Economics

Collapse in UK Investment Income Is Cause for Concern

By Darren Williams October 10, 2012

A collapse in direct investment income was the main factor behind the UK’s record second-quarter current account deficit. It's too early to know whether this represents a permanent shift. But, if it does, it would make rebalancing the economy more difficult and have important implications for the pound.

Recent data suggest that attempts to rebalance the UK’s economy since the bursting of the credit bubble in 2007 have been less than successful. The current account deficit reached a record 5.4% of gross domestic product (GDP) in the second quarter, which was the highest of any major industrial economy.

The obvious explanation is a deterioration in trade with the euro area, but that is only part of the story. In fact, the growth in the deficit on trade in goods and services has been modest. The real answer, we believe, lies with the income account, which includes net income from the UK’s overseas assets and liabilities. This year, a sharp deterioration in investment income has pushed the income account into deficit for the first time in more than a decade.

Between 2000 and 2011, the UK current account deficit averaged 2.1% of GDP, including a 1.2% surplus on income. However, in the first half of this year, the income account recorded a negative balance of 0.9% of GDP. The result was a current account deficit equal to 4.7% of GDP.

It's too early to say whether this is part of a new trend, but recent data provide grounds for concern. In recent years, the UK has enjoyed a sizeable surplus on investment income. In part, this is because the UK’s holdings of direct investment assets are bigger than its direct investment liabilities, while the return on these assets has typically been much higher .

But recent data suggest that the return on the UK’s holdings of direct investment assets has fallen sharply and is now the same as the return on direct investment liabilities. It is the associated decline in direct investment income which explains the recent deterioration in the income balance. In the first half of 2012, there was an £18 billion deterioration to a £7 billion deficit on the income account, compared with the same period last year. By far the most important factor was a £21 billion decline in direct investment income.

The limited figures we have suggest that the deterioration mainly reflects a decline in income from the direct investment holdings of UK nonfinancial companies in the euro area. In other words, the sovereign-debt crisis may be having a bigger negative impact on the UK’s external accounts than direct trade links would suggest.

It’s important to remember that the UK income account is often heavily revised as new data become available. That said, if recent data do indicate a permanent shift in the income balance, the UK’s current account deficit is likely to be far higher in future than we have been used to. That, in turn, would complicate the task of rebalancing and might have important implications for the exchange rate. We will be monitoring developments in this area very closely.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams.

Collapse in UK Investment Income Is Cause for Concern
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