The UK balance of trade: has the tide turned?

The UK economy has been persistently troubled by a balance of trade problems for seven years. Steve Perry examines the history of the balance of payments difficulties and suggest that the UK economy may be entering a new phase in its trading relationships.

In principle the balance of trade (sometimes called the current account) has four components: the import and export of `visibles' and the import and export of `invisibles'. Visibles are defined as goods that can be seen and include cars, steel, coffee, clothes and food. Invisibles, which cannot be seen, include all services, such as banking, insurance, freight haulage and tourist expenditure.

The interest earned by UK residents and companies on loans and investments abroad are also included as invisibles. In practice any item (visible or invisible) that typically gives rise to a purchase of foreign currency is recorded as a debit item on the current account. Similarly any purchase of an item that typically gives rise to a sale of foreign currency is recorded as a credit item.

The balance on the balance of trade is therefore the net of these credits and debits.

The UK experience

The UK economy has experienced a deficit (imports greater than exports) on the current account for the past seven years or so, with the exception of the last quarter's data. The pattern and size of the deficit as a proportion of gross domestic output is presented in Figure 1.

The deficit peaked in 1988 and 1989 at around five per cent of output, equivalent to around 20bn[pounds] a year.

Since the beginning of the 1990s the deficit has declined as a proportion of GDP as the UK economy experienced recession and UK consumers became reluctant to maintain previous spending patterns.

Determinants of the current account

There are two components to the current account: the domestic economy and the overseas sector. Both sectors are affected by the same drivers, principally the exchange rate and the rate of growth in output.

The exchange rate

The exchange rate prevailing between two countries determines the price of goods exported from one country into a second country in terms of the second country's national currency. If sterling were to weaken such that it was worth fewer French Francs, the price in French Francs of UK exports to France falls. Thus the exchange rate is the principal determinant of the flow of goods and services between countries.

In September 1992 when the UK government removed sterling from the Exchange Rate Mechanism, sterling's exchange rate fell dramatically. The sterling exchange rate against the European Currency Unit (ECU) is shown in Figure 2 and highlights its significant fall at this time.

The fall in the value of sterling provided a boost to UK exports which was the major factor leading to the improvement in the UK current account. Similarly, the same weakening in sterling raised the price of imports which also improved the current account.

Output growth

The improvement in the current account in the early part of this decade is in no small part attributable to the state of the UK economy. With consumer confidence low, unemployment high and the housing market subdued, the propensity among UK consumers to import fell.

The current account, whilst still in deficit, has been improving as a direct result of the weakening in the value of sterling and the deterioration in UK consumer confidence and output. In addition, revenues from North Sea oil have been increasing UK exports. The invisibles component of UK exports is the main reason behind the export improvement following the weakening in sterling.

Interestingly, invisibles have been accounting for an increasing proportion of UK exports. In 1960 invisibles accounted for one-third of the value of exports; in 1990 the proportion was half.

Looking ahead

To many commentators the current account has always been the Achilles heel of the UK economy. Even in times of deep and far-reaching recession, as experienced in 1990 and 1991, a current-account deficit of one to two per cent of output was common. Me same commentators hypothesised that once the UK recovery was underway the current account deficit would expand, reaching five per cent of output as previously.

On 22 December the Central Statistical Office (which measures and reports on the UK balance of payments) delivered a pre-Christmas present that made many commentators rethink their hypothesis on the outlook for the current account. For the first time in over seven years a quarterly current account surplus was reported. So, is the surplus sustainable?

There are several reasons why the current account could remain broadly in surplus over the life of the current government: 1 The sterling exchange rate remains low compared to its earlier ERM level. The consequential improvement in the price-competitiveness of UK exports is therefore apparent and sustainable. It would appear also that UK exporters are not allowing the improvement in price-competitiveness to leak into wage inflation. Thus, price-competitiveness appears to be holding. 2 There is no reason to assume that the current rate of sterling is artificially low and subject to any strengthening. Even if sterling were to rejoin the ERM it would be likely to do so at current rather than September 1992 levels of exchange. 3 UK consumers remain apprehensive about the prospects for the economy. Although the recession is over consumers are not confident about the prospects of the economy as it affects them. There are several reasons why this feeling of affluence is missing: * The UK housing market is at best stagnant. Severe negative equity amongst some home owners and the lack of real house price inflation equates to flat consumer confidence. * Inflation is largely under control: therefore pay rises in nominal terms will remain low. * Recent rises in UK interest rates remind consumers that any improvements in the economy could be transitory. Equally, higher interest rates reduce disposable income and therefore imports. * Various personal and VAT tax rises have also reduced disposable income.

Conclusion

Notwithstanding the low level of consumer confidence, the UK recession is over. More important, perhaps, is the fact that the improvement experienced is well balanced: growth in output is above trend (at around 4 per cent), unemployment has fallen for 20 consecutive months; investment is rising; price and wage inflation are under control - in fact, compensating for the impact of tax and interest rate increases on the retail price index, adjusted inflation is around one per cent.

As measured by the retail price index, the unadjusted rate of inflation is the lowest it has been for 30 years.

The European economies are coming out of their recessions: the EU, which in 1994 accounted for over half of the exports from the UK, is set to increase real output by 2 per cent in 1995. This improvement in the EU economies will have a favourable effect on UK exporters.

From these factors it is apparent that the current account could remain in broad surplus over the short to medium term. The longer-term outlook, as ever, is obscured. The current account will remain in surplus, or broadly balanced, for as long as UK consumers remain subdued. The main influence on consumers is the housing market, which is directly and positively related to movements in the rate of borrowing: the housing market will itself remain checked provided that the government uses its interest rate tool to control price inflation and consumer demand. If consumers are artificially stimulated in the run-up to a General Election the current account could deteriorate.

Finally, looking beyond the next General Election, the propensity among UK consumers to purchase foreign goods is strong. It is unlikely that the current account will in the long-term remain in surplus, as our main trading partners need to grow on average by one per cent more than the UK economy for the current account to remain balanced. Over the medium term the tide may have turned on the current account, but this sustainable surplus will be elusive if the UK economy grows in line with its trading partners.

Dr Steve Perry is Senior Vice President, Finance, of Visa International Service Association. The opinions expressed in this article are the personal views of the author.

Perry, Steve, The UK balance of trade: has the tide turned?. Vol. 73, Management Accounting (British), 03-01-1995, pp 42(2).