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The Credit Implications If The U.K. And EU Fail To Reach A Free Trade Deal By Year-End

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The Credit Implications If The U.K. And EU Fail To Reach A Free Trade Deal By Year-End

The recent decision to continue negotiations to reach a trade accord between the U.K. and EU means that we are maintaining our base-case assumption that a limited free trade agreement (FTA) will be agreed to prior to year-end. Nevertheless, given the substantive issues that remain to be resolved and the limited time available, the talks might still flounder. If that were to happen, the U.K. and EU could find themselves trading on World Trade Organization (WTO) terms as of Jan. 1, 2021. This would threaten to make the end of the Brexit transition period quite turbulent given the uncertainty it would create and the very limited time left for business to prepare, even though the U.K. and EU could unilaterally implement certain safeguarding measures to limit the worst of the fallout.

We think the loss of goodwill that would stem from this potential rupture could make it difficult for the EU and U.K. to resume trade negotiations quickly. Still, we don't rule out the possibility entirely--if, for example, the disruption caused by no deal leads to significant social unrest or extreme market volatility that risks investor confidence. But we see it as more likely that incentives to compromise would be reduced and the willingness to collaborate in other areas of mutual interest could be adversely affected. Particular uncertainty could persist over whether and when the EU will reach any decisions on granting equivalence to U.K. financial services. Another key issue would be whether the treatment of EU data held in the U.K. can be considered adequately protected from an EU regulatory perspective.

After four years of equivocation, a failure to reach agreement would not be a total shock. And from a credit ratings perspective, we would consider it to be an additional headwind on top of the difficulties stemming from COVID-19. This also accords with our risk assessment of a disruptive Brexit that has remained at elevated since the withdrawal agreement was ratified at the end of last year.

Economic Implications

A failure to agree on a core trade deal would have a long-lasting impact on the U.K. economy, in our opinion. We think that U.K. GDP growth in 2021 would likely fall to 4.6% rather than the 6.0% we forecast currently under an agreed trade deal. And we estimate that, by 2023, U.K. economic activity would still be 1.4% short of levels that could have been achieved with a core deal--albeit with significant downside risks to our assessment given the uncertainties. For example, while we don't see an imminent threat to London's status as Europe's financial center, although it is difficult to foresee, this might change in coming years if the EU looks to onshore services that London currently provides.

Our estimate of the economic cost is not higher because we have already incorporated the impact of a much-less-ambitious FTA into our forecasts since July 2020. This was when we abandoned our assumptions of a further extension of the transition period and a more encompassing FTA in favor of a limited-tariff, quota-free FTA, similar to the one Canada has with the EU, in line with government policy (see "The U.K. Faces A Steep Climb To Recovery," July 1, 2020). Under these assumptions, by 2023 the U.K.'s economic activity was already estimated to be 1.7% lower than under the previously assumed, more encompassing trade deal.

We anticipate the specific ramifications of this change would include disruptions at customs, higher trade costs because of more red tape, a less-efficient labor market as a result of the new immigration regime, and lower productivity and trend growth. Together, these would translate in our view to higher inflation initially, lower trade volumes, weaker growth in consumption and investment, and--ultimately--overall weaker economic activity. These downward revisions were--and still are--masked by the relatively strong economic recovery that we expect as the economy emerges from the pandemic.

If the U.K. reverts to trading with the EU on WTO terms, we believe there would be further pressure on the U.K. economy, among others, from:

  • An increase in tariffs on U.K. exports to the EU, which would reduce their competitiveness and lower demand;
  • A depreciation in the pound sterling, which we predict--along with higher nontariff trade costs--would cause inflation to rise toward 2.5% in 2021 and reduce household spending power; and
  • Weaker flows of foreign direct investment into the U.K., including into the large commercial real estate sector, both from EU investors and others that were investing in the U.K. to access the EU single market.

However, there would be several mitigating factors in the short term. For example, business has had some time to prepare, though many details remain unclear. Moreover, we believe there would be the possibility for more fiscal and monetary policy support to help soften the blow from the lack of an FTA.

