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PP RUEHAG RUEHDF RUEHIK RUEHLZ RUEHROV RUEHSR
DE RUEHLO #1231/01 1421659
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P 221659Z MAY 09
FM AMEMBASSY LONDON
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INFO RUCNMEM/EU MEMBER STATES COLLECTIVE PRIORITY
RUCPDOC/DEPT OF COMMERCE WASHDC PRIORITY
RUEATRS/DEPT OF TREASURY WASHDC PRIORITY
RUEHBL/AMCONSUL BELFAST PRIORITY 1326
RUEHED/AMCONSUL EDINBURGH PRIORITY 1133

UNCLAS SECTION 01 OF 02 LONDON 001231 
 
SENSITIVE 
SIPDIS 
 
E.O. 12958: N/A 
TAGS: ECON EFIN ETRD EINV UK
SUBJECT: CREDIT OUTLOOK TURNS NEGATIVE OVER HIGH DEBT CONCERNS 
 
LONDON 00001231  001.2 OF 002 
 
 
¶1.  (U) Summary: Standard & Poor's Ratings Services (S&P) revised 
its outlook on the UK from stable to negative on May 21 based on its 
concern that government debt could approach 100 percent of GDP by 
2013 and remain near that level in the medium term. If the UK does 
lose its Triple-A status, the government will face a higher cost of 
funding, a major problem given that the size of the gilt market is 
expected to double over the next few years.  While the negative 
revision caused concern in the stock market and raised concomitant 
concern about the level of US debt, S&P told HM Treasury that a 
negative change to the outlook has historically only resulted in a 
downgrade in one in three cases.  S&P warned the UK's credit rating 
could be downgraded after the upcoming general election (which must 
be held by June 2010) if the next government fails to rein in public 
debt.  Conversely, the outlook could be revised back to stable if 
comprehensive measures are implemented to put public finances on a 
sustainable footing.  Moody's and Fitch have reaffirmed Britain's 
Triple-A status and see the UK's outlook to be stable.  End Summary. 
 
 
Markets React But News Not All Together Unexpected 
------------------------- ------------------------- 
 
¶2. (U) In a May 21 press release, S&P revised the UK's credit 
outlook to negative, stating that the UK's high government debt 
burden, if sustained, would be incompatible with a Triple-A 
sovereign credit rating.  The S&P's report came just a day after the 
IMF called for much tougher measures to rein in state borrowing. 
The UK public debt at the end of April was GBP 754 billion, 
equivalent to 53.2% of GDP.  Following the S&P announcement, the 
British pound fell the most in four weeks against the dollar to 
$1.5639 and weakened 0.7 percent against the euro to 88.07 pence. 
The FTSE 100 index fell 2.75 percent, the most since March 30. 
Credit default swaps on UK debt increased by 5.5 basis points and 
gilt prices fell, pushing the yield on the UK's ten-year gilt up by 
13 basis points to 3.71 percent, before settling at 3.62 percent. 
 
¶3.  (U) Economists had a more measured response to the possibility 
of a credit rating downgrade.  Ben Broadbent, chief UK economist at 
Goldman Sachs, speculated that the market would have had a more 
pronounced reaction if the S&P announcement had come as a complete 
surprise - instead, a lot had already been priced in, with UK 
sovereign credit default swap spreads already very wide.  David 
Simmonds, head of research and strategy at RBS, agreed that the S&P 
announcement wasn't a huge surprise, although he said the timing 
caught markets unawares.  Simmonds said the UK rating outlook 
decision is only one in a series and that the new mantra could be 
"AA is the new Triple-A."  He reflected that the markets negotiated 
the actual loss of Japan's Triple-A status well.  He said, however, 
the markets sense that S&P might be using the UK case to gauge the 
potentially explosive reaction for a similar announcement about the 
U.S.  Max Watson, financial stability expert and Director of 
Research at John Howell and Co. Ltd. told us he expected risk 
premiums on borrowing to increase based on the announcement, but 
confirmed that announcement was largely a warning, which gave the 
next UK government an opportunity to reform spending. 
 
Political Reaction 
-------------------- 
 
¶4.  (U) S&P's decision is a politically important issue because the 
future of the UK's credit rating is contingent on the next 
government's ability to tame the public purse.  HMG is committed to 
ensuring the UK's public finances are sustainable in the medium and 
long term, according to the Prime Minister's spokesman.  During a 
press briefing, he said the Chancellor's April Budget established a 
clear plan to halve the deficit within five years.  He cautioned 
that during a recession, it would be dangerous to choke off the 
possibility of growth by reducing public spending, saying it would 
mean higher debt and higher deficits over the next few years.  He 
also highlighted the success of the largest gilt auction in history, 
of GBP 5 billion that received bids for GBP 13 billion, which 
concluded shortly after the S&P announcement, as proof that there is 
still a significant appetite for UK sovereign debt. 
 
¶5.  (U) For the opposition parties, the announcement provided 
another opportunity to undermine the government's former reputation 
for economic competence.  Shadow Chancellor, George Osborne, warned 
that the UK's economic reputation "is on the line at the next 
general election."  He accused Labour of putting the UK's economic 
stability at risk by refusing to face up to the debt crisis they 
created over the last 12 years.  Vince Cable, the Liberal Democrats' 
Treasury spokesman, echoed Osborne's accusations, saying that unless 
Chancellor Darling provides a viable plan for paying back the UK's 
debt, it is possible the UK will see a further deterioration in its 
rating.  He added that the Chancellor has relied on implausible 
growth forecasts for the British economy and has failed to provide 
certainty to the markets. 
 
 
LONDON 00001231  002.2 OF 002 
 
 
Fiscal Cuts Needed To Offset Long-Term Impact 
-------------------------- ------------------ 
 
¶6.  (SBU) Comment: S&P's announcement is unlikely to have any 
significant impact in the short term.  However, the announcement 
further calls into question Gordon Brown's reputation for economic 
competence, which had been partially restored after the success of 
the G20 London Summit.  The long-term impact of S&P's negative 
outlook is not yet clear.  Although analysts predict it will take as 
long as ten years to restore balance in the public finances, the 
next government will need to make a visible effort to quickly 
stabilize and then reduce the government debt burden to prevent a 
rating downgrade.   Moreover, as investors remain highly risk averse 
and as the amount of borrowing needed over the next five years 
remains high, the willingness of investors to continue to finance 
the UK's debt should be monitored. 
 
LEBARON