Sunday, November 06, 2016
Sterling's ill-wind could blow us back to balance
Posted by David Smith at 09:00 AM
Category: David Smith's other articles


My regular column is available to subscribers on This is an excerpt.

You would have to say that it has been bracing, not least for the pound. Blown in one direction Ė down Ė by the referendum result and government indications that it will be pursuing a harder form of Brexit Ė sterling was blown back up a little on Thursday by the High Courtís ruling that Parliament must have a vote on the triggering of the formal Article 50 process and ended the week above $1.25.

But the pound remains very substantially lower than it was, which will have some of the consequences, notably higher inflation, we are familiar with. It is an ill wind, however, which blows nobody some good.

Manufacturers are benefiting from the lower pound. The latest purchasing managersí survey for the sector from Markit showed that export orders are driving a mini-revival in Britainís factories.

That is good news but perhaps most remarkably, if a new forecast is right, one of Britainís longstanding Achillesí heels will, in just a few years, have been eliminated. I am referring to the current account deficit, the balance of payments gap, the amount that this country is in the red in its transactions with the rest of the world. Times have changed, but it used to be regarded as one of the best measures of the nationís economic health.

The deficit, as regular readers will know, has been running at record levels. Last year it was no less than £100.2bn, 5.4% of gross domestic product. In the first half of this year it averaged 5.8% of GDP. It was this that led Mark Carney, who has had a busy week, to say that Britain would be dependent on the kindness of strangers to fund all this red ink.

The good news then is that Britain may not be dependent on this kindness for too much longer. The latest forecast from the National Institute of Economic and Social Research (Niesr) attracted a lot of attention a few days ago because of its prediction that inflation will rise to 4% during next year, putting a big squeeze on real Ė after-inflation Ė household incomes, and thus restraining spending.

Also in the forecast, however, was a remarkable set of numbers on the prospects for Britainís current account deficit. Niesr expects this yearís figure to average out at 4.5% of GDP, a small improvement on last year. Next year there is a bigger drop in the deficit, to 2.7% of GDP. It is what happens next, though, which really caught my eye. The deficit is predicted to virtually disappear in 2018, dropping to a mere 0.1% of GDP. But then this is followed by three successive annual surpluses beginning in 2019, of 1.2% of GDP, 1.2% and 0.9% respectively.

Before explaining how this is expected to come about, it is worth taking a moment to record how unusual a single current account surplus, let alone three in a row, would be. Britain has not had an annual surplus in the past three decades. The Office for National Statisticsí dataset, going back to 1987, shows that the nearest we had to one was a 0.2% of GDP deficit in 1997. Last year, as noted, it was a record 5.4% of GDP. So this would be a very big change.

How does it happen? There are three main things happening in the Niesr forecast. Though it notes that Britainís exports often respond disappointingly to falls in the pound - in the jargon the elasticities are low - it does expect some impact on export growth. But, as far as trade is concerned, weaker domestic demand and higher import prices have the effect of reducing growth in the goods and services we buy from abroad. This indeed is what it sees as the main channel through which the trade picture improves.

The result is that net trade (exports minus imports) having made a negative contribution to growth in recent years, despite post-crisis hopes of export-led growth, makes a significant positive contribution next year and beyond. The trade deficit in goods and services, £39bn last year, is predicted to disappear before the end of the decade.

The second big factor is investment income, which has been responsible for much of the lurch into record current account deficit in recent times. This was the phenomenon under which foreigners were earning larger returns on their investments in Britain than British people and institutions were on their investments overseas.

The lower pound affects this in two ways. It boosts the sterling value of foreign assets and thus improves Britainís net international investment position; while leaving the sterling value of foreign-owned assets in Britain unchanged. It also boosts the sterling value of foreign income. It is enough to return to surplus this component of the balance of payments, the so-called primary income account, perhaps even before the end of this year.

Finally, in what Simon Kirby, who runs Niesrís UK forecast, admits might be a heroic assumption, another source of improvement is that Britain stops paying contributions to the EU in 2019-20. That assumes exit by March 2019, an assumption perhaps complicated by the High Court judgment, and assumes exit is not followed by the kind of arrangement Switzerland and Norway have with the EU, which involve contributions.

Anyway, the prospect of a return to surplus on Britainís current account, particularly from a position of record deficit, is encouraging. The Bank of England, by the way, also sees the deficit narrowing significantly but its forecast does not run as long as Niesrís.

Will it happen? Forecasts Ė good and bad - are forecasts, and subject to the usual health warnings. I had thought the big fall in the pound from the autumn of 2007 to early 2009 would lead to a big improvement in Britainís current account position but the outcome was disappointing, not least because of the weakness of Britainís export markets in the eurozone (one reason for the decline in the EU share of exports).

Niesr assumes the pound stays roughly where it was at the time of its forecast, $1.22 and Ä1.11, which implies a prolonged period in which sterling is below both fair value and historical averages. Currencies move, as we saw on Thursday. Depending on what happens on Tuesday in America, the dollar could move quite a lot. Currency market indications in recent days are that it would fall a lot on a Donald Trump victory, pushing the pound higher.

There is also, of course, that elephant in the room of Britainís future trading arrangements. Niesr expects the trade and current account positions to start deteriorating again in the first half of the 2020s. If Britain fails to secure good trade deals with the EU and the rest of the world, that deterioration could be very significant indeed. We should enjoy this return to surplus while it lasts.