Yawning UK current account deficit raises funding risks

As Kwasi Kwarteng prepares his mini budget on Friday, economists said one of the new chancellor’s main tasks was to bolster confidence in Britain’s economy.

The country has become more dependent on foreign capital inflows this year than at any other time since records began in 1955, underscoring its vulnerability to any decline in confidence in Britain’s economic management.

The current account deficit – which includes the UK’s trade balance and net foreign investment and transfer income – deteriorated to a record 8.3% of gross domestic product in the first quarter of this year, the country’s imports far exceed the value of its exports.

With such a gap between the country’s consumption and its production, the pound can only maintain its value if foreigners want to lend to Britain or buy assets such as land, housing or businesses across the country.

But if confidence drops, “capital inflows will fall [and] UK asset prices are also likely to fall as overseas investors head for the exit,” said Neil Shearing, group chief economist at Capital Economics.

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The UK has long had a current account deficit and has generally found it relatively easy to finance, except in times of crisis, such as in the late 1970s, when ministers had to go “head in hand” to the IMF and 1992, when the pound sterling fell into the EU exchange rate mechanism.

Although the sudden widening of the deficit was largely caused by soaring energy import prices following Russia’s invasion of Ukraine, the concern underlying the recent fall in the pound Sterling at its lowest level in 37 years against the US dollar is that investors will no longer be willing to finance the UK’s overconsumption.

Foreign financing is needed because the UK’s trade deficit is not matched by other flows of money into the country’s current account. In the early years of this century, the trade deficit was partly financed by income from British ownership of overseas assets which exceeded foreign ownership of British investments.

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However, recent data shows that net investment income is negative, as are transfers, such as foreign aid and remittances paid to citizens abroad.

With a current account deep in the red and dependent on foreign funding, the UK should be seen as an attractive location for lending or investing.

Simon Harvey, head of analysis at exchange firm Monex Europe, said it was a problem because investors were worried about “rising government debt”.

Susannah Streeter, senior investment and market analyst at asset manager Hargreaves Lansdown, said the need for foreign funding has also added to pressure on the Bank of England to raise interest rates. “The UK may not be able to attract enough foreign capital to fund its debt at today’s interest levels,” she said.

An alternative to lending money to the UK to finance its consumption of imports is to sell assets to foreigners, which also forces them to buy sterling.

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But that wasn’t a long-term strategy, said Ross Walker, chief UK economist at NatWest Markets. The country would become poorer, he said, and that would increase income from those overseas assets, weakening the current account in the future.

“This in turn puts downward pressure on the currency, fuels imported inflation and hurts living standards,” he added.

A falling currency is often part of the solution to a gaping current account deficit. Although exports become more competitive, it generally works by raising the price of imports, which causes consumers to end up buying less from abroad.

To avoid this revenue squeeze, confidence in the government’s economic strategy is vital, according to Shearing. The strength of UK institutions and the rule of law mean the UK “remains an attractive destination for foreign capital”, even with a large international current account deficit.

Another advantage for the UK is that other European countries also have deteriorating trade and current account balances, although for most of the last decade the UK has had the largest deficit against the size of its economy of all G7 countries.

The OECD predicts that the rising value of energy imports will turn Italy’s current account surplus into a small deficit this year, while Germany’s surplus will shrink and the France will sink. However, none have such large deficits as the UK.

Ultimately, this makes the UK most vulnerable to a shift in sentiment, where taking risks with the economy is most likely to lead to a sudden drop in currencies which can exacerbate inflation, raise interest rates and further reduce income.