The Pound’s Got An Achilles Heel

The Pound’s Got An Achilles Heel
Luke Suddards

about 1 year ago2 mins

A country’s current account captures the difference between its exports and imports (known as the trade balance), its net earnings on foreign investments (difference between earnings on foreign assets and payments for foreign liabilities), and its net transfer payments such as foreign aid. The UK has long run a sizable current account deficit, which recently expanded even more with the soaring price of its energy imports. A negative current account balance means that the shortfall to balance the books has to be made up somehow, usually by borrowing. But the UK isn’t the only country competing for investors' hard-earned money.

Investors care about their returns, so there are two channels through which the UK can entice them to its shores – a cheaper currency or higher yields. As global growth slows and inflation remains punchy, investors are paying attention to the real yield metric (yields less inflation) in deciding where to deploy their capital. If it’s not high enough, then the currency would have to weaken in order to entice those investors to buy UK assets and fund the current account deficit.

Unfortunately for the pound, the Bank of England (BoE) is trapped between a rock and a hard place, battling the country’s particularly sticky inflation but trying not to leave the housing market in a mess, with UK homeowners more exposed to rising interest rates because of their shorter-term lock-in rates. And thanks to the BoE’s go-cautious approach, it’s unlikely that the UK’s real yields will rise enough to attract investors. The chart shows us where its real yields would have to be based on the current account balance – at 1%. That’s 1.5 percentage points higher than its level now. With the UK’s external borrowing needs set to remain significant and real yields not high enough, this leaves the pound vulnerable during risk-off episodes when investors turn toward more defensive currencies.



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