By Guy Faulconbridge
LONDON (Reuters) - British finance minister George Osborne said he would not flinch from his austerity drive, despite increasing pressure to change course after the loss of the country's 'AAA' credit rating and with elections approaching in two years.
Moody's dealt Britain its first sovereign rating downgrade on Friday, saying the $2.5 trillion economy faced years more sluggish growth and debt would continue to rise until 2016.
Economically the one-notch cut will have limited importance - most of Europe, Japan and the United States have already suffered the same fate, and Britain continues to borrow at historically low rates.
But politically it is toxic for Osborne, who has repeatedly vowed to protect Britain's top credit rating since the 2010 election campaign. The downgrade exposes him to opponents who say his failure to deliver economic growth is driving Prime Minister David Cameron towards electoral defeat.
Osborne said on Sunday the move by Moody's showed he was right to focus on restoring Britain to fiscal health, which he said was the only way to get growth going again.
"We've had a stark reminder this weekend of the single most important truth about our economy. Britain has a debt problem, built up over many years, and we have got to deal with it," the 41-year-old Chancellor of the Exchequer wrote in a column for The Sun newspaper.
"If we don't deal with it, interest rates will soar, homes will be repossessed and businesses will go bust. If you doubt whether that's true, just look at what happened to all those European countries now deep in recession."
For investors, the downgrade underscores Britain's predicament: a debt-ridden, stagnating economy that has kept bond yields low in large part thanks to the Bank of England becoming the world's biggest investor in UK government debt by buying it with newly printed money.
A top official with a leading investment firm said the ratings blow was in part self-inflicted by the Conservative-led government, which had room to ease off on its belt-tightening.
"The coalition set out trying to please the ratings agencies, but the inflexible application of front-loaded austerity is partly to blame for the lack of growth that led Moody's to downgrade (the UK)," said Trevor Greetham, asset allocation director at Fidelity Worldwide Investment, which managed over $240 billion in funds as of December 31.
Osborne can take comfort from Moody's confidence that his austerity plan would eventually "reverse the UK's debt trajectory".
A Treasury official noted Moody's had given the UK's credit rating a stable outlook, meaning little chance of a further downgrade in the next 12-18 months. When the United States and France were downgraded, their outlooks remained negative.
But whether growth will return forcefully and long enough before the 2015 election to allow voters to appreciate it is now highly uncertain.
Sterling fell by almost a cent to around $1.5160 after the downgrade, just off Thursday's fresh 2-1/2-year low. Analysts said they expected it to fall further on Monday but most saw limited impact because the downgrade had been expected.
Some of the Conservatives' Liberal Democrat coalition partners questioned the political judgment of attaching so much importance to Britain's AAA rating.
"To be fair, he was very green in 2009 ... He foolishly erected triple-A status as a virility symbol," said Matthew Oakeshott, a former Liberal Democrat Treasury spokesman.
"BLEEDING THE PATIENT"
Cameron, who led his Conservative Party back to office as part of a coalition government after 13 years out of power, risks another year of stagnation and giving his opponents an open goal to aim at.
The Labour Party, from which Osborne inherited a record peacetime deficit when it lost the 2010 election, called for his head.
"The medicine is not working, so the Chancellor says increase the dose - that's crazy economics. It is like an 18th-century doctor bleeding a patient as they get sicker and sicker," said Ed Balls, the party's main spokesman on finance issues.
But people close to Britain's most powerful two politicians say they are completely aligned. Osborne led Cameron's bid for leadership of the Conservatives and ran the 2010 election campaign. There is little or no chance of him being sacrificed or being forced into a humiliating policy U-turn that would wreck his career.
"Osborne has lots of critics, both inside and outside the party, who are now going to be emboldened by this, but there is no coherent alternative," said Tim Montgomerie, editor of the influential ConservativeHome website.
Though Labour is about 10 percentage points ahead of the Conservative Party in polls, surveys show voters trust Cameron and Osborne more than Labour's leader Ed Miliband.
TIME FOR A TWEAK?
Osborne originally gambled that by slashing spending, growth rates of between 2 and 3 percent would kick in from 2013.
But with Britain's banks still recovering from the financial crisis and many of its main trading partners in Europe stuck in recession, his debt targets will be missed. His room for more spending is limited as he tries to avoid pushing up yields on Britain's 1.29 trillion pounds ($1.97 trillion) of debt.
With government spending so restricted, many investors' hopes lie with the Bank of England. Its governor, Mervyn King, this month voted to restart buying of government bonds. Although in the minority, his change of heart suggested the bank may be closer than expected to pursuing more stimulus.
If Osborne slows his debt reduction plans, he could upset bond investors and throw his deficit targets further off course.
"We should stick to the plan," said Kwasi Kwarteng, a Conservative lawmaker. "The prime minister would not want to be seen to be panicking, and he's committed to keeping George Osborne where he is."
"But we do also need to look at growth," said Kwarteng, who proposed cutting corporation tax and red tape.
David Blanchflower, who served on the Bank of England's interest rate setting committee from 2006 to 2009, suggested a swift cut to value-added tax, a labour tax holiday for workers under 25 and incentives for investment and hiring.
Business lobby the Confederation of British Industry has called for more investment on infrastructure and housing to be funded by more cuts in day-to-day spending. It also expects the government to guarantee more private-sector projects.
Osborne has a chance in his annual budget next month to deliver such tweaks to policy.
($1 = 0.6551 British pounds)
(Editing by William Schomberg and Will Waterman)