How UK's Downgrade from AAA Credit Impacts Your Portfolio

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Investors and consumers alike know the value of a good individual credit score. Corporate and government credit ratings are even more important, as most businesses and governments operate on credit instead of capital. Should the UK lose its all important AAA credit rating, shock waves will be felt around the world.

UK and Banking

The UK and the banking industry are nearly synonymous – even more so after nationalization pinned the two enterprises together. Prior to the fiscal chaos of recession, however, the UK had a thriving banking industry that drew billions of dollars of wealth from the rest of the world. Its banks were solvent, they produced decent interest yields, and the pound as a currency was relatively stable. Simply, the United Kingdom was making money by being the bank for the rest of the world.

Fast Forward to 2008

The next chapter in this financial story is titled “depression.” What was once making billions of dollars each year for the largest institutions in the world suddenly fell into ruins. Investors were left holding the bag, and banks were left with now worthless portfolios. In banking, it takes a tremendous amount of money to make even more money, and without capital or credit, the banks were unable to function as they had previously.

The Government Will Pay the Private Enterprise Price

In an effort to boost credit ratings of leading institutions, many world governments offered to issue or back debt on behalf of the banking sector. What happened initially is that investors and other government bodies were happy with the solution; bank balance sheets looked better and investors were willing to do what they do best – invest in the banks. But then investors realized that the debt merely shifted from one body to another, and the governments, instead of the banks, were on the hook for trillions. The problem was even more leveraged in the UK, where the banking system is one of the largest generators of profit for the nation. Banking is their leading export, if you could consider financing an exportable product.

Currency Wars

The Daily Telegraph reported that both Moody's and Standard and Poor's would each review the credit rating of the UK government. On that news alone, the British Pound lost 2% against the US Dollar in a matter of hours as investors, cautious to any changes in credit rating, sold off the Pound in order to limit exposure. Even though Moody's later announce they were not officially reviewing the UK's government, investors still remain leery.  

The drop of 2% was the first indication that investors would be quick take action on any credit rating changes. The “buy the rumor, sell the news” wisecrack is evident; should the credit rating for UK be downgraded, billions of dollars would flow out of the UK immediately, and sales of government debt would flood the market with excess Pounds.

At this point in time, it is important for the world’s governments to have sound ratings, or else they're forced to pay back even more through interest on their debt.

Government Debt

Government debt is usually considered a store of wealth rather than an investment because of how little each bond yields. Investing in government debt rarely provides a return greater than that of inflation, and subsequently investors actually lose by investing, even with positive yields. When a government experiences a drop in credit rating, however, the expense is paid in higher costs to service the debt. Investors view the government as a greater risk, and as a result, want more compensation for taking part in such risky endeavors.

An Endless Cycle

The vicious cycle of a falling credit rating slowly compounds itself. As governments pay more to service debt, they often become more indebted, as spending is not reeled in to reflect the new interest payments. A further drop in credit rating puts the top nations of today on the same level as that of the developing world. The only way to solve the problem, at that point, is by stimulating inflation, which again increases the rates that investors expect for their capital.

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