OREANDA-NEWS. December 16, 2015. 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. The credible monetary and fiscal policy framework and sterling's international reserve currency status further support the ratings. Strong civil and policy institutions and a high degree of transparency enhance the predictability of the business and economic policy environment, which compares favourably with peers in the 'AA' category.

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 close to 90% of GDP in FY15 (fiscal year ending in March 2016) and fall below 75% of GDP by 2024. The high level of debt expected over the next decade limits the government's fiscal space to absorb shocks.

The UK's multi-year fiscal consolidation strategy was updated most recently by the Autumn Statement and remains consistent with the government's own fiscal mandate. The Office for Budget Responsibility estimates that the budget deficit will decline to 3.9% of GDP in FY15, using the EU Treaty definition. The budget deficit has declined on average by 1.2pp of GDP in the last three years, broadly half of which is structural and half due to the cyclical economic recovery. According to the European Commission forecast, the structural fiscal consolidation in 2015-2017 will be somewhat stronger than in 2012-14 and also among the largest in the EU.

The mild growth slowdown has continued since the last rating review in June 2015. Fitch forecasts GDP growth of 2.5% in 2015 followed by 2.3% in 2016 and 2.1% in 2017, as the economic slack is gradually absorbed and the economy moves beyond the cyclical peak. Based on 3Q15 data, GDP is 6.3% above the pre-crisis level, compared with 9.6% in the US and -0.4% in the eurozone.

The increase in employment, and the corresponding fall in the unemployment, has been surprisingly strong so far during the recovery. The unemployment rate declined to 5.3% in July-September 2015, while the employment rate stands at 73.7%, the highest since the 1980s. This improvement in the labour market has been accompanied by subdued nominal wage dynamics. The weakness of productivity growth has been puzzling during the recovery, although this is picking up somewhat, adding to uncertainty over medium-term growth prospects.

Inflation has been in a very narrow range, between 0.1% and -0.1% since the beginning of 2015. The mild deflation of -0.1% was first recorded in February and it is the lowest CPI data since the 1960s. Fitch forecasts inflation to gradually converge towards the Bank of England's 2% target, driven by base effects in the short run, due to earlier sharp fall in energy prices, and by some pick-up in domestic price pressures over the medium term.

The UK referendum on EU membership will be held after the conclusion of negotiations around Prime Minister Cameron's proposals for reform. Our baseline is the referendum will be held in 2H16 and that the UK will remain in the EU. However, the referendum creates uncertainty in the short term and a vote for 'Brexit' would be a moderately negative credit development. The implications for the rating would depend on several factors, including the impact on medium-term growth and investment prospects, the UK's external position, and the risk of triggering a second referendum on Scottish independence. How a 'Brexit' scenario might play out is highly uncertain and the negotiations could be lengthy and complicated.

The current account (CA) deficit gradually widened to 5.1% of GDP in 2014, the largest since the official data series started in 1948 and compares with the 'AA' median of a 2.2% CA surplus. The deterioration is mainly due to the widening deficit in the income balance (3.4% of GDP), reflecting the lower returns on foreign assets, magnified by the UK's exceptionally large external balance sheet. The lower returns could signal temporary effects, like the weak recent performance in continental Europe or financial engineering of large UK-based multinational firms, but could also reflect a more secular deterioration of the risk/return profile.

The long average maturity of public debt (16.3 years, the longest of any high-grade sovereign) almost exclusively denominated in GBP and low interest service burden implies a higher level of debt tolerance than many high-grade peers. The Bank of England clarified in November 2015 that it will maintain the level of its sovereign bond holdings (GBP375bn, 20% of GDP) until the key interest rate reached a level 'from which it can be cut materially'.

The 2015 stress test results published on 1 December by the Bank of England confirm the improvement in the UK banking sector's capital and liquidity position. Legislative, regulatory and policy initiatives have significantly reduced the likelihood of sovereign support to UK banks and hence contingent liabilities arising from the sector.

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.
- A vote to leave the EU in the referendum, which would increase the risk of adverse impact on growth potential, the external position or on Scotland's future in the UK.

The main factors that could lead to positive rating action, individually or collectively, are:
- Further 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
Fitch maintains the key assumptions for the debt dynamics calculations: 2% potential growth rate, 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 75% 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.