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Investors look past UK rating downgrade but flag risks ahead

FILE PHOTO: The Fitch Ratings logo is seen at its offices at Canary Wharf financial district in London

By Dhara Ranasinghe and Ritvik Carvalho

LONDON (Reuters) - Britain's finances put it among the most vulnerable major economies in the face of the coronavirus crisis, investors warned on Monday, even as markets appeared to look past a credit rating downgrade before a splurge in state spending.

Britain's government is ramping up fiscal expenditure, pledging hundreds of billions of pounds in loan guarantees and an unprecedented job retention scheme, while the Bank of England (BoE) has expanded its bond-buying programme - winning praise from many economists for the speed and scale of the stimulus.

It is not alone: across the world governments are opening the spending taps to deal with the virus.

The problem Britain faces is that its twin current account and budget deficits make it more vulnerable to investor sentiment than most - ex-BoE governor Mark Carney has said Britain depends on the "kindness of strangers" to pay its way in the world.

According to official data, Britain had a current account deficit of 15.86 billion pounds ($19.7 billion) in the third quarter of 2019.

Although that deficit has narrowed to its smallest since 2012, it remains sizeable at around 3% of gross domestic product versus just under 1% of GDP in France. Germany has a current account surplus of more than 7%.

"The UK is more vulnerable than others," said Jan von Gerich, an analyst at Nordea. "It's starting position going into this crisis, say versus Germany, was much weaker."

GRAPHIC: Mind the gap: UK current account deficit - https://fingfx.thomsonreuters.com/gfx/mkt/jznpnezrvlm/deficit.png

Confidence in Britain has been shaky since the 2016 Brexit referendum, and while a decisive election result in December re-introduced a measure of calm, investors say the end of a Brexit transition period this December will raise new uncertainties.

"When fundamentals turn sour for whatever reason then you have a currency which is more exposed to its current account deficit," said Jane Foley, senior currency strategist at Rabobank.

"And what we've been talking about is a worsening of UK fundamentals - the political issues, the Brexit issues, the public finance issues - and I think all of these together means that sterling is more vulnerable to a current account deficit than it was five years ago."

RATINGS CUT

With the large spending announcements this month and an expected explosion in the budget deficit and national debt, it was little surprise when Fitch Ratings on Friday downgraded Britain's sovereign credit rating to AA-, with a negative outlook.

Fitch expects Britain's public debt, as a share of gross domestic product, to rise to 94% in 2020 and 98% in 2021, from 84.5% in 2019.

For an interactive version of the graphic click, https://fingfx.thomsonreuters.com/gfx/editorcharts/ygdvzynlpwa/eikon.png

Morgan Stanley believes the British economy will contract 5.1% this year and the budget deficit hit 10.4% of GDP in 2020/21 - up from around 2.1% this fiscal year.

For now, markets are taking Britain's worsening finances in their stride.

Analysts downplay the significance of downgrades for highly developed economies unless they tip a country into junk status, which shrinks the pool of investors eligible to buy their debt. Britain can also count on its vast defined benefit pensions industry for reliable demand.

British government bond yields fell on Monday as investors shrugged off the downgrade, with 10-year bond yields down 5 basis points at 0.31%, heading back towards recent record lows.

Sterling's reaction was also limited - the currency recovered from an initial plunge to trade back above $1.24, holding the majority of last week's gains. The pound has seen some wild swings in recent weeks and is the second most volatile of the major 'G10' currencies.

Given vast public spending plans to rescue their economies, investors say many countries will see their credit ratings pressured, and some downgraded.

"Markets won't care about the UK sovereign being downgraded, just as they didn't care when many developed economies lost their top credit ratings a few years ago," said Mike Riddell, head of UK fixed income at Allianz Global Investors.

"Markets are obviously already fully aware that credit ratings everywhere are on a downward trajectory."

GRAPHIC: Current account balance - https://fingfx.thomsonreuters.com/gfx/mkt/azgpomjopdx/CAB.png

(Additional reporting by Saikat Chatterjee, Tommy Reggiori Wilkes and Ritvik Carvalho; Graphics by Ritvik Carvalho; Editing by Alex Richardson)