Thursday, December 17, 2009

Why Current Accound Deficit Persists

The UK has had a persistent current account deficit in the past few years. However, given recent events we should expect an improvement in the current account deficit. Yet, rather surprisingly, the Current account deficit widened in the last quarter to be over 3.3% of GDP.

UK Current Account Deficit

Source: ONS retrieved Dec 14th 2009

The Current account deficit measures the balance of trade in
  • Goods
  • Services,
  • Investment incomes
  • Current transfers
The deficit is due to the UK's deficit in goods which is £19bn. We have a surplus on trade in services, incomes and transfers.

Why Current Account Deficit Should Have

Depreciation in Sterling. Since 2007, the value of Sterling has fallen over 20%. This should make British exports more competitive and imports more expensive. This should increase demand for our exports and reduce domestic consumption on imports. This should (assuming demand is relatively elastic) improve the current account deficit.

Deep Recession. Current account deficits tend to be cyclical. When consumer spending falls in a recession, it means we will buy less imported goods. UK consumer spending has fallen in 2009, due to higher unemployment and a rise in the savings ratio. In theory, this reduction in spending should reduce imports and improve the current account deficit.

Why Deficit hasn't Fallen

Terms of Trade hasn't changed. As we looked at here: Terms of Trade Effect The depreciation has not led to a change in the terms of trade. To summarise
  • Import prices have increased (as expected)
  • But, export prices have also increased.
There are more reasons in the Terms of Trade Effect but essentially, exporters have responded to a weaker currency by putting up prices and increasing profit margins - rather than exporting more. This suggests UK exports are specialist goods with a price inelastic demand.

Time Lags. The effect of a depreciation in the exchange rate often takes a long time to have an effect. Firms often have fixed contracts so it takes time for changed exchange rate to be reflected in prices. In the short term demand is often inelastic, but, over time becomes more elastic (Students of Economics may remember the J Curve Effect)

Slow Growth in other Countries. Although the UK consumer has been effected by the recession, so have our main competitors.

Outlook for Long Run

In the long run, I would expect an improvement in the current account.
  • Higher profit margins in exports should encourage more firms to increase supply
  • More expensive imports should over time switch demand to domestic consumption.
  • The UK recession seems to be longer lasting than our European competitors.

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