The current account deficit (CAD) has averaged around 3% of GDP since 2000 with the deficit in recent years driven by the government sector (Chart 1). The UK must attract net financial inflows to finance this deficit. This can be achieved through UK residents selling their overseas assets or through borrowing outside of the UK and increasing UK external liabilities. In practice, both of these mechanisms are used to finance the UK’s CAD.
Chart 1: The sum of the UK’s net financial balances by sector equals the current account
Footnotes
- Note: Flows are non-seasonally adjusted.
- Source: Office for National Statistics.
Crucially the UK’s net international investment position (NIIP), a stock measure, has been broadly stable over the past 20 years and actually improved once less flighty, and harder to accurately measure, foreign direct investment (FDI) is excluded (Chart 2). This improvement, in spite of the persistent CAD, is mainly due to valuation and currency changes as UK resident assets owned abroad appreciated more quickly than UK liabilities owed to non-residents over time.
From a financial stability perspective, Bank staff monitor the structure of the UK’s external balance sheet rather than its current account specifically. Vulnerabilities can build within the components of a country’s aggregate NIIP even if it is balanced overall. For example, UK banks had a reliance on short-term wholesale funding to expand domestic lending at the time of the global financial crisis (GFC). A significant part of this wholesale funding came from abroad in the form of ‘other investment’ inflows. During the GFC concerns about the health of the UK banking sector crystallised rollover risk for these funds, exacerbating the liquidity stress and the credit crunch.
Chart 2: The UK net international investment position has been broadly stable around zero since 2016 after excluding FDI
Footnotes
- Note: ‘Other’ includes items such as trade credits, and currency and deposits.
- Source: Office for National Statistics.
The good news is that private sector external vulnerabilities are much lower than before the GFC, and Bank staff judge the risk and impact of a sudden rapid fall in foreign investor appetite is low, in line with previous FPC communications on this.
But UK government external liabilities, in line with many other western economies, have increased since the GFC. That’s why Bank staff continue to monitor these risks and take into account the potential for them to crystallise other financial vulnerabilities and amplify shocks.
Ultimately, a stable political environment and independent institutions with a robust policy framework remains a key part when mitigating external balance sheet risks.
This post was prepared with the help of Colm Manning.
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