Much has been made of the made of Chancellor George Osborne’s success with austerity and the UK’s eruption back into growth, confounding his critics. However, ‘austerity’ has been more of a publicity exercise. Government spending as percentage of GDP has fallen only slightly, but is still higher than it ever was before the financial crisis.
The unsurprising result is that the UK has made far less headway than many other countries in addressing its budget deficit. It still sits at 5.7% of GDP, and is one of the worst in the developed world.
More concerning has been the ballooning current account deficit. In the 1960s a 1% deficit raised eyebrows, and a 3% deficit could precipitate a full-blown sterling crisis. Today’s 4.4% of GDP is mind-blowing, yet is not generating so much of a flicker of worry from policymakers.
This reaction is stunningly complacent given this is the second largest current account deficit, in dollar terms, in the world (after the US), and is the largest the UK has ever run. Taking into account the budget deficit, the UK is running the largest twin deficit in the developed world.
This current account deficit is beginning to look a structural issue. Recent declines have been driven by the income balance. This is the net of income flows (from dividends, coupons, capital gains, etc) that leave and enter the UK.
Despite having a net liability position (ie the UK’s foreign assets are less than UK assets held by foreigners), the UK is unusual in having a positive income balance. The only other country to enjoy this privilege is the US. However, the UK’s income balance is now negative and appears to be in free fall. It is this that is driving the current account lower.
Delving in to the numbers, it appears this is happening because the UK is beginning to earn less on the assets it holds abroad relative to what it pays to foreign holders of its assets. It is hard to pin exactly why this is happening (perhaps it is down to, post financial crisis, UK banks being forced to exit many investments that paid well), but it is a pattern that looks structural not cyclical, and the UK will come to resemble every other non-US country that has a negative net foreign asset position.
Indeed, the stakes are higher in the UK. Although the net liability the UK has with the rest of the world is small, the gross postions are large, as the chart below shows. Much of this is due to the still-bloated UK banking sector.
The UK’s gross foreign asset position is over 5 times GDP. If the UK is losing its comparative advantage in what it receives in overseas income compared to what it pays, then the sums involved could evenutally be very large, dragging the current account deficit down much further.
The Bank of England cannot continue to ignore this. In previous comments, Bank members have suggested the only feasible way to rectify the current account deficit is a nominal exchange rate devaluation. We believe that as it grows clear the current account deficit is not about to reverse course on its own, another sterling devaluation will become increasingly necessary.