UK Balance of Payments, The Pink Book: 2017

The current account deficit widened in 2016 to 5.9% of nominal gross domestic product (GDP), showing the largest deficit on record. The recent widening has been driven by a deterioration in the UK’s net investment income with the primary income deficit widening to 2.6% of nominal GDP, as UK earnings on assets abroad have fallen relative to the earnings on foreign investments in the UK. There was also a widening in the trade deficit in 2016 to 2.2% of nominal GDP, the largest trade deficit in six years.

The widening in the primary income deficit has been caused mainly by a deterioration in net earnings on direct investments, which switched from a surplus to a deficit for the first time in 2016 since the series began in 1997. The decline in UK direct investment income abroad is due to the reduction in the rate of return on these investments. Moreover, the rate of return on foreign investments in the UK increased, further contributing to the deficit in direct investment income.

Despite the widening in the current account deficit, the UK’s stock position (international investment position (IIP)) improved substantially in 2016 with a narrowing in the net liability position to £21.3 billion. Due to the composition of the IIP as explained in section 14 the increase in the sterling value of assets was mostly a result of the depreciation in sterling.

There have been a number of changes and improvements implemented in 2017, which has led to a number of revisions between the years 1997 to 2016. For more information on these changes please see our earlier articles released on 29 September and 21 August.

For more detail on the methodology of the balance of payments please see our Quality and Methodology Information report.

The balance of payments measures the economic transactions of the UK with the rest of the world. These transactions can be broken down into three main accounts: the current account, the capital account and the financial account.

The current account shows the flows of goods and services that comprise international trade, the cross-border income flows associated with the international ownership of financial assets, and current transfers between UK residents and non-residents. The sum of the balances on these accounts is known as the current account balance. The current account balance indicates whether the economy is a net lender to the rest of the world (surplus) or net borrower from the rest of the world (deficit).

The financial account shows net acquisition and net incurrence of financial assets and liabilities and is the counterpart to the current account. If a country is running a current account deficit, the financial account records how the country is financing its borrowing from the rest of the world. The international investment position (IIP) records the stock position of these financial flows. It shows at the end of the period the value of the stock of financial assets of residents of an economy that are claims on non-residents and the liabilities of residents of an economy to non-residents. The difference between the assets and liabilities is the net position in the IIP and represents either a net claim on, or a net liability to the rest of the world.

This commentary gives an analytical overview of the main components of the current account. It focuses mainly on the primary income and trade balances as these were the primary factors behind the widening in the current account deficit. There is also further analysis on the IIP, which looks into the impact of the depreciation of sterling during 2016.

Figure 1 breaks down the current account balance into its constituent parts:

• the trade balance
• the primary income balance (which comprises investment income, compensation of employees and other primary income)
• the secondary income balance that captures transfers between the UK and other countries (for example, official payments to and receipts from EU institutions and other international bodies as well as foreign aid)

The UK has historically been a net borrower from the rest of the world, running a current account deficit for the past 33 years. However, in recent years, it has widened to record-high levels. In 2016, the current account deficit widened to the largest in the series history reaching 5.9% of gross domestic product (GDP).

Since 2011, the movements in the current account balance have been attributable mainly to the decline in the primary income balance, which widened from a surplus of 0.4% of nominal GDP in 2011 to a deficit of 2.6% of nominal GDP in 2016. This was the largest deficit in the series history. This was driven by a deterioration in net income on direct investments, which switched from a surplus to a deficit in 2016 (see Figure 2). This is the first time since the series began in 1997 where direct investments were in deficit.

Earnings on the direct investment of UK companies overseas (credits) has been on a downward trend since 2011, falling from £104.6 billion in 2011 to £57.5 billion by 2016 (see Figure 3). Over the same period, the value of foreign direct investment (FDI) income paid to foreign investors (debits) has remained broadly constant, varying between £50 billion and £60 billion. The convergence in the value of credits with that of debits continued into 2016 to the extent that debits were higher than credits. Net FDI earnings were in surplus by £9.1 billion in 2015, becoming a deficit in 2016 at £2.9 billion.

The fall in the rate of return on UK direct investment assets overseas has played an important role in the widening of the primary income balance. In 2016, the rate of return earned on direct investments abroad continued to decline and was lower than the rate of return earned on direct investments in the UK, which picked up for the first time since 2011. The rate of return on direct investments in the UK has picked up from 4.1% in 2015 to 4.4% in 2016 (the highest in three years). This may have led to a reduction in incentives for UK firms to invest abroad and also contributed to an increase in inward investment.

