The ONS had a little surprise for us this week. The first quarter UK external deficit was much lower than expected. It came in at just 2.4 percent; the lowest number since early 2006.
The first quarter number stood in stark contrast to last year's deficit. In 2007, the deficit was just horrible. The UK imported about 4.5 percent of GDP more than it exported. In fact, in terms of GDP, the 2007 deficit was the second largest in around 50 years.
Insofar as this improvement was noted in the press, it was put down to the huge sterling depreciation, particularly against the euro, that had taken place since last August. The UK was supposedly exporting more and importing less.
Unfortunately, a closer examination of the data reveals a very different story. The UK has continued to import. The current account improvement came from a sudden reduction in the amount of profits and investment income that UK firms are sending to their foreign shareholders and creditors.
For those unfamiliar with balance of payments accounting, the current account comprises of four components; a trade account, which includes physical goods, a services account, which covers non-physical goods such as insurance; an income account, that records what income we receive on investments and what we pay out to our foreign creditors and holders of UK equity. Finally, there is the current transfers account, which covers our "charitable giving"; humanitarian aid and other such things.
The chart below records the first two items of the current account; the goods and services balance. There is no major improvement here; the UK continues to import more than it exports in much the same way has it has done for years.
The income balance, on the other hand, shows a major improvement. In the middle of last year, the balance was more or less zero. In the first quarter of this year, it recorded a surplus of over 2 percent of GDP.
So what happened last quarter? In terms of investment income, the UK received about ₤1 billion less than the previous quarter. However, UK firms paid out around ₤3 billion less. Since the UK was paying out less on a net basis, the income balance improved.
Overall, the UK net investment income improved by over ₤2 billion. Between the last quarter of 2007 and the first quarter of this year, the current account deficit fell from ₤12 billion to ₤8 billion. In percentage terms, net investment payments covered 56 percent of the improvement.
For years, the UK has run up huge external deficits. It has been able to do this because foreigners were willing to buy UK assets. These purchases generated an inflow that allowed UK residents to buy lots of imports. Foreign investors were happy to buy UK assets so long as they generated healthy returns. The sudden shift in the income balance threatens this happy arrangement.
Lower net investment receipts might improve the current account in the short run, it won't work in the long run. A large current account deficit needs to be financed. Foreigners will not buy our assets if investment returns continue to fall. It is just one more adjustment the UK economy must make in the new post-housing bubble reality.