(As a longtime Anglophile with an English grandfather and Scottish grandmother, I am taking a break from watching Ontario, Canada to comment on the 23 June referendum in Britain.)
Belittling European neighbors is a favorite sport of British politicians calling for the United Kingdom (UK) to leave the European Union (EU) in the June 23rd referendum. “Leave” campaigners take particular delight deriding France’s economic weakness and misguided policies. Former London Mayor Boris Johnson once called French President Hollande’s government “sans-culottes” -- meaning low-class revolutionaries lacking proper trousers. In a European Parliament debate, UK Independence Party leader Nigel Farage mocked France as a “pipsqueak”.
By most economic measures, the UK is well ahead of France. The UK unemployment rate of 5.1% for the 1st quarter of 2016 was half France’s 10.1%. The UK economy has grown at a 2.1% annual rate over the last 20 years vs. 1.5% for France. With its own floating currency, the UK controls its own monetary policy. France trapped itself in the euro zone with an exchange rate too high for the uncompetitive French economy.
A government’s bond rating is a summary measure of how a country ranks relative to other countries in economic strength as well as political stability and its history of paying debts on time. The UK does indeed outrank France on the bond rating scale.
Standard & Poor’s (S&P), one of the most influential risk assessment agencies in global financial markets, rates bonds issued by 126 sovereign nations. S&P grants its top AAA rating to the UK and only 12 other countries. In addition to the UK, 5 other AAA countries are EU members –- Denmark, Germany, Luxembourg, Netherlands and Sweden.
S&P ranks UK bonds higher than even United States (US) government bonds. S&P demoted the US from AAA to a AA+ rating in 2011 when the Republican Congress threatened to halt bond payments in a budget fight with President Obama.
France ranks even lower with a third-tier AA rating. Ironically, if Johnson and Farage win the referendum on Britain’s exit from the EU (now widely called “Brexit” for short), one of the first aftershocks will be a rating downgrade that could ultimately knock UK bonds back to the same level as pipsqueak, no-pants France.
After Prime Minister David Cameron’s EU referendum plan was confirmed by his re-election in 2015, S&P warned the UK that its top AAA rating was at risk. S&P assigned a “negative outlook” to the UK’s rating because the referendum “could negatively affect sustainable public finances, balanced economic growth, and the response to economic or political shocks”.
Many British voters have tuned out the conflicting economic arguments in the referendum debate. Each side claims the UK’s future will be rosy if their campaign wins and dire if their opponents prevail. Undecided British voters can cut through this confusion by paying attention to how professional risk assessors from the rating agencies view the UK’s prospects after Brexit.
Of course, the majority of Britons do not own bonds and may never have heard of S&P or any other rating agency. For these voters, an analogy with English soccer football might help. Think of the UK’s AAA rating as similar to S&P ranking the UK as a member of the elite Premier League of only the safest government bonds.
With their “negative outlook” warning, S&P told Britons that their country’s bonds are still top-ranked AAA for now, but risk being relegated to the AA+ second tier. In other words, UK bonds are like the Crystal Palace football club – barely hanging on in the Premier League after finishing the 2016 season just above the bottom 3 clubs sent down to the second-tier Championship League.
Moody’s Investors Service, whose clout rivals S&P’s, already rates UK bonds in their second-best Aa1 rank. For Moody’s, UK bonds are like Leeds United – no longer great enough to be a top Premier League side, but as a Championship League member still more reliable than most English football clubs.
Like S&P, Moody’s rates France’s bonds in its third tier, which Moody’s calls Aa2. In other words, France ranks in the Football League One of bond ratings. Think of France’s standing in the world of government bonds as similar to Scunthorpe United’s in English football.
Bond rating agencies and football associations both use grade inflation to make their clients feel better. An A+ bond rating from S&P sounds good. After all, A+ is the top grade for students in school. However, A+ is S&P’s fifth-best bond rating. Similarly, the title, Football League One, hides the truth that this is England’s third-best league. Indeed, Football League One was formerly known as the Third Division.
Both S&P and Moody’s have warned that Brexit could knock the UK bond rating down to their equivalent of the Third Division. Earlier this year, Moritz Kraemer, S&P’s Chief Rating Officer for government bonds, told Reuters that “departure from the EU … could lower the (UK) rating by potentially more than one notch, depending on the circumstances, such as the expected future relations with the EU”. A 2-notch demotion would drop the UK’s bond rating to third-tier AA, the same level as France.
Senior Vice President Kathrin Muehlbronner stated Moody’s view that “the economic costs of a decision to leave the EU would outweigh the economic benefits. Moody's would consider … assigning a negative outlook to the (UK) sovereign's Aa1 rating following a vote to exit, pending greater clarity on the longer-term impact.” In other words, if Brexit subsequently had the feared negative impact, Moody’s would cut its UK bond rating to third-tier Aa2, the same level as France.
A country’s bond rating matters for more than just national pride. Investors around the world treat S&P and Moody’s ratings as report cards on countries’ economic prospects. If Britons vote to leave the EU and ratings fall for UK government bonds, a knock-on effect would depress bond ratings for businesses based in the UK. In a forthcoming Journal of Finance article, Professors Almeida, Cunha, Ferreira and Restrepo “find that firms reduce their investment … due to a rising cost of debt capital following a sovereign rating downgrade”. Lower business investment would slow the UK economy both short-term and long-term.
Boris Johnson is so popular with Conservative Party members that he will likely succeed David Cameron as Prime Minister regardless of the referendum result. Paradoxically, a future Prime Minister Johnson would have an easier time managing the UK economy if his anti-EU campaign falls short on June 23rd.
If the UK remains in the EU, S&P might remove the “negative watch” outlook attached to the UK’s AAA rating. To return to the football analogy, the UK economy and government bonds would be viewed more like Manchester United near the top of the Premier League than Crystal Palace near the bottom.
On the other hand, if Brexit wins, Boris Johnson would take charge of a country with uncertain prospects and a bond rating heading to the status of third-tier France. If he wins the referendum, we can think of newly installed Prime Minister Johnson as like a Premier League assistant manager, who successfully plots to replace his boss only to find that his ascension to the manager’s chair coincides with his side’s slide down to the Third Division. Johnson's only consolation as Prime Minister may be sporting slightly nicer trousers than the President of France.