Britain's balance of payments disaster

Financial outflows have quietly caused the deficit to treble, with potentially worse to come, reveals John Mills.

During the last few years, there has been an alarming deterioration in the UK’s balance of payments. From an average foreign payments deficit of just over £25bn a year between 2000 and 2010, the deficit soared to £62bn in 2012 and £73bn in 2013. The total for 2014 is trending towards £90bn, which is well over 5 per cent of our GDP. What has gone wrong? Does it matter?

The balance of payments is the difference between the revenue we have coming in and the expenditure we have going out on a current account basis. There are three major components, all of which are currently in the red. These are our trade deficit, our negative net income from abroad and our net transfers overseas. Any surpluses or deficits have to be exactly balanced – as a double entry accounting matter – with either borrowing or sales of capital assets.

Balance of payments deficits are nothing new for the UK. We have not had a trade surplus since 1982 or an overall positive foreign balance since 1983. With a floating currency, no-one worries much about quite large fluctuations in the external value of the pound, so poor performance on the balance of payments front does not produce headlines about sterling crises, as it used to when we had a fixed exchange rate. Sterling has not, in any event, declined much in value because foreign payments deficits have been more than offset by capital inflows. Anyway, balance of payments deficits of two or three per cent of GDP are not a major problem if the economy is growing, so that there is adequate capacity for both servicing and – in the last analysis – repaying the borrowing required to the borrowing needed to finance the deficit. What has changed now, however, is the scale of what is happening – and this has come about as a result of a number of adverse factors all coming together.

The first is that we have a widening gap between the value of the goods and services we sell abroad and the amount we pay for imports. Generally, the picture is that we have a big surplus on services – £78bn in 2013 – offset by a considerably larger deficit on goods – £110bn that year. The resulting £32bn deficit is not, however, that different to what it has averaged for some time and on its own would not be too much of a problem at least in financing terms. It is therefore when we look at other components of our foreign payments that the position looks more alarming. These are our net income from abroad – or lack of it – and the net transfers we make from the UK to foreign countries.

For a long time, the UK had a substantial surplus of income received from abroad over what we had to pay out. In the ten years from 2002 to 2011, this averaged £19bn a year. From 2012 onwards, however, there has been a sharp deterioration. In 2012, instead of having a surplus we had a deficit of £5bn and in 2013 it was £13bn – but with worse to come. In the first half of 2014 alone, the deficit was £16bn, suggesting that the total for the current year might be as high as about minus £30bn. This is a huge swing from the average achieved only a few years ago. As with all such changes, there is no one single reason why this happened, but it is hard to believe that this huge deterioration has nothing to do with the wholesale sale of UK assets to foreign interests which has taken place over the last decade. Between 2000 and 2010 alone, the net sale of UK portfolio assets – shares, bonds and property but excluding direct inward investment in factories and machinery – came to a staggering £615bn, equivalent to about half our GDP at the time.

The other major change has been on our net payments to other countries. These amounted to £10bn in 2003, and had grown to £14bn by 2008 but by 2013 they had reached £27bn. This total is made up of just over £12bn in net contributions to the EU, another £8bn in other government transfers, mostly aid payments, and a further £7bn made up of remittances sent abroad by immigrants to support their families in their countries of origin. The most volatile of these payments is the contributions we make to the EU, whose net value has more than doubled since 2009 – from £6bn to over £12bn, despite all the efforts made by the government to contain this expenditure. Furthermore, this sum is schedule to go on rising as EU expenditure increases and the UK rebate gets phased down. The Office for Budget Responsibility expects the total we pay to the EU to rise by about £10bn over the next four years.

It is when these figures are all added together and viewed in the light of the steep overall upward trends that they encompass that the position begins to look so daunting. The problem is not only that the UK as a whole is getting deeper and deeper in debt as a result of borrowing huge sums every year to finance the foreign payments deficit. It is also that the foreign payment deficit is to a large extent the mirror image of the government deficit and if the balance of payments continues to deteriorate, this will ensure that the government deficit stays its present size – about £100bn per annum – or even gets larger.

The reason for this is that all borrowing in the economy has to be matched exactly by an equal amount of lending. There are four sectors – government, corporations, households and the foreign balance. At the moment, small corporate surpluses are offset by similar-sized household borrowing and this is why so far in 2014, the foreign payments deficit of £44bn closely matches the government deficit of £48bn. This relationship looks very unlikely to change significantly unless there are very large increases in business investment, mopping up excess corporate liquidity, or households go on another borrowing binge. Absent either of these two improbable developments, we are going to be stuck with a government deficit of at least its present size.

Why can’t the government deficit be reduced by cutting expenditure or increasing taxation? Because this will do little or nothing to alter the foreign payment balance. The effect of cuts in government expenditure in these circumstances will not be to reduce the deficit but to reduce GDP. The mechanism will be that government cuts will reduce overall demand, thus increasing unemployment and all its associated costs while tax receipts fall. The economy will tank but the deficit will not go down.

Where then does leave us? The answer is that any government coming to power in 2015 is going to face a dire prospect unless there are radical changes in economic policy. The trend increase in government deficit is currently about three per cent of GDP per annum. At this rate, in ten years’ time, total government debt will be about 125 per cent of GDP, crowding out expenditure on services, straining our creditworthiness and potentially inducing just the sterling crisis which we have got used to forgetting is possible.

Our worsening balance of payments position is not, therefore, something we can now safely ignore. There is little we can do in the short-term to restore our net income from abroad. Nor is there much we can do about the burden we shoulder on transfers. The only solution is for us radically to improve our net trade position, but we will never do this without a much lower exchange rate, which almost no-one is advocating, although it is in fact the obvious solution.

Which of our political parties is going to wake up first to the fact that our current economic policies are unsustainable and that something drastic needs to be done?