Bitesize: Trading your way out of debt

Simon Whitaker

Despite decades of trade deficits (spending more on foreign products than foreigners spend on UK products), the UK’s net liability with the rest of the world remains negligible.  How does it pull off that trick?  By earning a higher return on its foreign assets than it pays on its foreign liabilities.

Over the past 20 years the UK has earnt around 1pp more on its assets than it has paid on its liabilities.  As a financial centre the UK’s external balance sheet is huge (5½ times GDP), so that generates a lot of money, more than any other G7 country as a percentage of GDP (Chart 1).

The purple line in Chart 2 shows combinations of excess returns and trade balances that keep the UK’s net international investment position (NIIP) stable.  The green diamond represents the current situation – even with the current trade deficit, if the UK can replicate the excess return over the past 20 years then the NIIP would tend to rise.

But the large balance sheet means that small declines in this excess return would mean it has to export more or spend less to keep the NIIP stable: if the UK had to pay 50 bp more on its liabilities, net exports would need to improve by 3% of GDP to compensate.  The UK currently appears to have a cushion to absorb that.  But were excess returns to slip back to their 50 year average (red diamond) the UK would be sailing closer to the wind.

Simon Whitaker works in the Bank’s Global Spillovers & Interconnections Division.

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