Incoming Central Bank governor investigates UK deficit woes

The incoming governor of Ireland’s central bank has suggested that corporate financial engineering lies behind the deterioration in the UK current account deficit.

Philip Lane said Britain's external economic weakness was likely to have been overstated in official figures, at a time of artificial strength in the national accounts of Ireland and Switzerland.

His suspicions, if proved, would ease fears that Britain’s record current account deficit with other countries last year could generate a crisis of confidence in the UK and sterling, leading to higher imported inflation and raised borrowing costs.

Britain’s current account deficit hit a postwar record of 5.1 per cent of national income in 2014, raising fears that the economic recovery was unsustainable and the country was ever more indebted to foreigners.

A persistent puzzle has been that the trade deficit has been stable since the economic crisis, with the entire deterioration in the current account driven by a decline in net income from foreign direct investment.

The UK used to earn more than £40bn a year more on foreign assets than it paid on UK assets owned by foreigners. That surplus fell close to zero in 2014.

Last week the Office for National Statistics suggested that lower returns in the oil industry accounted for a large proportion of the drop.

Professor Lane's views were laid out in the economic review of the National Institute of Economic and Social Research, the UK's independent research institute and think-tank, with little net impact on the underlying international investment position for the UK, may have contributed to the decline in net FDI investment income. The review, which was undertaken before he was appointed to the Irish central bank, suggested that much of the drop might be a result of financial engineering by companies to gain tax advantages as opposed to poor performance by UK assets.

“Financial engineering, with little net impact on the underlying international investment position for the UK, may have contributed to the decline in net FDI investment income,” Prof Lane said.

If a multinational company changes its headquarters from the UK to a foreign jurisdiction without doing anything else, it can create significant flows of income abroad offset by higher foreign assets owned by its British shareholders. The UK’s net external position would be unchanged, but the current account deficit would be greater.

Given the many changes to corporate structures in recent years, “the headline current account balance [IS NOT]a sufficient indicator of the state of the UK’s external position”, Prof Lane said.

His research suggested that companies moving to Ireland and Switzerland were artificially boosting their current account surpluses, and a reverse effect artificially damaged UK’s current account.

Prof Lane said he could not prove his thesis because of a lack of sufficiently detailed data. But a measured drop in the return on Britain’s FDI assets from 8.1 per cent in 2011 to 5.8 per cent in 2014 was “consistent with some highly profitable firms switching headquarters to a foreign country”, he said.

He urged statistical agencies, both the ONS and international agencies, to collect more detailed data on cross-border transactions. “The recent UK experience provides just one more illustration of the challenges posed by the financial operations of multinational corporations in the interpretation of balance of payments data.”

-Copyright The Financial Times 2015