Commonly Asked Questions about the UK Balance of Payments

Commonly Asked Questions about the UK Balance of Payments

The diagram below shows the persistent deficit on the 'trade in goods' account that the UK has experienced over the last 30 years. Note that this is only a sketch and the figures are for annual trade deficits. All figures are in billions of pounds.

trade in goods

Note that the trade in goods section of the current account is always in deficit despite the fact that the UK in a net exporter in oil (worth over three billion pounds a year).

Cyclical changes

Whilst the UK has had a deficit in 'trade in goods' since 1983, one can see that the annual deficits have worsened over time.

During boom times, one should expect the trade balance to worsen. Other things being equal, the value of imports should rise due to the increased real incomes of consumers in the UK. The UK has quite a high marginal propensity to import, so when real incomes are rising, the demand for imports will rise more than proportionately.

Equally, during a recession, one should expect the trade balance to improve (in this case, that means the trade deficit should fall). Real incomes are either falling or not rising very quickly, causing a fall or a slowdown in the value of imports consumed in the UK.

In both cases we have to assume that the world economy (i.e. those who buy our exports) is neither booming nor in a recessionary situation. Obviously, if the UK is booming but so is the rest of the world then the increase in imports should be evened out by an increase in UK exports (although other countries do not tend to have such a high marginal propensity to import). As it happens, in the real world some economies tend to be doing well and others not so well, so the overall effect on UK exports is broadly neutral.

But even during the bad times when the UK trade deficit falls, the UK still has a significant trade deficit. There must be some more fundamental reasons why the UK continually imports more goods than it exports.

Deindustrialisation

De-industrialisation is the word used to describe the changing structure of the UK economy. Britain was one of the first economies in the world to industrialise in the 19th century. We were also one of the first to de-industrialise that is, move away from manufacturing towards the services.

Many economists do not regard this as a problem. Every developed country is doing the same now, allowing the developing countries to make manufactured goods at a lower cost whilst concentrating on high technology, high skilled industries. And at least the UK got there first!

The problem in terms of the current account of the balance of payments is that, whilst most 'goods' are internationally tradable, only around 20% of services can be traded. The UK is declining in a sector, which helps earn foreign currency to pay for imports and expanding in a sector that does not.

The UK has seen a slight revival in manufactures with many non-EU owned companies setting up in the UK to take advantage of the barrier-free EU single market, but on the whole, the UK is structurally in a position where a deficit on the 'trade in goods' section of the current account is here to stay.

The uncompetitiveness of the UK

Another reason why the UK struggles trade-wise is that British manufacturers are felt to be internationally uncompetitive. Many firms would argue that recent problems are down to the strong pound, making their exports relatively more expensive abroad. This is true to a certain extent, but there is some evidence that UK industry performs poorly in terms on 'non-price' factors, such as quality, design and after-sales service.

The diagram below shows the persistent surplus on the 'trade in services' account that the UK has experienced over the last 30 years. Note that this is only a sketch and the figures are for annual trade surpluses. All figures are in billions of pounds

trade in goods

As you can see, the annual surplus on services is always at least three billion pounds, and in recent years this surplus has risen close to 100 billion. This goes quite a long way to earning foreign currency with which to pay for the trade deficit (although not all the way).

The strength of the service balance is due, in the main, to the strength of a few particular elements of the service sector.

The UK is very strong in financial services. Most of the surplus is down to things like banking, insurance and management consultancy. We are good in 'high-tech knowledge' areas. We are strong in the law as well. Other countries are envious of the 'City' in London, one of the major financial centres of the world. It earns a lot of foreign currency for the UK.

Some would say that it is a bit of a worry that the UK's service balance relies quite heavily on an industry that is notoriously fickle in terms of where they take their business. If the Euro finally takes off, it would not be surprising to see Frankfurt become Europe's leading financial centre.

