How Long Can the UK's Balance of Payments Deficit Continue?

19/07/2016 09:05 | Updated 19 July 2016

The UK - and therefore its population - is living way beyond its means. We have a Balance of Payments deficit of about 7% of GDP means that, on average, we are all enjoying a standard of living which is 7% higher than we are earning. To support this unrealistic life-style we are either borrowing from abroad or selling assets to foreign interests year after year on a scale unmatched by any other developed country.

Furthermore, because the return on either the borrowing or the assets we are selling is about 5% gross, every year we have a deficit of £100bn of our net income from abroad, and - other things being equal - this deteriorates by approximately an additional £5bn year on year. It is the cumulative - and ultimately unsustainable - impact of this deterioration in our net asset position as a country, and the strongly negative returns which we are now earning on it, which, more than anything else, is driving the overall worsening of our foreign payments balance.

Public Sector Borrowing
The UK has no problem funding its public sector borrowing needs and is very unlikely to do so in the foreseeable future. Nevertheless, there are problems about the government constantly borrowing more and more money, especially at a time when the economy is growing very slowly and inflation is very low. As a percentage of GDP, total government debt is still well down as a percentage of GDP on what it was after the major wars which the UK fought in the past, but especially after World War II, a combination of relatively fast growth and inflation rapidly eroded away the 240% of government gross debt as a percentage of GDP in 1945 to 31% by 1991. Gross government debt is now 90% of GDP, net debt (which offsets against the gross figure the value of government owned assets) is 84%. As long as government borrowing each year as a percentage of GDP is higher than the growth rate, the ratio of government debt to GDP will go on rising and interest charges on government debt will become an increasing burden, squeezing other heads of expenditure. Growing amounts of debt are also a drag on growth as they sap confidence and crowd out investment.

The Future
The key problem the UK faces, therefore, is our inability to pay its way in the world, exemplified by our mounting foreign payments deficit, which in turn drives the increase in debt across the economy. This situation has come about because our trading performance is nothing like strong enough to offset the sums of money we pay abroad each year either on both transfers and, more recently, on our increasingly negative net income from abroad. If nothing is done to remedy this situation, sooner or later the markets will turn on us and the pound will crash, although it is hard to know how soon this might happen. We still have assets to sell and as long as we are ready to dispose of them we may be able to underpin continued borrowing from abroad for some time although not without limit. We may find the Bank of England willing to raise interest rates to try to offset sterling weakening, but trends which can't last forever won't do so. Far better would be to come to grips with the situation we are now in before we lose control of it. What could and should we recognise the problems as being?

We need to accept how deeply unbalanced our economy has become. Investment as a percentage of GDP is far too low. We have deindustrialised to a point where we do not have enough to sell the rest of the world to enable us to pay our way. For this and other reasons we have a huge balance of payments problem. In consequence both as a nation and as individuals we are borrowing too much, and what growth we have is driven by consumer demand and not by investment and net trade. What should be done to remedy these problems?

By the first quarter of 2016, investment, net of intellectual property, was still running in the UK at only 13%, compared to a world average of about 24% and almost 50% in China. Of this pitifully small sum for the UK, only a quarter was spent on Other Machinery and Equipment, which is the best proxy ONS has for machinery and technology, the only real investment sources for increases in productivity. No wonder that our output per head is almost the same now as it was in 2008. We urgently need to get the proportion of GDP spent on physical investment up to 20% or above.

The proportion of UK GDP derived from manufacturing is now barely 10% and still slowly falling. Because well over half - 55% - of all our exports are goods rather than services, our trade balance still depends heavily on sales abroad of manufactured goods. We are never going to be able to pay our way unless we get manufacturing as a percentage of GDP back up to about 15%.

Balance of Payments
Although we do well on services - with a surplus in the first quarter of 2016 of £22.3bn - this was more than offset by a deficit of £34.3bn on goods. If we are going to run a deficit on net income from abroad and on transfers for the foreseeable future, the only way we can finance this position on a stable basis is for us to do much better than we are at present on our trade balance.

The debt which is being accumulated by both the government, by individuals and by the country as a whole is rising much more rapidly than the economy's capacity to service it. The fundamental reason why this debt is accumulating is that, without it, the economy would be dragged into recession as demand - now fuelled at the margin only by increasing debt - was reduced. If we are going to get our long-term debt situation under control, therefore, we have to start living within our means.

Net of inflation and taking into account our rapidly growing population, average real incomes are now no higher than they were in 2008 and - because so much of what limited growth there has been has disproportionately benefitted the rich - median incomes have actually fallen over this period. Such growth as we have seen has been almost entirely fuelled by ultra-low interest rates, asset inflation and rising consumer expenditure rather than as a result of investment and improvements in our foreign trade performance.

The only way to tackle these problems is to make the economy more competitive, so that sufficient manufacturing can be re-established for us to have enough to sell to the rest of the world to pay for our imports, and the only way to do this is to have a much lower exchange rate.

Lowering the exchange rate is the only viable route to increasing investment as a percentage of GDP, containing the foreign trade balance at a tolerable level, avoiding the accumulation of an unmanageable amount of debt and getting the economy to grow sustainably. The reduction in the value of sterling since the referendum in June is a welcome move in the right direction, but there is still a long way to go before we have a viable and stable future ahead of us.