Sterling weakness and plenty of money

Charles Stanley

The UK has been battling down its government deficit for the last seven years.  In the March Budget book they forecast an annual deficit of £55bn for the present year, down from £72 bn this year. They also forecast a falling path for UK state borrowing as a proportion of our GDP, with net debt down to 82% of GDP this year and reducing further in later years.  None of this is out of line with other advanced countries, who all tend to have a stock of state borrowing close to the level of annual GDP. Some like Japan and Italy have much higher debt levels.

The UK state debt does not seem to be a problem. So far it has proved easy to finance the big increase in gross debt since the crash, at low and falling rates of interest. This has been much assisted by the intervention of the Bank of England. It is now well into another programme of Quantitative Easing, where it creates new money to buy up state debt. By the end of this programme the Bank on behalf of the government will own £435 bn of the debt, or over one quarter of the total stock of government  bonds. I do not expect them to sell these bonds back to private and foreign holders, so you cannot regard it as debt. The state now owes this money to itself. If you adjust state debt for this factor, the UK’s indebtedness is a relatively tidy 60% of GDP. It is true that so called Treaty debt, the calculation the UK has to make under European rules, places gross debt at 89% of GDP, so adjusted for the bought in debts that would be around 65% of GDP. The main difference between the two calculations is the UK Treasury figure is struck after taking off liquid assets which the UK state also owns.

More of an issue is the UK’s balance of payments deficit. This appeared in the Treasury Red Book in March at 4% of GDP or around £80bn. This deficit does need financing by overseas investors or lenders. It means that to sustain this deficit the UK either has to sell more and more assets to foreigners, or to accept more and more foreign loans which have to be serviced and repaid in the years ahead. The government and the Bank have been very conscious of this, and have helped craft large foreign deals which bring in substantial investment capital to the UK. The recent decision to go ahead with Hinkley Point will, for example bring in substantial  investment funds to build and commission the new power station. Only after completion does the UK have to start the long task of servicing the debts and eventually repaying them. The government welcomed the sale of ARM to Japanese interests and allowed the deal to go through. That too will bring an injection of foreign currency into UK markets.

The balance of payments deficit is more of a worry than the state deficit. When the currency falls then many of  those foreign loans and liabilities we have incurred are more costly for us in sterling terms. If the loan interest or dividends are defined in yen or dollars or Euros, we need to find more pounds to pay them. There is some offset where we have sold the ownership or shareholding to a foreigner, as they have simply lost on the transaction by the extent of the devaluation.  The balance of payments deficit has three principal components. There are the government transfers of cash to overseas. There is the account that nets out the interest and dividends we earn on the UK’s foreign holdings, against the interest and dividends we have to pay away on what overseas investors have here. There is then the part of the deficit that most people concentrate on, the balance between the amount of goods and services we sell abroad, and the amount we buy from overseas.

The government itself accounts for around one quarter of the deficit by sending substantial contributions to the EU which do not come back as payments, and maintaining a large overseas aid programme. Around half of this will disappear if the UK leaves the EU and stops all payments to it. Policy is committed to keeping overseas aid at 0.7% of GDP, though the new Secretary of State has indicated a tougher approach to value for money which could slow some of the spending.  The deficit on interest and dividends is a new feature. The UK used to have a healthy surplus on its investments abroad over their investment in the UK. However, the longer the UK runs a balance of payments deficit, the bigger the build up of liabilities to overseas investors and lenders. Returns are also very low on a number of foreign investments these days, thanks to very low rates of interest in the main advanced countries.

It is a substantial deterioration in the balance of interest and dividends that accounts for most of the large increase in the UK deficit recently. The total UK balance of payments deficit hit 5.4% of GDP last year owing to an increase in the investment  income gap.

The balance of trade is the issue at the centre of much of the present debate about how the UK leaves the EU. The substantial devaluation should boost exports, or boost the profitability of exports as companies receive more pounds for their goods than they were expecting where they have been invoiced in foreign currencies that have now gone up. It should also start to reduce the growth rate of imports, as these become dearer. There is considerable scope for import substitution, but that will require more investment and expansion of capacity in the UK. There are no quick fixes on the balance of trade, as the UK has got used to relying for a very wide range of products on imports. It is difficult to see the issue of tariffs as a big problem. It would be surprising if the rest of the EU after much pressure and posturing wanted to impose tariffs on its own trade with the UK. Even if the EU decides it does not want a trade deal and UK/EU trade ends up under WTO rules, the average tariff of around 3.5% is way below the devaluation so far, and the balance of items in UK exports is less exposed to tariffs than are the imports from the continent into Britain.  Some fear more difficulties for service sector access where the UK trades more successfully at the moment. Here the UK could end up on a worst case  with the same kind of arrangements that Japan and the USA currently use for their substantial service activities in the EU.

The recent sharp fall in sterling is said to be on the back of worries about the UK leaving the single market. This is a bit surprising as an explanation, as the argument that we would leave the single market because it comes with freedom of movement and budget contributions attached was often repeated in the referendum campaign. The issue is more access to the single market than membership of it. I suspect that many forces were at work in currency markets last week. The Bank of England’s decision to cut interest rates and create more money is the background to the fall, leaving the UK currency with an adverse interest differential against the dollar and with plenty of pounds around.  Maybe the Bank will decide in the weeks ahead that there is enough money in circulation and the pound has fallen enough. Then it will decide to end its Quantitative Easing and not cut rates further. That should help the pound.

The above article by John Redwood, Charles Stanley’s Chief Global Strategist, was first published by Charles Stanley on 10th October 2016.