The UK's current account: Key issues for the 2015 Parliament
During the last Parliament, the budget deficit captured much political and media attention. But recently another deficit – the current account deficit – has competed for the spotlight.
While the budget deficit fell from £142 billion in 2010 to £95 billion in 2014, the current account deficit more than doubled in cash terms from £41 billion to £98 billion over the same period.
The deficit must be financed; and were it to persist or grow, there could be implications for economic and financial stability.
What is it?
The ‘current account' records how much money flows into the UK from countries overseas, and how much money flows out of the UK to foreign countries.
A current account deficit indicates that more money flowed out over a given period than came in. Such deficits must be financed by selling overseas assets or borrowing from abroad.
The current account can be broken down into three broad components, all of which were in deficit 2014. The first is the balance of trade: the difference between exports and imports, which was £34bn in deficit in 2014.
The second, known as primary income, is the balance between the income (i.e. profits, dividends and interest payments) received on the UK's foreign investments, and the income paid to overseas investors on their UK investments (£29bn deficit in 2014).
The final component, known as secondary income, consists of ‘something for nothing' transfers, among the largest elements of which is the UK's expenditure on international aid (the secondary income deficit was £25bn in 2014).
What has happened?
In the past, worsening trade balances have been the major cause of deteriorating current account positions in the UK. But this has not been the case in recent years: at £34bn, the trade deficit in 2014 was £3bn lower than in 2010.
The main factor behind the worsening current account position has been a growing primary income deficit, which moved from a £19bn surplus in 2011 to a £39bn deficit in 2014.
Chart 1: Current account position
The short view - the recent deterioration in the current account position has been driven by a worsening primary income balance. Current account and component parts: balance in 2010 and 2014, £ billion
The deterioration in the primary account was driven by UK residents receiving lower income on their overseas foreign direct investments (FDI). This in turn was a result of both lower returns on those investments (thanks in part to economic weakness in the Eurozone), and a reduction in the total stock of UK overseas FDI.
In contrast, foreign residents have continued to expand their holdings of UK assets (something that may be linked to the relative strength of the UK's recovery and its status as a ‘safe haven'), and have shifted the composition of their assets from low-yielding debt to riskier, higher-yielding equity, thereby increasing the rate of return on their holdings.
Does it matter?
The UK has had a current account deficit in every year since 1984, although its recent size, both in monetary terms and in relation to the size of the economy, is unprecedented in peacetime.
Chart 2: Annual current account balance
The long view - the UK's current account deficit in 2014 reached its highest level in peacetime history. Annual current account balance, % GDP, 1814-2014 (shaded grey areas indicate WWI and WWII)
A current account deficit means that a country is dependent on inflows of capital from abroad and is therefore running up debts overseas or reducing its stock of overseas assets.
The UK has been doing both in recent years. Dependence on overseas borrowing may not raise any immediate problems while overseas investors are willing to provide finance, but it leaves the economy vulnerable should sentiments change: a “sudden stop” in overseas funding could force a sharp depreciation of sterling and a contraction in domestic spending, thereby jeopardising economic and financial stability.
It was this vulnerability to the changing views of creditors that led Sushil Wadhwani, then a member of the Bank of England Monetary Policy Committee to say in 1999 that current account deficits “appear not to matter until, well, they suddenly do.”
Some economists believe that the UK's record of monetary stability, its floating currency and its reasonably healthy net international investment position (see margin) offer reasons to be confident that investors will keep the faith, at least for now.
Will it get worse?
The risks from the current account deficit will become greater the longer that it remains at its current high level. Many forecasters see the outlook for the current account position as very uncertain, particularly for the primary income balance, which has been driving the changes in recent years.
The OBR forecasts that the primary income balance will gradually return to more normal levels, leading to a fall in the current account deficit overall. Whether and how fast this happens depends in large part on developments in the global economy, and particularly the Eurozone: an upturn could boost the return on the UK's overseas investments and increase demand for exports.
It is unlikely that the current account will gain as much attention as the budget deficit in the new Parliament.
However, a reduction in the current account deficit from its current record levels will be important for any government wishing to claim that the UK is making a balanced and sustainable economic recovery.