The U.K. Deficit That Risks Cutting the Pound’s Rally Short

A hole in Britain’s finances is starting to worry economists and stoke concerns about the pound. This time, the vast budget deficit created by the pandemic is not the issue.

The focus is gradually shifting to the current-account shortfall, the difference between money coming into the U.K. and money going out. The gap is forecast to reach its widest since World War II this year as Britain grapples with post-Brexit ties with the European Union and an imports-fueled rebound from the pandemic.

That will test the willingness of foreign investors to keep on funding the spending habits of the nation by buying British assets. Data on Wednesday will likely show that the U.K. had one of its biggest trade deficits on record in the first full quarter since completing the withdrawal deal with the EU.

The U.K. Deficit That Risks Cutting the Pound’s Rally Short

“A big jump in the trade deficit can put into question whether it can be sustained by capital flows,” said Sonali Punhani, European Economist at Credit Suisse. “This can increase the premium investors demand to invest in U.K. assets.”

The deficit is adding to the longer-term risks gathering over the pound, which also include the prospect of another Scottish independence referendum. While the currency has rallied this year amid a brightening economic outlook, strategists say further significant gains are unlikely.

The current-account gap, which also includes flows of investment income, may almost double to 6.4% of economic output this year, according to the U.K.’s fiscal watchdog. The forecast reflects an export performance hobbled by Brexit and strong demand for foreign-made goods as the economy rebounds at pace from the pandemic.

What Bloomberg Economics Says...

“It’s well known that the U.K. is a serial borrower from the rest of the world. One of the potential consequences of recovering earlier and more quickly than the rest of the world is the U.K.’s current account deficit widens even further as export growth lags imports. That’s likely to catch the eye of investors if the U.K.’s recovery proceeds as expected.”

-- Dan Hanson, senior U.K. economist.

The Bank of England, which upgraded the U.K.’s economic outlook significantly last week, predicts an 8.5% surge in imports and almost no growth in exports. The International Monetary Fund says Britain will have the biggest shortfall among major industrial nations.

The U.K. Deficit That Risks Cutting the Pound’s Rally Short

In recent years, Britain has had no problems funding the gap. Foreigners attracted by a robust legal and financial systems and the prospect of decent investment returns have proved eager buyers of British firms and high-end London properties. They also bought U.K. equities and debt.

While they may continue to regard the U.K. as a good bet -- the economy is forecast to outgrow its major peers this year -- Brexit has raised some awkward questions.

The U.K. is no longer part of the EU single market, access to which was a key reason for many firms choosing to invest in Britain.

The government also appears to have jettisoned the idea of trying to lure investors by turning Britain into a “Singapore of Europe” with low taxes and light-touch regulation. In his March budget, Chancellor Rishi Sunak raised taxes to levels not seen in half a century, with businesses bearing the brunt, in an effort to rein in the biggest budget deficit in peacetime.

In a recent research report, RBC Capital Markets said Britain can no longer count on being a “natural haven” for foreign direct investment, with neither the pound nor U.K. equities currently trading at cheap levels.

“There is no strong reason to think there will be a flood of foreign capital inflows looking to pick up bargains,” said RBC chief currency strategist Adam Cole.

Cole sees the pound falling to $1.25 and 91 pence per euro by the end of this year and weakening further in 2022. Sterling is currently at $1.41 and 86 pence per euro.

The U.K. Deficit That Risks Cutting the Pound’s Rally Short

To be sure, large current-account deficits do not hold the fear they did in past decades, when crises were precipitated by attempts to support fixed exchange rates by exhausting gold and currency reserves. The 1967 devaluation of the pound that humiliated Harold Wilson’s Labour government followed years of balance of payments problems.

Now the pound floats freely, meaning that the exchange rate can fall to a level where foreign investors once again find British assets attractive, sparing Britain an abrupt funding crisis.

With British assets owned by foreigners now worth around six times the size of the economy, an adjustment may not be without pain, however. Cole at RBC points out that recent inflows have shifted toward loans and deposits -- “hot money” that could quickly leave the country if sentiment on Britain soured.

“Seemingly unsustainable deficits can be sustained for a very long period and they don’t seem to matter until they do matter,” he said on Monday. “When they do, nothing else seems to matter.”

©2021 Bloomberg L.P.

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