#31. Deep in the hole

WILL STERLING SLUMP AFTER THE SCOTTISH REFERENDUM?

As some of you will know, I last week authored a paper for the Centre for Policy Studies (CPS) highlighting four independence risks – three of them specific to Scotland, and the fourth affecting the residual United Kingdom (“rUK”) in a post-independence situation.

In brief, my paper argues that the “yes” campaign has been over-optimistic about North Sea oil revenues, has underestimated the likely migration of the financial services industry from a post-break-up Scotland, and should also weigh the burden of its share of future public sector pension costs. You can read about this in my CPS report, which is available here for you to download.

The issue that all of us – Scots included – ought to be thinking about now is the fourth, UK-wide risk. That risk concerns our current account position. The current account deficit is more than the simple shortfall in the trade in goods and services. It also includes cash movements related to returns on capital.

In 2013, our trade balance was a deficit of £28.5bn, which may not seem all that shocking. After all, it was a lot worse than that in 2007 (£36.7bn), when buoyant consumers were still sucking in imports, and we’ve haven’t been in the black on overseas trade since 1997.

The recent trend looks pretty static – trade deficits of £23.3bn in 2011, and £33.4bn in 2012, before last year’s £28.5bn.

Broaden this from the simple “trade” imbalance to the “current account”, however, and a much more worrying position emerges. Our deficits in 2011, 2012 and 2013 were £22.5bn, £59.7bn and £72.8bn. It’s the difference between these two lines that is all-important.

In 2011, the £22.5bn current account deficit consisted of a trade gap of £23.3bn offset by a small (£0.8bn) positive cash movement number.

In 2012, a trade gap of £33.4bn was exacerbated by adverse cash movements of £26.7bn.

Last year, the trade deficit was £28.5bn but the cash outflow was £54.9bn, making a total of £72.8bn.

In other words, cash movements have crashed, from near parity to a huge outflow. This is very obvious from the chart included here.

The scary line that markets are going to worry about is the bright red one, showing how our current account has crashed. The dark red line – essentially the sum of interest, dividend and other current remittances – shows why this has happened.

 UK BoP annual

Two questions arise. Why has this happened? And what does it mean?

Cash flow has slumped because two line-items have lurched deep into the red. We’re paying out a lot more in interest than we’re getting in, and profits remitted from British-based businesses to their foreign owners now far exceed remittances coming here from British-owned businesses overseas.

What it means is that we’re living on tick. You see, there are really only two ways in which a current account outflow can be reconciled. We can borrow from foreigners, or we can sell assets to overseas buyers.

We’ve been doing both – in spades.

Obviously, the scope for both of these expedients is limited, and both lead to a worsening in the cash balance. Borrow more from foreign lenders this year and you’ll be paying them more interest next. Sell assets this year and more profits are remitted next year.

The time limit is set by our net international investment position – abbreviated NIIP, this really means “how much do foreigners own of us, and how much do we own of them?”
Official statistics put our NIIP at zero. Optimists (including H.M. treasury) think that, because our overseas investments are older than foreign investments here, marking all these investments up to current values would lift our NIIP to perhaps 30% of GDP.

They might even be right – but how long does 30% of GDP last, when the annual outflow is 5.5% of GDP, and seemingly rising inexorably? Not long ago, Robert Peston – one of the very few commentators who seems to have noticed this at all – reckoned that we might go on like this for five more years, but only if we could cut the current account gap from 5.5% of GDP to 4%.

That’s a tough ask anyway – and we’re in vortex territory here, of course, because the more that we borrow this year, and the more that we sell, the more we’ll be paying out next year in interest and profit remittances.

Here’s where Scotland comes into the equation. Take away Scotland’s oil and gas and our current account deficit lurches down from £73bn to at least £100bn, or 7% of GDP compared with 5.5% now.

We can’t put this issue off for long anyway, of course – not least because North Sea production continues to fall sharply – but, if you think about that 7% figure, you’ll realise why Sterling slipped on the merest rumour of a “yes” lead in the polls. If Scotland leaves, then, it’s a fair bet that Sterling will slump.

And here’s my other bet – Sterling will fall even if Scotland votes no.

My thinking here is that the markets have been running their slide-rules over Britain, and they don’t like what they see. Sellers may be holding off until they see the referendum result, with the hope of selling into any temporary strength that might happen if the “no” camp wins.

If I’m right, the capital outflows of recent weeks are not just the consequence of referendum jitters. They owe rather more to devaluation jitters.

$1.50 here we come?

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Please note: due to moving house, my replies here are likely to be delayed over the next few days

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5 thoughts on “#31. Deep in the hole

  1. Nice article, but do you think the decline would stop as £1.50 to the dollar? As apart from a few extremes either way we have been bouncing around in roughly £1.75-£1.50 for a couple of decades, so it wouldn’t be a huge shift.

    Do you not think more like £1.10-£1.30 could be in the new normal, in the same way that the past we had to get used to the new normal of £4 to the dollar then £3 to the dollar.

    • Thanks, and I agree that there’s no reason why the deterioration should stop at $1.50.

      What worries me here is that hardly anyone (Robert Peston aside) seems aware of the situation and how serious and imminent it is!

    • Tim,

      I think that it’s part of human makeup/psychology to ignore (or be unable to comprehend) big, complex, long term problems. We are, it seems, only able to react to such issues when they become more immediate. In the context of a creature with what is still effectively a stone-age brain, I suppose this rather makes sense. The following observation is from someone else who studies these issues:

      I’ve spent more hours than I care to admit having watched various earthquake and tsunami videos. If there’s one constant that’s impressed me in virtually all of them, it’s how long it takes people to realize the true magnitude of the situation.

      “Oh, ground’s shaking a bit.”

      “Oh, ocean’s acting funny.”

      “Oh, there’s waves on the horizon.”

      “Those waves are coming in to shore.”

      “Those waves look big.”

      “Holy hell, those are big waves.”

      “They’re going to reach the buildings.”

      “My god, when is this going to stop?!!” (After the 3rd or 6th set of tsunami waves roll through.)

      I rather suspect the same dynamic is at play in issues like the trade balance, the global economy, declining EROEI of fossil fuels, climate change, fishery collapse or whichever else of the nexus of “big problems” facing humanity you might happen to choose.

    • I agree with Sam. Also, I sense that we all believe in what we perceive to be our own best interests to believe, which may not be much to do with how things really are. This may explain why politicians and civil servants are in denial about the unravelling of our economies and their link to energy markets.

  2. Sam, Barry

    I agree. The whole referendum thing is Whitehall Farce. It could have been so simple. Devo max could have been on the ballot, but wasn’t because the govt thought they could rely on a “no” vote – then they offer it at the last minute, and even fly the saltire over Clowning Street – then they don’t consider how MPs and voters in England and Wales might react…..

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