Summary
UK Business Investment has recently slowed and many have attributed this development to firm anticipation of Brexit. While this could certainly be the case, several economic indicators point in different directions, simultaneously causing concern while also showing normal growth unrelated to Brexit pressures. An uncertain conclusion lacking a single, definitive trend surrounding Brexit is not necessarily negative and is simply a reality with which economists often contend. Often, certainty only becomes apparent after the fact, which is why a larger time horizon is required in the drawing of definitive conclusions.
What does the chart show?
The chart on the left plots UK Gross Fixed Capital Formation (£billions). This is a metric of investment, an important component of GDP and a key indicator of the performance of businesses and the UK economy overall. The chart on the right plots the UK Current Account Deficit (£millions). For clarity, the values have been plotted as positive but in reality these are negative numbers. The current account is a balance of payments economic indicator which aggregates several different variables. The largest metric measured in the current account is the trade balance. Any nation with a trade deficit is likely to also have a current account deficit. The current account also reflects net foreign and domestic income. This metric is largely the net of foreign asset income earned by UK-based investors, a positive cash inflow, and the income earned by foreign investors on UK assets, a negative cash outflow. Another important factor in the balance of payments is net direct transfers which includes Foreign Direct Investment, foreign aid, and remittances.
Why is the chart interesting?
In anticipation of Brexit, many economists and other experts have made pertinent predictions concerning what mid- to long- term effects leaving the European Union will have on the UK economy. These include Sterling depreciation and a decrease in new UK investment, especially from international sources. There is often discussion of potential economic stagnation among other concerning trends. When new information is released many are quick to claim that current data either confirms or negates these predictions. Many also use softer, noncommittal language to raise the spectre of uncertainty and apprehension, at once drawing in concerned readers while retaining plausible deniability should messages be proved false or misleading. Ultimately, in economics, receiving data which points to different, often contradictory conclusions is a very common occurrence. This highlights the need to detach from broader narratives and focus on factual evidence. Ultimately, where there is no story to be written or no concerning trend indicated by the latest development, this is not a bad thing, it is simply reality.
Leaving the European Union dictates many changes for the UK economy, including leaving the single market and the customs union. Beyond these outcomes, one of the largest potential detractors to the UK economy as a result of the negotiations has been the climate of uncertainty. Markets very clearly do not like uncertainty, as it prevents prudent decision-making. Participants such as firms and investors are often looking for ways to hedge risk and against a political backdrop of persistent Brexit uncertainty, many have been acting accordingly. Following the referendum, the uncertainty about UK investments and projects raised UK country risk for investors. As a result, outside demand for UK investments fell. In order to secure UK, foreign investors must convert their national currency into pounds Sterling. Thus theoretically a fall in demand for UK investment opportunities by firms and other relevant parties would mean a fall in Sterling demand. Since GBP is a floating currency, a fall in its international demand means depreciation vis-à-vis other alternative currencies, such as Dollars or Euros. In reality, the practice of currency trading (c. 90% of currency movements) pushed the pound down in anticipation of that theoretical movement.
This depreciation also creates other issues. Foreign holders of UK assets could face a potential capital loss as their holdings often maintain a constant Pound value (or a value unrelated to foreign exchange markets) but the value of the Pound itself is eroded against their national currency. This can serve to further deter new investment and provides an incentive for foreign asset holders to sell their positions in order to avoid further losses. At this point, it should be noted that a fall in investment and subsequent Sterling depreciation is a factor of uncertainty and expectations, as few know for certain what the UK’s exact statutory economic relationship with the EU will be in the future.
However, with currency traders repricing so quickly in what is probably the most efficient and liquid of all financial markets; it could also be argued that demand for businesses with significant overseas activity actually increases. Such businesses become cheaper to buy, their workers become cheaper to employ but the overseas income rises significantly in pound terms. Proponents of this view point to the jump in the FTSE 100 following the initial depreciation after the referendum Brexit as 70% of FTSE 100 revenue is international. The weakness since may be a product of potential trade barriers and the effects of import inflation on UK consumption (constituting approximately 70% of GDP) and how that affects high leverage.
Given that many of the aforementioned expectations have become realised occurrences, measures such as Gross Fixed Capital Formation and the Current Account should reflect Sterling depreciation and heightened country risk. As indicated by the first chart, UK investment did slow in 2017 and 2018, an intuitive result. Many firms have delayed new projects and many investors have grown wary of committing to new opportunities which may include Brexit, given the uncertainty of the exact economic and legal landscape after it occurs. Some firms and investors, as predicted, have left their current investment positions within the UK even before they gain a clearer picture of how detrimental Brexit will ultimately be on their ventures. Many have attributed the planned closure of Honda’s Swindon plant to the auto manufacturer’s concerns over Brexit, but it is ultimately unclear whether the firm would have chosen to close the factory anyway. Many firms would not take such drastic action to avoid the potential costs of a deal which has yet to be realised. Also, despite the stall in investment in 2017 and early 2018, this metric rebounded in the latter quarters of last year. Ultimately, if there is anything to be certain about, is that the time horizon is not yet long enough to conclude what the effect will be on overall UK capital formation. The trends of the past couple of years, as presented in the chart, are not necessarily indicative of abnormal contraction.
With respect to the current account, Brexit and the resulting Sterling depreciation should have had two effects. First, the fact that foreign buyers can now receive more Pounds for every unit of their national currency means that they are now increasingly willing to buy UK exports, the prices of which are relatively constant and unrelated to foreign exchange markets. Intuitively, this should mean that the UK trade deficit will narrow as international consumers will now find UK goods relatively more attractive. The opposite will happen for domestic consumers, who will now find it relatively more expensive to convert currency and pay for international imports into the UK. Yet this has not occurred, and trade deficit developments remain normal. It fell for much of 2018 and failed to rebound much in quarter four due to imports increasing and exports either falling or remaining stagnant amongst an international environment of trade uncertainty. Additionally, an increase in country risk as well as Sterling depreciation should have put the pinch on new as well as existing foreign investments into the UK as well as payments from UK assets to foreign holders. The decrease in new investments is evident but when it comes to net income on existing investments and assets, the opposite of what was expected has been the case and, according to Bloomberg, payments to foreign asset holders have increased since mid-2017. The combined effects of a larger trade deficit and decreased net income has meant that the overall UK current account deficit has increased. The contradiction between what ‘should’ be happening as a result of Brexit and what has actually been occurring is apparent in this case.
Ultimately, the inconclusive nature of data is not a bad outcome. Metrics such as investment and the current account often fluctuate with discernable trends remaining very hard to identify until after the fact. If abnormal contractions are to occur as a result of Brexit, it is likely that it will not happen or become apparent until Brexit occurs or until investors are certain about the nature of Britain’s departure. Expectations of future developments themselves cannot solely drive mid- to long- term trends. The developments themselves must eventually be realised for them to create discernable effects which have long term impacts on a nation’s economy. The longer Brexit negotiations continue to stall, the longer any votes are delayed and the status-quo persists, the more economic actors will simply revert to their old behaviours.
Week 9, 2019