Current Account.
The current account of a country, is arguably the most important statistic. It is made up of the money flows in and out of the country, excluding foreign borrowings/loans and inward and outward investment. If the current account is in balance or equal to zero we would, in economic terms, say that the country is " paying it's way".
We have often heard the phrase "paying our way in the world" repeated by politicians, but seldom has it been used in it's correct sense. The most important thing that a balanced current account tells us is that the country has a sustainable economy. It is not dependent on foreign borrowings or inward investment. Generally we expect developing countries to have a deficit on current account and developed countries to have a slight surplus.
The Brexit vote in the UK has tended to focus analysts' minds on the UK current account deficit. The immediate fall of Sterling in the the foreign exchange markets was as much a reaction to the vote as it was to the state of the UK current account. No country can expect to fill it's shortfall in money flows, in the long term, with borrowings.
Just for some perspective here is a graph I extracted from www.tradingeconomics.com during late 2014 for another piece I wrote at the time. The amounts reflected down the right hand side are the reported quarterly shortfalls.
I don't want to dwell on this graph except point out a few key moments. Until the late 1980's the current account was always close to a balanced situation, perhaps marginally negative. The first major dip we see in the late 1980's is John Major's attempt to pin the pound exchange rate to the DM at an excessivly optimistic level. The economy was brought back into near balance under the chancellorship of Kenneth Clarke, where the exchange rate had been allowed to slide. The Labour period from 1997 to 2010 marks a steady decline to around £10 billion a quarter. The Osborne era shows a rapid decline touching on £30 billlion. This is not simply an aberration as the first six months of calendar 2016 have yielded a current account deficit of £67 billion.
To understand the graph above and why the situation has deteriorated so badly under Osborne we need to look at the policies adopted by him. The thrust of his policies have been to create a "business friendly" environment. In this regard we look at the reduction of Corporate Tax rates from 28% to 18%. The actual object being to attract foreign businesses to re-locate their headquarters in the UK, by way of reverse takeovers in order to take advantage of the lower tax regime.
While encouraging the establishment of new businesses by reducing the Corporate Tax rate, might seem a good policy it has a far bigger negative effect. The objective should aim at encouraging investment by business, whereas the primary effect of a reduction of tax rates is to increase dividends paid out by companies. And because the corollary of the policy is to encourage takeovers and reverse takeovers, British business is increasingly foreign owned tending to increase the flow of dividends out of the country and widening the current account gap.
Whilst the foreign currency coming in from takeovers lessens the need for borrowing to meet the current account deficit, one must realise that it gets replaced by a permanent outflow which means an ever widening current account deficit. The situation that existed pre 1987 where the net inflows on factor account counterbalanced our deficit on the trade account has changed.
Current Account a function of exchange rates
The table below is extracted from the Pink Book 2015.
UK Current Account 2014/2015 |
|
|---|---|
Source | £ (billion) |
Balance of Trade and Services | -34.5 |
Balance on Factor Account (Net Income from foreign Investments) | -34.6 |
Contribution to EU | -11.7 |
Net Transfers by Foreign Nationals | – 4.4 |
Foreign Aid net of inflows from EU | – 7.7 |
Total | -92.9 |
My own estimate of the deficit in calendar 2016 is in the range £115 – £130, but this is dependent on where exchange rates settle, as fundamentally the current account is a function of exchange rate.
As the current account is really a guage on which to measure the value of a currency, with a zero balance indicating a correctly valued currency, a surplus indicating an undervalued currency and a deficit an overvalued currency, it should be within our capability to manage our exchange rate down towards equilibrium. We might believe markets should set our exchange rate, particularly after the disasters of John Major and Winston Churchill. However, In both those cases the country was setting an exchange rate higher than the economy could afford, they were not about achieving equilibrium.
While it is difficult to see the correct exchange rates on which to achieve a balance on our trade account it is possible to calculate an exchange rate that balances the factor account. By dividing our incomings by our outgoings we find a proportion that the exchange rate moves up or down to bring about equilibrium on factor account and other transfers.
If we examine the table above (UK current account 2014/2015) where I have shown all the elements of outflow/inflow. By ignoring Trade and Services we would find that a reduction in value of the pound by 22.5% would bring about an equilibrium and based on an average exchange rate of £1 = $1.5 during the period it would indicate an exchange rate of £1 =$1.18.
A strong case could, however, be made to ignore the contributions to the EU. Because of our membership of the EU, this is simply an issue of an IOU which is held by the ECB in perpetuity (after conversion in the markets to UK Government Bonds) or at least until we leave the EU. At which point their policies about reserve currency holdings might change. Depending on the actual net outflow to the EU after inward subsidies are deducted we would arrive at an exchange rate of somewhere between 1.28 and 1.25.
A lower exchange rate will help our trade and services account, however the impact is far from clear. Our main exports are in the armaments and high end engineering sectors, which are not really price sensitive and because imports account for nearly 50% of the input costs the price affect is not as large as we might think. Further a large portion of our imports are in the non discretionary area of consumption which means that until industry gears up for import replacement the impact is minimal.
Conclusion
These calculations show that there is a rational basis for current exchange rates, they are not simply a "Brexit" effect and would have happened in the long run. Analysts around the world have been focussing on the UK current account deficit for a while now, the "Brexit" vote has simply brought the sustainability of the UK economy into question … particularly as the main financing of the deficit has come from the Euro-Zone banks.