British Pound Strength post-Referendum Could be Short-Lived says Capital Economics's Bootle

If the UK votes to remain in the EU on Thursday, the pound will rise initially, however, its days of glory are likely to be numbered due to the widening Investment Income deficit, argues esteemed economist Roger Bootle and his colleague Jonathan Loynes

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The 'Bremain rally' has seen some extraordinary gains for the British pound of late with markets rushing to catch the expected bounce that a Remain vote will deliver to sterling.

The big question for currency markets is just how far it can go. 

For most analysts this is a question of GBP finding 'fair value' - the assumption is that the pound has fallen as markets absorb some kind of referendum-orientated risk. It must once again reflect economic fundamentals.

Just where that level is remains subject to debate.

According to Capital Economics, there is not too far to go.

The impact of the growing ‘current account’ deficit on the pound, may cause the currency to come under pressure over the long-term, even if there is a knee-jerk reaction higher in the event of the UK staying in the EU.

The current account is made up of the difference in trade, the difference in flows of capital and income earned from overseas assets and investments, and the difference in payment flows, such as salaries - in and out of the UK.  

It is currently showing a deficit, which means more money is leaving the UK than is coming in. This is negative for the pound as it shows less relative demand for the pound.

The Trade part of the current account has always tended to be in a deficit, because for years the UK has imported more foreign goods than it has exported, however, historically, this deficit had always been offset by a surplus in the second part, the difference in foreigners buying UK assets and British people buying foreign assets, as well as the income earned from those assets -  for example rent from foreign property.

Capital Market’s Roger Bootle (winner of the Wolfson Prize) and Jonathan Loynes, however, suggest that now this delicate balance has been disturbed, as the UK’s widening current account deficit is due to a failure of incoming investment - specifically income earned on foreign investments or assets -  to offset the hole in trade.

“The main culprit for the UK’s huge current account deficit is the recent deterioration in the UK’s investment income balance.” 

The main reason for this is a fall in earnings from UK-owned overseas investments -  for example, dividends on foreign shares, loan repayments or as above rent from foreign property - and a corollary rise in earnings from foreign owned UK assets:

“The swing in the UK’s investment income balance has been primarily due to a drop in the UK’s net income on foreign direct investment. The UK’s earnings on its overseas assets have fallen at the same time as foreigners have been earning more on their assets in the UK.”

Part of this they put down to ‘cyclical effects’ because a large number of investments owned by Brits are in the Eurozone which is still recovering from a crisis.

Another major contributor to earnings from foreign investments are British interests in mining and quarrying firms which have suffered during the commodity slump.

They argue, however, that cyclical factors don’t explain all the weakness:

“But net income on non-commodity assets has fallen too, as has the UK’s income from investments in non-eurozone countries. In any case, the euro-zone may not recover for a while. And more fundamentally, we shouldn’t be surprised that the UK is running an investment income deficit. After all, it holds fewer assets overseas than foreigners hold in the UK. And the composition of the UK’s assets has recently shifted towards lower-yielding ones.”

The lack of inflows from investment mean the gaping hole in the trade deficit is more noticeable than previously, and there will be more pressure on trade to increase.

The wider current account deficit is likely going to become a familiar feature in the future, which may very well weigh on the pound in the long run:

“In time, a recovery in the euro-zone will help to boost UK exports, but we also think that the pound needs to fall further. This might happen soon anyway if the UK votes to leave the EU; but even if the UK votes to stay, it is a reason to expect any rebound in sterling to be short-lived."