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A current account concern

THE UK’s current-account deficit rose to more than £70bn in 2013. At 4.4% of national income (GDP) this was the second-largest annual deficit since records began in 1948 – only the 4.6% deficit recorded in 1989, at the height of the ‘Lawson boom’, was bigger. But, while the economy was growing at a reasonable pace during 2013, it is hardly a boom. So what is driving the rising deficit and should we be concerned?

One possible explanation is the long-term relative decline in manufacturing, accentuated by the problems in our key eurozone export markets in recent years. Combined with a reliance on net imports of oil and gas, this pushed the deficit on goods trade up to almost 7% of GDP in 2013.

This has been matched, however, by a surplus on services, which reached records levels of about 5% of GDP in 2013. Before the crisis, this was driven by financial services, but recently other types of business services have led the way. Our services exports are less focused on the eurozone and more on the US and emerging markets. So we tend to be playing in faster-growing markets where UK businesses have more of an advantage.

The net effect of these trends is that our overall trade balance on goods and services in 2013 was in deficit by just under 2% of GDP. Although not great, that was somewhat lower than the average trade deficit of just more than 2% of GDP during the previous 15 years. So if a widening trade gap was not the problem, we need to look at the other two elements: transfers and investment income.

Net overseas transfers have risen from 0.9% of GDP in 2008 to 1.7% of GDP in 2013. This reflects a number of factors such as the policy of all recent UK governments of raising international aid to the UN target rate of 0.7% of GDP.

But the bigger factor has been a deterioration in net investment income over the past two years. Between 2001 and 2011, this made a positive contribution to the UK’s current-account balance, partially offsetting the deficits. But this has changed, as a 1.5% of GDP investment income surplus in 2011 turned into a 1.1% of GDP deficit in 2013.

During the surplus years, it was argued that the City had a knack for getting higher returns on overseas investments than overseas investors achieved in the UK. But there was a worry that this was at the expense of UK investors taking risks in the search for higher short-term returns. So are those chickens coming home to roost? It is hard to be sure. Investment income data can be volatile and the 2013 estimates are only preliminary. But the ONS release refers to losses for UK banks on overseas operations, which may be linked to the eurozone crisis. UK non-financial companies have also seen their overseas profits decline over the past couple of years.

If UK net investment income remains in deficit, we could continue to see record current-account deficits for years to come. Should that concern us?
In the short term, possibly not. At the moment, there is no major problem in financing this deficit. Many UK assets, from gilts to central London property, continue to be seen as a relatively safe haven for international investors. In the longer term, however, there is a danger that such flows could generate asset bubbles, and see them burst, with capital flowing out and the pound tumbling. That might be good for the deficit, but would impose a cost on consumers – from rising import prices and a renewed squeeze on living standards.

Can policymakers do anything to mitigate these risks? For the Bank of England, it will be a matter of ‘taking away the punch bowl’ as smoothly and predictably as possible. That will involve gradual interest rates rises over the rest of this decade, for which businesses and individuals need to prepare.

For the Treasury, bearing down on its own budget deficit should help to keep the nation’s deficit under control. But there is no substitute for the long-term grind of supply-side reform to boost infrastructure and productivity, which are key to the UK earning a living in the long run. ?

John Hawksworth is chief UK economist at PwC.

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