It should also be noted that the UK tends to run a deficit on transport services and tourism. The strong pound has made it much cheaper for Britons to go abroad, and relatively more expensive for foreigners to come to Britain.

The simple answer is that the capital account has to be in surplus if the current account is in deficit, which has been the case since the mid 80s (although the current account was in surplus in 1997). If the current account is in deficit, there has to be an equal and opposite surplus on the capital account (and vice versa). See the last Learn-It for details.

The more interesting question is how does the UK attract these flows of capital to finance the continual current account deficits? The UK is the second largest recipient of foreign direct investment (FDI) in the world (after the USA). How does it do it?

Member of the EU

The attraction of investing in any EU country for a non-EU country is the subsequent tariff-free access to a huge market of over 250 million people. The EU is a customs union. This means that all exports to EU countries from other EU countries are free of any trade barriers, but all non-EU imports are subject to a common 'EU' tariff. If a Japanese or American company can set up in an EU country then it will effectively be exporting into the EU free of barriers.

It should be noted, though, that the cars made by a Japanese company based in the UK and exported to the rest of the EU are counted as UK exports in the 'trade in goods' section of the UK current account, but the profits will still go back to Japan (and appear in the 'investment income' section of the current account).

But this is an advantage that all EU countries have and around 25% of all FDI comes from the EU itself, so there must be other reasons why countries pick the UK as a place in which to invest.

The flexible labour market

It is certainly true to say that the UK has one of the least regulated labour markets in the EU. The decline of the trade unions in the UK, due to structural changes in the economy as well as the government legislation of the 80s (see the topic called 'Labour markets' for much more detail), has reduced the number of days lost in strikes and fragmented industry pay bargaining, putting downward pressure on pay claims. The UK now has one of the lowest levels of unit labour costs in the EU. Given that labour costs form the majority of most firms' costs, this is a big advantage for the UK in attracting FDI.

The Labour government of 1997-2010 signed the EU's Social Chapter, giving more rights to workers, and introduced the National Minimum Wage. Both of these actions have made the UK labour market a little less flexible, but all EU countries adhere to both of these policies, so the factors above still make the UK stand out for potential investors.

Taxation in the UK

The UK currently has the lowest rate of corporation tax in the EU (the tax on company profits). The UK also has the largest network of double taxation agreements in the world. This basically means that foreign firms can avoid paying tax twice - once in the UK and again back in their home country.

It can also be argued that the relatively low marginal income tax rates in the UK may attract foreign businessmen.

Being in the EU but not part of the Euro

This is a very contentious issue. Those in favour of the Euro argue that the lack of stability outside the single currency would put foreign investors off. Those against the Euro argue that the rising FDI into the UK since the start of the Euro in January 1999 is evidence that the UK positively prospers outside the single currency. Various foreign firms have threatened to pull out of the UK if it doesn't join the Euro, and others have threatened to pull out if it does! Watch this space!

Some final thoughts

The four factors above must be fairly compelling given the UK's relatively poor record on productivity and quality. Perhaps the foreign firms feel they can import their higher productivity and quality standards into the UK. Certainly, foreign owned firms in the UK do seem to have improved their productivity compared with the competing British owned firms.

Another point to note is that with all the panic about the possibility of Japanese firms pulling out of the UK, one is often blinded by the fact that less than 10% of FDI comes from Japan. By far the biggest investor is the USA, with almost half of all FDI.

Finally, it should be noted that the huge rise in FDI has implications for future net investment income. In the 80s, the UK had the second highest net external assets after Japan (i.e. assets abroad net of foreigners' assets in the UK). Now the UK has net external liabilities (i.e. more foreign owned assets in the UK than UK owned assets abroad) of 58 billion pounds. Either this means that the UK investments abroad earn much more income pound for pound than foreign investments in the UK, or we are turning the corner and the UK's surpluses in investment income on the current account will turn into deficits. This could be dire for the UK's already poor current account position.

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