The quarterly paths of FDI earnings show that the value of debits was higher than credits over the first half of 2016. Net FDI earnings were in deficit over Quarter 1 (January to March) 2016 and Quarter 2 (April to June) 2016. This was partially offset by a surplus over the rest of 2016. The downward trend in FDI credits may have been mitigated by a positive exchange rate impact on the value of credits denominated in foreign currency. The sterling exchange rate depreciated over most of the year, increasing the value of those foreign-currency-denominated credits when converted into sterling.

Overseas investors also generated a higher rate of return on both portfolio and other investments compared with their UK counterparts, again contributing to the deficits observed in both portfolio and other investment income. The higher rates of return on direct, portfolio and other investments in the UK can be seen in Figure 4; with overseas investors earning higher rates of return than their UK counterparts since 2012.

The primary income deficit with the EU narrowed to the lowest level in seven years (0.9% of nominal gross domestic product (GDP)). This was a result of income earned on UK investments in the EU increasing to 3% of nominal GDP, the highest in three years and income earned on EU investments in the UK remaining broadly stable (see Figure 5).

Meanwhile, the primary income balance deficit with non-EU areas widened to the largest recorded in the series history, which started in 1999 (1.6% of nominal GDP). This was driven primarily by a rise in investment income paid by the UK, which rose to 5.6% of nominal GDP and a slight reduction in UK investment income earned abroad to 3.9% of nominal GDP (see Figure 6).

The UK’s total trade deficit – the difference between exports and imports – widened to 2.2% of gross domestic product (GDP) in 2016. The UK currently runs a deficit in trade in goods, which is partly offset by a surplus in trade in services. The goods deficit widened to 6.9% from 6.3% in 2015, while the surplus in services remained broadly unchanged at 4.7% over the same period – see Figure 7.

Goods exports increased by 4.6% in 2016 while goods imports increased by 7.4%, the largest increases in exports and imports since 2010, resulting in a widening of the trade in goods deficit to £135.4 billion in 2016.

The value of goods traded reflects both changes in the volumes and prices of exports and imports. Between 2015 and 2016, export volumes decreased by 0.9% while export prices increased by 5.5% – see Figure 8. Therefore, increases in export values were due primarily to increases in export prices. The decreases in semi-manufactured export volumes (9%) in 2016 were partially offset by small increases in exports volumes of oil (4%) and basic materials (3%).

Import volumes increased by 4.6% and import prices increased by 2.8% over the same period, see Figure 9, therefore the increase in import values are due mainly to increases in import volumes in 2016. This increase in import volumes was due primarily to a 5% increase in the imports of finished manufactured goods – particularly increases in imports of ships and aircraft, as well as cars.

The proportion of UK goods exports to the EU has generally been decreasing since 2007, while over the years prior to and during the 2008 to 2009 economic downturn, the share of goods exports to non-EU countries has gradually increased to the extent that non-EU exports now account for over half of UK goods exports. In 2016, the proportion of UK goods exports to the EU and non-EU areas were virtually unchanged from 2015, recording 48.2% and 51.8% respectively.

Although the value of UK exports of goods to non-EU countries exceeded goods exports to the EU (by £11.1 billion) in 2016, UK goods exports to the EU grew at a slightly faster rate than exports to non-EU countries – at 4.8% and 4.5% respectively in 2016. Evidence from the Economic review highlights that exports to the EU are more weighted towards foreign currencies (61%) – especially the euro – while exports to non-EU countries are more weighted towards sterling (51%). Therefore the stronger growth in EU exports may partly reflect movements in sterling trade prices driven by the substantial amount of trade conducted in a foreign currency.

The Economic review has detailed the economic theory of the expected impact of the sterling depreciation on export and import volumes and prices. Although the increase in export prices may appear contrary to economic theory, it is important to note that export prices are based in sterling for the UK and therefore it is possible there may be no change in the price in foreign currency terms. As detailed in the Economic review, the increase in export prices (on a sterling basis) is likely to be largely attributable to the substantial amount of trade conducted on a foreign currency basis as price changes are lagged in the short-term. The increase in imports of goods in spite of a weaker sterling and rising import prices, could reflect the increasing integration of the UK economy within global supply chains. Therefore, so far the recent sterling depreciation has had a limited impact on goods traded.

The increase in imports from the EU, which increased by 7.1%, more than offset the increase in EU exports in 2016. As a result, the UK’s trade in goods deficit with the EU widened by £9.4 billion to £96.5 billion in 2016 as shown in Figure 10. Figure 10 shows that the UK’s goods deficit with non-EU countries widened in 2016 for the first time since 2011, as a result of a larger increase in imports in relation to exports – 7.7% increase in imports compared with 4.5% increase in exports. The UK’s goods balance deficit with non-EU countries widened by £7.3 billion to £38.9 billion in 2016. This might suggest that the extent of overseas demand for UK products may have been limited by prevailing global economic conditions.

