Britain, or the members of the Conservative party, have just settled on a new prime minister. Liz Truss will have her work cut out: with inflation on the rise and energy prices skyrocketing.
And these problems could soon be accelerated by another risk factor, Britain’s worsening current account balance, which could potentially trap the country in a vicious circle of falling foreign direct investment, currency depreciation and in turn a further rise in imported inflation.
The UK’s current account balance – the balance between imports and exports with the rest of the world – stood at -£21bn by the end of 2021, according to ONS data and is set to rise further because higher energy prices are pushing up the cost of imports.
That in itself may be bad news, but not cause for panic. After all, other major economies, the US for example have also run up a significant current account deficit.
But as many readers will know, the US has something going for it that the UK doesn’t: a strong currency. In times of crisis, the dollar is still considered the world’s safe haven, whereas the pound has plummeted, and UK inflation is now the highest among G10 nations.
The picture is even worse when factoring in the narrow basic balance, which factors in foreign direct investment and GDP growth.
On that front, Britain performs worse than emerging and developed markets, according to Deutsche Bank. Now again, this piece of information should be taken with a pinch of salt, emerging markets tend to have relatively higher GDP growth after all, still, it doesn’t make good news for the incoming prime minister.
Enter Liz Truss, who intends to tackle the looming energy crisis with a £200bn increase in government borrowing and intervening more closely on the Bank of England’s mandate.
Markets responded to her announcement by voting with their feet. Yields on 30Y UK gilts have shot up by more than 3%, the biggest selloff since March 2020, when the news of the Covid lockdown first broke and on Wednesday, the pound fell to its lowest level against the dollar since 1985.
One of the investors ringing the alarm bells is Shreyas Gopal, foreign exchange strategist at Deutsche Bank in London.
In a note sent out to investors earlier this week, he warns that investor confidence on the UK economy could no longer be taken for granted. “If investor confidence erodes further, this dynamic could become a self-fulfilling balance of payments crisis whereby foreigners would refuse to fund the UK external deficit.”
Gopal warns that a currency crisis, as seen in emerging markets may be on the cards. A hard stop, which would force the country to reset its balance of payments, would require a 30% devaluation of the pound.
Unlike emerging markets, who are particularly vulnerable due to their issuance of hard currency, dollar denominated debt, Britain does have the added advantage that its debt is issued in sterling, which would allow it to lower the debt burden by reducing the value of its currency. But a lower sterling value would also accelerate the effects of imported inflation.
For UK institutional investors, this is a double-edged sword. The rise in long-dated gilt yields will look great on the balance sheets of DB schemes bringing down the present value of liabilities whilst also bolstering the income from fixed income holdings.
But institutional investors are not isolated from the broader macroeconomic backdrop, and a further rise in inflation, combined with an economic recession, are still a disastrous economic scenario.
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