Friday, 28 March 2008
UK records huge external deficit
(click on the chart for a sharper image)
While everyone is banging on about the crashing housing market and our collapsing banks, no one is paying any attention to the elephant sitting in the corner - the UK current account deficit.
The ONS just published the annual number for 2007. It came in at a massive 4.2 percent of GDP. This is the second highest deficit the UK recorded since 1948, which is as far back as I can get data. The last time the current account deficit was higher was 1989, when it reached 5.2 percent. Wasn't there a massive housing crash and a recession the year after?
Should we be worried about a 4.2 percent current account deficit? Absolutely; this deficit could suddenly "correct".
A deficit of that magnitude needs a lot of foreign financing, and there is a danger that we could wake up one day and find the financing isn't there anymore. People could lose confidence in the UK, capital could fly out of London, sterling would crash and all those cheap imports would suddenly become expensive.
If you think that a sudden crash is implausible; history is full of examples of countries who ran up huge deficits and then had to suddenly adjust to a new reality of zero current account financing.
To some extent this is happening already. Sterling has fallen sharply against most currencies since since the credit crisis began back in August. On a trade weighted basis, it has declined almost 12 percent since the summer.
This huge current account deficit creates a dilemma for the Bank of England. Banks, estate agents and builders - the backbone of the UK economic miracle - are calling for an interest rate cut. The banks want some relief from the credit crisis, while the agents and builders want to keep the housing market afloat. All hope that a rate cut will keep household consumption cruising at its current high altitude and keep the spectre of a recession away from our door.
However, if an interest rate cut kept consumption going, the current account deficit would further deteriorate. Households would continue to pull in imports. Foreign importer will naturally demand payment, which will require either a foreign credit or the sale of an UK owned asset. That is how current account deficits work. If a country has one, it usually means it is getting poorer. So while an interest cut might be good for housing, it would be bad for the UK's international net worth.
In any event, the Bank of England might think that a rate cut may not generate any additional consumption anyway. Households are now heavily indebted. Bank balance sheets are deeply compromised. A rate cut may not encourage more borrowing, and even if it did, banks may not be willing to lend.
So, the UK economy is an a bind. If it continues to grow, the external deficit will increase further, threatening trouble later. If it slows, import demand will tail off, and the current account deficit will fall. Unfortunately, that would put a stake through the housing bubble. It would raise default rates and do further damage to already weak bank balance sheets.
To cut or not to cut; neither option is particularly appealing, which might explain why no one wants to talk about our external deficit.