Should the UK worry about its record current account deficit?
The UK's current account deficit has reached its highest level since comparable records began in 1955. It rose to £32.7bn in the final three months of 2015, equal to seven per cent of GDP. A big current account deficit can often be a precursor to an economic crisis, so should the UK worry about it?
A sign of strength
Chancellor George Osborne had to tone down his talk on the economy in his March budget. The UK was now only the second fastest growing the economy in the G7, he said, after it was overtaken by the US last year.
The fact that the UK has outperformed most other major developed economies since the 2008-9 recession has been a major contributor to the current account deficit.
In the final three months of last year the UK’s total trade deficit – the amount it imports over what it exports – widened to £12.2bn, making up around a third of the deficit. Naturally, if the UK is growing faster than its main trade partners, UK demand for foreign goods and services will be higher than foreign demand for UK goods and services.
The same can also be said of the so-called primary income deficit. It is the difference between the income foreigners earn on UK assets and the income UK residents earn on their foreign assets. The primary income deficit increased dramatically to £13.1bn in the final three months of 2015. This was due mostly to a £5m drop in the income earned on foreign assets.
The secondary income deficit, which counts payments with no immediate economic good or service coming in return and includes foreign aid and EU payments, rose to £7.4bn. The trade deficit, primary income deficit and secondary income deficit make up the total current account.
In many ways, the UK’s current account deficit is the result of the fact it has outgrown other major economies.
Read more: Our current account deficit has risen sharply and is way above estimates
Risks
Current account deficits may be a sign of strength, but they also pose a risk. The deficit needs to be financed. It can be financed by selling assets abroad. These are recorded in the UK’s capital and financial accounts, which completes the balance of payments along with the current account.
The balance of payments should equal zero (the current, capital and financial accounts net out) but it often does not due to statistical problems. The UK ran a financial account surplus of £22.3bn in the final three months of 2015. That means foreigners invested £22.3bn more in UK assets than vice versa.
If foreigners suddenly lost interest in UK assets the UK would be unable to fund its current account deficit. This is quickly repaired by an adjustment in the exchange rate. Sterling would plummet, making British exports cheaper and foreign imports more expensive, levelling out the current account deficit. Investors might lose confidence in UK assets if there was uncertainty on the economy, which could occur in an around the Brexit referendum.
But the risks of this occurring have been downplayed. Bank of England monetary policy committee member Kristin Forbes recently said the UK was unlikely to suffer a sudden stop in capital inflows.
“About 81 per cent of net UK capital flows in 2014 were foreign direct investment, a more stable form of financial flows than the 'hot money' that is more likely to ‘suddenly stop’ and generate a crisis,” she said.
Read more: Kristin Forbes on Brexit: Don't worry about the current account
The Bank of England went further in a financial stability report last year. It said:
“Countries that rely on an increase in short-term bank lending to finance a current account deficit are particularly vulnerable to a loss of confidence because of the ongoing need to refinance the loans. If the loans cannot be refinanced, the country may need to run a current account surplus, forcing domestic residents to cut expenditure to below income levels.”
“The composition of recent capital inflows to the United Kingdom should make it less vulnerable to a sudden loss of confidence. The United Kingdom has been reducing its foreign short-term bank loan liabilities, included within ‘other investment’. In order to finance the deficit, however, the United Kingdom has had to incur new external liabilities. These new liabilities have been mostly longer term and include FDI, equity and longer-term debt.”
So-called balance of payments crises do happen. Britain itself suffered one during the Suez crisis in the 1950s and East Asia underwent a large one in the late-1990s. But in each case the exchange rate was being fixed or pegged. This removes the main correction mechanism for ensuring current account deficits – or capital account surpluses – correct themselves.