Trade in services remained in surplus in 2016, continuing the trend observed since 1966. In fact, the trade in services balance reached a record level in 2016, with a surplus of £92.4 billion (see Figure 11). Exports in services increased from £228.4 billion in 2015 to £245.4 billion in 2016, whereas imports in services increased from £142.1 billion in 2015 to £153.0 billion in 2016. Due to the UK’s large financial sector, the main drivers behind the expansion in services exports were a rise in financial services, and insurance and pension services. Growths in exports were partially offset by an increase of £4.4 billion in imported travel services.

In this section we focus on financial services as this was the biggest contributor to the increase in the trade in services surplus during 2016. The financial services balance increased by £8.4 billion, to a record high of £50.8 billion in 2016, a growth of 19.9% from 2015. This was due to exports in financial services, moving from £52.2 billion in 2015 to £61.4 billion in 2016. The increase in financial services exports was only offset by a slender rise in imported financial services of £0.7 billion. Figure 12 shows how imported financial services have remained relatively stable compared with exports throughout the period in question.

Financial services was the second largest industry in terms of services exports in 2016, with other business services ranked first; financial services exports accounted for 25.0% of UK export services, up by 5.7 percentage points compared with 1999. In terms of services imports, financial services were relatively low with travel services ranked as the most imported service.

In the five years preceding the financial crisis (2003 to 2007), exports of financial services more than doubled, increasing by 105.8%. However, in 2008 the level of financial services exports (other countries buying UK financial services) fell 4.5% and remained relatively unchanged from 2008 to 2009. It wasn’t until 2011 when exports surpassed their 2007 value. Despite having financial services growth in recent periods, the rate of growth is far less than the 15.3% average annual growth achieved throughout 1999 to 2007.

Travel services are the biggest imported service into the UK, accounting for 31.4% of all imported services. A travel service import is when a UK resident travels to a foreign country, for example, if a UK resident goes on holiday to Germany they will spend money on German hotels. Meanwhile, a travel service export is where a foreign resident travels to the UK and stays in a UK hotel.

The travel services balance is persistently in deficit, meaning that UK residents spend more on foreign travel services than their foreign counterparts spend on travel in the UK (see Figure 13). During the financial crisis, imported travel services diverted away from the increasing trend by falling 11.7% in 2009, declining for the first time on record. Interestingly though, travel to the UK was relatively unperturbed by the global downturn, in that the value of UK travel services exports remained stable throughout 2007 to 2009. Imported travel from the EU hit record levels in 2016, at £30.4 billion, an increase from the prior record of £25.4 billion in 2015.

Figure 14 shows proportions of imported travel services by destination are consistent throughout the three periods in question. The EU by far holds the majority, while there has been a slight movement away from North American travel services and more towards Asia over recent periods. During 2012 to 2016, levels of imported travel services from North America and Asia were very similar. UK travel imports from the EU, North America and Asia accounted for over 80% of total travel imports over all three periods, proving to be popular travel destinations for UK residents.

Figure 15 shows trade in travel services with Europe was the main driver behind the travel services balance deficit. The travel services balance has been in deficit since records began in 1987. Trade in travel services with Asia has been in surplus since 2009 (peaking in 2013 at £2.6 billion); meaning that since 2009, more Asian residents travelled to the UK than UK residents travelled to Asia. The travel services balance with “other” countries (which is comprised mainly of Australia) has been in surplus since 2010. Although the total travel deficit has increased year-on-year since 2013, it has not yet surpassed the largest travel services deficit recorded in 2008 (£20.1 billion).

From an international perspective, the UK ran by far the widest current account deficit out of the G7 countries (see Figure 16). In 2016, Japan, Italy and Germany all recorded current account surpluses, with Germany reporting a surplus of 8.3% of nominal gross domestic product (GDP).

Italy went from a current account deficit in 2007 to a current account surplus in both 2015 and 2016. In contrast, Canada went from a current account surplus in 2007 to a deficit in 2016. The UK and France both remained in deficit in 2007, 2015 and 2016.

The financial account is the counterpart to the current account, showing how the UK is financing its borrowing from the rest of the world. Despite the economic uncertainties surrounding the EU referendum result in 2016, the UK remained attractive to outside investors and the UK was able to fund its current account deficit with investments into the UK.

The net inflow of investments into the UK rose to £119.6 billion in 2016, the highest recorded in the series history which started in 1946. The UK continued to attract inward investment after the EU referendum, with Quarter 2 (April to June) 2016 registering £171.0 billion of inward investments (the highest in just under six years). Most of this amount was attributable to direct investments and portfolio investments made in the UK (see Figure 17). Direct investments are frequently characterised by stable and long-lasting economic links, as well as the provision of technology and management, therefore the financing of the current account deficit with direct investment inflows could be seen as a more sustainable approach for the UK economy.

