The UK risks losing its top-tier rating after Standard & Poor's downgraded its outlook to negative from stable Tuesday, citing a sharp deterioration in its public finances.
Even factoring in the fiscal tightening mentioned in the UK budget announced last month, the country's general debt burden may get close to 100% of gross domestic product and stay near that level for the medium term, S&P said in a statement.
The rating agency's projections include estimates for the potential fiscal toll of the government's support for the banking system, which S&P puts at up to 145 billion pounds ($226.2 billion).
This, together with uncertainty over when the erosion in government revenues may be curtailed and how fast can spending be reined in, are likely to bring the government debt burden to nearly 100 percent of GDP by 2013, according to the rating agency.
"A government debt burden of that level, if sustained, would in Standard & Poor's view be incompatible with a 'AAA' rating," the statement said.
The risk that the UK would lose its AAA rating is "certainly a possibility," Stuart Bennett, an economist at Calyon, told CNBC.com
"It wouldn't be the first European country to go down that route."
Up to the Government
Ireland, Greece, Portugal and Spain have lost their AAA ratings because of an acute deterioration in their public finances since the crisis started.
"Normally, an outlook downgrade is the first step" towards a full downgrade, Bennett said. "It's in the UK government's hands."
Prime Minister Gordon Brown's Labor government is in a tough situation, as it cannot boost government spending to fend off its Conservative rivals in elections next year.
But the danger of a full downgrade is not that imminent, Kenneth Broux, an economist with Lloyds TSB Financial Markets told CNBC.com.
The government's policy on ensuring fiscal discipline will be crucial in avoiding a ratings downgrade. S&P said a clear picture on fiscal strategy can only be determined after the policies of a future government, due to be elected in 2010, will be known.
"I think it's a heads-up. It doesn't exclude a downgrade but I think it's too early," Broux said. "Regardless of whether an elections is 12 months away or five years away, any government in the world would want to avoid a downgrade."
Besides weakening the pound , a downgrade would also undermine investors' confidence in the UK and would increase the cost of financing for the government debt.
"We think the risks for sterling are certainly on the downside over the short term," Broux said.
The timing of the S&P announcement is crucial, because it shows that the period between the warning and an actual downgrade, if one is done, may be as long as two years, Alan Clarke, an economist with BNP Paribas, said.
But a downgrade could come quicker than that if a gilt auction fails, if there is a run on the pound or if the monthly public finance data are worse than expected, and this would deepen UK's problems, Clarke added.
"If there is a genuine chance of a downgrade, overseas people who bought gilts may change their mind," he said.
The UK government will probably issue 900 billion pounds ($1.4 billion) worth of gilts over the next 4-5 years to cover the gaping budget deficit, and even if the Bank of England boosts its buying like it did last month, private investors will still have to buy most of these gilts, according to Clarke.