The Real Reason an EU Exit Would Punish the British Economy
One of the biggest unanswered questions of Britain's looming referendum is how much capital might flee the nation if it decides to go it alone.
As it stands, foreign investors do better in Britain than British investors abroad, and that investment has been a big driver in the U.K. economy. It also helps explain why there's so much concern about the nation's growing deficit in its current account -- the gap between what Britain pays foreigners and what it receives.
Britain's economy is one of Europe's strongest in terms of growth. But in 2015 the country's current account deficit hit a record, meaning more money was flowing out of the U.K. than into it. After widening for four consecutive years, the deficit reached 32.7 billion pounds ($46.47 billion) in the fourth quarter -- that's 7 percent of GDP, the highest of any developed nation's economy.
A big deficit in the current account isn't necessarily something to worry about. Countries may run large deficits if they're spending heavily for future growth, or recovering from a natural disaster. For Britain, it mainly suggests two things: The nation remains a highly attractive place for foreign investors, and it's living beyond its means.
Capital naturally flows to areas where investors can earn a higher return, and Britain's economy has performed well relative to its largest trading partner, Europe. But the worsening of the current account deficit has come largely from a decline in net income from British investments abroad. That means income paid out to foreigners on their investments in Britain outstrips the amount the nation takes in on its investments in other places.
The U.K. has for a long time imported more goods than it exports, while running a surplus in services, thanks to its large financial sector. But that still means Britons are again consuming more than they're producing. Whatever belt-tightening happened after the financial crisis seems to be gone. British household consumption has been expanding, with big increases in consumer credit; while savings are at historic lows and investment in tradable goods has declined.
One of the ways Britons are financing all the spending is with investments from abroad. The U.K. economy relies heavily on booming sales of high-end London property to foreign buyers, as Bloomberg View contributor Jean-Michel Paul explained Wednesday. Housing prices have now reached levels that are starting to look like a bubble. Any shock -- and an exit from the European Union would qualify -- is likely to reduce foreign inflows to the housing market.
All of this leaves Britain dependent on "the kindness of strangers," as Bank of England Governor Mark Carney put it earlier this year:
The global general environment has become much more febrile, much more volatile and relying on the kindness of strangers is not optimal in that kind of environment — and that is the case when you are running a 4 to 4½ per cent current account deficit.
Foreign investors can be fickle, especially when the boat gets rocked. In the 1997 Asian crisis, the economies of countries that suffered the most had the largest current account deficit -- meaning that imports plus income paid to foreigners exceeded exports plus earnings on foreign investments and other transfers. In the more recent financial crisis, European countries with the largest current account deficits were the hardest hit, even without a major shift in their trade balances.
One reassuring note about Britain's deficit: Most of the money flowing into the country, or about 81 percent of net U.K. capital flows in 2014, is more stable, long-term foreign direct investment, not the short-term "hot money" that is easily reversed in a crisis. But confidence can easily turn and even currency fluctuation may not be enough to restore a sense of order. Britain's current account deficit is too large to be whittled away through exchange rates. Sterling depreciated 25 percent on a trade-weighted basis in 2008, but the trade response to that was modest, while the U.S. has managed an export-led recovery despite an appreciating dollar. Unless Britain invests in new export capacity, a decline in the currency is little help.
Stable investment is the long-term answer. Even beyond the EU vote, protecting the British economy from shocks will mean that Chancellor of the Exchequer George Osborne needs to worry more about the current account deficit and less about the budget deficit that’s consumed so much of his attention the last five years. Productivity in Britain remains low, removing an important driver of economic growth. The single-minded focus on reducing the budget deficit means investment in human capital and infrastructure has been insufficient.
In the meantime, it's hard to see Europe riding to Britain's rescue. As JP Morgan CEO Jamie Dimon told shareholders in his annual letter Wednesday, the best case scenario for Britain leaving the European Union is "years of uncertainty." There are, of course, even worse things than uncertainty. Those voting in Britain's EU referendum in three months' time -- myself included -- will need to keep an eye on how the shock of an EU exit might prompt the "strangers" on which Britain's economy has become so dependent to consider other options.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
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