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A post referendum Scottish credit risk assessment

By Daniel Broby - Posted on 14 July 2016

The uncertainty following the EU referendum impacts the price of borrowing. Here, Daniel Broby of our Accounting & Finance department explains the implications for credit ratings.

The political farce that has followed from the referendum gives rise to the very real possibility of an independent Scotland. This would mean the break-up of the United Kingdom. In such a scenario, the separate entities would need to fund their respective governments through a blend of taxation and borrowing. This would require that Scotland gets its own credit rating.

A credit rating is a way for financial markets to determine how likely a country is to be able to repay its debts. It also helps traders determine the price of a country’s bonds. In this respect, a country credit rating helps assess the fair price for debt.

Following the referendum, the United Kingdom was downgraded from the highest AAA rating by Standard and Poors. It was also downgraded by the Fitch rating agency from AA+ to AA. These downgrades, as economists and political commentators have been quick to point out, are based on the forecast of an “abrupt slowdown” in growth.

Uncertainty is always bad for financial markets because it impacts the ability to make informed decisions. Businesses defer investment and individuals are hesitant to make big spending decisions. With potentially far reaching changes to the legal and regulatory environment, such uncertainty is the highest it has been since credit rating agencies began their assessments.

The possibility of Scottish independence increases the risk that the United Kingdom will face another embarrassing downgrade in its credit rating. Last year, S&P said it would expect Scotland to ‘benefit from all the attributes of an investment-grade sovereign credit.’ The technicalities of the way such ratings are calculated gives rise to the possibility that Scotland could enjoy a higher S&P rating than England in a dissolution scenario. In contrast to guidance by S&P, the Fitch rating agency has ruled out giving a new Sovereign Scotland a AAA rating.

Most likely, Scotland will have a good rating but not the best. Based on Standard and Poor’s guidance and our own analysis Scotland would only enjoy a AAA rating under the following scenario:

• Scotland avoids a recession
• Scotland is apportioned its share of United Kingdom debt on a per population basis
• Scotland remains in the European Union and the rest of the United Kingdom leaves
• Scotland wins a substantive amount of business from the City of London but loses the balance sheet risk of its banking institutions due to relocation of their head offices.
• Scotland has its own currency, not the Euro or the British Pound.

Fitch cited the possibility of Scottish independence in their downgrade of the United Kingdom. They observed that such an outcome “would be negative for the United Kingdom’s rating, as it would lead to a rise in the ratio of government debt/GDP, increase the size of the United Kingdom’s external balance sheet and potentially generate uncertainty in the banking system.”

Moody’s, which was the first rating agency to cut the United Kingdom’s AAA rating has gone on record as saying it would only assign Scotland an A rating.

In view of the lower price of crude Brent oil, the economic impact of the current uncertainty and the risk that the political situation may deteriorate further, we expect that Scotland would enjoy an S&P credit rating a notch below AAA were it an independent European Sovereign nation. This would mean that Scottish issued debt would be high quality with very low credit risk, but with a susceptibility to long-term risks.

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