The UK vote to leave the European Union gave new chancellor Philip Hammond a good excuse to abandon his predecessor’s plans for closing the budget deficit, but it shines a harsh light on the “other” deficit – in the balance of payments.
The current account, which compares how much the country spends abroad and how much it receives through sales and investment income, showed a deficit in the final quarter of 2015 equivalent to 7% of GDP. That was the widest since records began 60 years ago, and it has narrowed only slightly since.
This external deficit means, essentially, that we’re buying more than we sell, bridging the gap by attracting foreign investment with the promise of future payback. It has seemed a comfortable arrangement until now because more than 80% of the UK deficit has been financed by foreign direct investment (FDI): overseas investors buying production capacity and intellectual property in the UK. The US$32 billion sale of leading chip-maker ARM to Japan’s Softbank suggests that quitting the EU might not quench the appetite for large FDI deals.
But there have been fears, ever since the crash of 2008, of a permanent slowdown in FDI to “developed” countries. If they still want to build or buy plants abroad, multinationals increasingly target the much lower-cost emerging economies. The UK’s longer-term appeal to foreign investors may be reduced by the decision to leave the EU, which brought an immediate fall in UK sovereign credit ratings and forecasts of a sharp slowdown or even recession next year.
Signs of strength
Governments haven’t worried much about the current account since the 1970s, which began with the pound being “floated” and ended with the removal of foreign exchange controls. With a flexible exchange rate, the pound can always lose value against other currencies if the external deficit becomes excessive. A weaker currency traditionally boosts exports by making them cheaper abroad, while curbing imports by making them costlier at home.
Because an external deficit is always financed by capital inflows, some economists now view the UK’s current-account gap as a sign of strength. It’s become more attractive to foreign capital by offering a vibrant business environment, benign tax regime and strong institutions. Optimists note that the deterioration since 2012, when the deficit was just 3.3% of GDP, has resulted not from a worsening trade balance (imports growing faster than exports), but from a widening imbalance in flows of investment income. Put simply, the return on the UK’s investments abroad has fallen relative to the return on foreigners’ investment in the UK.
Sliding to safety
This suggests a global vote of confidence in the performance and prospects of the UK economy. Evidence presented in March by Kristin Forbes, a member of the Bank of England’s Monetary Policy Committee (MPC), showed the UK’s investment income deficit rising because it gives foreign investors bigger capital gains than it has earned on its investments abroad.
By implication, the UK is expected to deliver stronger growth and profits, at least compared to eurozone partners. And any “excessive” widening of the deficit, caused by this international difference in investment performance, can be easily cured by letting the exchange rate fall. A depreciation of sterling improves the ‘income’ balance on the current account, by giving UK investors more pounds for every dollar they earn abroad.
Currency depreciation used to cause alarm because it can lead to higher inflation, by boosting demand (if, as at present, the economy seems close to full employment and by making oil and other imported raw materials more expensive.
But faster inflation would at present be a bonus. It’s been stuck far below its 2% target for over two years, keeping borrowers’ real (inflation-adjusted) interest rates high and making it harder to pay down debts.
Attention: deficit disorder?
So with all these assurances, why should the new chancellor (or anyone) worry about the current-account deficit? First, because no other advanced economy comes close to the UK’s level of deficit. The US, although traditionally an even bigger magnet for inward investment at times of global tension, and able (unlike the UK) to do all its foreign borrowing in its domestic currency, ran a deficit of 2.7% of its GDP in the first quarter of this year. Germany runs a current account surplus that’s now above 8% of its GDP, and is the main reason there’s an external surplus for the eurozone as a whole.
The need for capital inflows to finance a current account deficit leaves countries vulnerable to abrupt slowdown and dramatic exchange-rate falls if those inflows experience a “sudden stop”. Crises of that kind have so far been confined to emerging economies. But the UK may not be immune if shock events, like turbulent Brexit talks or another banking crisis, cut the amount that countries with surpluses are able and willing to invest abroad.
While a country that can’t finance its external deficit can always reduce it, the mechanism tends to be painful: slower growth to curb import demand, and an all-round pay cut to make exports more competitive.
This underlies a more pessimistic explanation for the pound’s recent slide offered by another MPC member, Martin Weale. He traces it to foreign investors’ perception that UK productivity growth will now be even weaker, and GDP slower-growing in the longer term. This will mean a slowdown in the (already very weak) growth in real wages, driven by higher inflation that has to be offset by currency depreciation.
Falling with the pound
Forbes, Weale and a majority of MPC members are expected to vote in August for a further cut in UK interest rates. A major motive will be to narrow the current-account deficit, through the twin track of boosting net exports and amplifying foreign investment income.
The deficit tops the Bank of England’s list of post-Brexit risks to financial stability, despite its optimistic assessment of the causes. It ultimately reflects a strength of domestic demand made possible by record consumer borrowing, another escalating risk. And it points to an imbalance which might eventually require a rapid rise in interest rates, to rein in spending and stem inflation.
In his Brexit strategy, sketched before he was appointed to lead the UK out of the EU, David Davis anticipated a succession of quick trade deals that would redirect Britain towards “export-led growth”. His new Treasury colleagues must hope it works without the pound having to drop to parity with the euro. Any other route to current-account rebalancing could bring several ministerial careers to a sudden stop.