Why the UK's record current account raises Brexit tail risk

 
Kallum Pickering
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EU Referendum - Signage And Symbols
There's a risk if the UK votes to leave the EU on June 23 (Source: Getty)

The UK is a serial debtor. In every quarter since 1998, its current account balance has been negative.

In the last few years this deficit has grown rapidly. Currently, it is the largest in the G7.

While modest deficits can be sustained even in the long-run providing gross domestic product growth is strong and stable, very large ones cannot.

Read more: UK's trade deficit with the EU swells to a record in December

The day could come when the UK’s foreign lenders question just how sustainable this current path is. If the UK votes to leave the EU on June 23, that could be just the day.

The UK is a haven for foreign investment. This helps it to sustain its profligacy. Last year, the UK was third to the US and China for total inward foreign direct investment globally.

While impressive, it comes with a risk. If investors suddenly fear that the UK can no longer meet its obligations later on without a massive devaluation, they might attempt to exit their sterling positions in a hurry.

Over-reliance on foreign money has left the UK vulnerable to swings in market sentiment.

Since the start of the year, sterling has weakened as markets have begun to price in the risk of the UK leaving the EU and its possible economic implications.

Although a moderate weakening in growth - possibly even a short recession – is the most likely outlook if the UK votes to leave the EU, a balance of payments crisis is the tail risk.

With sterling continuing to weaken as the referendum day nears and Q4 2015 data showing that the UK’s current account swelled to a record seven per cent of gross domestic product, this tail risk now looms a little larger than before.

Expectations play an important role in determining economic outcomes. If markets expect a sharp weakening in sterling, that itself could trigger a self-fulfilling crisis.

Read more: London will be demoted if the UK votes for Brexit

Chances are, as average poll data show, the UK will probably remain in the EU and this risk won’t evolve. But underpinning this risk is a serious imbalance in the UK’s growth model that will need to be fixed over time.

Ultimately, deficits to drive growth today come at the expense of growth tomorrow.

The UK economy needs serious reform to shift it onto a less vulnerable and more sustainable growth path.

Otherwise, the UK will continue to both shorten the life expectancy of this on-going expansion and run the risk of a future sterling crisis whenever there is a serious bump in the road.

City A.M.'s opinion pages are a place for thought-provoking views and debate. These views are not necessarily shared by City A.M.

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