Fitch – Page 2 – Digital Finance Analytics (DFA) Blog

Biggest Threats to Dollar’s Global Supremacy are at Home

The US dollar will almost certainly remain the world’s most important reserve currency for the foreseeable future, as no other offers the same set of advantages to money managers, including central banks, or is as deeply embedded in the global financial system. The primary cost to the US is surrendered competitiveness due to dollar appreciation, but lower interest rates and unrivalled government access to funding bestow considerable benefits, ultimately supporting the sovereign’s ‘AAA’ rating.

The dollar dominates global bond markets, central bank foreign reserve holdings, international trade invoicing and cross-border lending. It is the standard currency used for commodity and other prices, and is the preeminent safe-haven asset and preferred store of value in times of financial turmoil. Crucially, the dollar is underpinned by the fact that the US Treasury market is the world’s largest and most liquid for risk-free assets, and the Federal Reserve operates independently of government with respect to the market, and in implementing policy more broadly.

The dollar’s role is so widespread that its supremacy is self-reinforcing. The additional costs and/or inconvenience of switching to another currency for transactions normally conducted in dollars create a high degree of inertia, making it difficult for other currencies to gain traction.

Calls for the dollar’s displacement were relatively infrequent — though not entirely absent — when US monetary policy was exceptionally accommodative in the aftermath of the global financial crisis. That changed in mid-2013 when the Federal Reserve announced it would begin to slow its asset purchases, causing considerable turmoil in emerging markets (the “taper tantrum”) and appeals to the Fed for greater consideration to be given to the international implications of its policy decisions.

The Fed now appears poised not only to continue with policy interest rate hikes that began in December 2015, but also to consider the pace and magnitude of eventual balance-sheet reductions. Dollar funding is already costlier in markets outside the US, and has been for several years, as reflected in elevated cross-currency basis spreads for several currencies versus the dollar. If they rise further, as they may when Fed balance-sheet reduction draws nearer, there will again be concerns about global stresses associated with Fed tightening and inevitable suggestions that the dollar’s hegemony be somehow curtailed.

Realistic, immediately available alternatives to the dollar are limited. It is important to note, however, that the dollar is not alone either as a reserve currency or in many of its other global roles; it is just the biggest player. Other recognised reserve currencies (tracked by IMF data) are the euro, Japanese yen, pound sterling, Swiss franc, Australian and Canadian dollars
and Chinese renminbi.

In most instances, financial markets in countries that have reserve currencies are far too small to pose a threat to the dominance of the dollar. The most obvious candidate to replace the dollar is the euro, given the size and depth of euro-denominated capital markets as well as the credible focus of the European Central Bank on controlling inflation. However, for at least as long as the currency zone is plagued by lingering existential risks amid questions over possible member withdrawals, it will not be in a position to overtake the dollar. The renminbi is growing rapidly in trade settlement, but neither it nor the yen offer truly risk-free assets given their sovereign ratings, and China seems some distance from having an open capital account and fully internationalised currency even if it were rated higher.

The lack of a ready substitute, however, does not mean the dollar’s current position is entirely assured. Perhaps the most plausible scenario for the dollar being meaningfully displaced does not begin with the emergence of a viable alternative, but rather it being undermined at home.

Two pieces of legislation currently working their way through Congress are the Federal Reserve Transparency Act (FRTA) and the Financial Choice Act (FCA). The first would allow the Government Accountability Office to audit the monetary policy decisions of the Fed and make subsequent recommendations for administrative or legislative actions. The second would restrict the Fed’s ability to provide financial sector support to avert or address a crisis, and empower a commission to review and recommend changes to the Fed’s operations, as well as to consider a rules-based rather than discretionary monetary policy framework.

It is the unambiguous intention of these legislative initiatives to curtail the independence of the Fed and allow for greater congressional oversight of monetary policy as well as the Fed’s regulatory decisions and interventions related to financial stability. If implemented, the proposals would diminish the appeal of the dollar as a reserve currency over time. Investors
considering dollar assets and other dollar exposures would weigh the risk of political interference in monetary policy decisions and the possibility of the Fed’s remit being broadened to include congressional priorities such as indirect funding of infrastructure investment. There may also be concerns about episodes of financial sector stress being deeper and more prolonged if the Fed’s policy response options were explicitly limited.

