UK current account deficit makes Brexit specially risky

The Brexit referendum would be risky under any circumstances: Britain is contemplating a rupture with its closest trading partners, with no consensus on its preferred alternative—the Norway model, the Swiss model, or something closer to Canada’s free trade deal with the EU. But the referendum is especially dangerous because of a peculiar British vulnerability. Every year, Britain relies on large inward flows of foreign capital. If these dry up, British families will suffer.

Britain’s current account deficit—that is, the gap between its export earnings and the cost of all imports—is running at 4.2% of GDP, the biggest shortfall among the advanced economies. The gap has to be plugged by loans and equity flows from other countries—otherwise, Britons could not afford to buy more than they sell. We rely, as Bank of England Governor Mark Carney said recently, on “the kindness of strangers.”

Until fairly recently, it could be argued that this equilibrium was stable. Rather than attracting flighty short-term capital—the sort that could suddenly change direction and plunge the economy into crisis—the UK economy was attracting foreign direct investment, the most stable and desirable form of capital inflow. Money that comes in to buy factories cannot be yanked out again in a hurry. It represents a long-term vote of confidence in Britain.

But the Brexit referendum may upset this picture of stability. Companies are less likely to invest in a factory in Britain if they can’t be sure of hassle-free access to European consumers. Foreigners are also less likely to buy houses in London if its status as the EU’s foremost commercial city is thrown into doubt. If the flow of FDI dries up, Britain will either have to pay for imports with riskier forms of foreign capital or it will have to tighten its belt.

In a recent speech on Britain’s vulnerability, Kristin Forbes, an MIT professor currently serving as an independent member of the Bank of England’s monetary policy committee, noted that the combination of current account deficits and political or financial shocks tends to produce “tighter financial conditions, currency depreciations, slower growth, higher interest rates, increased probability of debt crises and systemic banking crises”—hardly a pleasant cocktail. In every emerging-market crisis, countries with large current-account deficits get punished the hardest: their currencies collapse and their borrowing costs jump.

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Forbes’s careful analysis does draw attention to a silver lining. Fully 90% of the UK’s foreign assets (bonds, stocks, property and so forth) are denominated in foreign currencies; when sterling falls, the sterling value of these assets rises, making their British owners better off. In contrast, only 60% of Britain’s financial obligations to foreigners are denominated in foreign currencies, so the flip side of weak sterling—larger debts to foreigners—is mercifully less pronounced. Taking these effects together, the recent fall in the pound has generated some wealth gains to offset the risks and costs.

But there is a limit to this silver lining.  As Forbes concludes, the wealth gains are “moderate and would be unlikely to fully counteract the many negative effects from increased uncertainty on the broader UK economy.” The bottom line, unfortunately, is troubling. Not only would Brexit scramble our trade relationships. It might disrupt the flow of capital on which we depend.

Edited by Hugo Dixon