Is it curtains for George Osborne?

Britain suffered its first ever sovereign ratings downgrade from a major agency at the weekend when Moody’s stripped the country of its coveted top-notch triple-A rating, dealing a major blow to finance minister George Osborne. Marcus Denby considers the implications...

Since the Conservative-led coalition came to power in 2010, austerity has been the watchword of Chancellor George Osborne’s fiscal policy following an election in which he vowed to defend the nation’s financial rating, which can help keep down borrowing costs.

But weak prospects for economic growth, which have thrown the Government’s deficit reduction strategy off course, lay behind Moody’s decision to cut it by one notch to AA1 from AAA.

The same happened to France in November last year, and the US also suffered its first ever downgrade over fears about its huge national debt. Despite a European Commission report predicting Britain will be the best performing major economy in Europe this year, with growth of 0.9 per cent in 2013 compared with 0.3 per cent contraction across the eurozone, it remains true that the Government’s goal of largely eliminating the budget deficit by 2015’s election has been pushed back by at least two years.

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The UK retains its AAA credit rating with Fitch and Standard & Poor’s, the two other main agencies, but the Moody’s downgrade may fuel unease among many – including members of Osborne’s own party, and his Liberal Democrat coalition partners – that ‘Plan A’ is not working.

Sterling fell by almost a cent to around $1.5160 after the downgrade, just off Thursday’s fresh two-and-a-half year low, and analysts expected it to weaken further today, even if many had seen a downgrade coming sooner or later. Struggling this year amid uncertainty about the policy direction of the Bank of England, earlier this week sterling plummeted against the euro to a 15-month low of 1.14.

Mr Osborne said in a statement that “Far from weakening our resolve to deliver our economic recovery plan, this decision redoubles it.”

But will defiant language alone get him off the hook?

While an embarrassment for the Government and a cause for piqued pride, many suspect that the loss of the AAA rating will have only a limited negative impact for the UK economy.

This was the case for both France and the USA. There are so few countries left now with a AAA rating, that to lose it is not the stigma or major threat to market confidence that it would have been say a couple of years ago. Furthermore, the UK’s downgrading has been expected for some time and has been increasingly priced in by the markets

What actually bites at the end of the day (that is, can change the debt dynamics) are actual borrowing costs and they remain very low for the UK compared to past levels. Markets, in other words, aren’t yet prepared to charge significant country risk (that is, a markedly higher interest rate risk premium on the UK) despite its problems.

The strong likelihood is that it will not materially lead to a change in Mr Osborne’s plans. Changes are more likely from the Bank of England, which surprised markets last week after it revealed that Governor Mervyn King and two other policymakers favoured restarting bond purchases to boost the economy.

They remained in the minority among their fellow policymakers but economists increasingly expect more stimulus eventually by the central bank. This – and the central bank’s tolerance of above-target inflation – have combined to put pressure on sterling while leaving British government debt relatively shielded.

In many ways it was anomalous that the UK kept its triple A rating for so long given downgrades to the likes of France and the US.

Though unsurprising, we should not kid ourselves that this will not impact the real economy. The cost of borrowing will likely go up for business as well as the Government, so the thousands of zombie companies haunting the UK economy will come under further pressure. We can expect to see an increase in insolvencies and restructurings.

The damaging impact of ballooning national debt, public spending raging out of control and tax rises should not be underestimated. Taking immediate action to tackle the deficit must now be the priority. Mr Osborne should focus on making sufficient savings in public spending to implement a substantial programme of tax reductions.

With the size and scope of the state in Britain at current levels it is no wonder our economy is so fragile.

The stranglehold of regulation is hurting business prospects on almost every front. In the lead up to the budget Mr Osborne would be wise to respond by taking urgent action.