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Is the UK the New 'Problem Child' of Europe?

Monday, 25 Feb 2013 | 3:56 AM ET
Doug Armand | Photographer's Choice RF | Getty Images

Runaway debt, a credit downgrade, sluggish to negative growth and an unrepentant finance minister are prompting analysts to question the U.K. government's economic policy.

Last week, a senior German lawmaker called France the "problem child" of the euro zone. "The French need to do their homework - they're very, very behind other countries and that is alarming because France is the second biggest economy in Europe," conservative lawmaker Michael Fuchs said.

But in several key economic metrics, Britain isn't much better than France. Both the French and U.K. economies contracted by 0.3 percent in the fourth quarter of 2012. The U.K.'s current account deficit is expected to be 3.1 percent of gross domestic product (GDP) this year, only a bit lower than France's 3.7 percent.

In fact, the U.K. current account deficit is predicted to be higher this year than it was in 2009 - the only developed economy to suffer such an increase.

Britain's debt-to-GDP ratio is now at 85.8 percent, not far from France's 89.9 percent.

Moody's on Friday downgraded the U.K.'s prized AAA credit rating one notch to Aa1. While Moody's said the U.K.'s credit-worthiness remained "extremely high", it attributed the downgrade to weakness in the country's medium-term growth outlook and an increasing debt burden which would peak at 96 percent of gross domestic product in 2016.

Despite calls from the opposition Labour party that the finance minister focus on growth, George Osborne said the government would not change its austerity program.

No UK Plan for Bringing Down Debt: Pro
Kathleen Brooks, research director at Forex.com, tells CNBC that there has been absolutely no strategy in the UK for austerity and bringing down debt.

"Far from weakening our resolve to deliver our economic recovery plan, this decision redoubles it," Osborne said, dampening expectations he would change to "Plan B" when he delivers the 2013 budget on March 20.

(Read More: UK Suffers Blow, Pound Seen Under New Pressure)

The government has already had to extend its austerity program by a year to 2018 and Osborne called the downgrade "disappointing news".

On Monday, the pound lost ground against major currencies, with traders pushing the currency to a 31-month low of $1.5073 and a 16-month low of 0.8775 pound per euro.

(Read More: Why the Pound is Getting Pounded)

"The idea of austerity to bring down our debt is a fantastic goal but there's been no strategy…there is no plan from A to B," Kathleen Brooks, research director at Forex.com, told CNBC. "From what Osborne was saying, we're going to carry on with our goal-driven austerity drive and let what the Bank of England (BoE) do whatever it takes."

She added that the currency could fall further against the dollar, prompting uncertainty over whether more central bank quantitative easing (QE) will follow. "From a technical perspective you could see [the pound at] a $1.46-$1.45 area but in terms of the downgrade a lot of that was priced already, we knew that growth was going to be weak," she told CNBC Europe's "Squawk Box" on Monday. "The unknown is just how much QE they will do," she said.

(Read More: Tolstoy a Better Read Than Taxcode: Osborne)

UK Treasury: Bond Yields More Important Than Downgrade
David Gauke, from the U.K. treasury, tells CNBC the government will stick to its deficit reduction plan despite Moody's downgrade of the country's credit rating.

Marshall Gittler, head of global strategy at IronFX, told CNBC that the move was no big surprise: "Looking at Britain's economic performance - four quarters of negative growth out of the last five - I don't think anyone can argue with Moody's assessment that the sluggish growth poses challenges to the government's fiscal consolidation process."

"The FX market sold sterling on the news and is likely to keep selling it further, I would expect," Gittler told CNBC on Sunday.

The impact of the downgrade may be greater in the FX market than in the gilts market, he added.

"Aa1 is still better than a lot of other countries and investors who have to buy gilts will still have to buy them. In any event, the U.K. is hardly alone in this; the U.S. and France recently lost their triple-A rating and Japan lost its a long time ago, yet life goes on in those countries and they are still able to sell bonds. "

UK OK

"AA is the new AAA," research analysts at Credit Suisse noted on Monday. The prospect of more quantitative easing (QE) was unlikely and there were no direct implications for the country's economic outlook unless sterling depreciated significantly.

"On its own, this downgrade does not make QE any more likely. Unless there is a sharp rise in gilt yields or a marked deterioration in cyclical indicators in coming weeks or months, we think it more likely than not that the BoE will not resume QE," analysts Thushka Maharaj and Nevill Hill said in a note on Monday.

Credit Suisse expects a "muted sell off in gilts" as the move was largely expected and the possible intervention of the Bank of England would cap any rise in yields. However, the downgrade "further shifts the credit risk to the currency," they added.

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