UK's EU Exit Does Not End Uncertainty

Saturday, February 01,  2020   /08:00 PM  / By Fitch Ratings / Header Image Credit: The One Brief

The effect of post-Brexit developments in the UK-EU relationship on the UK's economy and public finances will remain an important factor in our UK sovereign rating assessment after the UK leaves the EU on 31 January, Fitch Ratings says.

The UK's formal departure has no immediate rating impact, as it was anticipated at our most recent rating review. The Conservative Party's decisive victory in the UK general election on 12 December made it highly likely that parliament would pass the Withdrawal Agreement bill, which it did on 22 January. The greatly reduced near-term risk of a 'no-deal' Brexit caused us to affirm the UK's 'AA' rating on 17 December and remove it from Rating Watch Negative (RWN).

A transition period in which virtually all EU law will still apply in the UK will last at least until end-2020, with negotiations on trade and other areas, including security cooperation, starting in March. The UK government has said that it is seeking a deep free-trade agreement (FTA) that allows it to diverge from EU rules (a so-called "Canada+" agreement). However, initial comments from the EU suggest that it is only willing to negotiate a shallow trade agreement for goods, unless the UK remains an EU rule-taker. There will be many flashpoints, such as fisheries and the enforcement of Northern Ireland border arrangements. There is also very little time to agree even a narrow trade deal.

As a result, other scenarios are possible, including a trade "cliff-edge" with the UK exiting the transition period at the end of the year and reverting to WTO terms, which would be negative for long-term economic growth compared with an FTA. Alternatively, the transition period could be extended. Last year's agreement regarding the removal of the Irish backstop would suggest that both sides can be pragmatic and seek to avoid the cliff-edge scenario.

The Negative Outlook on the UK's rating reflects these uncertainties over the relationship. Persistent Brexit uncertainty has already weighed on growth. Recent survey data, including a jump in manufacturing optimism, suggest some benefit from reduced political uncertainty and the US-China 'Phase One' trade deal. But a rapid rebound in business investment is unlikely while the UK and EU seek to hammer out a free-trade agreement.

Our UK GDP forecasts in December's Global Economic Outlook incorporated a recovery in sequential growth on the grounds that 'no-deal' would be avoided on 31 January and following weakness in 4Q19 (GDP rose by just 0.1% qoq in the three months to November). But this does not translate into a pick-up in annual growth in 2020, which we forecast at 1.3%, unchanged from last year. Our GEO forecasts see growth accelerating to 1.8% in 2021 as pent-up investment demand is released, assuming no cliff-edge.

Our forecasts also reflect the prospect of a looser fiscal stance. The Conservatives' new fiscal rules would allow an extra GBP22 billion of public sector net investment annually and the government has emphasised its desire to 'level up' UK economic performance across regions by improving transport infrastructure. This increases uncertainty around our government debt projections, which see debt on a gentle downward path.

The sharp reduction in the general government deficit (from 8.2% of GDP in 2015 to an estimated 2.3% in 2019) has created some space to ease fiscal policy. The budget due on 11 March will be an important indicator of how this space will be used and how far stimulus will lift growth. These will be important considerations in the next rating assessment.

The importance of the UK's economic performance and the public finances to our sovereign rating assessment is reflected in our rating sensitivities. Another relevant post-Brexit factor is whether the election of a government with a large majority reverses the deterioration in UK governance indicators (which remain slightly above the 'AA' median). In the longer term, renewed calls for Scottish independence, or concerns among Northern Irish unionists over their status within the UK, could to revive domestic political volatility.

Fitch's next scheduled review of the UK's sovereign rating is due on 27 March.

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