April 4, 2016

Forecast

  • Despite a temporary recovery after a British vote to stay in the European Union, the value of the pound will continue to weaken over time.
  • As it does, the purchasing power of the average British consumer will fall alongside it, shifting the economy away from consumption and reducing the United Kingdom’s ability to import.
  • The depreciating currency will also increase the United Kingdom’s exports, eventually correcting the country’s current account deficit.
  • Taken together, these developments will further undermine the British economy’s historical role as a leader in international markets.

Analysis

The British pound has been on a downward slide since January, a departure from the currency’s relatively strong growth over the past few years. Currency markets have been gradually accounting for the risk posed by the United Kingdom’s potential departure from the European Union. According to a report released in February by U.S. investment banking firm Goldman Sachs, a vote in favor of exiting the bloc in the United Kingdom’s June referendum would immediately decrease the value of the pound by about 20 percent. The sudden, steep drop would in turn cause serious problems for the United Kingdom, which would find it more difficult to pay for the imports upon which the country is so reliant.

Though Stratfor does not expect the United Kingdom to leave the European Union, and therefore does not predict Goldman Sachs’ scenario will come to pass, the report highlights an important weakness in the British economy: an extremely high current account deficit. Because of the deficit, the pound will likely continue to fall even after the British vote to stay in the European Union, with the exception of a temporary recovery in the immediate aftermath of the referendum. Over time, the floundering currency will drag the purchasing power of the average British consumer down with it.

An Economy in Disrepair

The United Kingdom’s current account deficit, which stands at minus 5.1 percent, is the highest of any of the leading industrial nations. The United States’ deficit comes in at a distant second with minus 2.7 percent, while Germany has a surplus of 8.8 percent. While the United Kingdom has had a deficit since at least the mid-1980s, over the past few years it has grown to a level unseen since 1989. Historically, such high deficits have been harbingers of disaster, since they reflect capital flowing out of a country, increasing that country’s reliance on foreign capital, whether in the form of investment or debt, for its survival. If foreign actors’ willingness to invest in that country or buy its debt diminishes, it is liable to see its currency depreciate.

There was a time when the United Kingdom’s current account deficit was useful. When one currency is dominant in the world, as the pound was before 1945 and the U.S. dollar is now, international markets need to be able to access it to function. The result is a reliable demand for that currency that enables the country controlling it to run a deficit safely, knowing the world will pick up the tab by buying its bonds. But the United Kingdom is no longer the dominant global power, nor is the British pound the prevailing currency. London cannot rely on the global financial system to support its spending as it once did. Compared with the holders of the other major currencies in the world, which, barring the United States, all have current account surpluses, the United Kingdom is an outlier.

A country’s current account is determined by three things: its trade balance, investment returns and remittances. The first, for the United Kingdom, has long been negative as its imports have increasingly outweighed exports. Gone are the days when tame commodities suppliers and captive markets gave the British Empire the means to dominate international trade. In the decades after World War II, Japan and Germany outcompeted the United Kingdom’s northern industrial regions, undermining their historical trading power. Though the 1980s brought a renaissance in British services, led by London’s financial sector, the country’s surplus in services exports is nowhere near enough to make up for its yawning deficit in traded goods.

Traditionally, the British current account’s main saving grace has been in its returns on investment. British enterprises and citizens own a considerable amount of overseas investments, another byproduct of the country’s imperial past. In fact, those investments have generally outweighed the assets owned in the United Kingdom by foreign entities, meaning that repatriated profits entering the United Kingdom have typically exceeded those leaving it. However, this is no longer a given. Over the past few years, the country’s net investment position has quickly deteriorated, for several reasons. First, the United Kingdom’s economy has grown faster than those of its peers, enabling foreign investors to make more money there than British investors can make in markets such as the eurozone. The pound’s strength, at least before this year, also reduced the value of foreign gains, while fines in foreign markets against banks based in the United Kingdom cut into the banks’ profits. And finally, corporate tax cuts have prompted British firms to invest money domestically that they might otherwise have sent abroad. (Though this might seem to be bringing money back into the United Kingdom, in truth it closes off future avenues of profit from investments abroad.)

