Pound Sterling's Current Account Headache Fades, Offering a Backstop of Support

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The risks of a precipitous decline in the value of the British Pound from here are greatly reduced by an improvement in the UK's balance of payment fundamentals with the rest of the world, an outcome driven by increased UK saving rates as well as lower oil and gas prices.

The UK current account deficit has improved markedly over the course of the past year and now stands at just 1.7% of GDP, according to one measure.

"The drop in the UK's current account deficit (% GDP) should afford the pound some protection meaning that there should be less potential volatility in GBP if recession fears rise," says Jane Foley, Senior FX Strategist at Rabobank.

The data comes amidst a strong rally in Pound Sterling that sees it hold an advance against all its major peers for 2023 amidst an environment of rapidly rising UK interest rates. Should the improvement in the current account persist, then a reversal of these gains becomes more remote.

At its most basic the current account deficit means the UK spends more on goods and services than it earns in goods and services. For the Pound, this would mean an automatic devaluation as more pounds are spent than bought on the international marketplace.

But, the inflow of foreign capital can offset these trade-related flows, allowing the Pound to remain supported, or rise in value.

When these inflows of investor capital decline - usually during times of crisis - the Pound can find itself exposed to weakness, hence analysts often look at the current account when assessing the Pound's vulnerabilities.

"The large current account deficit was a millstone around sterling's neck throughout the second half of the 2010s," says Samuel Tombs, Chief UK Economist at Pantheon Macroeconomics. "Britain continually had to attract a large inflow of financial capital to fund its excessive consumption, leaving the pound vulnerable to changes in investors' risk appetite."

Therefore, it is a supportive fundamental development for Pound Sterling that the ONS reported last week that the underlying UK current account deficit, excluding precious metals, narrowed to £17.0BN or 2.6% of gross domestic product (GDP) in Quarter 1 (Jan to Mar) 2023,

But when the trade in precious metals is included, the UK current account deficit stood at just 1.7% of GDP in Q1 2023.

This forms a material recovery on a year prior when the underlying UK current account deficit - excluding precious metals - expanded to £44.2BN, or 7.1% of GDP in Q1 2022. When the trade in precious metals was included, the deficit expanded to £51.7BN, or 8.3% of GDP back then.

Shreyas Gopal, Strategist at Deutsche Bank, says the Pound was looking extremely vulnerable to potential shocks in 2022 owing to the expanding current account deficit, "fast forward to the present day though, and sterling no longer looks as much of an outlier."

"The collapse in energy prices and a robust primary income surplus have made for real improvement even once those erratic gold flows are stripped out," says Gopal.

"Looking ahead, we think the current account deficit will narrow significantly, leaving sterling less sensitive than in the 2010s to changes in the willingness of overseas investors to extend finance," says Tombs.

Tombs, who has been consistently rated amongst the UK's most accurate economic forecasters, explains the country's deficit depends largely on developments in energy markets where futures prices point to energy imports being much lower this winter than last.

But, perhaps more significantly, the UK is seeing its savings rate improve significantly as domestic interest rates rise.

"More fundamentally, British households and private non-financial corporations are responding to the sharp rise in interest rates by taking out fewer new loans and increasing their repayments of outstanding debt," says Tombs.

This matters because the deficit reflects an economy driven by consumer-led consumption funded by debt.

"The current account can also be expressed as the difference between national (both public and private) savings and investment. A current account deficit may therefore reflect a low level of national savings relative to investment" - IMF.

But rising interest rates resulted in monthly net lending to individuals falling to zero in April for the first time since December 2011, and then recovered to only £1.1B in May, well below the average of £6.3B in 2022.

"With the MPC likely to increase official interest rates further - and to a higher peak than in many other countries - paying off debt will be an especially attractive option for many U.K. households and firms," says Tombs.

Pantheon Macroeconomics also notes data revealing UK Private non-financial corporations have repaid £32BN in external finance in the 12 months to May 2023, compared to an average annual increase in external finance of £29BN in the second half of the 2010s.

"The private sector's swing to net saving, from net borrowing, will help to reduce the current account deficit and the sensitivity of sterling to any renewed risk-off period in global financial markets," says Tombs.