Does cutting the deficit further and faster make for a good credit rating?

1 March 2013

"The two major economies that have the top rating are Germany and Canada and they are the two countries that have got to grips with their deficit."

Jeremy Browne MP, BBC Question Time, 28 February 2013

It's been a difficult week for the Government in the wake of the decision by ratings agency Moody's to downgrade the UK's credit rating for the first time in decades.

Until last Friday, the UK enjoyed the agency's top rating (Aaa) but following a year of 'negative outlook' (the agency's way of 'warning' that there may be a ratings downgrade if things don't improve) it now sits on the second tier with a Aa1 rating.

The two other major ratings agencies - Standard & Poor's and Fitch - still have the UK at their top AAA rating, but both put the UK on a negative outlook. In other words, this might not be the only impending ratings downgrade if the state of the public finances doesn't improve or deteriorates.

David Cameron's response was resolute: "I'm the one saying this credit rating does matter, and it demonstrates that we have to go further and faster on reducing the deficit".

Home Office Minister Jeremy Browne echoed this line on BBC Question Time yesterday, claiming that it is the countries which have "got to grips" with thir deficit have retained their triple-A credit rating.

Credit ratings and credit outlooks

Until last Friday, the UK shared its universal triple-A credit rating across all three agencies with a select group of countries: Australia, Canada, Denmark, Finland, Germany, Luxembourg, Netherlands, Norway, Sweden, Singapore and Switzerland. Back in mid-2010 the USA and France were also part of this elite, but have likewise fallen from the top.

So does deficit reduction have anything to do with downgrades? The ratings agency itself cites growing uncertainty over the pace of fiscal consolidation as a factor in its decision:

"...the weaker economic outturn has substantially slowed the anticipated pace of deficit and debt-to-GDP reduction, and is likely to continue to do so over the medium term. After it was elected in 2010, the government outlined a fiscal consolidation programme that would run through this parliament's five-year term and place the net public-sector debt-to-GDP ratio on a declining trajectory by the 2015-16 financial year. (Although it was not one of the government's targets, Moody's had expected the UK's gross general government debt -- a key debt metric in the rating agency's analysis -- to start declining in the 2014-15 financial year.)

"Now, however, the government has announced that fiscal consolidation will extend into the next parliament, which necessarily makes their implementation less certain."

In order to assess whether Jeremy Browne has a point about the cases of Canada and Germany, we need to consult OECD comparative figures and projections of sovereign net lending and borrowing. These don't tell us very much about the nature of the deficit reduction programmes in different countries, but it can give an indication of who's cutting farthest and fastest.

The above graph takes a subset of OECD countries - all of which had perfect credit ratings in 2010 - and compares projections of how high their deficits became as a proportion of GDP following the financial crisis and how they're forecast to fall over the coming years.

The UK's deficit peaked at almost 11% of GDP - a historically large amount. Since their peaks, Germany's deficit has fallen fastest, followed by France and the UK. Canada's deficit is also set to fall, but at a comparatively modest rate.

What's actually noticeable is not the rate of each country's projected deficit reduction but the starting point of each prior to the financial crisis, and in the first few years of consolodation. The structural deficit in Germany and Canada (along with Australia and most other triple-A nations) was much smaller at the outset of the crisis than that of the UK, US and France. In spite of their deficit reductions, they're still projected to have higher borrowing as a proportion of GDP than any of the remaining triple-A group.

Obviously, a rating agency's judgement of a sovereign economy is much more than just a measure of its fiscal consolidation, and OECD projections only tell part of the story behind each country's individual consolidation policy. That said, it's not entirely clear that the UK rate of reduction is the whole problem here, and the underlying structural deficit may bear some of the responsibility.

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