July 26 (Bloomberg) -- Over the past few years, the emergence of sterling as one of the world's most stable currencies has surprised many people -- especially the British, who were once used to a steady diet of currency crises and runs on the pound.

Now, one of the reasons for sterling's strength is starting to become apparent -- the U.K. has become highly dependent on the income it earns on its overseas investments.

Far more than most comparable countries, the U.K. has become reliant on its investment skills. The British, both as companies and individuals, used to be great industrial managers. Now they are great portfolio managers.

The trouble is, you can have a good run of beating the market, yet it's very hard to outperform year after year. ``Sterling is incredibly vulnerable right now,'' said David Bloom, a currency strategist at HSBC Holdings Plc in London, in a telephone interview. ``It has been doing very well, but there is clearly now a question over how long that can last.''

The extent to which the prosperity of the U.K., Europe's second-largest economy, is linked to its trading skills is clear.

Just like the U.S., Britain runs big budget and trade deficits. In May, the U.K. had a trade shortfall in goods of 5 billion pounds ($8.7 billion), a slight narrowing from a month earlier.

Public-sector net borrowing, the standard measure of the budget deficit, jumped to 5.9 billion pounds in June, the highest figure for that month since records began in 1993, increasing pressure on the government to raise taxes.

U.K. Anomaly

Most conventional analysis tells us that countries running large trade and budget deficits get punished in the currency markets. They have to borrow a lot of money overseas -- and that pushes their currency down.

Not so in the U.K.

Sterling has been strong in recent years. The pound traded at about $1.60 at the start of this decade and was as high as $1.95 in December last year. Late yesterday, it was hovering at $1.74 in London trading. Against the Japanese currency, sterling was near 165 yen in January 2000 and was fetching 194 yen late yesterday.

So what's the secret? Investment income.

In a big, open economy like the U.K., lots of international companies and funds invest in the country. At the same time, British companies and individuals invest abroad. The difference between what foreigners earn in the U.K. and what the British are making in the rest of the world is the nation's net investment income. If it is positive, it means money is flowing into the country.

U.S. Comparison

According to HSBC, U.K. net investment income accounted for 2.8 percent of gross domestic product at the end of 2004. That compared with an average of 0.5 percent in 2000. By contrast, net investment income accounts for 0.1 percent of GDP in the U.S., HSBC said.

Capital Economics Ltd. in London has come to a similar conclusion. In a report this month, it drew attention to ``the strength of the investment income component'' in the U.K. trade balance. ``Whereas this component has historically had little impact on the current account position, since the mid-1990s it has become a major influence.''

Clearly, investment income has been growing strongly in the past few years. And U.K. interest rates at a relatively high 4.75 percent also help to attract international investment, boosting the pound's value.

`Hot Money'

It is important not to become sentimental about this. There is no inherent superiority to trading, say, cars or computers over trading financial assets. In the past few years, British companies have been good at buying overseas rivals, particularly in sectors such as oil and telecommunications. In a global economy, with a surfeit of manufacturing capacity, buying and selling things can be more lucrative than making them.

Yet right now, the U.K. relies on being a better trader than anyone else to stay rich.

How long can it last?

``The dark side is that in order to buy the overseas investments, the U.K. has had to bring in a lot of investment that is mostly very liquid,'' Bloom said. ``It is hot money. So when interest rates have peaked, sterling has a long way to fall.''

Capital Economics put it another way. ``Either U.K. companies have been much more skilful than their international counterparts in making their investment decisions, or conditions have simply been extremely favourable to U.K. investors -- i.e. they have been lucky,'' it said.

Oil Prices

The U.K.'s trading skills made the country a great maritime power. It is why the City, London's financial district, is the world's most vibrant business center.

Still, the extent to which sterling is dependent on trading profits is worrying. While skill plays a part, luck does as well. At some point, that luck will run out. All that has to happen is for the returns on the U.K.'s investments to drop back to historically average levels before the pound comes under pressure.

Even if it holds, there are other problems. A big part of the U.K.'s investment surplus, according to HSBC, is accounted for by giant oil companies such as BP Plc. If oil prices start to slip from record highs, those firms will suffer.

Sterling has defied all laws of economic gravity for the past few years -- and may well do so for the next few. Still, anyone holding the pound should be aware they are betting on what has increasingly become a nation of traders -- and as well as making big gains, they can sometimes post heavy losses.

To contact the writer of this column: Matthew Lynn in London at matthewlynn@bloomberg.net.

Last Updated: July 25, 2005 19:04 EDT