Parties in favour of the FRTA and FCA might argue that the risks identified by those concerned about the Fed’s independence — and, incidentally, the dollar’s global role — are, in fact, the purpose of the proposed legislation, and that the overall economic interests of the US would be better served by their implementation. The debate is unlikely to end soon no matter the fate of the FRTA and FCA. Either way, the dollar is set to remain the world’s most important reserve currency, a position it is likely to hold for some time.

U.S. Bank Deregulation Advances, But Hurdles Remain

The momentum for U.S. bank deregulation continues to grow, but it is becoming more likely that it will take the form of multiple smaller bills targeting relief for specific segments of the financial sector as opposed to a single, comprehensive bill, says Fitch Ratings.

The Financial Choice Act (FCA) remains the benchmark for the full deregulation agenda given the upcoming House vote on a revised version that was passed by the House Financial Services committee earlier this month. The updated version (FCA 2.0) is mostly in line with the original bill from 2016 and still calls for the full repeal of the Volcker Rule, the Orderly Liquidation Authority (OLA) and the Department of Labor (DOL) Fiduciary Rule.

Broad and deep deregulation is generally viewed by Fitch as likely to have a negative impact from a bank credit risk perspective; however, the ultimate form of regulatory change and its application by individual banks will determine the ratings implication.

A repeal of Volcker is unlikely to result in banks’ returning to full-scale proprietary trading, but it could carry negative rating implications depending on banks’ response. The elimination of OLA could expose the banking sector to significant systemic risk in the event of a crisis, though resolution planning could be a mitigating factor to large bank failures. While eliminating the DOL Fiduciary Rule would likely benefit banks’ wealth management businesses and asset managers’ profitability, reputational and litigation risks would remain.

Key differences between FCA 2.0 and the original bill include simplifying the threshold for banks to opt out of most regulations, changing operational risk weights for global systemically important banks (G-SIBs), replacing the Consumer Financial Protection Bureau (CFPB) and relaxing some components of stress-testing.

Fitch does not believe proposed changes to the CFPB would directly affect most banks’ and non-bank financial institutions’ credit profiles, though they could reduce the regulatory burden and associated costs. Further revision to bank stress testing as proposed under FCA 2.0 is likely to be ratings neutral.

Global Growth Recovery on Track

The pick-up in global growth remains on track, with disappointing first-quarter US GDP data offset by better-than-expected numbers in China, and sustained growth in the eurozone and Japan, says Fitch Ratings in its Global Economic Update report.

“Weaker 1Q US growth was explained by consumption and looks to have been affected by temporary factors. Falling unemployment, wealth gains, improved consumer confidence and the prospect of income tax cuts should support a recovery in consumption from 2Q17. In China, the impact of earlier policy stimulus on activity has proved more powerful than anticipated and the slowdown in the housing market has taken longer to materialise than expected,” said Brian Coulton, Fitch’s Chief Economist.

The resilience and breadth of the eurozone recovery continues, with the region posting its eighth consecutive quarter of steady growth at an annual pace of 1.5%-2%.

“Rising bank credit to the private sector and strengthening housing markets suggest accommodative monetary policies are gaining traction in the eurozone, while a mild easing of fiscal policy since 2015 and strong job growth have also helped,” added Coulton.

Fitch expects world growth to rise to 2.9% in 2017 from 2.5% in 2016 and has slightly revised up its 2018 forecast to 3.1% from 3.0% in March. The US growth forecast for 2017 has been revised down slightly but this has been offset by a better outlook for China and Japan.

U.S. Bank Loan Losses to Rise as Loan Growth Halts In 1Q17

Quarterly earnings generally improved for U.S. banks in the first quarter of 2017, but loan growth came to a halt and loan losses are likely to increase over the near to medium term, according to Fitch Ratings’ U.S. Banking Quarterly Comment. Provision expenses for the 18 largest U.S. banks covered in the report rose 8% in 1Q17 from 4Q16 and loan losses in nominal terms increased on a linked-quarter basis. Growing concern in asset quality, particularly in credit cards, auto, and retail loan exposure from the disruption of e-commerce could contribute to increased loan losses going forward.

