DBRS: U.K. election risks to fiscal adjustment remain modest

Neither the Conservatives nor Labour have established a conclusive lead in the opinion polls (both around 33.5% each on average), while the Liberal Democrats have seen their position decline to 8% from 23% in 2010. Moreover, the rising support for the Scottish National Party (SNP) following last year’s independence referendum and for the Euro-skeptic Independence Party (UKIP) pose increasing challenges for the main parties, potentially depriving them of key seats in the election. Based on current opinion polls, the SNP looks to become the third largest party in the UK, likely to win up to 56 seats located solely in Scotland. By contrast, despite its visibility in the opinion polls, UKIP could win fewer than five seats.
The decline in support for the three mainstream parties and the rising popularity of the alternative parties makes the outcome less predictable than in 2010. Based on current projections of seats in parliament, DBRS’s current view is that the most likely outcomes are a minority single party government (Conservatives 280 seats or Labour 270 seats) or a minority coalition (Conservatives with the Liberal Democrats 27 seats, or Labour with the Liberal Democrats with external support from the SNP 47 seats). A Labour coalition that included the SNP is currently unlikely, but not impossible as it could contribute to a majority coalition.
However, neither a period of political uncertainty following the elections, nor the composition of the next government would likely affect DBRS’ AAA Stable sovereign ratings on the UK. All three major parties share a consensus in favour of fiscal consolidation, even if the approach and pace differ to some extent. Moreover, the robust fiscal framework in place and the oversight by the independent Office for Budget Responsibility (OBR) create sizeable constraints against fiscal loosening.
DBRS also believes that a period of political uncertainty is less concerning than at the time of the last election in 2010 when the economy was in the early stages of the recovery and the fiscal deficit was much more precarious at 10% of GDP. Since then, the economy has recovered and is on a stable path, with real GDP estimated to grow an average 2.5% over 2015-2016 and the headline deficit set to be 4.3% of GDP this year.

Political risks are modest
A period of moderate uncertainty seems likely following the election if cross-party negotiations are required before a government can be formed and a set of policy priorities agreed upon. From a policy perspective, DBRS does not expect a substantial deviation from the current fiscal policy stance. All three major parties likely to be part of any coalition or minority government remain committed to a multi-year fiscal consolidation programme.
The strong cross-party support for the Charter for Budget Responsibility, which was passed into law in mid-January means that the Conservatives, Labour and Liberal Democrats have similar fiscal targets. These are: (i) a cyclically adjusted current balance on a rolling three-year horizon and (ii) a falling debt-to-GDP ratio in 2016-2017. These fiscal targets are similar to those of the current coalition and would, if adhered to, be sufficient to put the debt to GDP ratio on a steady downward trend over the medium term.

Parties agree on fiscal consolidation
In the 2015 Budget, the OBR estimated that the incumbent coalition’s fiscal plans would tighten policy by 5% of GDP over five years. This would put the debt-to-GDP ratio on a downward trend, falling to 81.4% in 2019-2020 from 88.8% in 2015-2016, and would turn the cyclically adjusted current balance from a deficit of 2.2% of GDP into a surplus of 2.1% of GDP in 2019-2020. These plans are in excess of the Charter for Budget Responsibility (CBR) targets, which only require a zero cyclically adjusted current balance deficit, not a large surplus.
The main difference between the three main parties over fiscal policy would likely rest with the size, the pace of the consolidation and the composition of the expenditure cuts and increases in taxes. The Conservatives have pledged to eliminate the deficit by 2018-2019, largely through departmental spending cuts and welfare spending reductions with no major tax hikes. Labour and the Liberal Democrats have also committed to fiscal consolidation and aim to meet the CBR targets, but not to over-achieve.
Labour, in particular, advocated a fiscally neutral mix of a higher tax burden (imposing a tax on expensive properties, raising the top rate of income tax, and increasing the tax on the banking sector) and additional spending. The Labour plan may translate into a target for a cyclically adjusted current surplus of 0.5% of GDP, consistent with the CBR targets, allowing for extra spending from 2017-2018 onwards versus the Budget plans. As a result, a Labour-led government would need to tighten fiscal policy by 2.5% to 3% of GDP in the first three years after the election (similar to the coalition’s current plans), with a neutral stance thereafter. Such an approach would produce a less-rapid decline in the debt-to-GDP ratio after 2017-2018 than the Budget plans. Nevertheless, DBRS considers that this approach would be sufficient to produce a low fiscal deficit and a steady decline in the debt-to-GDP ratio over the medium term.
DBRS expects this outcome would also occur with a Labour-led coalition with the external support of the SNP which advocates similar spending plans to Labour and would likely to support Labour’s plans for a slower fiscal tightening. Overall, DBRS expects fiscal consolidation to remain on a gradual path, with a modest tightening for the next 2-3 years, regardless of the election outcome.

Increased risk of break-up
An election outcome that results in a greater role for the SNP in the UK government could well renew concerns about the potential for a break-up of the UK. An increased SNP role could embolden those who favour independence for Scotland. At the same time, it could exacerbate unease in England over the role of Scottish MPs in governing English affairs and the perceived fiscal impact of devolution. Over time, such pressure coming from both sides could put more momentum behind Scottish independence. Moreover, discussion of EU membership could exacerbate such tensions.

Uncertainty over EU membership
A Conservative-led majority government would raise the risk of an eventual departure from the EU because it would be committed to hold a referendum by the end of 2017. Whether the referendum yields a yes or no vote will crucially depend on how a Conservative-led government manages to renegotiate conditions of the UK’s membership in a number of policy areas prior to the referendum. These include: enhancing competitiveness through less regulation, policy flexibility through opt-out rules, returning power to member states, and immigration policy changes. If renegotiations are successful, the government could present the results to the British electorate and support continued membership of the EU.
If the likelihood of the UK leaving the EU were to increase substantially, DBRS would need to evaluate the impact of such an event on the UK's economy. The risk of an exit could endanger access to the EU single market, which accounts for around 50% of UK trade. A potential exit could also reduce foreign direct investment (FDI) ahead of the referendum. The stock of inward FDI in the UK ($1.6 bln at end-2013) accounts for 60% of UK GDP and is the highest of any European country.
Over the medium-term, the repercussions for the UK from leaving the EU would partly hinge on what alternative trade agreements the UK could negotiate bilaterally with the EU. With the UK importing more from the EU than it exports, and UK GDP worth 14% of total European GDP, DBRS expects that the UK would succeed in negotiating a new settlement that replicates at least part of current trade arrangements. However, not reaching such a settlement would adversely impact business investment and growth prospects with potentially negative implications for DBRS’ sovereign ratings on the UK.