Credit Implications

While the fallout from the lack of a deal would cause moderate incremental damage to the U.K. and the regional economy as a whole in our opinion, the key rating sensitivities and time horizons vary considerably across industries and sectors.

Sovereigns

aarti.sakhuja@spglobal.com

Our sovereign ratings on the U.K. (unsolicited AA/Stable/A-1+) assume the U.K. and the EU will reach a basic agreement at the end of the transition period. A no-deal scenario would have important implications for the U.K. economy, the country's ability to attract inflows of capital and labor over time, and its public and external finances, in our opinion.

Our sovereign ratings on the U.K. could come under downward pressure if the economic recovery is significantly weaker than we anticipate, making fiscal consolidation more challenging. This could happen, for instance, if merchandise and services exports from the U.K. lose access to key European markets for a prolonged period.

Ratings downside could also emerge if foreign financing for the U.K.'s large external deficit diminishes and sterling's status as a reserve currency comes under pressure. Typically over $100 billion (about 4% of GDP), the U.K.'s current account deficit is the second largest in the world, in absolute terms, after that of the U.S. Any reduction in the appetite of nonresidents to finance this deficit, or to roll over the U.K. private sector's elevated stock of short-term external debt, would also weigh on the U.K.'s growth prospects.

Nonfinancial Corporates

While some nonfinancial corporate sectors would experience more disruption than others, we anticipate only a limited number of rating actions could result. This partly reflects the nature of many rated companies, namely that they have diversified business models, sophisticated supply chains, and have been involved in contingency planning (including building inventories) for quite a while. We expect that smaller companies and supply chains highly reliant on frictionless trade between the U.K. and the EU--particularly in the food retail, autos, aerospace and defense, and chemicals sectors--would be most exposed.

The main factors that would affect operational and financial performance include:

  • Border and supply-chain disruption--Customs rules and (as applicable) regulatory compliance checks will be compulsory for all goods entering or leaving the EU single market, even with a trade deal. Ending the transition with no FTA could cause additional bottlenecks and reduce the efficiency of cross-border supply chains. This would be most problematic for short-life fresh food and the just-in-time supply chains that support the auto, aerospace, and even the regulated utility industries. Transport and logistics operators will be particularly affected by changes in the formalities required when crossing the U.K.-EU border. At the same time, over the last two years many larger rated companies have improved the efficiency and resilience of their supply chains in planning for the potential risk of a hard Brexit.
  • Tariffs--If no FTA is agreed to before transition ends, the U.K.'s Global Tariff (UKGT) and the EU's Common External Tariff (CET) schedules would apply to U.K.-EU goods trade. According to the U.K. Trade Policy Observatory, about 20% of imports from the EU--notably in the agriculture, auto, and fishing sectors--would become subject to import tariffs. The 43% of U.K. exports that are sold into the EU would also become subject to the CET. Whereas the U.K. has liberalized and simplified its UKGT schedule, the EU's CET targets a broader range of products, and the tariff rates are set at slightly higher levels. The chemicals sector is one of the more affected sectors; under the CET, substantial exports of many product lines to the EU will be subject to 5.5% tariffs.
  • Currency--The expected depreciation in the pound sterling would increase the cost of imported food, raw materials, and other intermediate products. This would erode margins in many sectors given the weak economy, though some exporters and U.K. service providers (aerospace and lodging, for example) might see stronger demand in the medium term as their products and service become cheaper.
Credit implications of failing to reach a trade agreement for nonfinancial corporate sector

