Commentary: The Balance of Payments and the Savings Gap
Weale, Martin, National Institute Economic Review
The recent national accounts showed the United Kingdom to be running a balance of payments deficit of 5.7 per cent of GDP in the third quarter of 2007, matching the record deficit incurred in 1988/9. In the period up to 1972, when exchange rates were fixed, a balance of payments deficit was a cause for concern, since there was the risk that it would not eventually be possible to meet the gap between imports and exports. The willingness of foreigners to invest in the United Kingdom might be limited and the foreign exchange reserves, which could be used to pay for imports, definitely were. With the change to floating exchange rates the exchange rate adjusts to clear the market. A balance of payments deficit does not then raise the same concerns, and this sometimes leads to the view that it is not very important. What should we make of the current balance of payments situation and what is it telling us about the state of the economy?
A balance of payments deficit is no longer a cause for concern per se, but it can be a symptom of economic imbalances indicating something wrong with the economy. These imbalances can be explored by understanding that the balance of payments deficit is equal to the gap between domestic investment and national saving. Thus a deficit arising because saving is low is one thing, while a deficit arising because of an expansion of investment opportunities is a different matter. Examination of the relationship between savings and investment in the United Kingdom allows us to form a preliminary view how far low saving rather than high investment is driving the deficit.
[FIGURE 1 OMITTED]
Figure 1 shows national savings and domestic investment measured as proportions of GDP. Both are measured gross of depreciation; nevertheless, the gap between them measures the balance of payments deficit. The broad picture is of savings being lower in the 1980s than earlier with a further clear decline in 1999 and another, which may prove less enduring, starting in 2005. The investment ratio is much where it was in the early 1960s, but we can see that there was a period of fairly high investment lasting from the mid-1960s until 1980. The late 1980s appear to have been a time of investment boom as well as rising consumption supported by falling saving, followed by low investment in the recession of the early 1990s and its aftermath.
Focusing now on the recent past, we can see that, compared with the period 2003-5, investment has risen by about 2 percentage points while saving has fallen by much the same amount. Thus a balance of payments deficit of below 2 per cent of GDP has been transformed into one close to 6 per cent of GDP.
The rise in investment has several possible explanations. Past work at the National Institute has drawn attention to the importance of variations in the risk premium as drivers of fluctuations in investment. But we have also noted the sharp rise in the UK labour force generated by flows of immigrants. We estimated in October 2006 that labour income had increased by 1.5 per cent in 2004-5 as a result of immigration. With a ratio of produced capital to GDP of 2.2 this points to an increase in the capital stock of 3.3 per cent of GDP as a result of immigration over this period. Immigration of course took place before 2004 and has continued in 2006 and 2007. Thus, while there are undoubtedly other factors present as well, the increase in investment can be linked to this. There is no obvious reason why this extra capital should be provided by domestic saving; it is perfectly reasonable for the balance of payments deficit to increase in response.
The fall in national saving of 2 percentage points is rather a different matter. If the country were plainly saving too much, one would be pleased by a fall in the savings ratio. But the evidence suggests (Khoman and Weale, 2006) that saving even in 2004 was a long way below the levels which would be required if each cohort were to pay its own way through its life and the situation has deteriorated since then. …