Investment Clock insights

Economic Times April 2016

Ian Kernohan

April 2016

The UK’s current account deficit has widened significantly, and now stands at 7% of GDP. The current account records international flows of payments to and from UK residents, generated mainly by trade and the ownership of assets. To fund the deficit, UK residents can sell some of their foreign assets or increase their foreign liabilities, either by borrowing more from foreigners, or selling UK assets. This means that the counterpart to a current account deficit is a net inflow of capital, with these flows recorded in the financial account as a capital account surplus.

The deterioration in the current account in Q4 was a consequence of weaker foreign income flows (the primary income balance) and a worsening trade deficit. The primary income balance reflects the difference between what the UK earns on overseas assets, and what the Rest of the World earns on its UK assets. This balance had showed some signs of improvement last year, but has not been sustained, with a sharp deterioration in non-EU net investment income, especially from the US.

The UK is a relatively open economy, and has been viewed as an attractive destination for foreign capital. In part, this has been due to the UK’s membership of the EU, though other factors, such as legal transparency and the UK’s long-standing openness to foreign investment, are also important. In a ‘Brexit’ scenario, the capital inflows which enable the UK to sustain this sizeable current account deficit would probably come under pressure, and sterling would need to fall to offset this impact, at least until uncertainty about the UK’s new position lifted.

Current account deficits become a real problem when they are difficult to fund, and just because an economy runs a current account surplus, does not mean that all in the economic garden is rosy: Japan runs a large current account surplus, as does China, and neither economy is short of economic concerns. Gilt spreads do not suggest markets are less keen to buy UK assets, while the recent drop in sterling is more to do with the risk of Brexit, rather than a sign of ongoing capital flight.

The UK long ago dropped attempts to peg its currency at an inappropriate level, which it would then be forced to abandon: Black Wednesday in September 1992 put paid to that approach. A free floating sterling should enable the UK to avoid an old fashioned “sterling crisis”; the market will find a level for sterling, consistent with funding the current account deficit.

The value of your investment and the income from it is not guaranteed and can fall as well as rise. This article is for professional customers only. The views expressed are the author’s own and do not constitute investment advice