By Sector Sector Lead Comment
Aerospace and defense david.matthews@spglobal.com In the short term, a no-deal Brexit could disrupt issuers that have material production capacity in the U.K., such as Rolls-Royce PLC, GKN, MB Aerospace, and Aernnova (via its Hamble plant). Over the longer term, many issuers hope that a devaluation of the pound sterling would lead to rising demand for their products and services, which would become more affordable. Applicable tariffs could be material given that tariffs range from 2% to 8% for a number of tariff lines applicable to this industry.
Autos and suppliers vittoria.ferraris@spglobal.com According to the European Association of Auto Manufacturers, Brexit disrupts the industry's just-in-time operating model, with the cost of just one minute of production stoppage in the U.K. alone amounting to €54,700 (£50,000). WTO tariffs on cars and vans could total €5.7 billion (£5 billion) to the collective EU-U.K. auto trade bill, raising prices for customers if manufacturers cannot absorb the additional cost. While a free trade deal avoids a hit to operating income from tariffs, it still would not prevent possible costs resulting from additional red tape and customs disruptions, especially in early 2021 after the transition ends.
Building materials renato.panichi@spglobal.com Given the local nature of the building material industry, we believe that the lack of any deal would cause limited short-term disruption to companies in Continental Europe. Instead, distributors in the U.K. could have some short-term risk of supply-chain disruption, including additional seasonal working-capital requirements. Foreign-exchange volatility could also affect their supply chains and operating results. Medium-term effects would depend on the shape of the recovery of the currently subdued U.K. construction industry.
Capital goods tuomas.ekholm@spglobal.com We would not expect large-scale disruptions for major rated capital goods issuers, not even for the few headquartered in the U.K. The capital goods sector's supply chains are globally diversified, and dual-sourcing for critical parts is an industry standard. In addition, the U.K. is not a major manufacturing hub, and global supply chains have been stress-tested this year by COVID-19 without major disruptions. We expect the implications of a no-deal Brexit would be rather indirect, manifesting in the form of lost sales volumes, due to less industrial investment in the U.K.
Chemicals paulina.grabowiec@spglobal.com The U.K. chemical industry is one of the sectors that could be most affected by a no-deal Brexit. This industry is one of the largest manufacturing sectors in the U.K. and a net exporter, with majority of the trade with the EU. Areas of disruption could include additional costs related to tariffs and trade barriers, uncertainty around the regulatory environment and the U.K.'s equivalence once the EU's REACH oversight no longer applies, and the depreciation of the pound sterling. These factors could make purchases of imported feedstock more expensive. However, we believe that the impact on our rated issuers would be limited due to the diversity of their operations.
Consumer products barbara.castellano@spglobal.com We consider the impact of the Brexit transition on the credit quality of large U.K.-headquartered consumer products multinationals would be very limited. Regional players with high exposure to the U.K. would be affected by the inevitable supply-chain disruption and by potential foreign-exchange volatility. However, in the past two years they've put significant effort into supply-chain efficiency and preparing for a no-deal scenario. Consumer manufacturers' operational procedures, including logistics and stock controls, have also been strength-tested by the COVID-19 pandemic. Further ahead, U.K. consumer product companies will continue using the levers of product development, simplified stock keeping unit structures, and operational efficiency to cope with rising costs related to regulation and sustainability. We consider these risks to be part of the competitive landscape of this mature industry, resulting in a wide divergence in performance and quality of earnings among its players.
Leisure hina.shoeb@spglobal.com Some potential depreciation in the pound sterling because of no FTA could result in cheaper U.K. holidays, which could boost hotels and lodging companies to a faster recovery. However, this assumes that there are no major changes in mobility restrictions because of Brexit, a vaccine becomes widely available to the general population by mid-2021, and consumers become more comfortable travelling abroad. Similarly, we would not expect a material disruption within the gaming sectors, as all operators hold multiple separate licenses for operating within the U.K. and the EU.
Media natalia.goncharova@spglobal.com We would not expect a no-deal Brexit to materially affect the operating performance of companies in the media industry. There might be some impact in terms of the labor force, as there is high exposure to talent coming from all over the world, including the EU, to work in the media industry. In addition, any pound sterling depreciation could affect the credit metrics of companies with debt issued in other currencies, resulting from higher pound sterling-denominated interest and principal payments.
Metal and mining elad.jelasko@spglobal.com We would anticipate no rating actions and negligible other impacts from the lack of a trade deal on rated U.K.-domiciled or listed miners with foreign or global operations.
Oil and gas simon.redmond@spglobal.com The implications for oil and gas companies operating or based in the U.K. would be mostly currency-related and essentially neutral or marginally positive. A weaker pound sterling implies lower costs in a U.S.-dollar-based industry. Many of these companies have already bolstered liquidity to counter COVID-19 risks. Beyond 2021, moves toward Scottish independence could likely increase uncertainties for both continued development and decommissioning of assets in the U.K.
