UK may suffer further downgrade

UK may suffer further downgrade

Good morning and welcome to today’s foreign exchange market commentary on Friday, the 1st of March.

Losing the triple-A rating is no big deal these days. The ‘shock and awe’ effect dies down after the first couple of times and you get used to it as time passes by. The US lost its crown nearly two years ago while France joined in last year. And mighty Japan lost the coveted rating years ago. So apart from the pound wobbling and then losing some ground, markets pretty much carried on as before.

But the trouble now lies somewhere else. Don’t be surprised if UK loses another A in future, and then another, until it hits the bottom gets below investment grade. There are many reasons for the slide. Let’s look at them sequentially.

First, the UK’s budget deficit continues to widen and shows no signs of narrowing. According to OECD, the UK government deficit rose to 8.7 percent of GDP in 2012. That is higher than Greece, where it was at 7 percent, and nearly double of Spain, where it was 4.4 percent. But both the governments have cut public spending substantially to balance their budgets.

In UK, the government spending is still rising rapidly. Expenses in January were 4 percent higher than a year ago. The only improvement that took place is that deficits are now widening at a slightly slower pace. Also, UK has the unique distinction of having massive private and public sector debts. UK’s total debt – personal, private and government, adds up to a massive 500 percent of GDP, according to McKinsey. That’s second only to Japan.

Second, the next government may push deficits even higher. It is unlikely Cameron will win in 2015 since he failed to secure a majority in 2010. The opposition Labour Party is already 10 percent ahead in polls. And it doesn’t see a problem to which more borrowing is not an answer.

If the reason for borrowing big is to kick-start the economy on the assumption that higher growth will help in paying down debts later, then irrespective of the strength for such Keynesian theory, the risks are obvious. If the growth falls short of expectations, the debt situation spirals out of control.

Third, increasing revenues through higher tax collection is not an option. Countries like Greece and Italy have notoriously weak tax/GDP ratio since evasion is rampant. Even US collects a relatively low 26 percent of GDP in tax. But for UK, the tax/GDP ratio is already 39 percent and there is very little tax avoidance. Imposing higher taxes on commodities like petrol is also not possible. Extra tax on petrol will raise only GBP 26 billion against the estimated GBP 30 billion. Petrol has become so much expensive that people just drive less these days.

Finally, Britain has stopped growing. There is sufficient evidence that if debt crosses a certain threshold, the economy slows down. UK can be considered as a copybook example of that theory. And when growth stalls, the debt situation worsens. Spain has been downgraded one notch above junk; still its debt is lower than the UK.

The currency will plunge as markets wake up to the reality when ratings agencies return after a year. But the biggest losers will be UK bond holders. Markets may be immune to an AA downgrade. But a junk rating can be catastrophic.

CURRENCY RATES OVERVIEW

GBP/EURO – 1.1592
GBP/US$ – 1.5168
GBP/CHF – 1.4312
GBP/CAN$ – 1.5622
GBP/AUS$ – 1.4835
GBP/ZAR – 13.6895
GBP/JPY – 140.46
GBP/HKD – 11.7665
GBP/NZD – 1.8350
GBP/SEK – 9.7887

EUR: The euro weakened against the US dollar and the pound on Thursday. EU data was generally weak as German unemployment fell less than anticipated while inflation in the eurozone came in on forecast at 2 percent. Markets turned wary on the prospect of further rate cuts, putting downward pressure on the shared-currency, as core inflation fell to 1.3 percent. French consumer spending also slumped, revealing the challenges faced by EZ’s second-largest economy. The GBP/EUR pair’s movement in the first-half of the day is likely to be influenced by UK manufacturing data before focus shifts to the other side of the Atlantic.

USD: Sterling advanced marginally against the US dollar after revised US fourth quarter GDP data showed the world’s largest economy expanded negligibly in the fourth quarter, reversing a preliminary estimate that showed a decline of 0.1 percent. Markets seem to be unwilling to build positions ahead of UK manufacturing data today and further firming up of manufacturing is likely to push the pound higher. The GBP/USD pair traded at 1.5178 compared to 1.5156 the prior day. The ICE dollar index, a measure of the greenback’s strength against a basket of six global currencies, rose to 72.53 from 72.76 on Thursday. The US manufacturing PMI is due in the afternoon and markets are expecting the gauge to remain in the expansionary region. Consumer spending and sentiment is also due for release today though focus is likely to remain on the gridlock due to sequestration – spending cuts by the government that is due to come into effect from today.

Have a great weekend!

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