Britain must not give investors cause for flight

It was Britain’s dependence on foreign financing that sealed its national humiliation in the Suez crisis of 1956: the US was able to force an end to the ill-judged military adventure by blocking the financial assistance needed to avert a disastrous devaluation. Sixty years on, the UK’s current account deficit has widened again, to hit the highest level in postwar records. This is not an immediate cause for concern. Yet as the vote on Britain’s EU membership approaches, the country remains — as Mark Carney, Bank of England governor, has warned — more reliant than ever on the “kindness of strangers”.

The sheer size of the deficit is alarming: the latest quarterly data implies that the UK needs to borrow or sell assets worth some 7 per cent of GDP to plug the yawning gap in its trading position with the rest of the world. By any standard, this is a huge deficit that must raise questions over the balance of Britain’s economy and its vulnerability, should there be any sudden change in investors’ appetite for UK assets.

Nonetheless, the data also offer some reassurance. Historically, fluctuations in the UK’s current account deficit have been driven chiefly by the travails of the export sector. This is no longer the case. There has been no renaissance in British exports, despite government aspirations, but the trade deficit has remained relatively stable in recent years. The big change has been a fall in net investment income. The amount British investors earn on overseas holdings has fallen, while foreign earnings on investments in the UK have held up. The Office for National Statistics thinks this may account for four-fifths of last year’s deterioration in the current account, with the effect amplified by falls in commodity prices.

So Britain’s deficit is in part a reflection of the relative strength of the UK economy. Foreigners remain happy so far to finance the deficit, whether by investing in industrial assets or purchasing prime London real estate. There have been some hints of slowing demand for gilts, but yields on government debt have not risen and a growing proportion of net capital inflows consists of foreign direct investment — a more stable form of financing than portfolio investments.

Kristin Forbes, a member of the BoE’s Monetary Policy Committee, argues that this shift in the composition of the UK’s current account could help cushion the economy in the event of a sudden increase in domestic uncertainty — of the kind that could accompany a vote for Brexit. Losses caused by falls in UK asset prices would be shared with foreign investors; and currency depreciation would increase the value of UK investments overseas relative to what it owes to foreigners.

Even so, such risk-sharing could do no more than mitigate a sudden crisis of confidence in the global or domestic economy. The UK’s large current account deficit means that it remains acutely vulnerable to a sudden stop in capital flows. With a free-floating exchange rate, this would no longer be as damaging as it was in 1956, or in the crises of subsequent decades. The UK proved able to weather a sharp devaluation of sterling in the aftermath of the global financial crisis. Yet it would still be painful, driving up inflation and hitting living standards.

The UK now has the biggest current account deficit in the developed world. Proponents of an exit from the EU argue that this reflects Europe’s reliance on trade with Britain. This is an absurd distortion of the data. Foreign investors are still willing to finance the UK’s deficit. But it is not the hallmark of a balanced economy and it would be risky in the extreme to give them any reason to take flight.