Saturday, 23 February 2008
How the UK economy pays for all those imports
(click on the image to see a larger version)
For years, the UK has been living beyond its means, importing more than it exports. Last year was one of our most extravagant, we ran up an external deficit of ₤50 billion, which was about 3.9 percent of GDP.
Over the last year, the spend fest accelerated. Between July and September, the last quarter for which we have data, we ran up an external deficit of ₤20 billion, which on an annualized basis is approaching 6 percent of GDP.
How do we get away with it? How do we pay for these huge deficits? It is not amazing how little press coverage is devoted to this extraordinarily important question.
An answer can be found. However, it needs some time and effort devoted to examining the UK's net investment position. Once this data is tracked down on table 8.1 of an obscure ONS publication called the Pink Book, the answer comes screaming back at you. We have been building up debts and selling our assets.
Comparing what we own to what we owe, the UK economy is about ₤340 billion in the red, which amounts to about 26 percent of GDP. Moreover, our net investment position has deteriorated to a level unseen for at least 40 years.
(click on the image for a larger version)
The above chart illustrates the dire state of UK external finances. Until the mid-1990s, the UK had a positive net investment position. Then, we entered the glory years of "no more booms or busts". We engineered a consumption-led economic upswing, and we sustained it with a massive domestic borrowing binge, coupled with assets sales to foreigners. Since about 2003, things have really spun out of control. As the above chart starkly illustrates, our spending has become increasingly dependent on reducing our net asset position.
Without dipping into the dreary accounting details too far, a country's net investment position comprises of three types of financial transactions; a) foreign direct investment, b) portfolio investment (comprising of debt issuance and equity transactions) and c) other investments (mostly bank deposits, bank loans and trade credits).
The importance of these categories towards paying for our external deficit varies from year to year. Sometimes, foreign direct investment provides the largest financial inflow (like in 2005). Other times, it is bank deposits and loans (like in 2006) that pays for our import bill.
However, these accounting categories obscure a simple truth; if a country is spending more than it earns, then its citizens are either selling their assets to foreigners or they are borrowing from abroad. This is what the UK has been doing on a massive scale for the last decade. This is what is captured by the sudden decline in our net investment position.
Tracing out a direct line between the housing bubble and the UK's net investment position is not easy. However, at the centre of this relationship is the UK financial sector. On the one side, it has provided the easy credit to households that pushed up house prices. This sudden increase in "housing wealth" encouraged households to massively reduce savings and increase consumption, leading to large increase in imports and a deteriorating current account. On the other side, the financial sector also facilitated the sale of UK-owned assets to overseas residents. It has also arrangeed for new debt issuance, and bank loans that financed this huge current account deficit.
The UK economy is one comprising of charts surging off to the limits of the page. House prices rocketed into absurdity a long time ago; the savings rate crashed to zero, credit growth is well into double digits; while personal sector debt is out of control. Our external deficit and net investment position are two classic examples of how we have pushed the economy to the edge. Our consumption binge is at the mercy of foreigners; it can only continue so long as their buy our assets and lend us money.
There is one further question that keeps bothering me; how long can we get away with this lark? Could it go on for another ten years? Could we string it out for another five?
The answer comes down to how much forbearance our foreign friends have for our reckless spending ways. How much longer will they keep buying our assets and lending us money to pay for our deficit? No one can know the answer to this question for sure, but somehow I suspect that the answer is not ten years or even five.
Recently, the UK mortgage industry has complained about a funding crisis. The wholesale money market is no longer prepared to bankroll the housing bubble. This is a clear message from those that have funded the 10 year spend fest. The message is "no more partying; it is time to clean up the mess".