“Better capital markets results, lower taxes from new accounting guidance and modest improvement in spread income boosted earnings for the majority of U.S. banks, however, loan growth came to a standstill, expenses and credit costs climbed and mortgage revenue slowed during the quarter,” said Julie Solar, Senior Director, Fitch Ratings.

Overall industry-wide loan balances declined 2.5% on an annualized basis. For the large U.S. banks, this trend was less pronounced, with total loans down approximately 0.8% on an annualized basis. Pay-downs in energy credits, large corporate borrowers accessing the capital markets, discipline in maintaining risk-adjusted returns, and seasonally lower credit card balances all contributed to the decline in loans. Many borrowers are also waiting for more definitive policies from Washington despite improving business optimism before borrowing.

“Looking ahead, loan growth will be dependent on continued economic growth and will vary by loan category particularly with concerns in auto and signs that banks are demonstrating greater commercial lending discipline,” said Joo-Yung Lee, Managing Director, Fitch Ratings.

Twelve of the 18 banks reported higher net income in 1Q17 than in 4Q16 and several banks reported increases in net interest margins (NIM) including M&T Bank, Bank of America, Fifth Third Bancorp, and BB&T. The better NIM is largely due to the December 2016 interest rate increase as the March rate rise came too late in the quarter to materially impact the results. Capital markets results for the five large global trading and universal banks increased 19% in aggregate from 1Q16, with most of the improvement in equity and debt underwriting, up 92% and 51%, respectively, from the prior year.

In addition, several banks benefited from one-time tax benefits from the adoption of new stock-based compensation guidance. Goldman Sachs saw a large benefit witch the change accounting for 21% of its income. The new guidance is expected in impact first quarter results going forward.

Bank capital ratios remain solid with a median CET1 of 10.8% at March 31, 2017. Commentary from banks indicates that capital distributions will increase across the industry.

Housing Slump & Eurozone Key Australian Investor Concerns

High household debt and further strong house-price gains are fuelling Australian investor’s concerns around a domestic housing-market downturn, according to Fitch Ratings’ latest survey of the country’s fixed-income investors. Investors also believe developments in the Eurozone now pose a greater risk to Australian credit markets than a China hard landing.

The 2Q17 survey was undertaken in partnership with KangaNews – a specialist publishing house that provides commentary on fixed-income markets in Australia and New Zealand. Findings represent the views of managers of more than AUD300 billion of fixed-income assets, accounting for over three-quarters of Australia’s domestic real-money market.

Australia is facing mildly tougher economic conditions according to fixed-income investors. Their outlook for three key economic indicators suggests the next three years will see modest interest rate increases, a drift to slightly higher unemployment and house price declines. Interestingly, 60% of investors expect house prices to rise by between 2% and 10% by end-2017, while 52% expect house prices to decline by between 2% and 10% by end-2019.

Investors believe banks are better placed to manage risks, despite their less-than-rosy economic outlook, following steps taken to strengthen bank balance sheets and tighten lending standards. Property market exposure remains investors’ key concern, but the proportion ranking it as ‘critical’ has dropped to 30%, from 43% in our previous 4Q16 survey.

Corporate Australia’s credit profile is also expected to strengthen, with more investors taking the view that corporates will deleverage. The proportion of investors expecting corporate leverage to decrease has risen to 23%, from 4%, over the three surveys conducted over the past twelve months. Investors have nominated the corporate asset class as their preferred investment choice.

Australian investors anticipate a strong rebound in structured finance RMBS and ABS issuance over the next 12 months. Fifty-eight percent believe there will be increased issuance in 2017, up from just 16% in our 4Q16 survey.

Significant Shift in Global Interest Rate Environment Ahead

Borrowers should prepare for a significant shift in the global interest rate environment in the next few years, Fitch Ratings says. Fitch expects US real interest rates to increase to levels that are more closely aligned with US economic growth potential.

