Small Potatoes

Story Highlights:

• On Thursday, Standard & Poor's (S&P) lowered its rating outlook for the UK from stable to negative, based on the UK's escalating net public debt and uncertainties surrounding fiscal tightening policies.
• The "negative" outlook could eventually lead to a downgrading of the UK's current AAA credit rating, and could make it costlier for the UK government to borrow.
• A lowered outlook doesn't always lead to a rating change, and some UK rating assessments can't happen until after elections in mid-2010—giving investors plenty of time to evaluate the situation.
• Ultimately, credit ratings are just one factor in determining a country's borrowing costs.

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A change in status can be costly. Just ask Pringles. British judges recently deemed the snack a potato chip despite arguments it contains little potato content—and thus subject to a 15% national tax. But whether Pringles are considered potato (or "potahto") doesn't change the product—only its classification. Likewise, a threat to the UK's AAA sovereign credit rating could raise borrowing costs for the government, but it doesn't necessarily change the country's credit worthiness—just its classification, as given by credit agencies.

The UK's current AAA sovereign credit rating puts the country among the world's safest borrowers. (For a quick breakdown of ratings, click here.) But on Thursday, the credit agency Standard & Poor's (S&P) lowered its rating outlook for the UK from stable to negative, based on the UK's escalating net public debt (projected to reach £1.4 trillion over the next five years) and uncertainties surrounding fiscal tightening policies due to upcoming elections.

Rating outlooks assess what potential direction a rating may move, meaning the UK's "negative" outlook could eventually lead to a downgrading of its current AAA rating. A cut in credit rating could make it costlier for the UK government to borrow, because a lower rating means a higher default risk default, and thus lenders require more compensation to lend.

Downgrade fears may have sunk global markets Thursday. But a lowered outlook doesn't always lead to a rating change. S&P will take up to two years to assess how well the UK government can stabilize and reduce its debt burden before making an actual decision. Some assessments can't happen until after the UK elections—in mid-2010—giving investors plenty of time to evaluate the situation. Plus, in lowering the UK's outlook, S&P didn't cite lack of competitiveness or diminished productive capacity—which were among the risks given when credit ratings for Portugal, Greece, Spain, and Ireland were downgraded.

The UK credit outlook revision may raise fears the US—another country with swelling public debt—could suffer the same outlook cut and rating downgrade threat. But even if the UK and US were downgraded a notch or two from AAA, what does that mean? What do ratings mean, for that matter? Recall, major credit agencies, including S&P, issued positive outlooks and investment grade ratings (BBB or better) to various "toxic" CDOs and large financial institutions even in the months before the financial crisis. So exactly how predictive or viable are outlooks and ratings to lenders and borrowers? Ultimately, credit ratings are just one factor in determining a country's borrowing costs.

Right now, the UK, US, and several other major governments are running large budget deficits to combat recession, stabilize the banking system, and loosen credit. Aggressive fiscal spending now is appropriate, and public debt levels will likely revert to suitable levels as economies regain order and spending eases. A lower credit outlook today may be hard for the UK government to swallow, but worrying over credit ratings is small potatoes next to doing what's needed to right the economy.