This report does not constitute a rating action.
Key Takeaways
- In our view, U.K. local authorities continue to demonstrate solid credit quality.
- Several headwinds are challenging the sector and leading to temporary fiscal imbalances.
- We expect strong systemic fundamentals and safeguards, economic recovery, and a longer-term strategy on reforms will help improve the sector's financial standing.
Strong systemic fundamentals and a supportive institutional framework will see U.K. local authorities maintain solid credit quality despite short-term challenges. We expect councils will keep operating spending under control to meet the balanced-budget requirement and that uninterrupted access to government funding will remain a reliable external borrowing source. While higher costs will persist in the medium term, economic growth and moderating inflation will contribute to a gradual improvement in financial performance.
After the July 4 general election, we anticipate the government will revisit long-debated sector reforms. Reforms have been postponed amid other challenges--including Brexit, the pandemic, and high inflation--that have taken priority. This has left long-term financial pressures unaddressed. These reforms are planned to cover grant distributions, the business rates framework, and social care responsibilities, among others. After the July 4 general election, we expect that changes to the system would take at least one-to-two years to implement, as they would require consultations, changes of funding mechanisms, operational adjustments, and time for implementation. We expect that reforms will not only ease financial pressure, but also add certainty to local authorities' medium-term planning and bring clarity to funding arrangements.
The overall credit quality of U.K. local governments remains robust, in our view. We performed credit assessments of 33 U.K. local authorities that we consider a fair representation of the sector. We believe that most entities belong to the 'a' category, with the average credit rating at 'a+', two notches below our rating on the U.K. (chart 1). We think the main differences are in councils' economic bases and their policies, which define their financial trajectories.
Chart 1
Supportive government mechanisms and regulations enable councils to maintain strong credit quality despite financial headwinds from high inflation, elevated interest rates, and rising demand for public services, among others. In addition to the balanced-budget requirement, we view council's access to government funding via the Public Works Loan Board (PWLB) as a vital support. Local governments can access PWLB funds within five days, ensuring solid access to liquidity irrespective of market conditions. With easy access and limited restrictions, PWLB remains the primary source for financing capital investments, representing 70% of local authorities' debt. Furthermore, throughout the pandemic the sector received unprecedented government assistance, which helped it navigate financial pressures and post sound operating results and surpluses in cash terms through fiscal years 2021 and 2022.
We forecast U.K. local governments' finances to reach their weakest point in fiscal 2024, and gradually improve over the coming two years (chart 2). Slower inflation should ease the pressure on the sector's cost base and the projected economic recovery will increase the tax base and allow for higher government transfers.
Chart 2
Local authorities have experienced financial pressures over the past two fiscal years because of heightened costs, sluggish revenue growth, and the winding down of government support. These headwinds have resulted in an increasing number of authorities issuing a Section 114 (s114) notice. This is an early warning sign that a local authority cannot balance its budgets. We view the s114 regime as a system safeguard to prevent financial distress, rather than a default or bankruptcy. It is proactive approach to addressing potential issues before financial performance deteriorates. The s114 process would typically include stricter measures to restore financial stability including, for example, freezing all non-statutory spending to balance an authority's budget.
The government can also take other steps to ensure financial sustainability. These include appointing a commissioner to councils with financial difficulties and grant capitalization direction, which allows an authority to take loans to balance their operating budget (chart 3). Despite increasing significantly, capitalization directions still account for a small share of local government revenues.
Chart 3
Related Research
- Back On Track Or A Path To Bankruptcy: Section 114 And Credit Risk In U.K. Local Authorities, Nov. 19, 2020
- Institutional Framework Assessment: Strong Fiscal Policy Safeguards Will Help U.K. Local Authorities Cope With Lower Grants, Nov 01, 2022
| Primary Credit Analysts: | Felix Ejgel, London + 44 20 7176 6780; felix.ejgel@spglobal.com |
| Noa Fux, London + 44 20 7176 0730; noa.fux@spglobal.com | |
| Natalia Legeeva, London 44 20 7176 0618; natalia.legeeva@spglobal.com |
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