Do not discount a run on sterling

Is sterling riding for a fall? The UK’s current account deficit is certainly worryingly large. From less than 2 per cent of GDP in 2011, it ballooned to more than 6 per cent in the fourth quarter of 2014 — the largest since modern records began in 1955.

Yet the reason for sterling’s vulnerability lies not in the current account deficit itself but in its cause. Exploring what that is leads to a less conventional perspective on currency valuation, but one that is vitally important in today’s financially globalised world.

The first interesting question is where Britain’s chronic imbalance of external cash flows actually comes from. It is not, after all, from the trade account. The balance of the UK’s trade in goods and services, though negative, has actually been improving since 2008.

Instead, it is Britain’s investment account that has driven the deterioration — the difference between what the UK earns on its holdings of overseas assets, and what the rest of the world earns from the UK.

From having contributed on average a positive 1.4 per cent of GDP a year to the current account throughout the pre-crisis 2000s, the UK’s net investment income has turned increasingly negative since mid-2011, notching up a deficit of nearly 2 per cent of GDP over the year to the end of the second quarter of 2015.

Such a large deficit on external investment income is highly unusual among the advanced economies — and points to the root of the problem. Britain’s external vulnerability derives not from its operations but its balance sheet. The continuing haemorrhage through the investment account is a reflection of foreign assets and liabilities that are mismatched in risk and maturity — and above all, simply too large.

The risk mismatch is the simplest to see. For the past decade and a half, the UK’s net external equity position has been positive, while its net external debt position has been negative. The analogy the Bank of England used in 2006 is still true today: Britain is “like a bank or venture capitalist that earns net income by borrowing to invest in projects that earn a higher return than the cost of funding”.

Or rather, projects that did. For most of that period, this giant carry trade proved profitable: external investment income was positive, and helped cover the deficit on trade.

In the past couple of years, however, the trade has gone sour. As the European recovery stalled and emerging markets have foundered, the UK’s foreign equity investments have failed to cover their funding cost. The result has been the crash in the investment account — the cause of Britain’s current account collapse.

If the risk mismatch has already materialised, the liquidity mismatch is still to hit home. Britain’s debt-skewed external liabilities are shorter-term than its equity-heavy assets, making it vulnerable to a run.

Yet the biggest problem of all — and the root of all the rest — is simply one of size. The UK’s gross external assets amounted to 516 per cent of GDP as of Q2 2015; its gross external liabilities were about 536 per cent of GDP.

That 20 percentage point gap is nothing too egregious, being roughly the same as that of France and only about half that of the US. But France’s gross external assets and liabilities are only a little over three times GDP, and the US’s are less than two times. The size of the UK’s external balance sheet is a significant outlier.

As any fund manager or corporate treasurer knows, when gross exposure gets out of hand, even minor mismatches of risk and liquidity can generate violent swings in performance. A big balance sheet is a not a guarantee of stability, but a sign of fragility, as Long Term Capital Management discovered in 1998, and Citibank a decade later.

It is not all bad news. There is one other mismatch in the UK’s external balance sheet that may ultimately ease, rather than exacerbate, its predicament: the UK is net long foreign currencies.

That implies a convenient adjustment mechanism. A devaluation of the pound might restore net investment income, and shrink the current account deficit, in a trice.

Unfortunately, with size comes complexity: so it is difficult to say with any conviction how large a drop in sterling would be needed to recondition Britain’s gigantic balance sheet. I suspect one old proverb may provide a rough guide, however: the bigger they are, the harder they fall.

Felix Martin is a fund manager at Liontrust Asset Management and author of ‘Money: the unauthorised biography’

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