Britain’s current-account deficit: the deficit that nobody’s talking about

UK overlaid on Union Jack © Rex Features
Is the pound still as good as gold?

Politicians are obsessed with the UK’s budget deficit, but our current-account deficit is the largest since the 1940s. Could Brexit turn it into a crisis? Simon Wilson reports.

What is the current-account deficit?

A nation’s current account is an overall measure of whether that country is a net lender to the rest of the world, or a net borrower from it. When the account is in deficit, it means it’s a net borrower, which has been the situation for the UK for more than 30 years.

The current-account measure consists of three elements. First, there’s the trade balance: the total value of exports (of both goods and services) minus imports. Second is net transfers, for example remittances sent abroad or home by migrant workers, or international development spending. And the third part is net investment income – the difference between the money that the UK earns on overseas investments and what it pays out to investors overseas.

Why does it matter?

The current-account deficit was for many years a closely watched barometer that dominated domestic politics. In 1970, for example, Prime Minister Harold Wilson famously appeared to be heading for another election victory when unexpectedly bad trade figures changed the course of the campaign and allowed Edward Heath into Downing Street.

However, today it’s principally the UK’s fiscal deficit – the gap between tax revenues and government spending – that makes news headlines (the Conservative government’s stated aim is to turn the deficit into a surplus by 2019-2020). But some argue that the current-account deficit should be watched much more closely than it is – especially given the vote in favour of the UK leaving the EU.

Why is that?

Because it’s become so large, hitting a post-war high of 7% of GDP in the last quarter of 2015. (The figure for the whole of 2015 was £96.2bn, or 5.2% of GDP.) A current account is not a bad thing in itself, and nor is a current-account surplus.

For example, says  Oliver Kamm in The Times, countries that are developing rapidly often run current-account deficits. This is natural for an economy that has many investment opportunities and not enough domestic savings to take advantage of them. Foreign investors can provide the capital, and the inflow of funds means a widening current-account deficit.

So it’s good news for the UK?

No. A large and persistent deficit can signal an economy with strong domestic consumption that’s not paying its way in the world, while a large surplus can signal a country where domestic demand is too weak and growth is too reliant on exports. In the case of Britain, the deficit could in one sense be seen as a vote of confidence in its ability to balance the current deficit with a capital surplus. After all, a country can sustain higher borrowing if its investments are growing. However, that’s not been the case in recent years: on the contrary, Britain’s net investment income has fallen.

As Duncan Weldon, head of research at investment firm Resolution Group, puts it: “For advanced economies like the UK, current-account deficits have a habit of not really mattering until such a time as investors decide they do matter. At which point they can matter a great deal”.

How is this linked to Brexit?

Some analysts believe that the vote to leave the EU could be exactly the kind of negative shock that could precipitate a crisis of confidence in the UK economy. If investors in Britain were collectively to lose their nerve, there could be a sudden halt in capital inflows, forcing the current account into a balance of payments crisis. In a fixed exchange rate or common currency system, the result is a wrenching economic adjustment of the kind we have seen in several eurozone countries in recent years.

For a country with a floating currency, such as the UK, it has the potential to cause a disastrous depreciation of the currency (in which any gains for exporters are wiped out by the overall recessionary impact) and widespread default on debt.

Are there reasons to be cheerful?

Thankfully, yes. In the case of the UK, it’s not a widening trade deficit that has been the biggest factor in the current-account deficit, but a collapse in net investment income. That is potentially reassuring. The fact that the UK is earning less on its external investments than it is paying to foreign investors in the country – and that the gap is increasing – could be seen as a function of the fact that the UK economy is in generally better shape than most.

Could the deficit be good news?

The stability of the UK’s structural trade deficit (at around 2% of GDP) is arguably an encouraging sign – especially now. The next government, which must negotiate the terms of Britain’s future relationship with the EU, will no doubt be armed with the latest figures showing that Britain had a £34.7bn deficit in the trade of goods in the first three months of 2016, up by £1.4bn on the final quarter of 2015.

Crucially, the deficit with the EU accounted for more than two thirds of the shortfall, around £24bn. That’s an awful lot of net exports that other EU countries have no wish to put at risk.

Is overreacting the real risk?

Of course, there are risks to running a current-account deficit, says Frances Coppola on FT.com. “All that inward investment has to go somewhere: we would like to think that it would go into productive business investment, but it could go to blow up property prices in London and Edinburgh.” A widening external deficit “also makes it harder to close the fiscal deficit, since the domestic private sector (households and/or companies) must run larger deficits to compensate”.

However, there is a simple solution to this: stop trying so hard to close the fiscal deficit. The fiscal deficit “has never been the biggest risk to the economy, and the current-account deficit isn’t either. The biggest risk is that fear of these deficits will lead to policy decisions that squash a promising recovery”.

