Current account weakness shows scale of rebalancing challenge

The latest figures (pdf), released by the Office for National Statistics (ONS) today, show the UK had a current account deficit of £10.5 billion in the final quarter of 2010, equivalent to 2.9 per cent of GDP. For 2010 as a whole, the deficit totalled £36.2 billion, or 2.5 per cent of GDP.

In the latest quarter, there was bad news all round: larger deficits on trade in goods and on current transfers (both were the largest deficits on record in nominal terms) and a smaller surplus on trade in services.

The government has said that it wants to see a rebalanced economy, with growth driven more by net exports and investment spending and less by consumer spending. These figures illustrate the scale of the rebalancing challenge.

Optimists argue that the large fall in sterling in 2007 and 2008 has increased the UK’s competitiveness and will eventually lead to a better current account position. The fact that no improvement has been seen yet is because the initial effect of the devaluation was to push up import prices, so making the trade position worse.

Only after some time will trade volumes adjust to fall in the currency, eventually leading to an improving trade position (economists call this delay between a devaluation and a better trade position the J-curve effect).

The Office for Budget Responsibility is optimistic that the rebalancing challenge can be met. Its latest forecasts, released with last week’s budget, show export growth outstripping import growth in each of the next five years. As a result, net exports are forecast to add 0.7 per cent to GDP growth in 2011, followed by 1.0 per cent in 2012, 0.7 per cent in 2013, 0.6 per cent in 2014 and 0.5 per cent in 2015.

If this is achieved, it would represent the best trade performance by the UK economy in the post-war period – matching what happened in the mid-1970s. But, as Stephen King, chief economist at HSBC, has pointed out, it will require a period of exceptional export performance and a period of import growth that is unusually weak outside of a recession.

While this is possible, three things will need to happen:

• First, demand in the UK’s major export markets – particularly the euro area – will have to be strong. Any relapse into recession in Europe would blow these forecasts off course.

• Second, the growth in consumer demand in the UK will have to be moderate. Recent experience shows UK consumers have a high propensity for buying imported goods.

• And third, sterling has to stay around current levels. In the mid 1990s, after sterling had fallen sharply when it was ejected from the European exchange rate mechanism, the UK enjoyed a few years of improving trade performance.

But then sterling was pushed higher on the foreign exchanges and the trade and current account deficits started to widen again.

So, while it is possible to imagine growth in the UK economy being driven more by net exports and less by consumer spending over the next five years, an awful lot needs to go right if this is to happen. The OBR’s forecast does not look like a central case in this respect.