In the latest issue of the Deloitte Economic Review, our Economic Adviser, Roger Bootle, considers how the UK’s large current account deficit will unwind and what impact this will have on the wider economy. His main points are as follows:

• Any correction of the UK’s large current account deficit will be extremely painful for the wider economy, involving a prolonged period of very weak domestic growth. The UK economy will grow by just 1% next year, eventually prompting the Monetary Policy Committee to cut interest rates all the way to 3.5%, if not lower.
• The significant widening in the UK’s current account deficit by £57billion, or 4% of GDP, over the last ten years is largely the result of the sustained high spending of the public and household sectors in the context of the weak spending in our major export markets, mainly Europe.
• And lower competitiveness – caused by poor control of unit labour costs and a strong pound – has made this situation worse. Indeed, the UK’s exports are now less competitive in world markets than at any time in the past 25 years.
• The UK cannot continue to borrow the equivalent of 4% of its GDP from the rest of the world indefinitely. And it looks like we are getting close to payback time.
• The only possibility the UK has of enjoying a painless current account correction is if its exports were to receive a major boost from a sustained period of stronger domestic demand in the euro-zone. But while this is the best solution for the UK, it is also the least likely to happen. Given that European households have been reluctant to spend over the last ten years, it seems unlikely that they will become more gung-ho just at a time when the world economy is close to melt-down.
• The next best solution would be a further significant fall in the pound that would boost the competitiveness of the UK’s exports. Although, in our view, this will indeed happen, it cannot do so on a scale sufficient to narrow the current account deficit appreciably. Moreover, a lower pound will tend to raise inflation, thereby making it more difficult for the Bank of England to cut interest rates.
• Hence, any correction to the current account will be associated with a prolonged period of weaker spending in the UK. The only question is which areas of the UK economy will bear the burden of such an adjustment.
• On both the previous occasions that the UK’s current account deficit has narrowed from similar levels to those seen today, the public sector has not contributed to the adjustment. And it seems unlikely that the government is going to tighten its belt this time too, at least not until after the next general election in 2009 or 2010. 
• A squeeze on corporate spending is probable, not least in residential construction. But on its own this will not be enough to bring about the adjustment.
• The bulk of the necessary adjustment to the domestic economy will therefore fall on the shoulders of households, resulting in a significant retrenchment of their spending. However you look at it, households appear to be in for a very rough ride over the next couple of years. Household spending growth will slow to 1.5% this year and just 1.0% next year – the lowest rates of growth since the early 1990s recession.
• The good news is that once the pound has fallen a fair bit further, before too long UK exports should start to grow more strongly. This will help to usher in a new phase of healthy, better-balanced, economic growth. But there is a painful period – and perhaps a long one at that – to get through first.

Ends

Notes for editors
This press release has been prepared by Roger Bootle, Economic Adviser to Deloitte.  If you have any questions regarding the views in it, please contact Roger Bootle directly on 07887 955 875 or 020 7823 5000 or via email on business@capitaleconomics.com.

This press release contains general information only and is not intended to be comprehensive nor to provide professional advice.  It is not a substitute for such professional advice and should not be acted on or relied upon or used as a basis for any decision or action that may affect you or your business.  Deloitte & Touche LLP accepts no duty of care or liability for any loss occasioned to any person acting or refraining from acting as a result of any material in this publication.

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