Sunday, July 10, 2016
Why we should all mind Britain's very large gap
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

This continues to be a record-breaking time, though the records being broken are not necessarily those you would want. So, the pound’s peso-style two-day fall in the wake of the referendum was the biggest in the post-Bretton Woods era, in other words for four and a half decades.

Consumer confidence has also taken a tumble, according to a snap assessment published by GfK on Friday. Having been very high – last year was the best year for confidence in the more than 40 years GfK has been surveying it – the post-referendum dive was the sharpest for over 20 years. People may be more worried about their jobs. Another firm, CEB, which monitors online job postings, says they almost halved in the week after June 23.

These things will, as I noted last week, take time to fully reveal themselves. The problems in commercial property which have led to the suspension of withdrawals in several property funds may be the isolated difficulties of an overextended sector or the canary in the coalmine. It is reassuring, I hope, that banks have been stress-tested against a 30% fall in commercial property values.

This week I want to concentrate on what is potentially both a short-term and long-term problem for Britain. I had planned to look at the current account deficit regardless of the referendum outcome. It is timely to do so now.

Just to be clear on terminology, because I know some people get confused, I am talking here of the current account of the balance of payments, which comprises the trade deficit/surplus on goods and services, primary income (mainly investment income) and secondary income (including transfers such as payments to and from the EU).

That something unusual has been happening to the current account is not in doubt. In the final quarter of last year the deficit reached £34bn, a record 7.2% of gross domestic product. It narrowed in the first quarter, but only slightly, to £32.6bn, 6.9% of GDP. The last time we really worried about the current account deficit was in the late 1980s, at the end of the Lawson boom. Its peak then was however smaller, at 4.8% of GDP.

Why has the current account deficit widened so dramatically? Five years ago, the deficit was close to being eliminated, if only for a couple of quarters. Its widening to record levels is not mainly due to the usual culprit, the trade deficit. Though bigger than is healthy, at 2.5% of GDP, it is pretty close to its average of the past decade and a half, 2.4% of GDP.

The problem, instead, lies on the income side, mainly investment income. Just over a decade ago, during 2005, Britain had a surplus on primary income of 3.1% of GDP. Now there is a deficit of a similar among; exactly 3.1% of GDP in the first quarter. It is the turnaround on investment income which has put the current account into a parlous state.

Why the turnaround? It mainly reflects a substantial drop in the investment income that British residents, and British businesses, are getting from their investments abroad, while foreigners’ earnings on their investments in Britain have held up.

Some of that – about half – is directly related to weak oil and commodity prices. Energy and mining companies have seen their overseas earnings slump. Some of it reflects the fact that Britain’s economy has been growing more rapidly - generating more investment income – than most other advanced economies.

Does a big current account deficit matter? The balance of payments has to balance, as every student is taught. A current account deficit has to be matched by capital inflows.

The Bank of England’s financial policy committee, in its twice-yearly financial stability report last week, put the current account deficit at the top of its list of concerns. As it put it: “The current account deficit is high by historical and international standards. The financing of the deficit is reliant on continuing material inflows of portfolio and foreign direct investment.

“During a prolonged period of heightened uncertainty, the risk premium on UK assets could rise further and overseas investors could continue to be deterred from investing in the United Kingdom. Persistent falls in capital inflows would be associated with further downward pressure on the exchange rate and tighter funding conditions for UK borrowers.”

Incidentally, there is a strand of bonkers criticism around about the Bank and its governor, Mark Carney. Having warned against the consequences of Brexit, he and his colleagues have been quick to take action to minimise those consequences. The Bank’s actions may extend to a cut in interest rates this week. Yet all this, according to some economic illiterates out there, is merely an extension of pre-referendum scaremongering.

Will the risks from Britain’s gaping current account deficit diminish, or will they crystallize, to use the Bank’s phrase, in an even lower pound than we have seen so far? The balance of payments, as noted, has to balance, the question is at what exchange rate it does so.

On the current account itself, there are reasons to believe that over time the deficit will narrow rather than widen to, say, 10% of GDP. The fall in the pound so far will help, though not in the way most people expect. The drop in sterling has a direct translation effect on Britain’s overseas investment income, boosting receipts on assets denominated in foreign currencies. This is the main mechanism the Bank sees through which the deficit will narrow.

The trade deficit may respond to sterling’s weakness. The usual way this would happen is through the so-called “J-curve”, whereby the deficit initially worsens as imports become more expensive but then improves as Britain’s exports become more competitive. It could happen, though as I noted last month, sterling’s 25% fall in 2007-9 was notable for its disappointing impact on exports. Foreign tourists will find Britain cheaper, while British tourists will see the cost of their foreign holidays rise. The Brexit vote could thus see more foreigners flocking to Britain.

The current account could also improve if there is a further recovery in oil and commodity prices, boosting the overseas earnings of firms in this sector. There has been a recovery in prices from the lows of earlier this year, though so far it has only taken us back to where we were in the final months of last year.

Finally, the deficit could narrow if the hit to growth in Britain both reduces demand for imports – already we have seen the first signs of a weakening in new car registrations – and results in lower investment income for foreigners with British investments. This, of course, would be the least desirable way in which the deficit becomes less of a problem.

Will the current account deficit narrow by enough to take it off the Bank’s list of critical risks for the economy? That is the big question. To do so it probably needs to be no more than half its present level of nearly 7% of GDP. Getting there may take some time.