As we said in our report "Countdown To Brexit: No-Deal Risks Revisited," published on Oct 4, 2019, we are sticking to our base case that the U.K. will exit the EU with a deal. Nevertheless, the probability of a no-deal Brexit remains relatively high. On the assumption that a general election will be called in November, the main risks to ratings, as we currently see it, relate to two scenarios: either the present government having a renewed mandate to leave the EU, including, if necessary, on a no-deal basis; or, conversely, a Labour-led coalition government pursuing a less immediately disruptive Brexit policy and possibly radical shifts in economic policy, as well as new referenda on Brexit and Scottish independence.
A no-deal Brexit remains a material risk for U.K. public sector entities. It could pressure our sovereign rating on the U.K. (unsolicited; AA/Negative/A-1+). A sovereign downgrade would negatively affect the ratings on public sector entities that factor in extraordinary support from the government. Additionally, ratings that are at the sovereign level would move in step with the sovereign rating. Furthermore, the projected economic contraction in a no-deal scenario, with a substantial drop in housing prices and rising unemployment (table 1), could dent the intrinsic creditworthiness of social housing entities, universities, and local authorities.
|U.K. Economic Indicators In S&P Global Ratings' Base Case Versus A No-Deal Brexit|
|Baseline||No-deal Brexit Scenario|
|GDP (% year)||1.8||1.4||1.2||1.1||1.3||1.4||0.8||(2.8)||0.8||1.6|
|CPI (% year)||2.7||2.5||1.9||2.0||2.4||2.0||2.3||4.4||2.1||1.9|
|USD per GBP||1.29||1.34||1.25||1.26||1.31||1.37||1.2||1.1||1.2||1.2|
|BoE Policy Rate||0.3||0.6||0.8||0.9||1.1||1.4||0.6||0.0||0.0||0.0|
|House Prices (% year)*||4.6||2.4||0.0||1.5||3.5||4.0||(1.7)||(10.2)||(6.1)||5.9|
|f--Forecast. *House price inflation is reported year-on-year for the fourth quarter in each year. Source: Oxford Economics, ONS, BoE, S&P Global Economics & Research. Oct. 4, 2019|
We have conducted our sensitivity analysis of a no-deal Brexit to observe the performance of our ratings. We found out that in this scenario we might lower the ratings on nearly half of the 47 U.K. social housing providers, universities, and local governments we rate publicly, assuming no change to their financial policies. The overall impact of a no-deal scenario, though, will depend on management responses to these challenges.
Housing Associations Could Suffer From Economic Contraction And Lower Housing Prices
Our analysis of a no-deal Brexit shows that we could downgrade half of the 41 publicly rated U.K. social housing associations (HAs) in our portfolio by one notch (chart 1). We see as particularly vulnerable the ratings on providers who increasingly depend on proceeds from market sales, or receive uplift for extraordinary support from their related government.
We believe that Brexit uncertainty has already started to trickle down into lower housing prices and sales volumes, especially in London. Over the past 12 months, we have lowered the ratings on six HAs and revised the outlook to negative on five others. In most of these cases, due to expected lower proceeds from development-for-sale, we revised down our medium term forecasts of HAs' financial performance and interest coverage.
We have also started to observe significant shifts in the business plans of HAs that are heavily exposed to outright sales. They have adapted their strategies following the market slowdown and in anticipation of a further contraction.
In a no-deal scenario we foresee further pressure on our ratings on HAs mostly because of economic contraction, especially in the real estate sector. We assume that, in this case, we would lower the ratings on 11 HAs because of changes to their intrinsic credit characteristics. The main source of rating changes would be a deterioration of their debt profile. We expect lower earnings to result in increasing funding needs and, as such, we forecast debt metrics would come under pressure (charts 2 and 3)
The ratings on providers whose market sales have increasingly formed part of their activities are the more vulnerable. However, we highlight that for some providers ratings downside stems from our forecast that increasing unemployment could exacerbate arrears and lead to a deterioration of economic fundamentals in our enterprise profile assessment.
Ratings on some HAs could come under downward pressure in a no-deal scenario if we were to lower the related government rating. The final rating on these HAs would lose the corresponding rating uplift derived from our view of the likelihood of support. If we were to lower the U.K. sovereign rating this could result in downgrades of nine HAs.
The ultimate impact of a no-deal Brexit depends on management responses to these challenges. While our base case does not take into account proactive measures, we acknowledge that many HAs have mitigation strategies in place that they can swiftly implement. In most cases, they can delay maintenance and capital spending, and from 2020 would be able to raise rent fees.
We believe that despite the risk of HAs' creditworthiness weakening in a no-deal scenario, the credit quality of social housing financial agencies such as The Housing Finance Corp. Ltd. (THFC; A/A-1/Stable), MORHomes PLC (A-/A-2/Positive), and GB Social Housing PLC (A-/Stable) will remain intact due to their solid financial profiles.
