Sunday, 16 March 2008

The UK is in the red and no one seems to care

(Click on the chart for a sharper image)
The UK's external finances are in trouble. For the last four years, our current account deficit has been rising sharply. In 2006, the deficit reached almost 4 percent of GDP. So what is behind this deterioration?

(Click on the chart for a sharper image)

The answer turns out to be remarkably straightfoward. The above table breaks down the current account deficit into its key components and compares 2006 with 2007. Overall the deficit increased by 1.3 percent of GDP. However, the goods and services balance remained unchanged. The income balance went from a surplus of 2 percent of GDP to just 0.6 percent of GDP - a deterioration of 1.4 of GDP.

This part of the current account largely comprises of investment income we receive on assets UK residents hold abroad minus dividend and interest payments we make on UK assets held by foreigners.

The UK's net investment position in 2006 tells a sorry tale. The UK now owes more to foreigners than assets we own abroad. In other words, we are in the red. If the UK was a company, it would be bankrupt. Moreover, the extent of our financial difficulties is significant. Our net investment position, which is negative to the tune of about 340 billion, represents about 6 percent of our total external assets and about 26 percent of GDP.

(Click on the chart for a sharper image)

Our net investment position was not always this bad. For many years, we had a positive net worth, which allowed us to run on large current account deficits. It has only been in the last three or so years that our net investment position turned from a positive balance to a negative one.

(click on the chart for a sharper image)

With a negative net investment position, it should surprise no one that our investment earnings have also turned negative. This happened last year. For most of last year, there was a net outflow from the investment balance.

(click on the chart for a sharper image)

The options here are rather stark for the UK. Either we cut back on our deficit on goods and services, which implies a significant reduction in living standards, or we can expect the current account deficit to become larger. In the past, the UK could rely on investment income to produce a surplus of about 2 percent of GDP each year.

Should the UK decide to ignore its external difficulties, then larger current account deficits will need financing. We can either sell some more assets, or we can borrow. Both of them implies a further outflow over the medium term. Foreigners will invest in the UK so long as they can receive dividends in the future. They would also lend us money, but that will require interest charges and repayments.

Another alternative would be an exchange rate devaluation. That would increase the value of our external assets, in sterling terms. However, the size of the devaluation would need to be quite large and it would lead to higher inflation. It would also make all those imports we depend upon more expensive. We would, in effect, rip off all those foreign investors by reducing the foreign currency value of their UK investors. This might make them a little wary of investing in the UK in the future. In sum, the exchange rate route would also be rather painful.

In the UK today, people have become so inured to debt that a serious discussion about the UK's external position is all but impossible. People can no longer conceive of any external difficulties, just like it is beyond the bounds of imagination to think that personal debt could, in the long run, pose any problems.

However, the UK's external payments problems are real and they will not easily be ignored. One day, our foreign creditors are going to say "enough" and pull the plug on our extravagant spending.


Anonymous said...

Those numbers are scary, what makes up the difference? Is it debt?

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