Since the financial crisis the UK’s fiscal and current account balances have persistently been in deficit. These ‘twin’ deficits are significant in historical terms, with a record peacetime fiscal deficit in 2009 and a record current account deficit in 2015. But how closely related are these ‘twins’ and do they pose a risk to financial stability? Using a new ‘from-whom-to-whom’ dataset I find that the two deficits are not directly related to each other and are being financed through relatively stable channels.
In this post, I use a constructed complete set of ‘from-whom-to-whom’ information across financial instruments and sectors. The new ONS experimental statistics cover most of the dataset, but there remain areas where full counterparty information is unavailable. There has therefore been an allocation of the ‘unknown’ element.
The method used is a simple proportional allocation: for each financial instrument, the sectors with unknown counterpart assets are proportionally matched with sectors with unknown counterpart liabilities. Occasionally, information on the underlying data enabled a more ‘intelligent’ estimate of the allocation. But this method has little impact on the analysis undertaken: all of the main movements are evident in the original dataset.
The recent Flow of Funds
The ‘from-whom-to-whom’ data can be visualised through the use of a chord diagram, shown in Figure 1. A chord from one sector to another (in the originating sector’s colour) represents the first sector’s holdings of the second’s liabilities. Returning to the twin deficits, the stock of public sector debt is represented by the series of chords into this sector, mainly from the domestic financial sector and the rest of the world (RoW), while the negative international investment position (IIP), a key component of the widening current account deficit, is represented by the difference between the total assets and liabilities of RoW. While this may look relatively small, it constitutes a RoW net asset position of £269bn.
The picture of the UK economy shown in the chord diagram is quite different to that prior to and immediately following the financial crisis. Focussing on the post-crisis economy, there have been large movements in net sectoral balances since 2011, as shown in Figure 2. Both households and corporations have gradually moved from a large surplus into deficit. Public sector borrowing has significantly narrowed since its peak, along with the increasing RoW surplus. But what has been driving these movements?
Figure 3 shows the changes in inter-sectoral net positions from 2011 to 2015. An arrow from one sector to another represents a positive net flow of funds from the first sector to the second over the period. This could be due to increased assets or decreased liabilities, with changes over the period reflecting transactions and revaluations/other volume changes. Net changes below £50bn are excluded.
At a glance, the diagram clearly highlights the main movements, including the increase in public sector debt (arrows into the public sector) and the worsening of the IIP (arrow out of RoW). Interestingly, this diagram suggests that these two developments are not directly related, although they are likely linked in a general equilibrium sense. So what has been going on?
Since 2011 the government has increased its issuance of gilts to finance the fiscal deficit. Around half of these have been purchased by monetary financial institutions (MFIs), predominantly by the Bank of England. But there has also been an increase in gilt holdings by the wider financial sector, likely as a means of safe investment and for regulatory purposes. While RoW holdings of gilts increased during the crisis, new holdings since 2011 have been much smaller than those by the domestic sector, and thus don’t feature in the diagram.
Over the same period the IIP has worsened, accompanied by an increasing current account deficit. The large pink arrow in the diagram indicates the driver of this: an increasingly negative net position between PNFCs and RoW, primarily related to increased inward foreign direct investment (FDI) due to both new inflows and a rising value of existing investments. This is compounded by a smaller fall in outward FDI, with both effects contributing to weaker net income flows.
But if the financial sector is increasingly financing the fiscal deficit, and foreign investment in PNFCs is driving the increased current account deficit, are these ‘twins’ related at all?
The diagram shows there has been a positive net flow of funds from the PNFC sector to MFIs over the period, through increased deposits and a fall in bank loans and holdings of PNFC equity. So a proportion of FDI inflows to PNFCs are being recycled through the financial system and in turn used to finance the fiscal deficit. This is in contrast to the increased net liability position between PNFCs and ICPFs, largely relating to an increase in the value of workplace pension schemes.
Households are also playing a part in funding the fiscal deficit through positive flows to the financial sector. The large purple arrow represents an improvement in the net asset position of households with ICPFs as the value of pension schemes has increased over the period, due to both new contributions and positive revaluations on existing schemes. This is similarly the case for MFIs, albeit on a smaller scale, whereby households have increased their deposits and reduced loans with banks and building societies.
The fiscal deficit is therefore being increasingly financed by the UK financial sector, which in turn is being partly funded by the real economy. But some of this funding has arisen as a result of increased foreign investment in PNFCs, which is driving the worsening IIP and a key factor in the widening current account deficit.
Implications for economic and financial stability
So given how and by whom the deficits are being financed, an important question is whether these trends are worrying, and if ‘twin deficits’ in particular give cause for concern? This depends on whether the new funding positions are prone to reversal and if there is a risk that a deficit sector will reach a point where it cannot finance its liabilities.
Looking first at the fiscal deficit, this has been increasingly financed by the domestic financial sector rather than relying on the willingness of investors abroad to hold UK government debt. Domestic holdings may be more stable than foreign holdings where exchange rate risk is a concern. An IMF working paper also finds that a higher domestic share is associated with less volatile gilt yields. So in terms of the stability of the funding position, a higher domestic share seems like good news.
With respect to the current account, the worsening of the IIP post-crisis has primarily been driven by inward FDI, explained in detail in a 2015 ONS article. These are investments with a controlling interest and are therefore often associated with stable and long-lasting financing relationships, as well as being less vulnerable to refinancing risk. While the recent EU referendum result may influence new FDI inflows, the reversal of existing investments is still unlikely relative to other types of financing, so this trend does not appear to pose significant risks.
But does the presence of these two deficits simultaneously cause additional concern? This might be the case if there is home bias in investment preferences. A confidence shock may find the government struggling to fund its deficit due to reduced domestic appetite and little scope to find alternative funding abroad. Alternatively, twin deficits may pose additional risk if foreign investors are taking on credit and currency risk at the same time. A confidence shock that causes the likelihood of default to increase could lead foreign investors to withdraw from the UK, making it harder for the government to fund the deficit through both domestic and foreign channels.
But analysis of ‘from-whom-to-whom’ data suggests that these potential amplification mechanisms are not currently a problem for the UK. The fiscal and current account deficits are being financed through relatively stable channels and are not directly related to one another. The developments in the real economy are also positive; households and PNFCs have used their financial surpluses to pay off existing debt and provide additional retail funding to the banking sector, which is generally fairly sticky.
The benefits of being able to analyse inter-sectoral relationships are therefore clear. In order to examine the risks of sectoral deficits you need to know who holds the liabilities and how stable these positions are. The new dataset provides this information by showing who is financing the deficit sectors and the type of financing they are using. But there are still significant restrictions on how deeply we can really understand what is happening in the economy. Risks tend to build up in the tails of distributions and thus an increase in the granularity of data, for both sectors and instruments, is required. The UK Flow of Funds project, conducted jointly between the Bank and ONS, is aiming to achieve this granularity and as such will be important in enabling further analysis.
Lauren Bowers works in the Bank’s Conjunctural Assessments and Projections Division.
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