Prospects for the UK hang in the (im)balance
Mon, Aug 31 2009, 11:22 GMT
by Lloyds TSB Financial Markets Economic Research Team
One of the positive by-products of the UK economic downturn over the past two years - and there have not been many - has been the improvement in the UK’s economic imbalances. It is hoped that these improvements, if sustained, will eventually leave the UK economy better placed to benefit from the next cyclical upturn. So what is meant by the UK’s imbalances; why have they improved; and what are the implications for the UK economy over the coming years?
Opposite sides of the same coin
There are two key imbalances that economists typically refer to when discussing the structure of an economy: the internal and external imbalance. By construction, they are the opposite sides of the same coin. The internal imbalance represents the difference between domestic savings and domestic investment. By implication, the gap shows the extent to which domestic saving is available to finance domestic investment. The history of these imbalances in the UK are shown in chart a. As can be seen from the chart, the UK has traditionally had a domestic savings shortfall. As a consequence, the UK has tended to rely on borrowing from abroad to plug the deficit. The amount of money borrowed from abroad, known as net foreign investment, represents the UK’s external imbalance. By implication, it is equal, but opposite in sign, to the UK’s balance of payments. In other words, a positive inflow of foreign investment is represented by a current account deficit.
In the UK, the economy’s dependence on debt-financed consumer spending for much of the 1990s and 2000s was reflected in a marked deterioration in the household saving ratio – see chart b. The decline in the saving ratio over much of this period occurred at a time when house prices were rising sharply. It appears that households viewed the increase in the market value of their housing wealth as a reason to reduce their savings. At the same time, the strength of consumer spending was fuelling a rise in imports, leading to a widening the UK’s current account deficit, or its external imbalance. Since reaching a flat payments position in 1997, the UK’s current account deficit rose steadily, hitting a recent high of 3.4% of gdp in 2007.
The deterioration in the UK’s economic imbalances since the mid-1990s is widely viewed as having left the UK more exposed to economic shocks and sharp movements in its domestic currency. Indeed, this appears to be borne out by recent evidence, with sterling and the US dollar having experienced greater volatility since the credit crisis began than the swiss franc or euro - currencies whose economies have domestic saving surpluses – chart c. Moreover, the UK and US have experienced sharper downturns in their housing markets and, judging by the latest data, have remained in recession longer, with Germany and Japan both posting positive growth in Q2.
The tide appears to have turned
Nonetheless, there are now clear signs that the UK’s imbalances are improving, as evidenced by the recent fall in the current account deficit and the closing in the domestic saving and investment gap. As the recession has taken root, and credit availability has tightened, the private sector has started to deleverage. For households, the desire to reduce debt and rebuild savings has no doubt been motivated by the 20% fall in house prices since mid 2007 and by fears of unemployment. Similarly, firms have sought to retain internal surpluses rather than undertake new investment, mindful of the need to remain liquid in the current environment.
That the process of deleveraging has started in the private sector can be seen in chart d. Since the beginning of 2007, the financial deficit run by the household sector has fallen from 4% to 2% of gdp, consistent with the improvement in the saving ratio over this period. Notably, the corporate sector started its process of balance sheet repair earlier this decade, aided by strong profitability. Although corporate profits have turned lower over the past two years, the corporate sector has continued to run a financial surplus by reducing investment spending. In the second quarter alone, business investment dropped by 10.4%, a fall of 18.4% on the year. Similarly, since the credit crisis erupted, the financial sector has undergone substantial balance sheet repair.
The one notable exception to this process of deleveraging, of course, has been the public sector. It’s financial balance has widened from a surplus of 2% of gdp in 2000 to a deficit of over 6% of gdp currently, and rising. For now, the increase in public borrowing is being relatively easily absorbed by the rise in private sector savings – hence gilt yields remain historically low. Unless the scale of public borrowing is addressed over the coming years, however, it risks crowding our private sector investment, leading to higher borrowing costs and a potentially disorderly decline in sterling’s exchange rate. Faced with this risk, it appears almost certain that, whichever government is in power after next year’s general election, fiscal policy will be tightened.
A painful period of adjustment ahead
The prospect of continued balance sheet repair and a tightening in fiscal policy should lead to a further improvement in the UK’s imbalances over the coming years. When the dust eventually settles, the UK could emerge less reliant on debt-financed consumption, be less exposed to the vagaries of foreign investor sentiment, and have more internally-generated funds to help finance productive business investment. All of these outcomes represent virtuous goals that could be forced upon the UK by the scale of deleveraging that needs to take place. Unfortunately, however, in the absence of monetary reflation, the process of adjustment is likely to be long and painful. In an environment where households and businesses are seeking to rebuild savings, and the government is not in a position to act as a buffer, domestic demand is likely to remain constrained for some time. As such, prospects for UK growth may well hinge crucially on the external sector.
As the UK’s internal imbalance has improved, so has its external imbalance. Since 2007, the current account deficit has trended lower. The main reason for this has been falling imports, as domestic demand has weakened. A further import led improvement in the current account deficit is likely over the coming years. Yet, falling imports do not generate long-term economic growth. What is needed is an improvement in UK exports. Unfortunately, there is little sign of this, with export volumes having fallen around 15% since 2007. Still, it is to be hoped that global demand will recover sufficiently over the coming years to help lift the UK’s export performance, and that sterling’s exchange rate adjusts to boost the UK’s competitiveness. If this occurs, the UK could eventually end up with a current account surplus. However, if this does not happen, the implications for the UK economy would be all the more severe.