Pharmaceuticals and health care marketa.horkova@spglobal.com The health care sector is highly regulated, and it's our understanding that the leading players have already taken steps to prepare for a no-deal Brexit. These steps include the required licensing of medicines and devices, clinical trials, exporting active substances, pharmacovigilance procedures, and investments to IT systems. We understand that most companies are holding up to six months of inventory, and we therefore assume a low risk of medicine shortages in the U.K., including Northern Ireland (after the recent extension agreement signed in November 2020). However, more bureaucracy and complexity could increase administrative and procurement costs and cause delays along the supply chain.
Real estate franck.delage@spglobal.com U.K. office REITs are vulnerable to Britain's decision to exit the EU because tenants that benefit from EU trade agreements might decide to relocate outside the U.K. to continue operating across the EU. An adverse economic impact from reverting to WTO arrangements could also hamper companies' expansion plans in the U.K. and dampen overall demand for offices. Retail property REITs might also be affected, as rent would become less affordable for U.K.-based retailers damaged by any additional trade-related costs and the negative potential impact on consumption.
Retail and restaurants raam.ratnam@spglobal.com The retail sector could not escape the brunt of the operational and economic disruptions arising from the end of transition without an FTA. Domestic production only accounts for just over half of food consumed in the U.K., and the EU is the largest source of imported food and the main supply of all fresh food. In the short term, grocers and food retailers would be confronted with a multitude of supply and logistics challenges. While most have contingency plans, large-scale disruptions and delays at ports would present the possibility of shortages and higher prices, at least for some fresh food products. While nonfood retailers face less operational risk, as they are better positioned to plan their inventory pipelines, their credit quality has been significantly damaged by the effects of COVID-19. They would face further top-line pressures from drops in demand in the face of the weaker economy and higher import costs for some products due to a weaker pound sterling. Despite high competition, we expect pricing flexibility would be low, as operational costs and wages have already escalated due to the effects of the pandemic.
Service companies terence.smiyan@spglobal.com Ending the transition without a trade agreement would likely have limited impact on service companies, given they have no material cross-border trade and generally local workforces. At this stage, we also don't anticipate any material affects to recruitment, as U.K.-based services will instead continue to look at right-sizing their cost bases.
Technology thierry.guermann@spglobal.com A no-deal Brexit would have a limited impact on European technology companies. U.K. tech companies could face difficulties in accessing qualified staff in specific areas. However, for the large technology companies (Ericsson and Nokia, STMicro and Infineon, and SAP), the impact would be limited given the small exposures they have to the U.K. Similarly, we would not expect any disruption to the R&D or supply chains of hardware companies because such activities have limited exposure to the U.K.
Telecommunications mark.habib@spglobal.com We would expect little short-term impact given the domestic focus of telecommunications markets. If lower trade translates into reduced EU-U.K. travel, roaming revenues could fall. Over the longer term, weaker GDP could lower business spending on telecommunications projects and services and--to a lesser extent--economization by retail customers. If infrastructure equipment from the EU (Ericsson and Nokia) becomes more expensive, capex costs could rise. This would either slow the rollout of fibre and 5G or, if schedules are maintained, reduce free cash flow.
Transportation infrastructure juliana.gallo@spglobal.com The lack of an FTA by year-end would be marginally negative for U.K. airports (Heathrow and Gatwick) and Getlink, the holding company owner of Eurotunnel. The ratings on these entities have already been heavily affected by the pandemic. We believe basic connectivity will continue based on previously agreed contingency arrangements. Lower discretionary income could weigh on the fragile traffic recovery we forecast in 2021, while pound sterling depreciation could spur retail revenues per passenger. In addition, higher inflation could increase funding costs on retail price index (RPI) linked debt. As for ports and Getlink, the pre-Brexit stockpiling could probably reverse in the first half of 2021.
Transportation rachel.gerrish@spglobal.com Flying rights are a reciprocal benefit for both populations and economies. As such, we expect at least basic connectivity between the EU and U.K. would be maintained in a no-deal scenario to prevent flights from being grounded. We believe that in time, a comprehensive air transport agreement would be reached. Ownership and control is another issue that airlines have been preparing for since 2016. The airlines that we rate with material exposure to the U.K. have publicly stated that they are confident that they will comply with both EU and U.K. ownership and control rules post-Brexit. There could be some short-term disruption at borders for both goods and passengers. These issues, though material, have now been somewhat dwarfed by the impact COVID-19 has had on the aviation sector, as airline capacities, cost bases, fleet sizes, and ratings are now all very much lower following the industry's dismal year.
Utilities--regulated pierre.georges@spglobal.com We would expect very limited impact, as regulated utilities operate on British regional monopolies. There could be a longer-term impact on recruitment.
Utilities--unregulated pierre.georges@spglobal.com There would be limited impact, except for a potential disruption to part imports that could delay capex, difficulties in recruitment, and access to competitive financing.

