flat at close to 89% of GDP between 2014 and 2018, before starting to decline. An elevated debt level for a prolonged period limits the government's capacity to absorb shocks.

The budget deficit was high at 5.2% of GDP in FY14 (fiscal year ending in March 2015), using the EU Treaty definition, indicating that the UK faces several more years of fiscal consolidation in order to place the GGGD/GDP ratio on a secure downward path. Nevertheless, the budget deficit has declined from 5.9% in FY13 and a peak of 10.9% in FY09. The European Commission estimates that the fiscal improvement in FY14 was purely cyclical as the structural deficit remained practically unchanged at 4.7% after 4.6% in the previous fiscal year.

Following the 7 May general election, in which the Conservative Party won an absolute majority, the new government will set out its fiscal plans and provide details of the predominantly expenditure-based fiscal consolidation strategy in the budget on 8 July. Based on the March 2015 budget and the new government's commitment to tighten the fiscal mandate Fitch forecasts the headline and structural deficit to gradually narrow, predominantly due to expenditure side consolidation measures. In Fitch's view, the government's plan to legislate to rule out increases in personal income tax, VAT and national insurance contributions during the lifetime of the parliament reduces its fiscal flexibility in the event of shocks.

The UK economy has benefited from more than two years of strong recovery, but is approaching the peak of the economic cycle as the economic slack is gradually absorbed. GDP growth, while still driven predominantly by domestic demand, eased to only 0.3% quarter on quarter in 1Q15, the slowest growth rate since 4Q12. Year on year growth slowed to 2.4% in 1Q15 compared with 2.8% annual average growth in 2014.

Unemployment is relatively low and has been declining rapidly. It reached 5.5% in January-March 2015 from 6.8% a year earlier, while the employment rate for the 16-64 year-old-population increased to 73.5%, exceeding the pre-crisis peak. The improvement in the labour market has been accompanied by subdued wage dynamics. Productivity growth has been puzzlingly weak, albeit starting to rise somewhat, casting some uncertainty over medium-term growth prospects

Inflation declined to -0.1% in April 2015, its lowest rate since 1960. Inflation has been below the Bank of England's 2% target since January 2014, partly due to lower energy prices, competition in food retailing and sterling's appreciation. Fitch does not believe that deflation will set in.

The UK economy's external vulnerability has increased since 2014. Its current account deficit widened to 5.5% of GDP in 2014, from an average of 3.3% in the previous three years. This is the largest recorded deficit since the official data series started in 1948 and compares with the 'AA' median of a 6% current account surplus. The widening deficit was mainly due to the deterioration of the income balance (3.4% of GDP), which probably reflects some temporary factors such as lower returns on FDI in continental Europe during the cyclical downturn, while the UK's trade deficit narrowed last year to 1.9% of GDP.

The long average maturity of public debt (16.4 years, the longest of any high-grade sovereign) almost exclusively denominated in local currency and low interest service burden implies a higher level of debt tolerance than many high-grade peers.

The improvement in the UK banking sector's capital and liquidity position as well as legislative, regulatory and policy initiatives have reduced the likelihood of sovereign support for senior creditors of UK banks and hence contingent liabilities arising from the sector. The financial sector is supporting the economy by better transmitting the loose monetary conditions.

RATING SENSITIVITIES
The Stable Outlook reflects Fitch's assessment that upside and downside risks to the rating are currently balanced:

The main factors that could lead to negative rating action, individually or collectively, are:
- Failure to place the GGGD to GDP ratio on a downward path over the medium term.
- Adverse macroeconomic or financial shocks that significantly slow the economic growth, adversely affecting the public finances or the financial sector.

The main factors that could lead to positive rating action, individually or collectively, are:
- Sustained reduction of the budget deficit, leading to a track record of decline in the GGGD to GDP ratio from its peak.
- Increase in medium-term growth prospects.

KEY ASSUMPTIONS
In line with the Conservative Party's manifesto, the new government has started its negotiations on EU reforms with key EU member states and officials and has already introduced the EU Referendum Bill to Parliament confirming that the referendum will be held by end-2017. As we said in a comment on 8 May, making a firm judgement on the sovereign credit impact on the UK of leaving the EU (opinion polls indicate meaningful support for membership) is not possible at this stage, because the terms of the exit scenario are highly uncertain (see 'UK Faces Fiscal Continuity, Constitutional Uncertainty' at www.fitchratings.com). Negotiating the shape of a UK exit would be lengthy and complicated and multiple different outcomes are possible. This prolonged uncertainty could itself dent UK economic growth by weighing on confidence and investment.

Fitch assumes that the UK's fiscal framework will not be significantly weakened by further devolution of fiscal responsibilities to Scotland.

Fitch maintains its view that the UK's growth potential is around 2.0%-2.25% over the medium term and growth rates will continue to converge towards the potential rate in 2015 and 2016. The GDP growth forecast is 2.5% this year and 2.3% in 2016 after 2.8% growth in 2014. The key assumptions for the debt dynamics calculations are a 2% potential growth rate, the lower bound of the range for potential growth, a GDP deflator gradually converging to the 2% inflation target and a longer term primary surplus of 1% of GDP and marginal interest rates increasing towards 3%. Based on these assumptions, GGGD would fall below 80% of GDP by 2024.

Fitch assumes that Bank of England will be able to tighten monetary conditions gradually without excessive market volatility and macro-prudential risks as the economic slack is absorbed but inflation pressure remains subdued. The task of normalising monetary conditions after keeping the policy interest rate unchanged at the zero lower bound for almost seven years, while holding GBP375bn government bonds (21% of GDP) on its balance sheet is historically unprecedented.