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How the U.K. can turn its debt downgrade around

February 26, 2013: 5:00 AM ET

Don't be fooled by the market's non-reaction to the downgrade of the United Kingdom's debt. The government must give the perception that the country is a safe haven for foreign investors.

By Cyrus Sanati

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FORTUNE -- The loss of the U.K.'s coveted AAA credit rating shouldn't be taken lightly. While some might try to downplay the significance of the loss, the bruise to the nation's credibility could have painful economic consequences over the long term. The government must act quickly to shore up investor confidence abroad as it continues to impose harsh austerity measures at home if it ever intends on pulling the U.K. out of this long-running economic rut.

It is easy to gloss over reports of yet another sovereign credit downgrade, especially one that involves a European nation. The downgrade of the United Kingdom, initiated by Moody's late Friday night, pulls the nation's credit rating down one notch from AAA, the highest rating possible, to AA1, giving the it the same credit rating of nations like the U.S. and France. The market response has been somewhat muted as this action was seen by many as being far overdue.

The ho-hum reaction to the downgrade by the markets is being compared to the time when Standard and Poor's (S&P) downgraded the U.S. in 2011, when there was little, if any, big move in the markets the day after the news. Indeed, yields (interest rates) for U.S. Treasuries actually fell in the wake of the downgrade, giving investors the impression that sovereign credit ratings didn't really matter anymore, especially for advanced economies.

But the United Kingdom is not the U.S. -- not even close. Its economy is not as diverse, robust. or as nimble as that of the U.S. and never will be, given the island-nation's size, geography, and lack of abundant natural resources. There is no guarantee that foreign investors will continue to see U.K. gilts (sovereign bonds) as a safe investment as they continue to see U.S. treasuries post downgrade. In the same vein, there is no way of knowing if billionaires and oil-sheikdoms will continue to see the London property market as a cash cow that keeps on giving.

MORE: El-Erian: Alarm bells should be ringing in European capitals

For now it seems that the market is waiting to see what, if any, changes the U.K. government will make to its economic policy in the wake of the downgrade. The current Conservative government made maintaining the U.K.'s AAA rating a top priority, setting the basis for its highly unpopular, yet necessary, austerity-laden fiscal policy. Now having failed at keeping the top rating, the government will surely come under pressure from its critics to change tack by either spending more or taxing less to provide some sort of "stimulus" to the economy.

While it is true that the U.K. economy is in need of some major structural changes, the government should continue to cut spending in non-vital areas that yield little, if any, economic pluses. It has been this commitment to slashing spending which allowed the U.K. to hold on to its AAA credit rating for this long. This has allowed the U.K. to borrow cheaply, saving the government billions of pounds in interest payments -- money used to bring government spending in line with revenue. The U.K. Office for Budget Responsibility projects that every 100-basis-point rise in gilt rates would increase net debt by 1.2% of GDP between 2014 and 2016. The U.K. will need to borrow between 130 and 150 billion pounds per year for the next few years as it attempts to close its budget gap, according to Barclays, so it is therefore extremely important to maintain low rates.

In order for that to happen, the government must give the perception that the U.K. is a safe haven despite the loss of its AAA rating. Foreign investors may be more willing to give the U.K. government the benefit of the doubt and stick with their gilts if they know that the government is doing whatever it can to slash spending to meet its future debt payments.

But as Moody's explains, while the U.K. is doing well slashing spending, it has failed at generating new income. This presents the U.K. government with a dilemma: Should it temporarily increase spending and cut taxes to "stimulate" the economy, or should it continue to cut spending to balance the budget? The two aren't necessarily mutually exclusive but they usually are perceived as such. It is possible for the U.K. government to do both by sticking with its budget and targeting its spending wisely.

MORE: Why less debt among young adults is bad news

There is still plenty of fat in the U.K. to cut. For example, in the U.S., Medicare spends 3% of its budget on management, while in the U.K. the National Health Service (NHS) spends nearly five times as much, amounting to a 10 billion pound difference. Surely there is a way to cut some of this administrative bloat without sacrificing patient care. In another example, the U.K. continues to subsidize half the tuition costs for university students, despite big cuts it made in 2010 to the nation's education budget. Subsidies should only exist for students going for degrees in majors where there is a shortage of graduates, like in computer science. This could cut costs while helping to stimulate the economy as it could fill major skill gaps in the nation's workforce.

As for further stimulating the U.K. economy, encouraging deeper trade relations with its Commonwealth partners and with the so-called BRIC nations (Brazil, India, China and Russia) should be a top priority. The share of U.K. exports going to the BRICs has the potential to double to around 16% by 2030, according to a study by PricewaterhouseCoopers. In order for this to become reality, the U.K. needs to target the right market while being more competitive than Germany and the U.S. For example, U.K. vehicle exports to China have grown 34% in the last decade. The demand isn't for a cheap British econo model -- the Chinese can always make a cheaper car; rather, the demand is for luxury and iconic brands like Rolls-Royce, Bentley, Range Rover,  and Aston Martin. Bi-lateral trade agreements between the U.K. and China lowering tariffs in this one market could help stimulate demand for British cars. That would not only stimulate the domestic economy but also decrease the nation's burgeoning trade deficit.

So far the U.K.'s economy hasn't performed as well as the Conservative government had hoped it would when it took power a few years back. Now facing the prospect of a damaging triple-dip recession, Moody's has put investors on notice that Great Britain may not be that "Great" of an investment after all. It is now up to the Conservative government to convince investors and its critics that while it is sticking to its guns when it comes to austerity, it's also making a concerted effort to expand British exports. If it fails to make its case, the U.K. could quickly find itself caught in a dangerous downward spiral, setting it back economically for a generation.

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