“With the Fed having now achieved its inflation and employment objectives, becoming more focussed on the risk of labour market tightening and starting to discuss the unwinding of its balance sheet, we expect interest rate normalisation will take place by 2020 and that the Fed Funds rate will reach 3.5% to 4%,” said Brian Coulton, Chief Economist at Fitch.

This estimate is above the Fed’s current “DOTS” projection for the long term and substantially higher than current financial market expectations for US rates in three years’ time. It would also imply a sizeable upward shift in bond yields to the 4% to 5% range as long-term expectations for the Fed Funds rate adjust.

The fall in US real interest rates (i.e. nominal rates adjusted for inflation) has been one of the most striking macroeconomic trends over the last decade or so and has gone well beyond what can reasonably be explained by shifts in economic growth or inflation performance.

One school of thought puts this shift down to long-term fundamental changes in the real economy that have boosted the supply of savings at the same time as the demand for funds for investment has diminished. Demographic changes, rising inequality and an emerging market (EM) savings glut are claimed to have pushed out the supply of savings, while lower public investment, falling capital goods prices and an increase in the risk premiums required for private investment projects are seen as having driven down investment demand. The fall in real rates is seen as a lasting shift to a new ‘equilibrium’, where the relative price of savings is permanently lower and real interest rates are unlikely to rise much above zero per cent even over the medium to long term. This view appears consistent with market expectations that the nominal Fed Funds rate will not increase much beyond 2% – i.e. in line with the Fed’s inflation target – even by 2020.

However in Fitch’s view, this conclusion does not look robust. US saving rates actually fell as the working age share of the population increased after 2000 and Fitch’s calculations suggest that the increasing share of the top quintile in total household income (a group which has higher saving rates than average) is unlikely to have significantly raised the aggregate saving ratio. Financial linkages between the US and EM are weaker than those with other advanced countries and EM current account surpluses and FX reserve accumulation have fallen since 2014 without prompting a correction in US real rates. Public investment has fallen to historical lows but there could be upward pressure over the medium term. The relative price of capital goods has been broadly stable since the mid-2000s. Finally, rising risk premiums can just as easily be explained by distortions to government borrowing rates from central bank Quantitative Easing polices as by increased hurdle rates for private investors.

An alternative view sees current exceptionally low real rates as the outcome of an elongated credit cycle whereby commercial bank and central bank actions have driven real rates away from equilibrium for an extended period. The narrative that accompanies this view highlights loose monetary conditions in the US in the early to mid-2000s, which set the scene for aggressive credit creation and risk pricing by commercial banks. These conditions contributed to the sub-prime crisis, which then saw central banks loosen monetary policy aggressively to minimise the impact of the crisis on the real economy. This view implies that real rates will revert to more normal levels – more closely aligned with economic growth – once the credit cycle has played out. Fitch sees considerable intuitive appeal in this characterisation.

A crucial question is where the economy lies in the current credit cycle. This boils down to the capacity of the US economic recovery to withstand higher interest rates. Aggregate macroeconomic data on debt burdens suggest that it can. The US household debt to income ratio has fallen to early 2000s levels, household debt service ratios are at record lows and the interest-coverage ratio for the US corporate sector in aggregate is at a multi-decade high.

“If the credit cycle view of US real rates is correct and if the cycle is nearly over, the implication is that nominal US interest rates will adjust quite sharply in the next few years,” added Coulton.

Fitch’s assessment of US potential real GDP growth is around 2%, which would imply a real Fed Funds rate of 2% or slightly below. Given the Fed’s inflation target of 2%, this would imply a nominal Fed Funds rate of 3.5% to 4.0% once the current cycle has ended and rates have normalised.

UK Article 50 Notification Begins Challenging Negotiation

The UK’s notification of its intention to withdraw from the EU sets the stage for a challenging negotiation process with a wide range of possible outcomes regarding trade and institutional arrangements, Fitch Ratings says.

The UK has triggered Article 50 of the EU Treaty, which envisages that the Treaty will cease to apply to the UK when a withdrawal agreement comes into force, or failing that, two years after notification (unless the other EU 27 members unanimously agree an extension). EU 27 leaders will meet in late April to discuss their negotiating position.

