Friday, September 12, 2008

UK Debt - Is it a problem?

Note: I have made an error below - the second comment was not Arlo, but another person. Apologies to Arlo and the other poster for the confusion. I have left the post as it stands, however, as I was trying to address the themes in both comments (I have to admit that the two perspectives did not quite tally, so should have realised).

Original post below...

I have had two comments from a 'Arlo' in my post 'UK Bankrupt?' which I think I should respond to (apologies for the time taken, but my 'real life' is rather hectic at the moment). Arlo has made two challenging comments as follows:
'This raises the philosophical question of whether you can "realise" something that isn't true.

UK has a big external debt but is also a big external lender. Whether we're bankrupt or not depends on the net position. UK external assets are about 95% of UK external debt, so the problem is about 5% the size you claim.

Your 18C aristocrat has a portfolio of shares almost as large as his debt, so his net annual payments to creditors is a tiny fraction of his income from non-financial activities (GDP). That's why they keep lending to him.

Sorry it's not as exciting as a financial apocalypse, and it doesn't really add much to big-picture arguments about a postindustrial economy or whatnot. But that's accounting for you.'
'If the 18C aristocrat had a load of shares he could cash in, why would he borrow money at interest? Wouldn't he use up his cash first?

With regards to the UK, what happens if the people 'we' have been lending money to cannot repay the loans? Presumably we are still liable for the 12 trillion dollars in debts?'
Note: For new visitors to this blog, I would suggest that you read my essay 'A Funny View of Wealth' before continuing here. The essay is quite long, but I hope it is worthwhile.

The first thing to say is that I appreciate comments, and enjoy challenging ones. With regards to the current state of the UK's net position, according to a paper by Whitaker (1), the position is as Arlo describes. According to the paper, the following is the case:
'Official data suggest that the United Kingdom’s financial liabilities exceed the value of its financial assets — net foreign liabilities were equal to around 14% of GDP at the end of 2005.'
The only problem with this rather rosy scenario, is the nature of the financial assets. In particular many of the assets that the UK can point to are actually assets owned by UK based companies, representing foreign direct investment (FDI) or portfolio investment, and those companies are not necessarily UK owned. This may present some problems. The first is that the companies may be based in the UK, may be listed on UK stock markets, but that does not imply that the ownership is UK based. Are the figures for FDI calculated on the basis of the companies being owned by UK individuals, or are they calculated on the basis of UK based companies? I suspect the latter and that means that many of the UK's overseas assets are not actually UK owned (I am open to being corrected on this, but I believe this to be the case).

Of course, we could make the same point as the above for other countries and ownership of assets, but the important point to make here is that the UK economy is very open, and the UK has had one of the highest levels of inward investment of any of the countries in the world, suggesting that the UK will be in a position where international ownership of companies is particularly high.

The second is that a company is not tied to the UK, and has the freedom of relocating itself to another country where there is a better business environment. This has recently been happening in the UK, with companies relocating to Ireland for example.

Another problem is that our net assets are largely based in Europe and the U.S. and I have discussed at length the underlying problems with the OECD economies, in particular the U.S. and Europe. As such, these assets are not necessarily going to hold their value. For example, it will be interesting to see what happens to the value of commercial property held by the UK in the U.S. However, set against this, the value of assets in the UK will also drop, as will the return on those assets for overseas investors.

Another problem is the question of how the figures are calculated, which is in part why I have cited Whitaker. He points to the following rather strange effect:
'net investment income has improved at the same time that the United Kingdom has become more indebted'
By way of explanation he says the following:
'Two factors are behind the United Kingdom’s ability to obtain net investment income despite increasing net indebtedness. First, the yield that the United Kingdom pays on the bonds and equities issued to overseas investors — termed portfolio debt and equity — appears to have declined relative to the yield that the United Kingdom earns on the bonds and equities issued by the rest of the world that it owns. Second, there has been a shift in the composition of UK external assets towards foreign direct investment (FDI). FDI assets generate a higher yield than the United Kingdom’s predominantly debt-like liabilities.'
To quote my own tag-line 'I just don't buy it'. It just seems too close to the idea of 2+2=5, but my purpose here is not to discuss his thesis. Interestingly, he also acknowledges that the figures that are used for the paper are somewhat problematic, but believes that they are understating the UK's assets.

Another way of looking at this is the current state of the balance sheet of individuals in the UK. With regards to debt, it is no secret that individuals in the UK have shockingly high levels of debt (see here for an example break down - it is out of date and therefore understates the scale of the problem, but is interesting nonetheless). On the other side of the balance sheet, savings have been falling back and are at the lowest level for 50 years, such that on a chart the lines are going in the opposite direction (see here - sorry, again out of date as I am as ever pressed for time, and it is the first useful chart I could find, but hopefully you will get the picture). Savings represent the accumulation of assets, both in the UK and overseas. As such, if the savings rate is low, there will be a commensurate drop in aggregate ownership of overseas assets by individuals in the UK. What we are therefore seeing is increased borrowing by individuals, and a significant proportion of that from overseas sources (the sub-prime crisis has demonstrated the international nature of lending to consumers), compared with less investment overseas.