  • “No. A large and persistent deficit can signal an economy with strong domestic consumption that’s not paying its way in the world”

    Utter rubbish.

    We are indeed ‘paying our way in the world’. It’s just that you are ignoring the export that achieves it – Sterling Savings.

    That’s what the rest of the world wants and that is what we can give them in infinite quantity.

    And there is no need to pay them for doing so either. They hold Sterling Savings because that is how they achieve the ‘export surplus’ the idiots in charge say they have to achieve for prosperity.

    In a floating rate exchange system there cannot be any ‘excess deficits’. Very simply the system runs out of the right sorts of money to make the trade happen unless somebody somewhere accepts the saving.

    So the trade and the balancing savings always happen at the same time *or the deal fails*. Think letters of credit for shipments.

    The problem here is drawing an arbitrary line on a map around a political division and believing that actually makes a difference to finance in a global world.

    It doesn’t.

    • Cynic_Rick

      When referring to Britain’s current account deficit I like to think of Britain in terms of UKplc, a single business.

      The annual current account Deficit is then analogous to a ‘Loss’ on the balance sheet of the single business.

      In the context in which you are writing, am I wrong to deduce that Sterling Savings is analogous to the single business’s Overdraft Facility?

      • You are indeed, because Sterling doesn’t stop at the country’s borders. In fact what is happening is the number of people across the world in the Sterling currency zone grows and shrinks in a dynamic fashion.

        Once you see the zone in this way, the ‘current account deficit’ is just an accounting policy artefact to do with drawing up accounts on a national border on a denomination that is no longer limited to a national border.

        There is little difference between somebody saving Sterling in Birmingham or London UK, and somebody saving Sterling in Birmingham, Alabama or London, Ontario. The economic effect of both is the same – like a voluntary tax that stops the next person down the line earning an income.

        It’s better to see Sterling Savings as an export product, like an ornament you buy and put on the shelf.

        • Cynic_Rick

          Sounds like something akin to a sort of Ponzi scheme to me. I have empathy with what jaizan has said about inflation.

          Ornaments are susceptible to falling off shelves; including those serviced with ‘fraudulent’ money.

          In my view it is imperative that UKplc turns its Balance Sheet from Loss to Profit. Once freed from the shackling constraints of the EU the UK should be in a much better position for that transition to be enabled.

    • jaizan

      When we start printing an infinite quantity of Sterling, the rest of the world will cease to be interested in it.

      The value of Sterling will fall, the cost of imports will rise and very high inflation will follow.

      • When you start using the word ‘infinite’ in childish excluded middle fallacies you can be safely ignored.

        • Joss Bolton

          Neil, I think you may be “technically right”, but at the same time of course the deficit matters, because if we are running a trade deficit, and balancing the books with capital inflows, two highly negative effects are taking place: First, we are allowing other countries to have the jobs and profits created by our consumption, and second, we are selling the UK to foreigners bit by bit – sure, their FDI creates jobs (and tax revenues), but the profits flow overseas. I understand that is a very simplistic model, but at the same time, if you step back that is how it functions, and as we are finding out, when this does become visible, it is forced to change – hence the falling pound, which is mostly caused by the possibility of declining FDI failing to offset the trade deficit (as a result of a hard Brexit).

          • “First, we are allowing other countries to have the jobs and profits created by our consumption”

            They can’t eat profits. Yes they get jobs, but there is no finite amount of jobs. We just create different jobs here.

            “second, we are selling the UK to foreigners bit by bit ”

            And? Just because they own something doesn’t mean they get to take it away or get any income from it. That is a matter of policy for the UK.

            The Chinese may own Hinkley point, but it is a matter of law whether they get anything from that ownership.

            “t is forced to change – hence the falling pound, which is mostly caused by the possibility of declining FDI failing to offset the trade deficit”

            It is caused solely by a change in demand for pounds vs other currencies. That is it. The balance then shifts until the equilibrium between foreign saving and imports vs. exports is restored. If there is no savings, then there can be no excess imports either.

            It is very important to realise that for an import excess to exist there *must* be matching foreign financial savings that occur at precisely the same time. Otherwise the deal cannot complete and the financing arm fails. Nothing is bought or sold.

  • AAJ

    Right now the value of the £ is in decline and so we are told this will help exporters and so reign in that deficit. However this also means I personally have less money to buy foreign companies and real estate and so in future I will bring less money into the UK. It will make it easier for foreign investors to buy UK companies and land and in so doing take more money out of the UK.

    So what do we need? Do we try and compete with low wage economies by devaluing the £ Do we sell off more of the UK to subsidise low pay with benefits only for people to spend that money on products from abroad?

    I feel there is something fundamentally wrong with the UK economy. We are obsessed with buying stuff we don’t need from abroad and wanting someone else to pay for it. We also don’t invest enough in the UK’s future and only look at what is happening today.