The UK has lost its top AAA credit rating for the first time since 1978 on expectations that growth will “remain sluggish over the next few years”.
Moody’s became the first ratings agency to cut the UK from its highest rating, to Aa1.
It said the UK government’s debt reduction programme faced significant “challenges” ahead.
Chancellor George Osborne said the decision was “a stark reminder of the debt problems facing our country”.
“Far from weakening our resolve to deliver our economic recovery plan, this decision redoubles it,” he added.
“We will go on delivering the plan that has cut the deficit by a quarter.”
The UK has had a top AAA credit rating since 1978 from both Moody’s and S&P.
Shadow chancellor Ed Balls said the decision was a “humiliating blow to a prime minister and chancellor who said keeping our AAA rating was the test of their economic and political credibility”.
In announcing the ratings cut, Moody’s cited the “challenges that subdued medium-term growth prospects pose to the government’s fiscal consolidation programme, which will now extend well into the next parliament”.
It added that the UK’s huge debts were unlikely to reverse until 2016.
“The main driver underpinning Moody’s decision to downgrade the UK’s government bond rating to AA1 is the increasing clarity that, despite considerable structural economic strengths, the UK’s economic growth will remain sluggish over the next few years due to the anticipated slow growth of the global economy and the drag on the UK economy,” Moody’s said.
But it added that the outlook for the UK is “stable”, meaning it sees no further downgrades in the near future, and added “the UK’s creditworthiness remains extremely high”.
It will massively increase the pressure on George Osborne, from both those who want him to raise taxes and cut spending further and from those who want him to alter course in next month’s Budget and spend more to try to boost growth.
The UK’s net sovereign debt was the equivalent of 68% of the country’s annual economic output, or GDP, at the end of last year.
“The very fact that we didn’t see this downgrade happen in the past few years is a testament to the UK’s credibility,” said Lena Komileva, an economist at G+ Economics.
“There are no magic fixes for this kind of problem. It’s not a question of what the government is willing to do, it is what it can do.”
All three major credit agencies last year put the UK on “negative outlook”, meaning they could downgrade its rating if performance deteriorates.
In his Autumn Statement in December, George Osborne acknowledged public finances were taking longer to rectify than planned, and admitted he would be forced to extend austerity measures by at least another year.
Germany and Canada are the only major economies to currently have a top AAA rating – as much of the world has been shaken by the financial crisis of 2008 and its subsequent debt crises.
A downgrade of a credit rating does not necessarily substantially damage the ability to borrow.
The US – the world’s biggest economy – was downgraded from its AAA rating last year, a move that has not materially changed its borrowing costs.
Moody’s removed France’s AAA rating in November.
The UK has experienced a double-dip recession since 2008. It grew in the third quarter of last year – boosted by the impact of the Olympics, but shrunk again by 0.3% in the last three months of 2012.
Earlier this month, the Organization for Economic Co-operation and Development said the Bank of England should be ready to inject more money into the economy to boost growth.
The Bank has so far pumped £375 billion into the financial system, creating money to buy-back government bonds.
The credibility of ratings agencies have also come under attack. S&P is being sued by the US government over ratings it gave to some mortgage-backed assets in the run-up to the global financial crisis in 2007, which subsequently fell dramatically in value.
Moody’s announcement sent the pound falling further in value, but financial analysts said the impact was likely to be limited because the markets had been expecting a downgrade for some time.