Avarice of strangers
Don’t overstretch current account analysis
by Brian Reading in London
Mon 23 May 2016
The balance of payments – which looms large in the debate over Britain’s membership of the European Union – is double-entry book keeping. A current account deficit always equals financial (and capital) account inflows. A floating exchange rate clears the currency market.
Either financial flows or the current account deficit can be in the driving seat at any one time. When financial flows dominate, sterling appreciates and the current account worsens. Sterling has been reasonably firm in the last year or so because capital has been flowing into the UK, seeking a sound home for restless and insecure savers.
What is not so evident is that a sizeable component of these sometimes destabilising foreign capital inflows can comprise, under the UK’s statistical system, the category of ‘foreign direct investment’ – a form of inflow often thought of as being wholly benign to UK economic performance, but which can often turn out to have malign effects.
Britain’s record current account deficit last year of 5% of GDP shows how inflows have been the dominating influence, leading to economic imbalance. Whether the UK stays or goes after 23 June, the direction of causation is likely to reverse and sterling will fall (and possibly collapse) in coming months until cheap assets attract sufficient inflows. The current account then would improve.
The statistical measurement of large foreign direct investment flows into the UK – which play a major role in financing the deficit – contains many elements of financial transactions that would not normally be counted as long-term investment.
Referring to such deficit-offsetting inflows, Mark Carney, governor of the Bank of England, erroneously said in January that the UK has to rely on ‘the kindness of strangers’ to finance this unduly large deficit. Rather than ‘kindness’, the shortfall is in fact plugged by the ‘avarice’ of strangers seeking enhanced returns from investing in a dynamic economy.
Most people suppose that FDI is physical investment in new businesses and factories. But this is not how FDI is measured in official British statistics.
Direct inflows are measured by the extent to which they increase foreigners’ financial claims on the UK. Other inflows are labelled as portfolio (foreigners’ purchases of UK stocks and bonds), banking inflows, trade credit and financial derivatives. The distinctive feature of FDI from all others is the creation of a long-term commitment.
The issue of how the money flows in is difficult to gauge. This can be determined only in retrospect, if and when it flows out again. Any foreign equity purchase of at least 10% of voting share in a UK enterprise (nearly always too small for control over investment plans) is defined as direct investment. Any subsequent retained earnings are allocated to direct investment pro rata with stakes. In some cases loans and trade credit to subsidiaries are included.
None of the FDI data directly measures physical capital investment in the UK through factories, plant, machinery, shops and so on. FDI can increase, diminish or leave unaffected physical capital. The Sunderland car factory established in northeast England by Japan’s Nissan has, for example, demonstrably increased jobs and investment in the area and helped the rebirth of the car industry across the whole of the UK. At the other extreme, US food company Kraft took over Cadbury and closed its Bristol factory. Tata of India has invested heavily in Jaguar and Land Rover. But its takeover of Corus, the old British Steel, ended in tears for the UK steel industry.
French and German ownership (sometimes through state-owned companies) of UK transport, services and utilities business has been blamed for price hikes faced by British consumers. Foreign companies can exploit control of UK enterprises to avoid UK taxes. Distorted transfer mispricing between related enterprises and parent companies can shift profits offshore at the expense of the investment recipient.
Analysing balance of payments and foreign direct investment data has a role in the debate about Britain and Europe. But no one – including the governor of the Bank of England – should overstretch the arguments.
Brian Reading was an Economic Adviser to Prime Minister Edward Heath and is a Member of OMFIF's Advisory Board. This is No.65 in the series – the 100th article will appear on 23 June.
OMFIF’s series on the UK EU referendum presents a wide variety of perspectives from Britain and around the world ahead of the 23 June poll. We are assuring a balance between many different points of view, in line with OMFIF’s overall neutral stance on the issue.
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