Will the UK be downgraded – and does it matter?

Rating agency Moody’s has warned that it may downgrade the UK's AAA credit rating. Matthew Partridge looks at what this would mean.

When Standard and Poor's slashed the credit rating of France and several other European countries, there was an outcry both at the decision, and the fact that the UK was not affected. One German politician even argued that, "If the agency downgrades France, it should also downgrade Britain in order to be consistent".

It now looks like this wish may come true. Rating agency Moody's has decided to place the UK, along with eight other countries, on "negative watch". This means there is a chance that it might decide to downgrade these countries in the near future although the UK still keeps its AAA rating for now.

Should we be worried about this? Is it even worth listening to rating agencies at all?

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Are rating agencies any good?

There are many reasons to think that credit ratings aren't worth the paper they're printed on. Ratings agencies completely failed to warn of the subprime crisis for example. And credit spreads on sovereign debt are better at predicting default than ratings themselves.

Certainly, the market isn't phased by the downgrade threat. The cost of insuring ten-year UK bonds is well below the peak levels of early 2009 and has even fallen from three months ago.

However, because of the political sensitivity as much as anything else, decisions to downgrade are not taken lightly. So, while Moody's warning doesn't mean much for the price of gilts, it's a reminder that Britain's economy faces some serious problems.

The good news for the government is that, in its review, Moody's agrees that austerity' is a good idea. Indeed, it notes that, "the government has demonstrated its willingness and ability to take action to address shortfalls".

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However, the bad news is that all this could count for nothing if the economy stalls. A recession would hit the tax base, while more people out of work means more benefit spending. Lower growth also means that the UK government will have to work harder to cut the debt-to-GDP ratio. This would, "put into question the government's ability to place the debt burden on a downward trajectory by fiscal year 2015-16".

Moody's is also worried that the eurozone's troubles will affect the UK and it's hard to argue with this point, given Europe's significance to Britain as a trading partner.

What to do?

Of course, the chances of a genuine fiscal crisis remain extremely remote Britain is not Greece. However, it does raise the question: what the UK can do to protect its sovereign rating and boost growth at the same time?

Fiscal expansion (more government spending) is a non-starter since it would increase debt levels. Indeed, Moody's has argued that reversing cuts would make a downgrade much more likely.

So the solution that everyone will reach for is almost certainly further monetary stimulus: Moody's comments can only add to the pressure on the Bank of England to engage in another round of quantitative easing.

Such a policy would be controversial and we've already covered the arguments for and against. However, regardless of objections, it's what's likely to happen. And with other central banks around the world, from Japan to Europe to the US, threatening to do the same, it all adds up to another very good reason to have some gold in your portfolio.

Dr Matthew Partridge

Matthew graduated from the University of Durham in 2004; he then gained an MSc, followed by a PhD at the London School of Economics.

He has previously written for a wide range of publications, including the Guardian and the Economist, and also helped to run a newsletter on terrorism. He has spent time at Lehman Brothers, Citigroup and the consultancy Lombard Street Research.

Matthew is the author of Superinvestors: Lessons from the greatest investors in history, published by Harriman House, which has been translated into several languages. His second book, Investing Explained: The Accessible Guide to Building an Investment Portfolio, is published by Kogan Page.

As senior writer, he writes the shares and politics & economics pages, as well as weekly Blowing It and Great Frauds in History columns He also writes a fortnightly reviews page and trading tips, as well as regular cover stories and multi-page investment focus features.

Follow Matthew on Twitter: @DrMatthewPartri