Britain 'could lose cherished AAA credit within 12 months'

Investment chief at Pimco warns of disaster facing UK's public finances and banking

Economics Editor,Sean O'Grady
Friday 02 April 2010 00:00

One of the world's most powerful investment houses has given notice that Britain's cherished AAA credit rating could be lost within a year, with disastrous consequences for the public finances and the stability of the financial system.

Scott Mather, the head of global portfolio management at the world's largest bond investor Pacific Investment Management Co (Pimco), also said the eurozone's potential joint bailout of Greece with the International Monetary Fund would be ineffective.

On Monday, there was a marked sell-off of Greek government debt and an auction of bonds on Tuesday went badly. The spread between the yield on Greek bonds and German Bunds soared again to 340 basis points. Pimco has previously said that Greece's "initial conditions and demographics are abominable".

Pimco is reducing the weight of UK, US and European sovereign debt in its portfolios. "Miracles are needed in the next six months in order to keep economic growth in the developed world," Mr Mather said. Pimco stated last month that it was keeping its negative outlook on British gilts because of fears of inflation and a further deprecation of sterling.

Mr Mather's intervention is the latest in a series of blows to hopes that Britain will be able to retain its AAA rating. A fortnight ago, the ratings agency Fitch said it was "uncomfortable with the fiscal adjustment path set out by UK authorities" and called for a "more credible and stronger fiscal consolidation plans during 2010". Moody's, meanwhile, said Britain had moved "substantially" closer to losing its AAA status.

Most dramatically, Bill Gross, the co-founder and co-chief investment officer of Pimco, said in January that "gilts are resting on a bed of nitroglycerine". This week, he heaped further pressure on the gilts market and sterling. Spreads on UK 10-year gilts have crept up to 14 basis points above those of Spain, one of the so-called Piigs – the eurozone's most indebted economies, comprising Portugal, Italy, Ireland, Greece and Spain, which have threatened the future of the single currency itself. With the end of the Bank of England's programme of quantitative easing – a £200bn injection of money into the economy through a programme of gilt purchases – a major underpinning has been removed.

Although the Chancellor trimmed his borrowing forecasts in the Budget, they are still among the highest among the advanced economies and well over 10 per cent of Britain's gross domestic product (GDP). The national debt will exceed £1.4 trillion by the end of the next parliament – or 100 per cent of GDP, which is regarded by most observers as dangerously high.

In such circumstances, the burden of debt interest, especially if rates rise sharply, could be unsustainable and require a government to impose ever-higher taxes and succumb to increasingly sluggish growth. This type of "death spiral" was raised earlier this week by Mr Gross.

In his April note to investors, Mr Gross said the flow of gilt issuance would "lead to inflationary conditions and a depreciating currency". That, in turn would reduce the foreign currency-equivalent return and push gilt prices down further. "If that view becomes consensus, then at some point the UK may fail to attain escape velocity from its debt trap," Mr Gross wrote.

Pointing to uncertainty and headwinds across the world, he added: "The uncertainty comes from a number of structural headwinds in Pimco's analysis: deliberating, deregulation, and the forces of deglobalisation – most evident now in the markets' distrust of marginal sovereign credits such as Iceland, Ireland, Greece and a supporting cast of over-borrowed lookalikes. All of them now force bond and capital market vigilantes to make more measured choices when investing long-term monies."

One factor that works in Britain's favour is the unusually long maturity profile of its debt, of 14 years. This means it takes longer for debt to "roll over" and makes it less likely that the nation will be faced with sort of short-term funding crisis that has afflicted Greece.

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