Stephen Burgess and Rachana Shanbhogue
In 2016 the UK’s current account deficit was 5.9% of GDP, the widest since official records began in 1948. Many economists, including the IMF and FPC have suggested the UK is therefore vulnerable to foreign investors becoming less willing to invest in the country. In this post we challenge the idea that the UK is at the mercy of the “kindness of strangers”. Looking at gross, rather than net capital flows since 2012 suggests inflows have been extremely subdued relative to past levels. Instead, the UK has benefitted from increasing capital gains on past foreign investments and used these to fund its spending. We argue this carries lower financial stability risks than relying on gross inflows to cover the current account deficit.
There has been no “kindness of strangers”
Rather than a pauper relying on the charity of strangers, the UK is more like a member of the landed gentry, using its past foreign investment to fund its lifestyle of excess. To understand why, remember first of all that the two most important components of a current account balance are the trade balance, or the difference between what the country exports and what it imports, and the primary income balance, which includes the difference between investment income earned abroad by residents, and that earned domestically by non-residents. The UK’s trade balance has consistently been in deficit since 1998; the primary income balance has deteriorated substantially since 2011, perhaps reflecting a decline in overseas income for multinational companies.
One way of financing a current account deficit is through foreign investment in UK financial or physical assets. But this “kindness” has not helped fund the UK current account deficit in recent years. In fact, between 2012 and 2016, there was no kindness at all: the UK current account deficit over that period amounted to £480bn, while foreign flows into the country were -£82bn (Table A). In other words, non-residents actually ran down their holdings of UK assets, rather than helping to fund the deficit.
Instead, the UK has cashed in on some of its past investment abroad to fund its foreign spending: between 2012 and 2016, UK residents ran down their stock of foreign holdings by £526bn (an average of around 6% of GDP over those five years), more than funding the current account deficit.
An obvious question is “how long can the UK continue to fund its current account deficit in this way?” It has a large stock of foreign assets, of around 420% of GDP (excluding derivatives), so in theory at least, it could do so for decades. Further, despite the sales of foreign assets by UK residents, the overall value of these assets has not fallen over the same period, because of so-called revaluation effects. Revaluation effects do not reflect sales of assets or liabilities from one country to another, but capture a change in their nominal value (see this ONS analysis).
These revaluation effects have boosted the UK’s foreign asset holdings by much more than its foreign liabilities, as shown in the blue bars in Chart 1. In other words, they have pushed up the UK’s net international investment position, shown as the black line on Chart 1. Between 2012 and 2016, these net effects have amounted to a chunky £650bn. That more than offset the sales of assets needed to finance the deficits on trade and investment income (the red and yellow bars respectively).
Chart 1 Accounting for changes in the UK’s net international investment position since 1995
In 2016 these blue bars were driven by substantial foreign currency movements, as shown in the November 2016 Financial Stability Report, where the currency effects are calculated using previous ONS work. As the majority of UK’s foreign assets are denominated in foreign currency, while a significant proportion of foreign liabilities are denominated in sterling, a fall in the exchange rate tends to boost the NIIP.
However, exchange rate falls cannot explain all of the growing blue bars (see for example Figure 10a in this paper). Capital gains – for example, unrealised gains in the value of equities and bonds held by UK investors overseas – are likely to explain some of the remainder. But there remains an element of mystery about these blue bars, and it’s an area where we think future research could be valuable.
Why does it matter that the UK isn’t a pauper?
The FPC has been drawing attention to the size of the current account imbalance itself (i.e. net inflows), arguing that the UK is at risk of a fall in foreign investor appetite. But we believe gross flows are likely to be at least as important as net flows as an indicator of vulnerability (as has been argued by Forbes and Warnock, Obstfeld and Shin).
When a current account deficit is financed by gross inflows, new liabilities are created which domestic residents have to pay off. External imbalances that are associated with rapid inflows of capital are more likely to be associated with rapid domestic balance sheet expansion and often fast domestic credit growth. If these lending flows stop, say because foreign investors take fright, then some domestic residents may find themselves facing cash-flow problems or much higher borrowing rates, leading them to cut spending. This is sometimes referred to as a “sudden stop”.
Chart 2: Gross inward investment flows
This is what happened before the financial crisis, when gross inflows of capital into the UK peaked at more than 60% of GDP (Chart 2). But it has not been the case recently. Over the past three years capital inflows to the UK have averaged less than 4% of GDP.
Chart 3 provides a simple illustration that the risk of a future “sudden stop” is lower when gross inflows are lower. We use a cross-country sample of 185 episodes of sudden stops in external financing in advanced and emerging countries since the 1980s, based on the identification proposed by Forbes and Warnock. For all of those countries, we measure gross capital inflows at each point in time and, for every observation, we ask whether or not that country was in a “sudden stop” one year later. The chart shows the observed frequencies, given different levels of inflows.
We want to draw attention to two points here. First, there is a clear positive relationship: countries which attract a lot of new foreign inflows are more likely to experience a stop in the future. Second, the UK’s recent capital inflows would place it close to the bottom of this distribution. Based on this evidence, the UK would be relatively unlikely to experience a stop in financing flows in the near future.
A reasonable challenge to this analysis could be that Chart 3 still suggests that the UK may have a probability of around 5% of experiencing a stop in a year’s time, which feels uncomfortably high. However, we note that the Forbes and Warnock identification is based on simple statistical criteria and a number of their episodes may have been “benign” ones, with limited financial instability. Indeed if you choose a country and time period at random from this sample, the probability of it being in a “sudden stop” in a year’s time is more than 10%.
Chart 3: Proportion of episodes resulting in a “sudden stop”
This does not mean UK policymakers can be complacent. The UK’s large stock of outstanding liabilities to overseas residents, partly reflecting its role as a financial centre, could leave it vulnerable to a decline in foreign investor sentiment (see Whitaker et al.). We estimate that around 30% of UK government bonds and perhaps as much as half of the stock of equities and corporate bonds are owned by foreign investors. An extreme reversal of attitudes to the UK– so that foreigners not only stop investing in the UK, but sell off their existing holdings – would clearly have large effects on UK asset prices. But, as we’ve shown above, the UK is less vulnerable to the whims of foreign investors than they have been in the past, because recent borrowing flows have been so small.
The current UK experience raises some interesting research questions. What exactly are these large revaluation effects which have raised the net international investment position so much? And can we look at the past experiences of countries with wide current account deficits, but weak gross inflows, to draw inferences for the future of the UK’s external finances? We would be interested to hear from any researchers who have insights to share on these or on related questions, or who would be interested in collaborating with us on future work.
Stephen Burgess works in the Bank’s Macrofinancial Risks Division. This post was written whilst Rachana Shanbhogue was working in the Bank’s Macroprudential Strategy and Support Division.
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