Direct investments in the UK increased at the sharpest rate, since the survey began in 1987, during 2016 (£220.5 billion). This was driven mainly by an increase in total equity investment into the UK, which rose to its highest level since the series began. UK direct investments abroad also rose in 2016 for the first time in three years, but this was only slight overall and much less than the amount invested into the UK. As explained earlier in the article, the rate of return earned on direct investments in the UK picked up in 2016, from 4.1% to 4.4%, which may have contributed to the attractiveness in direct investments made into the UK.

The main contributors to the widening in the inflow of portfolio investment was UK residents net selling of foreign debt securities and foreign investors investing in UK debt securities, mostly government bonds.

In contrast, there was a net outflow of other investments from the UK for the second year running. The main contributors to the net outflow of other investments were UK residents increasing their foreign deposits as well as extending loans to non-residents.

The international investment position (IIP) measures the stock of assets and liabilities at the end of the period, which is the sum of the opening balance, financial flows and other changes (where the other changes could be price changes, currency changes and so on). All else the same, the widening in the current account deficit would imply a deterioration in the net IIP, as the UK would have to incur net financial liabilities to finance its borrowing from the rest of the world.

However, the net IIP liability position narrowed substantially from 18.4% of nominal gross domestic product (GDP) in 2015 to 1.1% of nominal GDP in 2016 (see Figure 18), which was a result of total assets increasing by £1,356.7 billion to £10,944.7 billion, the highest value of assets held in five years. However, due to the make up of the IIP as explained previously, the increase in total assets is not necessarily driven by an increase in investment abroad.

Financial flows are one of the main components driving the change in IIP assets and liabilities, which feed into the stock position of foreign assets and liabilities that are held by the UK. However, the change in the value of the stock not only reflects the accumulation of new assets and liabilities, but also the revaluation of existing ones and other changes in volume. Due to the UK assets that are held abroad being held mostly in foreign currency, changes in the sterling exchange rate will have an impact on the sterling value of these assets. Another factor that could impact upon the revaluation of these assets and liabilities are equity price movements, which impact upon the value but not the underlying volume.

In 2016, following the vote to leave the European Union, the sterling exchange rate fell to an eight-year low¹. The decline in the effective exchange rate by 13% from 2015 led to a higher revaluation in the stocks held abroad when converted back into sterling.

In order to obtain the exchange rate impact we have calculated currency changes by calculating sterling exchange rate movements against the currencies that have 0.1% or higher of the IIP’s world total. Meanwhile, price changes are modelled using a combination of stocks and bond indices, including end-quarter share prices for the Dow Jones, Euro Stoxx, FT-SE and Nikkei exchanges (for more information on the methodology see our article on analysis of the UK's international investment position, which was released last summer). From Figure 19 we can see that in the year 2016, currency changes (the exchange rate depreciation) was the main factor behind the increase in the main components that make up total IIP assets. In fact, IIP assets would have declined year-on-year had the exchange rate remained unchanged.

Figure 19 also shows currency effects as having a positive impact on assets in 2008 when the sterling exchange rate fell during the financial crisis.

Exchange rate movements will also impact the liabilities side, although only other investments will be significantly impacted by the fall in sterling as the majority of these investments are held in foreign currency due to the UK’s large banking sector. Using the same method as described previously, we can split out the total changes into four main impacts (that is, other changes, currency changes, price changes and flows). Looking at Figure 20 we can see that in 2016, currency changes again had a positive impact on the value of liabilities. In 2016, the depreciation in sterling led to an increase in liabilities by £616.9 billion. Again the financial crisis is highlighted here, with the sharp sterling depreciation in 2008 leading to an increase in total liabilities of £1,299.2 billion.

Figure 21 shows the breakdown of the impacts on the net IIP. Again the impact of the depreciation in sterling can be clearly seen in 2008 and 2016.

In conclusion, the net IIP deficit improved dramatically in 2016, going from a net liability position of £347.3 billion in 2015 to only £21.3 billion in 2016. One of the main drivers for this improvement is the depreciation in sterling. This is not only shown in 2016 but also during the financial crisis in 2008. This also explains the difference we see between the primary income, financial account and the IIP, with both the primary income and financial accounts showing a worsening in the deficit whilst the IIP is showing an improvement in the net liability position.

Notes for: Net IIP net liability narrows due to a depreciation in sterling

1. Throughout this section when we refer to the sterling exchange rate we use the sterling end year effective exchange rate from the Bank of England

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