The uncertainty created by the EU referendum is a sovereign rating weakness for the UK (AA/Negative). But the wide spectrum of possible outcomes from negotiations means the rating is not predicated on any particular base case. Our analysis will focus on the impact of Brexit talks and their outcome on growth, public finances and the UK’s political integrity.

The number and complexity of issues to resolve, and the multiple national interests involved will make the negotiations difficult. There is no precedent for leaving the EU, and the UK will not be in control of the negotiating agenda. Two years is a short time to reach a free trade agreement (one of the Brexit aims set out in Prime Minister Theresa May’s 17 January speech), and the time available may be less if the terms of the UK’s withdrawal, including any “exit bill” relating to items such as budget commitments and staff pensions, have to be agreed first.

Domestic political challenges include the lack of a unified national position on Brexit, potential shifts in public opinion, and the Scottish government’s current intention, backed by a vote by the Holyrood parliament, to hold a second independence referendum.

The UK government has ruled out continued membership of the single market or the full EU customs union. An exit agreement could include a period of continued preferential access to the EU single market extended beyond the two years provided for by Article 50 to give more time for trade arrangements to be finalised, although this could imply the “four freedoms” of the EU, including freedom of movement, also being extended beyond the two years.

But it is possible that the UK fails to secure a future trade relationship with the EU or agreement for an implementation phase in the two years of negotiations, and reverts to WTO terms. The “cliff effect” and likely shock to the UK economy made a WTO scenario the most negative of the three hypothetical Brexit trade scenarios we examined in December last year.

The UK has not experienced an abrupt economic slowdown since the EU referendum, but our GDP forecasts reflect a weaker investment outlook due to uncertainty during the negotiation period. They also incorporate slower consumer spending growth due to higher inflation following the depreciation of sterling that occurred after the referendum. These effects are partially offset by better prospects for net trade given the weaker pound. We forecast UK GDP growth to slow to 1.5% in 2017 and 1.3% in 2018, and consumer price inflation to rise to 2.8% by end-2017 before falling back slightly to 2.6% by end-2018.

Brexit: Now Comes the Hard Part

According to James McCormack Global Head of Sovereigns at Fitch Ratings, nearly nine months after the UK voted in a referendum to leave the EU, the British government will soon provide notice to the European Council of its intention to withdraw under Article 50 of the EU Treaty, marking the beginning of exit negotiations. As contentious as the last year has been, first in debates on the merits of Brexit leading up to the referendum, and more recently amid criticisms of the government’s negotiating priorities and strategy, the period ahead promises to be even more combative.

Being the first country to leave the EU, the UK has no pre-established path to follow, and will forge ahead knowing only that Article 50 stipulates a two-year period to negotiate and ratify an agreement on the terms of exit, unless Member States unanimously agree an extension. There are five primary challenges facing the UK that are identifiable from the outset.

Timing is Tight, and the Exit Bill Looms

Most fundamentally, the UK will not be in full control of the negotiating agenda, and specifically the order in which issues will be addressed. Prime Minister May has said that a comprehensive free trade agreement with the EU is one of the government’s objectives, and that a smooth and orderly Brexit means having it in place by the end of the negotiating period. Most observers agree that two years is a short time to negotiate a free trade deal, but the actual time available to do so could prove even shorter, as some European leaders have suggested that the UK’s post-exit trade arrangements can only be negotiated once the most important terms of its exit have been agreed, which could take several months.

This may simply be an early negotiating tactic, but if less time is available, it becomes more likely a transition agreement would be needed to avoid what the prime minister has called “a disruptive cliff edge”. However, such an agreement would also take time to negotiate, and, once in place, it could reduce the urgency of reaching a final agreement, possibly drawing out negotiations well beyond two years.

The second major challenge faced by the UK will be settling the financial terms of its EU departure, or its “exit bill”, which EU leaders have indicated will be among the issues they seek to resolve up front. The main elements to be discussed will be future EU spending commitments agreed when the UK was a member state and EU officials’ pensions, and a figure of EUR60 billion has been bandied among European leaders. The amount will certainly be disputed by the UK, but it will have a strong incentive to agree to terms quickly and move on to more contentious and important issues, even though the concept of post-membership payments to the EU will be portrayed by some in the UK as an early and unnecessary concession.

