THE OUTCOME OF BREXIT MATTERS FOR THE UK S BALANCE OF PAYMENTS

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1 THE OUTCOME OF BREXIT MATTERS FOR THE UK S BALANCE OF PAYMENTS nthe main drivers of Balance of Payments are the Current Account deficit and the Financial Account surplus. nthe UK Current Account has historically been driven by trade, but primary income has, in recent periods, taken over as the main driver. Ben Rodriguez Multi-Asset Investment Analyst npositive drivers of the Financial Account have been portfolio and foreign direct investment (FDI) into the UK. nfrom a trade, FDI and primary income perspective, Europe is extremely valuable to the UK. nalthough a significant proportion of UK primary income comes from Europe, Europe is no longer responsible for the majority of FDI into the UK. The outcome of Brexit matters for the UK s Balance of Payments and, as a consequence, UK assets, with a softer Brexit requiring the Financial Account to compensate for the potential worsening of the Current Account. In recent years, and in contrast to the decade pre-global financial crisis (GFC), the magnitude of the UK Current Account deficit has been increasingly driven by the primary income account (Figure 1). This means that the UK pays more on debt and equity securities than it receives from abroad, with relative moves in both sterling and rates of return playing an important role. The relationship between movements in the currency and the Current Account deficit is in some respects circular. A weaker sterling inflates UK investment returns from abroad (primary income) making it a more positive/less negative contributor to the Current Account deficit, as has been the case since Q2. Figure 1: Breakdown of the UK Current Account GBP, Billion Trade Balance Primary Income (Investments) Secondary Income (Government) Primary Income (Employee Compensation) Primary Income (Other) Current Account Balance Source: ONS and Macrobond, as at July.

2 Drilling a step deeper and breaking down the primary income component of the Current Account, it is clear that the switch to negative net primary investment income and recent reverse back up to neutral has been driven by fluctuations in net earnings on direct investment abroad. Furthermore, Figure 2 highlights the importance the relative moves in sterling have to UK primary income. There is a striking correlation between EUR/GBP and the primary investment income balance since, highlighting the significance of the UK s investment ties to Europe (USD/GBP holds a much looser relationship). It also suggests that if sterling were to continue to weaken, UK primary income could turn positive for the first time since Q2. Figure 2: Breakdown of UK Primary Income vs. EUR/GBP Euro/GBP Earnings on Reserve Assets Net Earnings on Other Investment Net Earnings on Equity Securities Net Earnings on Foreign Direct Investment Net Earnings of Debt Securities Investment Income Balance EUR/GBP Source: ONS, Banque de France and Macrobond, as at July. Meanwhile, the Financial Account (which offsets the Current Account deficit), has not developed as one might have expected post-brexit. An argument could have been made that post-brexit the UK would experience an increase in portfolio inflows in order to take advantage of the competitive advantage given to the large UK exporters by the sterling depreciation. It may also have been expected that this would have been accompanied by a simultaneous decrease in net FDI inflows due to the increased uncertainty surrounding UK long-term business prospects following the referendum. However, this was not the case: large net equity portfolio outflows at the end of were more than offset by a significant increase in net FDI inflows (Figures 3 & 4). It is worth noting that, whilst Europe remains a significant UK trade partner and source of overseas investment earnings (Figure 2), this is not the case in terms of net inwards FDI to the UK where, according to the latest available data, the US is now the largest source.

3 Figure 3: Net UK FDI Flows 125 Figure 4: Net UK Portfolio Flows Net Debt Transactions Net Reinvestment of Earnings Source: ONS and Macrobond, as at July. Net Equity Capital Net FDI Transactions Net Equity Transactions Net Debt Transactions Net Portfolio Transactions The increase in net FDI inflows last year could partially be explained by the fact that saw higher-than-usual net inwards merger and acquisition (M&A) flows to the UK. FDI is also a long-term investment that may have already been committed pre-brexit resulting in a lag in the reversal of FDI inflows. Turning to portfolio flows of UK Equities, the large divestment was amplified by the takeover and de-listing of SAB Miller, given a market capitalisation of over 7 billion and significant non-uk ownership. These large swings in net FDI and portfolio flows seen at the end of last year have since moderated and slightly reversed in Q1. How might Brexit impact the UK Balance of Payments? All in, a harder Brexit would likely be associated with a weaker currency and lower bank rate (and relative rate of return on UK assets to those overseas, particularly within fixed income). The result would be an increase in primary income and therefore more favourable Current Account. Under a softer Brexit, a higher bank rate and stronger currency could have the opposite effect where decreasing primary income increases the Current Account deficit. If a soft Brexit is reached and the resulting potential worsening of the Current Account deficit is not offset by sustainable increases in the Financial Account surplus, this would lead to a weaker overall Balance of Payments. It remains uncertain whether under a soft Brexit the Financial Account could sustainably offset the potential increase in Current Account deficit, largely due to the fact that we have no idea what soft Brexit may look like. If Brexit is truly soft in that passporting etc. continues, then it is possible that we revert back to the pre-brexit status quo. In this scenario strong FDI and portfolio inflows due to a positive UK business outlook may enable the Financial Account to successfully offset the Current Account deficit. However, despite recent speculation, a truly soft Brexit looks unlikely due to the lack of: a) strong cooperation from the EU, b) a clear strategy from the Conservative party and c) some give from the UK on immigration, which looks especially unlikely given this was the very reason a lot of voters chose Brexit.

4 If the UK follows the hard Brexit plan, the state of the Balance of Payments will depend on the extent to which the Current Account potentially improves due to the lower bank rate and exchange rate increasing primary income. If it improves to a level where post-hard Brexit inflows on the Financial Account are sufficient for a stable Balance of Payments, then there may be no need to worry. However, it should be noted that as mentioned, the expected significant net outflows of FDI due to Brexit uncertainty have not been seen yet (Figure 3). If the outcome of hard Brexit increases UK business outlook uncertainty further, these FDI outflows may quickly come to fruition posing a risk to the UK Financial Account and therefore the Balance of Payments. If investors begin to question the sustainability of funding for the UK Current Account deficit due to lack of long-term inflows into the UK Financial Account, this would sap demand for UK assets further. As investors withdraw funds, bond yields would rise and sterling would begin to lose value relative to other currencies. Although this may seem like a never-ending spiral, eventually the depreciation in sterling would increase returns from abroad and help to stabilise the Current Account deficit the relationship between a country s currency and Current Account deficit is in some respects circular. However, the preceding volatility would be uncomfortable for UK assets.

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