Capital shock for sterling

THERE is much that is highly tendentious in both the International Monetary Fund and Bank of England assessments of the pestilence that will impact us all should Britain vote to leave the European Union on June 23.

Nothing could be considered more daft than the decision of the Fund to publish a range of a gross domestic product loss of between 1.5pc and 9.5pc if we did choose to exit the EU. All this does is underline the suspicion of ordinary people that the economic experts don’t have a clue what they are talking about.

Nevertheless, there is one aspect of the Bank and Fund analysis which does bear deeper scrutiny.

Both institutions fear that the uncertainty of the Brexit vote could have a particularly volcanic market impact because of the overall state of the country’s balance of payments – known as the current account.

We tend to think of the monthly trade figures, which record physical imports and exports, as a good guide to what is going on with our economy. Indeed, in the second half of the 20th Century a bad set of trade numbers was enough to trigger a sterling crisis or, even worse, a political upheaval.

The late Harold Wilson blamed bad figures, caused by the import of a couple of aircraft engines, for losing him the 1966 General Election.

But the balance of payments consists of much more than physical trade, which remains in deficit largely because of the British public’s love of fancy Germany cars, cheap Chinese steel and fashionable clothing from the Far East. None of this matters very much because of Britain’s secret weapon: the export of financial and other services, sometimes called invisibles.

Britain has a huge surplus on this account (around £70bn a year) which includes a diverse range of interests from insurance to Adele’s copyright income.

This largely neutralises the shortfall in our physical trade performance. Since the financial crisis the income from the often disparaged City has soared, increasing everyone’s economic well-being.

But there is a third, much less understood aspect to our balance of payments, known as the current account. This pulls together all our trade in goods and services as well as other income flows across the UK’s borders. It largely consists of profits and other income repatriated to Britain every year from multinationals and investment overseas, and cash moving in the opposite direction, which incidentally includes the £10bn-£12bn or so we send to Brussels.

Alarmingly, as the Bank of England’s latest Inflation Report chronicles, the current account has been widening at a dramatic rate.

In the third quarter of 2015 it stood at 4.3pc, climbing to 7pc in the fourth quarter. That is the highest figure since records began in 1955. The Bank says this was largely due to a shortfall of net payments of foreign direct investment and portfolio investment.

The truth is, no one is quite sure why the current account deficit has ballooned.

ONE theory is that since the financial crisis, our banks – the Royal Bank of Scotland was among the largest in the world – have been pulling out from overseas, cutting off huge income flows back to Britain.

Another is that the collapse in commodity markets means that some of London’s richest companies, such as Rio Tinto, BHP, Shell and BP, are no longer returning big dividend income to these shores.

One explanation (which I like) is that when we sold Cadbury to Kraft, Scottish & Newcastle to Carlsberg and Heineken, ICI to AkzoNobel and Boots to Walgreen (and many more) we cut ourselves off from the overseas income from these companies.

The current account deficit doesn’t matter a jot while the UK economy is growing faster than many of its competitors and the euro is under threat.

Foreigners are perfectly happy to pour money into the UK and make up the shortfall. It will help, for instance, if EDF and China finance the building of the controversial Hinkley Point nuclear plant. Or if all that mysteriously obtained Russian and Nigerian cash were to come flooding back into the London property market.

But what if foreigners are put off by the scaremongering around Brexit and the uncertainty, and decide to put the cash into gold held in Switzerland, the US dollar or the Japanese yen?

Then there will be a huge problem. The pound will come under further pressure and the Bank of England will have to raise interest rates (damaging growth and the housing market) to stop the rot.

This may all sound very speculative. But the capacity of an old-fashioned sterling crisis to upset the plans of mice and men should never be underestimated.

The better outcome is that once the crisis passes we should have a cheaper currency and be able to sell ever more goods and services overseas.

The trade balance will improve and foreigners will turn the faucets back on.

But the weakness of the current account means that it could get very hairy first.