A good summary of the state of the UK household balance sheet can be found here (an IFS powerpoint presentation). Whilst it shows a positive overall balance sheet, the trouble is that it is a snapshot of the value of assets, and does not account for a downward spiral in the OECD economies. As the banking system has discovered, even the Basel capital adequacy ratios can not assure assets can be valued accurately - until it is time to sell them. It is here that matters become complex, because we have a situation of mutual interdependencies. The balance sheets of households are dependent upon the overall state of the economy in the OECD, and the state of the OECD economies is, in part, dependent on the balance sheet of households within the OECD. What happens when, for example, stockmarkets fall? Or what happens when the value of assets such as housing fall? What then happens is that the interdependencies kick in, causing a downward spiral. As I have pointed out, most of the overseas assets held by the UK are within the OECD, with particularly high exposure to the U.S. and Europe. Throw in the complication of an abstract idea of confidence, and there are ever more feedback loops that will push the economies downwards.

If we actually look at what has been happening in the UK we see consistent balance of payments deficits over a long period of time, and even invisible earnings are now in deficit. I have already discussed inward investment and questioned whether it is a 'good thing' in 'A Funny View of Wealth'. This is now reflected in our position on invisibles.
'The continued weakness of manufacturing exports and the strength of import demand, fuelled by the consumer spending boom, have led to a widening current account deficit, put at £57.8 billion or 4.2% of GDP in 2007, not far short of double the level of £30 billion two years earlier. Indeed, the deficit would have been closer to £70 billion but for a surge in investment income in Q4, a one–off result due to the impact of the credit crunch as foreign banks posted record losses. The surge in the deficit is largely the result of consumers living beyond their means, lured into more spending by offers of cheap credit, in turn sucking in greater imports. As a result, the merchandise trade deficit widened to £87.6 billion (6.3% of GDP) last year from £77.4 billion (5.9%) in 2006, with the deficits for finished manufactured goods, basic materials and food, beverages and tobacco all rising significantly. But, at the same time, the current account has also been hit by falling net invisible earnings. The deterioration in portfolio investment income has been fairly modest but the traditional surplus on the income account fell to £5.3 billion in 2007, far below the level of £25.8bn just two years earlier, primarily the result of sharply lower net inflows of direct investment income (although the latter rose to £37.5 billion last year after the very strong Q4). On top of this, net outflows of transfers have continued to climb, reaching nearly £14 billion compared with around £12 billion in the two previous years.' (2)
Looking at another part of the equation, UK government debt is fixed an firmly attached to the UK. Also, if we look at individuals, there is considerable outward migration from the UK. As I have discussed in my essay 'A Funny View of Wealth', those migrants will be taking all of their assets with them. They are very unlikely to be in debt, whereas the state of individual debt in the UK is, as is being widely discussed, parlous. This debt is also firmly attached to the UK as these individuals are unlikely to leave the country taking their net debt with them. In short, for individuals, those in debt are tied to the UK and those that are leaving are taking their net assets with them. Unlike the assets held by companies, that are able to relocate, or where those assets are often partially owned by overseas investors, the consumer and government debt are not going to go anywhere. They are 100% UK owned debts.

Quite simply, as I have discussed in 'A Funny View of Wealth' the UK economy has been supported by a net increase in debt, and sterling has been supported in part by a flood of inward investment. However, as I pointed out at some length, such inward investment is not necessarily a good thing, unless it is investment in business that generates income from outside of the UK.

As I have stated previously, the UK economy is in a very, very bad position. I have mentioned before the problem that we include in GDP economic activity that is resultant from increase in debt. This makes the UK economy appear much larger than it is in reality. As such, whilst it may look like we have a size of economy that might be able to service our liabilities, the simple fact is that, when an ever growing debt mountain is stripped out of the GDP (remember the multiplier effect), then the UK economy is actually going to be nothing like the size it is reported to be.

We have massive external liabilities, and I do not believe that we have the ability to service these liabilities. We have assets that are declining in value, a negative net income, fast expanding government debt, a shrinking economy that MUST shrink back to a level with debt growth stripped out, and increasing competition in the few sectors in which we have competitive advantage, and finally the (albeit illusory/temporary) support of inward investment is disappearing.

To quote Arlo again:
'Your 18C aristocrat has a portfolio of shares almost as large as his debt, so his net annual payments to creditors is a tiny fraction of his income from non-financial activities (GDP). That's why they keep lending to him.'
The first question is who owns the shares? Even if he does sell the shares that he owns, then there is still not enough to cover his liabilities. The second point is that, even if they were all sold, his income does not begin to cover his expenditure. There is no prospect of his income increasing, so creditors will see no way of his paying back any future lending. The only way they will lend to him is if he savagely cuts his expenditure such that his income is enough to repay the debt. However, his income is actually declining, so who would take a risk on him?

As I have said before, the UK is structurally bankrupt. By this I mean that it is not clear how we can pay off our external debt in our current situation. This is why I am proposing structural reform.

(1) Whitaker, Simon,The UK International Investment Position. Bank of England Quarterly Bulletin, Fall 2006, Available at SSRN:
(2) (2008). "Are the UK's twin deficits a risk to stability?" Economic Outlook 32(2): 14-19.

Other Useful references
Kirsanova, T. and J. Sefton (2007). "A comparison of national saving rates in the UK, US and Italy." European Economic Review 51(8): 1998-2028
Vladimir Klyuev, Paul Mills. (2007). Is Housing Wealth an "ATM"? The Relationship Between Household Wealth, Home Equity Withdrawal, and Saving Rates. IMF Staff Papers, 54(3), 539-561. Retrieved September 12, 2008, from ABI/INFORM Global database. (Document ID: 1330902681).

1 comment:

  1. Great stuff, as usual.

    (Just thought I would point out that the second comment you attribute to Arlo, was in fact a couple of questions I was asking *of* Arlo, myself, having read his comment)


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