Fitch Ratings said Britain risks losing its top investment grade because of its limited ability to deal with shocks, days before Chancellor of the Exchequer George Osborne will present his annual budget.

Fitch changed the outlook on Britain to “negative” from “stable,” indicating a “slightly greater” than 50 percent chance that the “AAA” rating will be reduced within two years, the company said in a statement in London late Wednesday, citing the weak economic recovery, high debt levels and threats from Europe’s debt crisis. Osborne will meet coalition partners later this week to agree on a budget he will present on March 21.

The decision “reflects the very limited fiscal space to absorb further economic shocks in light of such elevated debt levels and a potentially weaker than currently forecast economic recovery,” Fitch said.

While the warning is a blow to Osborne’s strategy of implementing the biggest squeeze on government spending since World War II, it may strengthen his hand in negotiations with Liberal Democrat coalition partners, who want him to cut taxes to help the poorest workers.

Treasury minister Danny Alexander, a Liberal Democrat, said the announcement is a “salutary warning to those who think it is possible to loosen the purse strings.”

The credit warning from Fitch echoes a similar warning from Moody’s Investors Service, which said last month that Britain risks losing its top-level credit rating if the economy deteriorates. Bank of England Governor Mervyn King said on Feb. 29 that the Moody’s warning was a “perfectly reasonable” assessment. 

While surveys this month indicated Britain’s economy may return to growth in the current quarter after a contraction in the last three months of 2011, King has said the economy will only “gradually” strengthen. Data Wednesday showed U.K. jobless claims rose more than economists forecast in February and a broader measure of unemployment remained at the highest in 16 years, underscoring the weakness of the labor market.

Fitch said Britain’s top rating is underpinned by its “diversified and flexible economy” and the flexibility that comes from its independent monetary policy and the pound’s status as an international “reserve currency.”

Fitch also said Osborne’s fiscal plans are “credible” and that his budget next week “is expected to reaffirm the government’s commitment to deficit reduction.”

The government’s fiscal program, along with the Bank of England’s bond-purchase plan, have helped support U.K. gilts. The yield on the country’s 10-year debt was at 2.34 percent Wednesday, down from more than 3.5 percent a year ago.

The government’s budget is close to being signed off on by the “quad” of senior ministers who conduct negotiations on behalf of the two parties in the coalition government. The group is made up of Osborne and Prime Minister David Cameron for the Conservatives and Deputy Prime Minister Nick Clegg and Alexander for the Liberal Democrats, the junior partner in the coalition.

The quad met March 12 and may meet again on March 16, when Cameron and Osborne have returned from the U.S. They will meet for the final discussion of the budget next week.

Business Secretary Vince Cable, a Liberal Democrat who has been at the vanguard of calls for more action to support the economy, said in a letter leaked last week that the government lacks a “compelling vision.”

The leak came after Cable said his party is prepared to scrap the 50 percent top rate of income tax as long as the Conservatives agree to introduce new taxes on the rich. The business secretary said his party favors the introduction of a “mansion tax” on the most expensive properties so the wealthy contribute “their share.”

Clegg, looking for ways to show his Liberal Democrat party that he’s extracting a price for being part of Cameron’s coalition, said he’ll push for a “tycoon tax” on high earners.

Fitch’s warning will give Osborne’s Labor Party opponents in Parliament ammunition to attack him for the government’s austerity measures, which they say risk tipping the U.K. into its second recession in less than three years. 

(Bloomberg)