Scotland and Other Internal Divisions

The three remaining challenges are domestic, and centre on Scotland, the lack of a unified national position on Brexit and the need to manage expectations.

The Scottish Parliament’s Culture, Tourism, Europe and External Relations Committee has published a report calling for “a bespoke solution that reflects Scotland’s majority vote to remain in the single market”. It would greatly complicate both the negotiations with the EU as well as border and logistics issues if such a bespoke arrangement were in place post Brexit. The lingering risk of a second independence referendum raises the stakes in how the UK government deals with any Scottish requests, and will require policymakers’ careful attention when government resources will already be stretched.

Beyond Scotland, it has been made clear in a variety of forums that the UK is not entering Brexit negotiations with unified views of the most desirable outcomes. In considering future UK trade arrangements, for example, Parliament’s International Trade Committee recently recommended joining the European Free Trade Area, and there are sure to be a raft of other proposals put forward on this issue alone from public and private sector groups. In the midst of negotiations, open debates within the UK can expose domestic political pressure points that could be strategically exploited by the European side. It may be of some comfort that the EU will be subject to similar internal disagreements, but the upshot of this is likely to be delays in formulating negotiating positions — an unfavourable outcome for the UK.

The final UK challenge as negotiations begin is managing expectations and uncertainties. Prime Minister May promised “no running commentary”, but there will be leaks, as with any negotiation. Progress will not be linear, in the sense that the UK and EU will appear alternatively to be closer to achieving their objectives, and financial markets may react accordingly. Domestic opponents of the UK government are likely to be quick to attribute any economic underperformance or market turbulence to shortcomings in the government’s approach to negotiations. The biggest associated risk is that the balance of public opinion shifts to a decidedly more negative view of Brexit, lending support to ideas already circulating on either a greater role for Parliament in approving the final negotiated agreement or another opportunity for the electorate to formally express its view.

EU Defends Use of Banks’ Internal Capital Models

The European Central Bank (ECB) review of internal models TRIM, is a project to assess whether the internal models currently used by banks comply with regulatory requirements, and whether they are reliable and comparable. Banks sometimes use internal models to determine their Pillar 1 own funds requirements, i.e. the minimum amount of capital they must hold by law. TRIM was launched in late 2015 and is expected to be finalised in 2019. This underscores the ECB’s desire to safeguard internal model use for retail and SME portfolios from the potential imposition of a capital floor.

ECB Banking Supervision is making a large investment in TRIM in terms of its own staff as well as the cost of external resources. With regards to staff, close to 100 ECB and national supervisors will be involved.

The targeted review of internal models, or TRIM, is a project to assess whether the internal models currently used by banks comply with regulatory requirements, and whether they are reliable and comparable. Banks sometimes use internal models to determine their Pillar 1 own funds requirements, i.e. the minimum amount of capital they must hold by law.

One major objective of TRIM is to reduce inconsistencies and unwarranted variability when banks use internal models to calculate their risk-weighted assets (RWAs). This may occur because the current regulatory framework gives banks a certain freedom when modelling their risks.

TRIM also seeks to harmonise practices in relation to specific topics. As a result, the review should help to ensure that internal models are being used appropriately.

Thus, the objectives for TRIM coincide with two major goals of ECB Banking Supervision: to foster a sound and resilient banking system through proactive and tough supervision and to create a level playing field by harmonising supervisory practices across the euro area.

This signals the EU’s determination to restore market confidence in banks’ use of internal models to calculate capital requirements, Fitch Ratings says. It may indicate a desire by the ECB to safeguard internal model use for retail and SME portfolios from the potential imposition of a capital floor.

For the eurozone, whose lawmakers and regulators mostly support the use of internal models and the risk-weighting framework for banks, TRIM is important to their argument that internal models make sense for certain portfolios. The ECB hopes to iron out unwarranted variability between models and restore credibility to the use of internal models, at least for “high-default” portfolios where there is sufficient default data for good-quality modelling.