Still, if the British current account deficit grows but the pound remains steady — discounting its recent weakness related to a potential Brexit — the United Kingdom must be making up for its deficit in some other way. The first place to look would normally be debt, since the easiest way for London to generate more capital would be to issue more debt. But British debt, albeit high, has not risen much in recent years; in fact, U.K. debt growth has leveled somewhat since expanding dramatically after the 2008-2009 financial crisis. The Conservative government has been trying to limit its spending to get a handle on the debt, shrinking the budget deficit from 11.4 percent in 2009 to 4.4 percent in 2015. Meanwhile, the share of British debt owned by overseas investors has also fallen sharply, from 30 percent in 2013 to 25.5 percent in 2015. Household debt has declined overall since 2008 as well, suggesting that British debt is not what is counteracting the current account deficit.

Foreign investment, on the other hand, is a different story. Lately, the United Kingdom has been outperforming its peers in attracting foreign investment. In 2014, foreign direct investment equaled 1.5 percent of the United Kingdom’s GDP, compared with 0.8 percent in the United States, 0.3 percent in France and 0.2 percent in Japan and Germany. However, the picture these statistics paint is deceptive. According to Ernst & Young’s 2015 U.K. Attractiveness Survey, 48 percent of the country’s foreign direct investment growth since 2008 has occurred in sales and marketing. In other words, foreign companies are pumping money into the United Kingdom largely to further their own sales capabilities, not to create more goods and services that can be exported or generate money for the country. In fact, some of the investment could be aimed at gaining access to British consumers, which could increase British imports down the road and exacerbate the country’s current account deficit.

The country’s ongoing reliance on foreign investment to support its deficit may be why one of London’s major political themes last year was to attract more investment from China and India. A visit from Chinese President Xi Jinping opened extensive discussions about Beijing’s potential investment in British infrastructure. British Finance Minister George Osbourne also seized the opportunity to advocate for his “Northern Powerhouse” plan, which calls for building up manufacturing in the United Kingdom’s run-down northern regions — something foreign investment would help make happen. The goal of the plan is to renew the country’s exports of traded goods. In theory, both avenues of investment would help London pay off its current account bill by bringing money into the United Kingdom while boosting industries that would improve the British current account balance over time. But prospects for the Northern Powerhouse project look bleak, and the Conservative government has made little progress on the proposal since it was suggested in 2010.

This is not to say that the United Kingdom has had a hard time persuading foreigners to invest in the country. London has long been the city of choice for the wealthy around the world looking for a safe place to keep their money. Compared with both the rest of the country and the rest of the world, London property is expensive. In the past three years, the city’s housing prices have skyrocketed — a surge that, though in part driven by uncertainty elsewhere in the world, is also likely a bubble. And bubbles have a habit of bursting without warning.

A Once-Great Power Continues Its Decline

It seems, then, that the British economy is precariously balanced. The country’s widening current account deficit is pulling down the pound, which so far has been supported almost solely by foreign investment. The United Kingdom is highly indebted, though the government is implementing an austerity program intended to reduce its debt. Foreign direct investment, which has been high since the 2008-2009 financial crisis began, is largely focused in areas that do not increase economic productivity and is unlikely to alleviate the British current account deficit. And while foreign capital has been flowing into British property — particularly in London — an unexpected reversal in high real estate prices (and the subsequent outflow of capital into safer markets) is a real possibility. The British pound, bearing the fallout as each of these negative imbalances works itself out, is thus in for a lengthy period of depreciation.

The currency’s prolonged weakness will effect the British economy in several ways. First, it will gradually shift the economy away from consumption as the average citizen’s spending power declines. Second, it will stimulate exports, returning the current account balance to a state of equilibrium. The United Kingdom — and its economy — has been slowly adjusting to the realities of the global market since the end of World War II. Though Britain’s role as the global superpower has long since diminished, certain aspects of Britain’s economy still bear the mark of a dominant international force, and the country has continued to enjoy many of the privileges born of its historical pre-eminence. But all things must eventually end, and in the coming years, the United Kingdom’s economic reality will no longer reflect its lofty legacy.

 

— Britain’s Deficit Weighs Down the Pound is republished with permission of Stratfor.