Lend us a fiver?
13 February 2018
The UK has failed to balance the books with the rest of the world for the past 30 years. Over this period it has run increasingly large current account deficits, reflecting long-lasting trade shortfalls, and more recently a deficit in its primary income account (as returns on foreign assets have deteriorated relative to those on its external liabilities). These current account gaps have been financed by correspondingly large net inflows of capital (see Chart 4). These can take a number of forms, from foreign direct investment (FDI), to portfolio flows, to financial derivatives, to the ambiguously labelled ‘other investment’ component of the financial account (mainly composed of short-term bank liabilities). The composition and resilience of these flows, which have averaged just shy of 5% of GDP over the last five years, have come under increased scrutiny in the wake of Brexit. In particular, there have been concerns around a change in investor appetite for UK assets given the increased uncertainty around future institutional arrangements, trade arrangements and their impact on the current account and long-term growth prospects.
We now have five quarters of balance of payments data to draw upon since the referendum to gauge these effects. The first obvious takeaway is that there have been few signs of disruption to net capital inflows, which have continued to run at an almost identical pace. Part of the resilience of these flows can be attributed to sterling. A large depreciation in the pound has provided a discount on UK assets for foreign investors, making them more attractive. The composition of capital flows also provides a degree of comfort (see Chart 5). FDI inflows have been robust, with this funding considered one of the stickiest capital inflows. Net portfolio flows have also been generally supportive, although this has differed widely by asset class. Foreign investors have snubbed UK equities with cumulative outflows from this asset class amounting to 1.1% of GDP since the referendum. Conversely, we have seen large inflows, totalling some 4.5% of GDP, into UK government bonds over this period. Finally, the UK has not been relying on inflows under the ‘other investments’ category, which can be prone to sudden reversals.
While capital flows since the referendum have been resilient, last week provides a good example of how this imbalance could affect the UK under different scenarios. First, we saw a spike in global financial stress as market volatility jumped, pushing sterling 1% lower in trade-weighted terms. This serves as a reminder that countries with large external imbalances can be sensitive to changes in global risk sentiment. Second, Michel Barnier, EU Brexit negotiator, warned that a transition agreement after Article 50 was “not a given”, triggering another stir in sterling markets. This could reflect concerns over short- and long-term growth prospects should the UK chose a hard Brexit. Markets might also become less tolerant of the UK’s current account shortfall in this scenario. In particular, they might worry that a fall back to WTO rules would imply particularly large barriers for services trade (an area where the UK runs a surplus), implying an even worse current account position. If it becomes less willing to finance this imbalance, then sterling would need to adjust further and domestic demand potentially slow to help close the deficit. While it continues to struggle to pay its way the UK will remain sensitive to international investor sentiment.