Here’s what Deutsche Bank’s Shreyas Gopal wrote in a note just published as Liz Truss is officially announced as the UK’s next Prime Minister (our emphasis below): With the current account deficit already at record levels, sterling requires large capital inflows supported by improving investor confidence and falling inflation expectations. However, the opposite is the case. The UK is suffering from the highest inflation rate in the G10 and a weakening growth outlook. A large, unfunded and untargeted fiscal expansion accompanied by possible changes in the BoE’s mandate could lead to an even greater rise in inflation expectations and — in the extreme — the emergence of fiscal sovereignty. Taking emergency measures around the Northern Ireland Protocol could increase uncertainty about trade policy. With the global macroeconomic framework so uncertain, investor confidence cannot be taken for granted. The risk premium for UK nursing females is already rising, coinciding with unusually large foreign outflows. If investor confidence erodes further, this dynamic could turn into a self-fulfilling balance of payments crisis where foreigners would refuse to finance the UK’s external deficit. . . . With the current account at risk of running a deficit of almost 10%, a sudden stop is no longer a negligible risk. The UK is increasingly at risk of no longer attracting enough foreign capital to finance its external balance. If so, sterling would need to depreciate substantially to close the gap in the external accounts. In other words, a currency crisis commonly seen in EMs. As DB points out, a balance of payments crisis may sound extreme for a G7 economy, but it is hardly unprecedented. Aggressive fiscal spending, a major energy shock and the fall of sterling sent the UK into the arms of the IMF in the 1970s. Today’s environment looks eerily similar. Gopal estimates that sterling needs to fall another 15 per cent in trade-weighted terms just to bring the UK’s external deficit back to its 10-year average. At the same time, economic fundamentals are showing. . . not very well. So, in an extreme EM-type sudden stop scenario, how far could sterling fall? A whopping 30 percent could be required, DB estimates. Truss wants to avoid a recession by cutting taxes and supporting households through soaring energy costs. DB is concerned that while fiscal support is appropriate to support growth, massive bailouts could be risky. A very large but untargeted package of spending — such as the VAT cut of 10 p.m. — would risk significantly worsening the already large current account deficit and exacerbating investor fears about its sustainability — in addition to fiscal sustainability concerns. Indeed, given the ongoing squeeze on real income, the bar is extremely high for increasing private sector savings to offset rising government borrowing. This is no time to expect ‘Ricardian equivalence’. Therefore, debt-financed government spending should almost mechanically widen the current account deficit. . . . Certainly, in the UK, the new government is likely to pay lip service to a smaller state and a desire to keep the debt-to-GDP ratio low, but the bar for the market to believe that this would be high if the actual policy of sweeping and of unfunded VAT cuts. It’s not the first time people have worried about the UK. Bill Gross famously said the UK government bond market was resting “on a bed of nitroglycerin” in 2010, but gilts had the last laugh. The country’s net international investment position has weakened, but remains a defense against a sudden disruption. The money that finances its external deficit is not the ‘hot money’ that emerging markets have historically relied on, and the UK has not borrowed money in other currencies – another classic EM vulnerability. The price of insuring against a UK outright default has risen slightly recently, but remains very low and well below the levels seen in the wake of the 2008 financial crisis. However, the DB remains concerned that there is a “non-zero chance” of policy errors leading to a balance of payments crisis. Sterling’s weakness this year is far from just a story of pure pessimism about the pound itself. There is also a broad global dollar factor. To the extent that sterling’s weakness was idiosyncratic, we would argue that a mild recession is now in the price. But from here, we argue that the pound is threading a fine needle. The danger is that the policy exacerbates the key vulnerability: the external imbalance. If large and untargeted fiscal stimulus pushed the current account deficit to 10% of GDP, the risks of a sudden stop would increase substantially, in our view. Let’s hope Nigel Farage’s denim venture takes off overseas.