The ECB’s large investment in TRIM suggests that internal models will continue to play an important role in how eurozone banks compute their regulatory capital requirements. TRIM’s focus on retail and SME credit risk may reveal where the ECB’s focus is for discussions on international bank regulation. The EU may be prepared to lose the use of internal models for “low-default” portfolios, such as financial institutions and large corporates, where it is more of a challenge to model statistically robust estimates for unexpected losses.

TRIM seeks to reduce inconsistencies and unwarranted variability when banks use internal models to calculate their risk-weighted assets (RWAs), by harmonising bank and national supervisory practices relating to models. The ECB has issued a 150-page guide allowing banks to assess themselves against common standards and prepare for the scrutiny to come. TRIM is the biggest single investment made by the ECB in supervision since it started in November 2014. The ECB will lead more than 100 reviews in 2017, involving more than 600 people, at 68 eurozone banks, covering approved internal models for credit, market and counterparty credit risks.

TRIM will take place in 2017 and 2018 with a possible extension into the following year. The ECB will ask banks to put right any shortcomings based on the final version of the guide. We expect the ECB to take a harsher stance with tighter timelines for shortcomings due to the banks’ own practices, while allowing more time to adjust for changes from national standards applied by supervisors in the past. Banks are likely to start work this year on aligning their models with the ECB’s standards. This may lead to movements in RWAs from model changes in 2017-2018, before TRIM is completed in 2019.

Disclosure of RWA movements due to model changes would provide helpful insight to analysts, creditors and investors. These market participants will need to be convinced of the TRIM process if the ECB is to remove their scepticism of RWA calculations based on internal models, in our view.

UK Faces Debt Challenge Despite Short-Term Growth Boost

Reducing public debt remains a long-term challenge for the UK despite the upbeat news on the near-term outlook for growth and borrowing in yesterday’s Budget, Fitch Ratings says. This challenge is reflected in the Negative Outlook on the UK’s ‘AA’ sovereign rating.

The Office for Budget Responsibility (OBR) has raised its growth forecast for this year to 2% from 1.4% in the Autumn Statement. But downward revisions for the following two years leave the level of both real and nominal GDP by 2019 broadly unchanged from November. The OBR expects real GDP growth to be around 2% beyond 2019.

We have also revised our near-term UK growth forecasts higher in our most recent Global Economic Outlook to reflect the resilience of the economy in 2H16 following the Brexit vote. But we still forecast lower growth than the OBR this year (1.5%) and next (1.3%), with the difference mainly due to our forecast for weaker investment, due to the uncertainties about UK trade relations after Brexit.

Discretionary fiscal measures in the budget were very small, reflecting the government’s intention to move its main fiscal policy event to the autumn. Higher spending on social care and schools over the next three years is offset by changes in dividend taxation and social contributions for the self-employed. The overall impact is deficit-increasing in FY17/18 and FY18/19, and deficit-reducing thereafter – but the changes are minimal (around 0.1% of GDP in FY17/18, for example).

Currently we assume that the government debt to GDP ratio will peak in 2018, but that would still leave the UK with one of the highest public debt ratios among highly rated (‘AAA’ and ‘AA’) sovereigns. The OBR’s latest projections underscore this view. The OBR estimates that in the current financial year government borrowing will be GBP16.4bn (0.8% of GDP) lower than previously expected, due to higher-than-expected tax receipts and some underspending by government departments. But it expects the positive impact of such one-off factors and timing effects to unwind over the next three financial years.

The government’s plans imply a consolidation of around 1.6% of GDP until the end of the current parliament. Official projections point to the public deficit in structural terms falling to 0.9% of GDP by FY20/21 – below the government’s target of under 2%. But they also indicate that additional tightening is likely to be needed to meet the government’s overall objective of balancing the budget as early as possible in the next parliament.

Furthermore, the OBR expects that general government gross debt as a share of GDP will remain broadly at its current level over the next two financial years, and only start declining in FY19/20. This underlines the scale of the challenge of putting the debt ratio on a downward path.