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.

4 comments:

traderboy said...

this is an excellent post. fundamental data combined with common sense points to a horrible future for the UK.

banks may not be willing to lend

exactly. the news over the last few days has been almost comical...nationwide hikes mortgage rates so that borrowers WON'T borrow from it, then the rest of the banks do the same. Where does this stop?

Rental yields are 4%, give or take. Any owner should be scared...if the environment stays the way it is, you'll need rental yields of at least 8% to make sense. That's a 50% fall. Book it.

Anonymous said...

Alice

Again, zeroing in on what matters and I'm eternally gratefull that you are doing the legwork and the analysis so we don't have to.

I think this post is getting at the crux of it. Lower interest rate = higher long term rates = higher cost of government borrowing.

Add to that the fact that every injection of "liquidty" is hits a roadblock in the banks' balance sheet and never passes through to the economy and I think we are getting to deflation.

Nick

Ross said...

Nick,no signs of deflation down at tescos.

Anonymous said...

Ross,

I think we are talking at cross-purposes. For me:

Inflation = net increase in money supply relative to demand for it
Deflation = the opposite.

Money velocity has slowed to a crawl (i.e. banks won't lend, businesses and consumers won't borrow). Credit is evaporating. The money base is remaining about the same but the credit side of supply is going fast.

The result is imploding asset prices. Yes, commodities are up but what percentage of your monthly outgoings are bread and milk (compared to rent/mortgage, education, services, health).

Deflation can happen within the context of rapid increases in commodity essentials. When the big ticket discretionary items and the luxury services go up in price, then we might question deflation IMHO.

Nick