The current account is one half of the balance of payments – the other half being the financial account. It consists of the balance of trade, primary income account (net income in foreign investment) and secondary income account (net transfer payments). Current account deficit occurs when a nation is a net borrower from the rest of the world in a given year.
The first cause behind the UK’s historically high current account deficit is a deficit in the balance of trade. The balance of trade consists of trade in goods and trade in services. The UK is currently experiencing a deficit in the trade in goods. This is due to weak demand for UK goods, caused by the fact that the majority UK’s leading trade partners, such as the European Union and the US, are still in economic recovery from the 2008 financial crisis. The Euro Area is currently in an expansion but still in recession. What’s more, weak demand for British goods is also caused by their price uncompetitiveness. The strength of pound sterling in recent years is partly to blame, as it creates the UK exports to be more expensive and the UK imports to be less expensive. As a result, more imports and fewer exports are bought. Another reason behind the UK price uncompetitiveness is the high cost of production compared to other countries, such as China or the US. The productivity of labour in the UK, a significant determinant of the cost of production, is 30% lower than in the US and 35% lower than in Germany. Cost of labour, another significant factor of the cost of production, is higher in the UK than anywhere else in Europe. A higher cost of production causes exports to be more expensive and, as a result, fewer exports are bought. This weak demand for British goods internationally is also complemented by high demand for both British products and foreign goods inside the UK. Consumers in the UK are, in fact, using their savings to fund their spending. Many borrow to spend. This has led to consumer spending rising to 310 billion pounds in the fourth quarter of 2016. This expenditure indicates high demand for both domestic goods and imports among British consumers. Overall, this demand causes net imports of goods into the UK to rise. All these economic factors led to a deficit in the trade in goods the UK is experiencing today.
The UK’s deficit in goods has, in fact, been sustained for so long, that there has not been a single surplus on manufacturing since the early 1990s. What this also shows, however, is that the recent worse performance of trade in services and higher deficit in the primary income account are more to blame for the recent increase of the current account deficit. Both, trade in services and primary income account, in Britain rely heavily on the performance of the financial sector. In recent years, foreign investors have been more money on their foreign direct investment in the UK than the UK investors have been making on their investments abroad. This is evidenced by the fact that the deficit in investment income in 2014 was 45 billion pounds. The reason for this recent trend is that British investors have invested heavily in Europe, in which countries are still either recovering from the 2008 financial crisis or in a crisis currently (e.g. Greece), with 9% of the UK’s foreign assets in France alone. These investments have been yielding progressively worse returns due to weak European growth. At the same time, after the 2008 financial crisis, British investors have lost their appetite for risk, leading to much less investment going to higher risk higher return countries. This is evidenced by the fact that less than 1% of the UK’s foreign assets are in China. To add to this, the stability of the UK economy and high domestic demand has meant that foreign investments have paid off very well. This, in aggregate, resulted in the primary account adding 12.6 billion pounds to the current account deficit in the third quarter of 2014.
The final factor contributing to the historically high current account deficit is a deficit in the secondary income account. This includes remittances sent home by foreign nationals working in the UK and contributions to budgets of various international organisations paid by the UK. This added over 5 billion pounds to the current account deficit in the third quarter of 2014.
The current account deficit the UK is experiencing is a cause for concern. Firstly, it is too large. It has exceeded 3% of GDP for several years and stood at 6% for 2016 when usually any deficit above 3% of GDP is considered dangerous. «No big developed country has a bigger current account deficit as a share of GDP», according to The Economist. In absolute terms, the UK has the world’s second-largest deficit. What’s more, the immensity of this deficit is even more worrying; usually, countries experience sizeable current account deficits at the end of economic booms, as was the case in 1988 and 1973 in the UK. However, we are not at the end of an economic boom: the recovery is only about 2 years old. This shows that the current account deficit is too massive for the stage of the business cycle the UK is currently in.
However, many would argue that if the UK’s current account deficit is too large, then our financial account would dry up, as investors would be less willing to lend UK money due to a growing risk that the UK would default on its growing debt. However, the financial account has not dried up. Therefore, the size of the deficit is not a cause for concern. This logic is flawed, because to the rest of the world, the UK is seen as a very stable and growing economy relative to the overall global economic climate. As a result, investors were willing to disregard the UK’s current account deficit problem, but this is changing as the deficit grows and as the global economy recovers from the 2008 financial crisis.
The second side to why the UK should be concerned about its current account deficit is that it has been sustained for too long. The UK has not posted a surplus since 2002. The current account deficit has exceeded the 3% guideline every year since 2012. What’s more, it is only increasing: in 2013, it stood at 4.7%; in 2014, it rose to 5.9%; in 2015, it rose again to 6%; and only in 2016, did it drop 5%, which could be explained by the devaluation of the pound boosting exports. 5% is still 2% higher than the 3% guideline. The UK’s prolonged deficit is further evidenced by the fact that the UK’s debt exceeds 60% of GDP, which is the guideline.
In conclusion, the UK’s historically high current account deficit has been caused by an accumulation of worse performances in all of the components of the current account: the balance of trade, primary income account and secondary income account. However, it is the growing deficit in the primary income account and worse performance in trade in services which caused the current account deficit to rise to historical highs. This essay also showed that the current account deficit is a significant cause for concern. The deficit is too large relative to the UK’s GDP, stage in the business cycle and the deficits of other countries. This will ultimately result in worse standards of living for future generations as they will be the ones who will have to pay the debt. Finally, the fact that the current account deficit was sustained for such an extended period of time suggests the existence of a large structural deficit, which is a sign of very low productivity. This highlights UK’s price uncompetitiveness in the world – a substantial cause for concern.