Universities' Reputations Might Erode In The Long Term
In our opinion, any potential negative effects of a no-deal Brexit on U.K. universities will materialize in the long term rather than imminently. Isolation from EU research projects, uncertainty about work permit conditions, and the pound depreciating further against the euro could render U.K. universities less attractive to EU academics. Over time, this could erode the global reputations of some U.K. universities, especially those below the top tier. On the other hand, a weaker sterling in a no-deal scenario could attract overseas students to U.K. universities and somewhat boost their competitiveness.
Of our four publicly rated U.K. universities, two carry a negative outlook and we have downgraded one in the last 12 months. The negative pressure on these universities has materialized domestically, with rising staff and pension costs weighing on universities' financial performance. The domestic market has also become more competitive since the lifting of the student cap in 2014, which has been exacerbated of late by a demographic dip in 18 year olds in the U.K. Consequently, universities are facing several headwinds at present.
On a positive note, though, universities will likely get compensation for a reduction in EU research funding and will continue to attract international students, including from the EU. The U.K. government has announced that, in the case of no deal, it will guarantee funds for all bids to the EU framework program for funding that are submitted before the U.K. leaves the EU. The government also appears poised to potentially fill any gap left by EU research grant funding drying up. On a similar note, if EU student numbers drop, we expect students from other countries would fill the gap (chart 4).
Moreover, the central government has announced that EU students starting university in England next year would continue to operate in the same tuition-fee-payment framework as they currently do. The post-study work visa, which dictates how long an international student can stay in the U.K. post-graduation, has been extended. Previously, international students could only stay six months to find a job post-graduation. This has now been extended to two years, which should encourage rather than deter international students looking to study and work in England. Combined with revised policies, England may become more attractive to international students through the weaker sterling. Depreciation in the pound strengthens the business case for international students to study here, making tuition fees and living cheaper for them.
Local Governments Would Face Pressure From Sovereign Links And Limited Budgetary Flexibility
In a no-deal scenario, our ratings on Greater London Authority (GLA; AA/Negative) and Transport for London (TfL; AA-/Negative) might come under pressure, mainly because of the link with the sovereign rating and dependence on central government funding. The rating on GLA is currently at the sovereign level and may come under pressure if we were to downgrade the sovereign. We do not rate U.K. local and regional governments above the sovereign.
The rating on TfL reflects our expectation that GLA and the Department of Transport will continue to cover cost overruns generated by TfL's flagship investment projects, including Crossrail (the Elizabeth line). Economic slowdown may limit TfL's ability to raise tariffs, while GLA's revenues from business rates that are allocated for TfL's projects may shrink. This will constrain resources available for capital spending on London transport infrastructure and either delay implementation of TfL's projects or raise its debt burden.
Overall, under a no-deal Brexit we anticipate that the U.K.'s local governments would experience additional pressure on their credit ratios. A weaker economy would likely reduce their revenue base while rising demand for services and benefits would prevent local governments from making further spending cuts. Consequently, local governments' budgetary performance will weaken, with operating margins shrinking along with projected deficits after capital accounts over 2020-2021.
We assume revenues will reduce mostly because of lower council taxes, mainly driven by a reduction in property value. Council tax accounted for about 20% of local governments' total operating revenue in 2019. At the same time, we do not expect further cuts to central government grants on the back of a countercyclical policy which will likely be conducted to stimulate the economy. Grants from the U.K. central government continue to account for close to 60% of the sector's total operating revenue in 2019. We also believe that local authorities will have less leeway to increase rates in the context of an economic downturn.
On the expenditure side, we forecast that much higher inflation will weigh on local authorities' spending on goods and services. Also, we believe that spending on social services, care, and benefits would substantially increase in 2020-2021 to mitigate the shock of a no-deal Brexit on the economy and people. For the same reason, even if there are lower capital grants, we expect local governments to embark on development projects to offset a likely reduction of private capital spending.
Weakening budgetary performance would likely translate into debt acceleration. In a no-deal scenario we assume that direct debt would reach 76% of total operating revenue in 2021, from about 66% in 2019. Nevertheless, we believe local governments will retain access to loans from the Public Works Loans Board as well as rely on large reserves, which were about £26 billion just for English local authorities in 2019 or a solid 20% of the sector total operating expenditure.
- Countdown To Brexit: No-Deal Risks Revisited, Oct. 4, 2019
- Research Update: Ratings On The United Kingdom Affirmed At 'AA/A-1+'; Outlook Remains Negative, April 26, 2019
This report does not constitute a rating action.
|Primary Credit Analysts:||Felix Ejgel, London (44) 20-7176-6780;|
|Jean-Baptiste Legrand, London (44) 20-7176-3609;|
|Abril A Canizares, London (44) 20-7176-0161;|
|Christopher Mathews, London + 44 20 7176 7115;|
|Additional Contact:||EMEA Sovereign and IPF;|
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