Financial Institutions

osman.sattar@spglobal.com

A failure to reach an FTA would have no immediate impact on the ratings on U.K. or EU banks. Our outlooks on 40% of the top 100 European banks are already negative, highlighting the negative impact of the COVID-19 pandemic. Even under our base case of an economic recovery into 2021, we expect bank earnings and asset quality to remain challenged and pandemic-related downside risks to persist.

Against that backdrop, we see the effects of a potential no FTA between the U.K. and EU on banking sectors as indirect, arising from the possibility of further adverse consequences for economic activity and business and consumer sentiment and asset prices. We see this as a greater risk for U.K. banks than for most EU banks. Since the 2016 Brexit referendum, U.K. banks have assessed corporate customers' dependence on EU countries for export markets and supply chains. We expect banks will book any additional IFRS 9 provisions and possibly event-specific overlays in their fourth-quarter earnings due to weaker macroeconomic assumptions and disruption to the most affected corporate sectors. At the same time, we see U.K. banks' liquidity buffers providing a sizable cushion against market volatility, supported by the Bank of England's measures to ensure sufficient banking-system liquidity.

Among EU banks, we believe Irish banks would be the most exposed. This is due to the significant trade links between Ireland and the U.K., Irish banks' exposure to U.K.-focused exporters/sectors like agriculture, and some Irish banks--including the two largest--having direct commercial banking operations in the U.K. To a lesser extent, banks in open economies with strong links to the U.K.--like the Netherlands, Belgium or Denmark--could also experience a moderate deterioration in the credit quality of their exposures to export-oriented companies. Overall, we would not expect these factors alone to lead to any near-term negative rating actions on EU banks.

Any failure to reach an agreement could mean greater political uncertainty and market volatility, particularly in the U.K., that could ultimately affect investor sentiment over banks, which are confidence-sensitive institutions.

We do not include government support in our U.K. commercial bank ratings. As such, any changes in the U.K. sovereign credit rating would not automatically affect these ratings.

Insurance

U.K.: tatiana.grineva@spglobal.com

Europe: volker.kudszus@spglobal.com

In a no-deal scenario, the long-term implications for the U.K. economy could in our opinion threaten income levels, growth prospects, government finances, external financing prospects, and financial markets. These significant effects might have ripple effects for the insurance industry, which is correlated with economic developments. The shift to a new post-Brexit regime will also occur when the U.K.'s economic recovery from the pandemic is still fragile.

