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Never mind public debt – Britain’s investment deficit is a much bigger problem

Money with graph lines
Money with graph lines

We all know that the pandemic has greatly increased the UK’s national debt. It is already about 100pc of GDP, well above the level previously thought safe, and it may well climb higher.

But most of this debt is held by UK citizens of one sort or another – mainly investing institutions and the Bank of England. So the debt is public rather than national. This is not to suggest that such debt doesn’t matter. It certainly does but the problems it gives rise to are largely distributional within this country.

There is another sort of national debt that doesn’t receive much attention and deserves much more. I refer to the net asset (or liability) position of the UK vis-à-vis foreigners. Foreign holdings of British Government debt (which amount to about a quarter of the total) are part of this position, but only a part. Overall net international indebtedness is equal to all liabilities owed by British nationals to foreigners less British nationals’ overseas assets and claims on foreigners. Last year, whereas our public debt increased by 16pc of GDP, our national net overseas liabilities increased by only 1.5pc.

The determinants of this sort of national debt are different from the determinants of public debt. The latter is driven by the accumulation of government borrowing, i.e. the gap between its spending and its tax revenue. By contrast, our international indebtedness position is driven primarily (though not exclusively) by the accumulation of surpluses and deficits on the current account of the balance of payments, that is to say, the gap between exports and imports plus the balance on investment income and transfers between countries.

We hear little about the current account these days but in decades past it used to figure prominently in the news. Suffice it to say that it is still very much there – and it is still very much in deficit. In 2019, the last year before the pandemic struck, the deficit was 3pc of GDP. This year it will probably be about 4.5pc. On its own, that would lead to a corresponding worsening of our net international indebtedness.

Mind you, Britain’s international asset/debt position has been through remarkable changes in the past. During the 19th century we amassed a huge surplus of overseas assets over liabilities to foreigners. At its peak before the First World War, this surplus was over 150pc of GDP. This earned us a substantial investment income which enabled us to sustain trade deficits, that is to say, an excess of imports over exports.

This comfortable position suffered two hammer blows in the 20th century. During both the First and Second World Wars, we used up substantial amounts of our overseas assets to fund military spending. By the end of the Second, our net overseas assets were down to almost zero.

Even so, for most of the early post-war period the UK still managed to maintain a small positive net asset position. During the 1980s, our net international assets were running at over 10pc of GDP. Since then, however, continued current account deficits have eroded the stock of net assets. Last year we had net international liabilities of about 30pc of GDP.

Felixtowe Port - Dan Kitwood/Getty Images
Felixtowe Port - Dan Kitwood/Getty Images

Yet for quite a while after we became a net debtor we were still able to earn an investment income. We did this in a risky way by operating as a sort of hedge fund. Essentially, most of Britain’s liabilities were bank deposits or bonds which yielded comparatively little while our assets were mainly equities and foreign direct investment which tended to give a higher return. But after 2007, that ruse ceased to work. Since then, with the exception of a few years, we have ceased to enjoy a net surplus on investment income. Last year there was an investment income deficit of about 2pc of GDP.

Every so often, though, a lower pound has come to the rescue. Most of our liabilities to foreigners are denominated in sterling whereas most of our overseas assets are denominated in foreign currency. Accordingly, a drop in the pound’s exchange rate raises the sterling value of our overseas assets while leaving the sterling value of our international liabilities largely the same. Similarly for the flow of investment income into this country versus what we have to pay out to foreigners. Of course, there are limits to how long you can play this game before international investors adjust their portfolios to take account of it.

Does being a net debtor matter? It all depends. For the world as a whole, surpluses and deficits must net to zero. So we cannot all be net creditors. Moreover, when a country faces the prospect of sustained rapid economic growth which it cannot easily finance itself, it makes sense to import capital from abroad. This was the position of many countries in the 19th century, including the US, and large parts of Latin America and the British Empire – supported by capital supplied by the UK. But this is hardly Britain’s position today. The rate of investment by both the private and public sectors is low.

A deterioration in our net international asset position amounts to negative investment. So its essential downside is that it erodes our future living standards.

What’s the solution? We need to increase investment in the UK, but if such an increase were counterbalanced by a further deterioration in our net international asset position then we would be in danger of achieving no overall benefit. The upshot is that we should also improve our net trade position.

On Wednesday, the latest trade data will be published. While it will reflect exceptional one-offs, such as the pandemic and Brexit, let us hope it nonetheless contains hints at an improvement in our trade position that we need to register over coming years.

Roger Bootle is chairman of Capital Economics. You can contact him at roger.bootle@capitaleconomics.com

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