Britain could face a 1970s-style balance of payments crisis in which the pound crashes if Liz Truss’s government loses the confidence of international investors, one of Europe’s biggest banks has warned.
In a note entitled “Crunch time for sterling”, published on the day Truss won the Conservative leadership race, Deutsche Bank’s foreign exchange analyst Shreyas Gopal said a large, unfunded and untargeted package of tax cuts and spending pledges could alarm global markets.
It could lead to foreign investors refusing to fund the UK external deficit by buying government debt, as investor confidence “cannot be taken for granted”, Deutsche says.
Gopal pointed out that the UK’s current account deficit is already at record levels, meaning sterling needs large capital inflows, supported by improving investor confidence and falling inflation expectations to support the currency.
“However, the opposite is happening,” Gopal wrote. “The UK is suffering from the highest inflation rate in the G10 and a weakening growth outlook.”
The UK’s current account measures the difference between UK imports and exports of goods and services, and between UK investments overseas and the returns that foreigners make on their investments in the UK. It hit a record 7.1% of GDP in the first three months of the year.
Inflation expectations could rise even higher if Truss’s administration changes the Bank of England’s mandate to fight inflation, as was suggested during the leadership race.
“A balance of payments funding crisis may sound extreme, but it is not unprecedented: a combination of aggressive fiscal spending, severe energy shock, and a slide in sterling ultimately resulted in the UK having recourse to an IMF loan in the mid-1970s,” Gopal said.
When he was Bank of England governor, Mark Carney described Britain as reliant on the “kindness of strangers” to finance its current account deficit.
Back in September 1976, with the pound hitting a record low, James Callaghan’s Labour government approached the IMF for a loan of $3.9bn – the largest amount ever requested from the fund at that time. That crisis followed the “Barber boom” of the early 1970s, when Conservative chancellor Anthony Barber slashed taxes in a dash for growth that weakened the pound, leading to stagflation after the Opec oil crisis.
Truss could spook foreign investors if she triggers Article 16 of the Northern Ireland Protocol to override parts of the post-Brexit treaty.
“Taking emergency measures around the Northern Ireland Protocol could add to the uncertainty on trade policy. With the global macro backdrop so uncertain, investor confidence cannot be taken for granted,” Gopal warned.
During the campaign, Truss promised to reverse the recent increase in national insurance and scrap a rise in corporation tax. Her team have also suggested that VAT could be cut by five percentage points to help households.
Truss promised on Monday to deliver a “bold plan to cut taxes and grow our economy” and to deal with energy bills. A price freeze for some energy bills could cost tens of billions of pounds, adding to the UK’s borrowing needs unless it is accompanied by tax rises.
HSBC warned that Truss faces an “exceptionally challenging time”, due to the energy crisis hitting households, businesses and public services.
They estimate that the UK could borrow £87bn more than expected this financial year. That includes £17bn of tax cuts pledged by Truss during the campaign – rising to £29bn next year – £35bn of additional support for households and businesses, including possibly an energy bill freeze, and an extra £25bn on debt servicing.
“In normal recessions, that might be expected. But this is not a normal recession: the BoE is hiking rates and is about to start selling bonds,” said Elizabeth Martins, a senior economist at HSBC. “And the prospect of stoking demand is more complicated than it was in the global financial crisis, say. This time, it risks keeping inflation higher, forcing the BoE into delivering more rate rises.”
UK government borrowing costs have already risen sharply in recent weeks, amid a wider selloff in sovereign debt. The yield, or interest rate, on 10-year bonds is the highest since the end of 2013, at almost 3%, and rose by the most since 1986 in August.
“If investor confidence erodes further, this dynamic could become a self-fulfilling balance of payments crisis whereby foreigners would refuse to fund the UK external deficit,” Gopal says.
The pound fell near to a 37-year low on Monday, as the closure of Russia’s Nord Stream 1 gas pipeline added to the pressures on the UK and European economies. Sterling dropped to $1.14 against the US dollar, the lowest level since March 2020.
Wholesale gas prices rose sharply, erasing some of last week’s losses, with the month-ahead UK contract up over 10% in afternoon trading to 455p per therm, more than three times higher than a year ago.