The UK Current Account Deficit After Brexit
Are foreign investors still willing to fund a large deficit?
By James McCormack
Concerns about foreign investors’ willingness to fund the UK’s current account deficit after Brexit are premature and may prove misplaced
The Brexit referendum result casts uncertainty over the economic outlook, undermining the UK’s attractiveness as an investment destination. This is important in the context of the large UK current account deficit, which must be matched by equally large capital inflows. With the UK deficit running at just over GBP100bn annually, exceeded only by the US in nominal terms, the question is whether foreign investors are still willing to fund a large deficit and on what terms.
Assessing the sustainability of UK current account funding is complicated by the country’s status as a global financial centre, whereby capital flows are large and volatile. Brexit adds uncertainty, with the UK’s dominant role in international finance subject to change, possibly altering the balance of payments (BOP).
The UK current account deficit has attracted increased attention since 2013, when it exceeded 4% of GDP for the first time since 1989. The deterioration was due to a negative “income balance”, reflecting a decline in earnings on UK foreign assets relative to foreign investors’ UK earnings. The deficit grew to a record-high 7.2% of GDP by 4Q15, prompting concerns about the cost and availability of external financing.
Headline Flows and Volatility May Conceal Underlying Stability
Capital flows in the BOP are listed as direct investment (controlling interest in a foreign enterprise), portfolio investment (in equity and debt) or other investment (bank and non-bank lending). In most countries, analysing the capital account along these lines leads to firm conclusions on current account sustainability. This is not the case for the UK, where portfolio and other investment flows are disproportionately large relative to the current account and the size of the economy.
Capital flows are large relative to UK GDP, but they are proportionate to the underlying stocks of external assets and liabilities, which are oversized due to the UK being an international financial centre. The international investment position (IIP) shows that UK external assets and liabilities exceed 500% of GDP, more than double the level for the US, Japan and the eurozone.
TThe UK’s unique circumstance among large advanced economies means a more revealing — and unconventional — way to analyse its capital account is to group debt flows (other investment plus non-equity portfolio investment), which are exceptionally large and frequently offset each other. This reduces the volatility of the data, and crudely separates flows driven by the financial sector from more traditional investors, which are moving funds in and out of the UK based on its attractiveness as an investment destination.
On this basis, UK current account funding in recent years appears favourable. Even though the deficits have been large, they were funded exclusively by non-debt flows, with portfolio equity and direct investment inflows together averaging about 8% of GDP since early 2014. Direct investment, the larger of the two, is the most stable and reliable source of external funding.
Brexit Need Not Mean Yawning Deficits
Separating debt and non-debt capital flows provides reassurance on recent current account funding, but not for future funding. With no clarity on the UK’s ultimate trade relationship with the EU, and no announced strategies for dealing with EU-based regulatory and legal issues, it seems improbable that direct investment flows will continue uninterrupted.
It is possible that, with the right deals negotiated, the UK will retain its access to EU markets and, by extension, its status as a global financial centre. In this scenario, the BOP may be no cause for worry.
Another, less favourable, scenario has the UK without EU access, and with a diminished role in global finance. Direct investment could stop, or reverse, and the current account deficit would be funded largely by external borrowing. Rising external debt would not be a positive development.
But it is possible that UK current account funding issues would not materialise even without EU access and global financial centre status. The IIP would contract, but a faster decline in UK foreign assets than liabilities might mean large net capital inflows if UK-based investors brought money home faster than foreign investors sold their UK holdings. The size of the stocks means the flows associated with their wind-down could last some time.
It is also arguable that if the UK loses its global financial centre status, the current account deficit could decline, reducing the need for external funding. GDP growth and the value of sterling would probably be lower, implying a current account improvement. Weaker UK growth would reduce foreign investors’ UK earnings, reversing the deterioration in the income balance of the current account, the largest contributor to the higher deficit in recent years.
There are no definitive conclusions yet on future funding stresses for the UK current account. Negotiations on access to EU markets, and broader investor sentiment regarding the UK after Brexit remain issues to watch.