However, we anticipate that within the U.K. insurance sector, downward outlook revisions would be more common than rating downgrades. We don't anticipate that U.K. insurers' business risk profiles will change significantly after the end of transition, as most insurers have already incorporated subsidiary companies within the European Economic Area (EEA). An abrupt switch to a no-deal with the EU could also have long- and short-term effects on financial markets, such as increased equity volatility and collateral requirements or reduced liquidity. We believe the industry's strong capital adequacy should be sufficient to help it weather the short-term effect of any insurance or investment losses arising from these events.

From an EEA perspective, we do not expect that any insurer ratings would be affected by the lack of an FTA. Since the Brexit referendum in 2016, EU insurers have been preparing for this potential separation. For example, many U.K. branches of EU insurers have been transformed into subsidiaries to accommodate potential U.K. regulation. Potential developments like capital-market volatility might have a limited impact on investment returns, but we would not anticipate a sustained, material drop in investment markets in Europe that would hurt EU insurers' capital adequacy. Some EU insurers have investment concentrations with banks--some headquartered in the U.K.--including a substantial volume of over-the-counter interest rate swaps (and swaptions). However, in recent years, U.K. banks have opened headquarters in the EU, and most EU insurers have redomiciled assets and hedges back into the EU.

To minimize disruption, the U.K.'s FCA is also preparing for all post-transition scenarios, such as allowing firms to continue to access U.K. trading venues in the absence of mutual equivalence. Chancellor of the Exchequer Rishi Sunak announced on Nov. 9, 2020, that the U.K. would be granting a package of equivalence decisions to EEA states, including the EU states. These will allow non-U.K. companies to operate in the U.K. immediately after the transition period--that is, when passporting ends on Dec. 31, 2020--without any disruption to their businesses.

U.K. Public Finance

felix.ejgels@spglobal.com

We believe that public universities would be relatively immune to a no-FTA Brexit. Although the enrollment of EU students could decrease, this drop would be offset by higher enrollment of overseas students, which has happened so far in 2020. We also expect that additional grants from the U.K. government and an abundance of market liquidity would make up for a termination of EU grants and access to European Investment Bank funding. Fragmented involvement in EU-wide research projects could damage the reputation of U.K. universities in the long term, however.

Social housing and local authorities might suffer if the real estate market-- residential and commercial--remained soft for a prolonged period. If this were to happen, their revenues could decrease, but the effect would be a gradual budget loss. The Public Works Loan Board covers short-term funding needs of local authorities, while social housing landlords have generally maintained solid liquidity. We expect that Transport for London will unlikely be affected more than it already has been by COVID-19.

Structured Finance

andrew.south@spglobal.com

We do not foresee any cliff-edge effects in European structured finance where the intended functioning of transactions is dependent on the outcome of U.K.-EU trade negotiations. Instead, given the diverse nature of collateral pools backing European securitizations and covered bonds, we anticipate that any differential effects will only be felt more gradually as wider macroeconomic implications filter through to underlying credit performance. U.K. housing will be one area of focus, though any incremental stress due to the Brexit outcome might prove insignificant relative to effects surrounding the pandemic and the eventual roll-off of associated fiscal and monetary support. That said, the operation of European securitization markets more broadly will see significant changes from Jan. 1, 2021. Notably, the lack of full reciprocal recognition between the EU27 and U.K. regulatory frameworks for securitizations would mean that U.K. transactions can no longer carry the EU incarnation of the "simple, transparent, and standardized" (STS) quality label, leading to higher regulatory capital charges on such holdings for some EU investors.

Related Research

This report does not constitute a rating action.

Primary Credit Analysts:Paul Watters, CFA, London + 44 20 7176 3542;
paul.watters@spglobal.com
Boris S Glass, London + 44 20 7176 8420;
boris.glass@spglobal.com
Osman Sattar, FCA, London + 44 20 7176 7198;
osman.sattar@spglobal.com
Patrick Drury Byrne, Dublin (00353) 1 568 0605;
patrick.drurybyrne@spglobal.com

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