Britain was stripped of its AAA-rated debt status for the first time ever on Friday night in a move that puts pressure on George Osborne, who had pledged to use his austerity measures to protect the rating.
The chancellor, who had 12 hours' notice of the decision by Moody's ratings agency, insisted he would stick to his course and had "redoubled" his resolve to tackle Britain's financial problems. However, the downgrading will have major political implications for the coalition.
Labour and the Tories acknowledge that the next election is likely to be decided on the debate over the best way of fixing the economy. Osborne, however, will be forced to listen to a series of opposing politicians reminding him of his previous promises that he would maintain Britain's top rating. Shadow chancellor Ed Balls saidon Friday: "This credit rating downgrade is a humiliating blow to a prime minister and chancellor who said keeping our AAA rating was the test of their economic and political credibility."
Moody's, the first of the major agencies to remove the UK from the elite club of AAA countries, blamed "subdued growth" and a "high and rising debt burden" for the decision to cut the rating by one notch to AA1.
The rating is significant because it can affect a country's cost of borrowing and is also symbolic to governments determined to prove their economic credentials. Sterling may now be expected to come under pressure on foreign exchange markets.
Osborne, who has often cited the importance of the triple-A status said: "Tonight we have a stark reminder of the debt problems facing our country – and the clearest possible warning to anyone who thinks we can run away from dealing with those problems. Far from weakening our resolve to deliver our economic recovery plan, this decision redoubles it. We will go on delivering the plan that has cut the deficit by a quarter, and given us record low interest rates and record numbers of jobs."
As far back as February 2010, he told an audience of Tory activists: "What investor is going to come to the UK when they fear a downgrade of our credit rating and a collapse of confidence?" In the Tory manifesto, published weeks later, he said: "We will safeguard Britain's credit rating with a credible plan to eliminate the bulk of the structural deficit over a parliament."
Balls said the decision by Moody's showed that chancellor was running out of credibility. "George Osborne said keeping the credit rating was the key goal of his economic policy. As his economic plan has floundered, it has been the last thing he has clung on to. And bizarrely his response tonight suggests he is not reflecting on why things have gone so badly wrong, but using this downgrade as one more reason to plough on with his failing plan – regardless of the damaging impact on struggling families and businesses. The issue is no longer whether this chancellor can admit his mistakes but whether the prime minister can now see that, with UK economic policy so badly downgraded in every sense, things have got to change.
"In the budget the government must urgently take action to kickstart our flatlining economy and realise that we need growth to get the deficit down," he said.
"If David Cameron and George Osborne fail to do so and put political pride above the national economic interest, we face more long-term damage and pain for businesses and families."
Moody's decision to cut the rating without awaiting the detail of Osborne's 20 March budget may surprise some economists, but it decided to move now because of the evidence of a "high and rising debt burden".
With the UK one quarter away from a triple dip recession, Moody's blamed "continuing weakness in the UK's medium term outlook with a period of sluggish growth which Moody's now expects will extend into the second half of the decade".
But it added that a "combination of political will and medium term fundamental underlying economic strength will, in time, allow the government to implement its fiscal consolidation plan and reverse the UK's debt trajectory".
Moody's has now placed the UK rating on a "stable footing" but its rivals Standard & Poor's and Fitch have the country under review for a potential downgrade.
Lord Oakeshott, the Lib Dem peer and close ally of the business secretary Vince Cable, said he believes the markets have fallen because bank lending and housebuilding are "flat on the floor".
"If there is no change, the economy is going to remain being stuck. It matters most for him [George Osborne] because he was the one saying that before the election that it wouldn't happen," he said.
"The policies are not bold enough, they are not working, the economy is flat and I am afraid that the economy is just not working."
As well as chiding the chancellor, Balls was critical of Moody's, and warned it was important not get carried away with what it or other ratings agencies said.
"Tonight's verdict does not change the fact that the credit rating agencies have made major misjudgments over recent years, not least in giving top ratings to US sub-prime mortgages before the global financial crash.
"But what matters is the economic reality that the credit rating agencies are responding to. Moody's themselves say the main driver of their decision is the weak growth in Britain's economy.
"Their judgment is in response to nearly three years of stagnation, a double-dip recession, billions more borrowing as confirmed this week and broken fiscal rules. This is why the chancellor is fast running out of credibility."
This quarter is regarded as crucial for the chancellor if the country is to avoid a triple dip recession following the 2008 banking crisis which led to sharp reductions in growth in early 2009.
The economy contracted by a surprise 0.3% in the last three months of 2012 and if it shrinks again in the subsequent three months it would be regarded as once again in recession. Employment, though, ended 2012 at 29.7m – the highest number of people in work since records began in 1971.
Sterling had been jolted earlier in the week when it emerged that Bank of England governor Sir Mervyn King had wanted to print more electronic money – quantitative easing – in an effort to bolster growth. In the last minutes of trading in New York on Friday, sterling was knocked down to $1.516, but is expected to come under pressure when Asian markets open for trading on Monday. Moody's also cut the central bank's rating last night.
"It's a pretty big deal. We didn't see a huge reaction in the pound because it's late in the New York session but you'll see some more aggressive selling when the market opens (in Asia) on Sunday," Kathy Lien, managing director of BK Asset Management in New York told Reuters.
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