The UK is more dependent on foreign capital than at any time since the end of World War II. Exceptionally, the trade deficit is not to blame:
(Source: National Statistics Office, moving average over 4 quarters)
In a series of posts, we’ll explain the causes of the yawning gap between the blue and red lines, including:
– The frightening size of UK banks
– Amendments to the corporate tax code in the United Kingdom
– The setbacks of European telecom operators
– Decrease in demand for raw materials
We will also discuss some of the implications for UK residents. Our survey will conclude that a combination of changing investor preferences and UK business behavior likely means the UK will find it increasingly difficult to pay for its place in the world.
Our survey will focus on the evolution of income received by UK residents on their foreign assets compared to income received by foreign holders of UK assets – this is what is behind the large movements in the account deficit. current from the UK for the past 15 years.
As of mid-2011, this excess investment income represented around 1.3% of the UK’s gross domestic product. As you can see, this surplus has since turned into a deficit:
In the second quarter of this year, British workers, shareholders and taxpayers paid 1.7% more of GDP to foreigners than they received from their investments abroad.
Even setting aside the unusually large net income received during the peak of the credit bubble, the scale and speed of the recent change is unprecedented in the past 60 years:
How did it happen? Should UK policymakers be worried?
Ben Broadbent gave a blood speech on the subject at the end of July. Its main argument was that the massive growth in the UK’s gross balance sheet over the past decade will inevitably make net revenues much more volatile than in the past.
In addition, UK investors are heavily exposed to European growth, which has not been of much help in recent years. Sterling also appreciated about 13 percent on a trade-weighted basis since mid-2011, lowering the value of dividends and interest payments received in foreign currencies while increasing the real value of payments made to foreigners. In theory, a strong recovery in euro area domestic demand, perhaps accompanied by an appreciation of the euro against the pound, would reverse the recent trend.
First of all, the long-term view. The UK’s gross international investment position has grown incredibly large, which may give the impression that the difference between the value of UK assets and liabilities is misleading:
Focus on the net international investment position:
From the mid-1970s to the mid-1990s, the UK had more assets abroad than it owed to foreign investors, although this ratio peaked in the mid-1980s. Since 1995, foreigners have historically owned more UK assets than UK investors have overseas.
(The positive spike in the fourth quarter of 2008 was due to changes in the valuation of large derivative positions by UK banks.)
However, UK investors got lower returns on their foreign assets than foreign investors on their UK assets until the mid-1990s. We calculated this by simply dividing asset payments to and from the UK. United by the declared value of assets and liabilities. From 1980 to 2005, this yield differential fell from -2 percentage points to just under +1 percentage point. Since 2005, the yield gap has narrowed to -0.3 percentage point.
The difference in yield turned out to be larger, so the net income balance was consistently negative until the late 1990s, then turned into a gigantic surplus in 2005, and is now in its biggest deficit ever. The cumulative change since 2005 is equal to 4 percentage points of GDP.
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To get a better idea of what drove it all, we delved into the detailed figures on foreign investment income and asset and liability positions in the just released report. Pink book, published annually by the ONS. We will start by looking at the balance sheet before analyzing the evolution of income earned and paid on each category of assets and liabilities over time.
Foreign assets and liabilities (excluding derivatives) both doubled between 2003-2013. Relative to GDP, assets and liabilities excluding derivatives each increased by around 140 percentage points during this period.
However, an examination of the ten-year changes ignores the significant fluctuations that have occurred during this period, as well as the behavior of different sectors of the economy.
British banks increased their holdings of foreign assets (excluding derivatives) by about 127 percent from 2003 to 2008, and they increased their foreign currency liabilities by about 123 percent. From 2008 to 2009, UK banks reduced their holdings of foreign assets by 15%, although their balance sheets grew again until 2011.
Since 2011, however, cross-border banking investments have declined further. British banks reduced their assets abroad by 17% between 2011 and 2013. Since 2008, UK bank assets held abroad have fallen by just over 21%, while debts to foreigners have fallen. fell 24%. Despite this, their external asset position is still about 80 percent larger than it was in 2003, while their external liabilities are about 70 percent larger.
Throughout this period, UK banks owed more to foreigners than they owned overseas, although this gap has more than halved since 2008.
The non-bank private sector behaved very differently. Assets held abroad have always been worth more than debts owed to foreigners. From 2003 to 2008, UK businesses and households increased their foreign assets (excluding derivatives) by 73 percent, while debts to foreigners increased by 62 percent. Since 2008, the non-bank private sector has increased its foreign investment by 24 percent while foreigners have increased their holdings of non-bank private liabilities by 38 percent.
The UK’s non-bank private sector net surplus is roughly the same size as in 2004, as a percentage of GDP, although it has declined significantly since 2011.
Finally, consider the role of public debt. In the early 2000s, Britain’s public debt was relatively low and foreigners did not own much. Central government debt held by non-UK residents was less than 7% of GDP in 2003.
Thanks to the combination of financial globalization and the attractiveness of somewhat higher real yields, obligations owed to foreigners rose to around 13% of GDP in 2007. Since then, UK credit security vis-à-vis countries troubled eurozone, and of course the rising stock of debt pushed foreign obligations to a peak of 31% of GDP in 2012.
The burden eased slightly from late 2012 to late 2013, both in absolute terms and relative to GDP, possibly due to the convergence of global yields and the easing of concerns about sovereign defaults in Europe.
The UK government has also increased its modest foreign holdings from around £ 34bn to around £ 91bn over the past decade, so the net amount owed to foreigners was around 23% of GDP in 2013.
It all looks more dramatic if you choose to count derivatives, as in the upward chart, although the net positions are mostly unchanged. (This is how derivatives tend to work.)
Including derivatives, UK bank assets held abroad and debt to foreigners both increased by around 200 percentage points of GDP between 2003 and 2007. In 2008 (a frightening year), both assets and bank liabilities were each worth about six times Britain’s GDP. Since then, UK lenders’ foreign assets and liabilities have each shrunk by around 41%, with most of that drop occurring since 2011.
In the next article in this series, we will look at the evolution of the asset allocation preferences of UK and foreign investors, which has been an important factor in explaining the different returns they have achieved.
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