Britain risks losing its precious triple-A credit rating because of the danger that government debt may soar close to 100 percent of GDP, and uncertainty over policy before an election due by next year.
The pound tumbled 3 U.S. cents, bonds nosedived and the FTSE-100 stock index lost almost 2 percent on Thursday after ratings agency Standard and Poor's issued this warning, saying that Britain's outlook was negative and no longer stable.
Rival agencies Fitch and Moody's disagreed. They quickly reaffirmed Britain's triple-A status and said the outlook was stable. But S&P's warning is yet another blow to Prime Minister Gordon Brown, who seems on course to lose power.
Whoever wins the next election, tax hikes and sharp spending cuts will be the order of the day, but today's announcement by S&P puts that much more pressure on the next government to act quickly, said Colin Ellis, economist at Daiwa Securities.
S&P's move also leaves Gordon Brown's fiscal reputation in tatters -- the already long odds of him winning next year's general election have just lengthened even more.
After a decade of preaching prudence as finance minister, Brown has had to sanction government borrowing rising to record levels as the economy shrinks at its fastest pace since World War Two and the state has had to bail out the banking sector.
Stripped of its reputation for economic competence and reeling from scandals over smears and lawmakers' expenses, Brown's Labour Party is trailing badly behind the opposition Conservatives in opinion polls.
Scenting blood, opposition politicians renewed their call for an immediate national election. It's now clear that Britain's economic reputation is on the line at the next general election, another reason for bringing the date forward, said George Osborne, the Conservative Party's shadow finance minister.
Official data released shortly after the S&P announcement showed British public borrowing hit a record high for the month of April -- the first month of the new tax year -- as the recession-hit economy battered public finances.
The Treasury said there was a lot of economic uncertainty around and that it had already published plans to halve the budget deficit -- predicted to hit 175 billion pounds this year -- over the next five years.
The problem is S&P does not believe the government numbers.
We have revised the outlook on the UK to negative due to our view that, even assuming additional fiscal tightening, the net general government debt burden could approach 100 percent of GDP and remain near that level in the medium term, Standard & Poor's credit analyst David Beers said.
While sterling and bond prices fell after the S&P warning, UK assets still remain in high demand. Britain's record 5 billion pound gilt sale was nearly three times oversubscribed, and the pound later regained much of its losses.
The S&P stuff was a delayed reaction to the budget and from what they're saying today, they could have said that when we had the budget, said Francis Diamond, gilt strategist at JP Morgan.
While the April 22 budget was widely derided as being too optimistic on a return to economic growth next year, the pound has gained more than 10 U.S. cents since then after months of weakness.
S&P said the looming election was creating uncertainty about government policy.
The rating could be lowered if we conclude that, following the election, the next government's fiscal consolidation plans are unlikely to put the UK debt burden on a secure downward trajectory over the medium term, Beers said.
Conversely, the outlook could be revised back to stable if comprehensive measures are implemented to place the public finances on a sustainable footing, or if fiscal outturns are more benign than we currently anticipate.
(editing by David Stamp)