Sterling is increasingly vulnerable and could collapse if Brexit talks fail, with international investors taking flight, an economics consultancy has warned.
Pantheon Macroeconomics is worried about the UK’s large current account deficit, given that the nature of the country’s external financing has shifted from foreign direct investment (FDI) to short-term bank loans.
A note from Samuel Tombs, Pantheon’s chief UK economist, said: “The UK’s still-large current account deficit makes us nervous that sterling will need to depreciate further over the medium term and would collapse if Brexit talks fail, causing international investors to take flight.”
Pantheon noted that the balance of payments figures for the second quarter of 2018, published last week, showed that the current account deficit widened to £20.3bn ($26.4bn, €22.8bn), compared with £15.7bn in the first quarter.
The UK's still-large current account deficit makes us nervous that sterling will need to depreciate further over the medium term
It added that, as a share of GDP, the deficit increased to 3.9% from 3%. Although, it did point out that the deficit is a lot smaller than in 2016, when it averaged 5.3% of GDP.
Investment income deficit grows
However, Pantheon’s focus is on the investment income deficit, which worsened to £8.6bn from £6.4bn. It warned that this is not merely noise but potentially something more fundamental.
The note added: “This deficit has grown because the value of investments in the UK owned by foreigners now exceeds the value of UK-owned overseas assets by 13% of GDP. Sterling’s depreciation led to only a temporary improvement in the net international investment position (NIIP).
“The UK occasionally ran an investment income surplus in the 2000s, despite having a negative NIIP, because the rate of return on UK-owned capital overseas exceeded the rate earned by foreign investors on their British assets.
“But since 2012, returns of UK-owned overseas assets have consistently underperformed, partly reflecting the high concentration of assets in the struggling financial and natural resource sectors. This poor allocation of investment can’t be changed overnight.”
Negative finance loop
Pantheon warned that the current account deficit and the NIIP are bound together in a negative feedback loop, where the deficit can only be financed by overseas investors acquiring more assets in the UK than visa versa.
It said the NIIP would drift further into the red, leading to progressively larger investment income deficits.
“This loop will be broken only if sterling falls sharply, boosting the NIIP, or if external finance dries up, leading to a contraction in domestic demand,” Pantheon added.
“We wouldn’t be worried about the current account deficit if it stemmed from a surge in direct investment by overseas companies in Britain. FDI brings know-how that helps to raise domestic productivity and boost production, which then helps to readdress the current account deficit.”
It noted that FDI picked up immediately after the 2016 depreciation – peaking at £199bn in the four quarters to Q1 2017 as overseas companies rushed to acquire their UK competitors at a discount. But it has since fallen to just £58bn in the four quarters to Q2 2018, as anxiety about Brexit has grown.
Short-term loan volatility
The consultancy said that the current account deficit increasingly is being financed by short-term loans and deposits to banks. These loans then are underpinning cheap unsecured loans to households, which people still are drawing on readily to finance consumption.
“This source of finance is far more volatile than FDI and must be refinanced more frequently,” it said.
Pantheon further noted that on some measures the position is significantly better than it was pre-crisis.
Banks are less reliant on external finance and short-term funding accounts for just 4% of UK banks’ total funding, down from 16% in 2007. Banks are also required to hold more short-term liquid assets if they increase their reliance on short-term funds and they can access liquidity, including in foreign currencies, from the Bank of England.
However, it added: “The sheer scale of the current account deficit and the external borrowing that has been accumulated to finance it over the last two years leaves sterling vulnerable to a sharp depreciation if overseas investors lose confidence in the UK economy.
“A no-deal Brexit clearly could trigger such a reappraisal. The resulting disruption to economic activity, as supply chains disintegrate and precautionary saving rises, likely would trigger an increase in corporate insolvencies, unemployment and mortgage arrears, thereby undermining the creditworthiness of the banks.”