COVID | Fiscal Policy | UK
Fiscal expansion in response to COVID and the forthcoming spike in debt have dominated investor concerns in recent months. But these significantly larger fiscal deficits will also have implications for external balances as the gap between government savings and investment shifts. For the UK, where the current account (C/A) has been in deficit for almost four decades and which heading into the current crisis was one of the largest globally, this is worrying. A wider deficit from here could raise significant concerns over financing, particularly with the future relationship with the EU remaining uncertain.
UK Continues to Run One of the Largest C/A Deficits Globally
Recessions typically see imports collapse in response to weaker demand and C/A deficits naturally corrected. The UK has not, however, followed this pattern during the past several decades. A C/A deficit of 4.2% of GDP in 2008 gradually narrowed in the years following the global financial crisis. But this trend ended in 2011, with subsequent years witnessing a sharp worsening in the deficit to a record high of 5.2% in 2016. This was partially corrected in 2017 with the deficit narrowing to 3.3%, but the past two years have been stuck just below 4% (Chart 1). Apart from a handful of emerging market economies who run bigger deficits, this leaves the UK with one of the largest C/A deficits globally, albeit with the US not too far behind.
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Fiscal expansion in response to COVID and the forthcoming spike in debt have dominated investor concerns in recent months. But these significantly larger fiscal deficits will also have implications for external balances as the gap between government savings and investment shifts. For the UK, where the current account (C/A) has been in deficit for almost four decades and which heading into the current crisis was one of the largest globally, this is worrying. A wider deficit from here could raise significant concerns over financing, particularly with the future relationship with the EU remaining uncertain.
UK Continues to Run One of the Largest C/A Deficits Globally
Recessions typically see imports collapse in response to weaker demand and C/A deficits naturally corrected. The UK has not, however, followed this pattern during the past several decades. A C/A deficit of 4.2% of GDP in 2008 gradually narrowed in the years following the global financial crisis. But this trend ended in 2011, with subsequent years witnessing a sharp worsening in the deficit to a record high of 5.2% in 2016. This was partially corrected in 2017 with the deficit narrowing to 3.3%, but the past two years have been stuck just below 4% (Chart 1). Apart from a handful of emerging market economies who run bigger deficits, this leaves the UK with one of the largest C/A deficits globally, albeit with the US not too far behind.
The global nature of the current crisis means that both exports and imports will collapse in tandem, potentially leaving trade balances little changed. It is also true that as C/As globally should sum to zero, it cannot be the case that the huge fiscal response to COVID will push external positions worse on aggregate. Dynamics in private sector savings-investment positions will, therefore, drive the C/A shifts over the coming year. The UK could repeat the shifts seen in the aftermath of the financial crisis where the fiscal expansion and increased government net borrowing were partially offset by households and, to some extent corporates as well, stepping up net saving. The likely slump in investment is one way this can be achieved, albeit at the expense of longer-term growth.
C/A Composition Is Shifting
The UK’s position as a global financial hub has an important impact on the BoP. Within the C/A, the widening income component largely accounts for the earlier worsening of the headline deficit. And as these flows are generally recycled back via portfolio flows in the financial account, the C/A in isolation does not fully reflect the external position.
Another complication is the UK’s sizeable trade in gold, which causes volatility in the quarterly trade data. The Q4 2019 headline C/A deficit dropped to its lowest in almost a decade to 1.0% of GDP on the back of exports of gold (and other precious metals). A slightly smaller deficit on the income balance (-1.3% versus -1.8% in Q3) also helped through reduced outflows to foreign investors. But given the gold flows tend to net out on an annual basis and represent transactions with no underlying impact on GDP, the ONS has recently started publishing C/A data ex. gold. This new series shows a 3.1% C/A deficit for Q4, the lowest for at least three years and a significant improvement from 4.9% in Q4 2018.
Looking at the C/A deficit on an annual basis, little has changed in the past two years, either with or without gold trade, leaving it well above the historical average. But as we can see from Chart 3 the services surplus has shrunk with the impact on the overall C/A partly neutralised by a lower trade deficit (imports growth turned negative in USD terms in 2019 while exports growth remained positive). Income deficits, by contrast, have remained largely stable. Given the UK’s services balance is the only component of the C/A in surplus, and reflects the UK’s standing as a global financial centre, a smaller services surplus could bode very badly for the broader economy both via net trade and the direct sectoral hit. And with the last five years witnessing the slowest average growth in services exports since the early 1980s (and 2019 barely positive) Brexit may already have made its mark.
(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)