One question keeps coming back to me from readers. Why, when it was such a big issue in the past, does the balance of payments no longer seem to matter anymore?
And, related to this, are we now entering a period in which it may indeed start to matter again, perhaps quite a lot?
There has never been a better time to write this piece than now and it may help to start by defining terms. The trade deficit is the gap between exports and imports of goods and services.
Traditionally we used to talk about the visible trade deficit – the gap in goods (£108bn last year) – but now it is customary, and helpful to Britain, to include services (the goods and services deficit in 2013 was a more manageable £27bn).
The current account deficit – £71bn last year – is the trade deficit plus two other flows, income and transfers, of which more in the moment. The current account deficit is the one to watch. Because the balance of payments has to balance, as every economics student is taught, there are two other accounts, the capital and financial accounts.
Actually, when I was first taught economics, we always expected the capital account to balance any red ink we recorded on the current account.
But, as the Office for National Statistics (ONS) reminds us, the combined current and capital account has been in deficit since 1983. For three decades we have relied on the financial account – direct and portfolio investment and, perhaps scarily, financial derivatives – to keep our heads above water.
The current account was more important in the past, certainly in the 1960s, because current flows (trade and invisible earnings) were not then dominated by capital flows, and because it was an era of fixed exchange rates. Balance of payments pressures required a swift response from the authorities in the form of higher interest rates.
Now there are reasons why we should take note again. Not only were the numbers for last year awful, but they took a decided turn for the worst in the second half of the year.
When, a few weeks ago, the ONS released current account figures for the third quarter of 2013, showing a deficit of more than £20bn, my initial thought, given there was such a lurch into larger deficit from under £10bn the previous quarter, was that it must be an aberration and would probably be revised lower.
A few days ago, however, that third quarter figure was revised up, to £22.8bn, and the number for the fourth quarter came in at a high £22.4bn.
Moreover, the fourth quarter deficit was 5.4% of Britain’s gross domestic product, only marginally down on the 5.6% figure for the third. Add the two together and you get a deficit of 5.5% of GDP, the biggest for any six-month period in post-war history.
For once the problem was not with the trade deficit, which narrowed from £10bn to £5.7bn on the back of a record high for service sector exports.
No, the problem lay elsewhere, and in particular for investment income, which showed a deficit of £10.3bn in the final quarter and £17bn for 2013 as a whole, up from £3.7bn in 2012.
The turnaround in Britain’s investment income has been sudden. In 2008, there was a surplus of £33.2bn from this source. As recently as 2011 Britain was in the black to the tune of £22.7bn. Losing this source of balance of payments is like a star racehorse going lame.
It has happened, say official statisticians, because of losses abroad by British banks – or the realization of earlier losses – together with a drop in income on overseas investments by British firms.
Tied to this, there has been a turnaround in relative returns on investment. Michael Saunders of Citi points out that from 1998 to 2011 the annual rate of return on British investments overseas, 3.9%, exceeded the return on foreign-owned assets in Britain, 3.5%.
Since then, the position has been reversed. Both sides suffered as a result of the crisis but at the end of last year British investments overseas were only returning 1.7% annually while foreign-owned assets in Britain returned 2.2%.
It is possible some of this is temporary. It may, in part, be an aftershock of the financial crisis.
But these shifts can be long-lasting. Though we came in recent years to regard investment income as one of the sure things of the balance of payments, there was a deficit on it for all but a couple of years over the period 1977 to 1997, partly as a result of the income paid to foreign owners of North Sea oilfields. There was a trade surplus on North Sea oil most of that time, but an outflow of investment income.
This time, according to an interesting analysis by James Carrick, an economist with Legal & General Investment Management, the big shift has been in Europe. Depressed demand in the eurozone, coupled with strong export performance by countries such as Germany, led to a sizeable current account surplus.
In the final quarter of last year, that surplus was 66.8bn euros (£55bn), well over double Britain’s deficit. So Britain’s poor numbers for investment income partly reflect what is happening in the eurozone. British investors, and British businesses with operations in Europe, have been getting poor returns.
Europeans, however, have been happy to use their current account surplus to pour money into Britain, and not just into London housing. We are relying on the rest of the European Union to fund our current account deficit, a point it might have been worth Nick Clegg raising in his debate with Nigel Farage.
How risky is this? Britain’s current account deficit, Carrick points out, is in similar territory to the so-called “fragile five” emerging economies. The financial flows that have kept Britain afloat could be vulnerable to political uncertainty and change, such as a yes vote in September’s Scottish independence referendum and, even more, a vote to leave the EU in an in-out referendum.
The best long-term solution is to trade our way into a stronger current account position. Until then the pound, and ultimately interest rates, will be worryingly dependent on the willingness of others to fund our current account deficit.
This piece is cross-posted from EconomicsUK.com with permission.