UK Current Account Sustainability in the Post-Brexit Era: Insights from an Intertemporal Current Account Framework

Abstract

British voters decided in a June 2016 referendum that they wanted the UK to leave the European Union (EU). The Brexit referendum result represents a critical turning point for the UK and the EU alike, and the decision to exit the bloc is bound to have far-reaching consequences. UK’s persistent current account deficits and its outsized external assets and external liabilities reflect Britain’s deep economic and financial integration with the European Single Market System, and highlight London’s central role as Europe’s financial capital. Unraveling of the symbiotic relationship between the UK and the EU will profoundly impact Britain’s ability to entice foreign investors to fund its current account deficits. Using a rich intertemporal current account framework that incorporates valuation effects, this study examines the potential impact of Brexit on UK’s current account sustainability and on UK’s net foreign debt position. It argues that a “hard Brexit” outcome would imperil UK’s ability to sustain current account deficits. UK’s role as a gateway for non-EU states looking to invest inside EU, and the benefits enjoyed by UK-based financial institutions from the European “financial passport” system would both be endangered if UK is shutout of the European Single Market system. UK is bound to become far less attractive to foreign investors in such a scenario, and a rapid and painful current account deficit reduction is probable. On the other hand, the study shows that a “soft Brexit” outcome in conjunction with a sustained and orderly depreciation of the pound would actually improve UK’s current account balance and its net foreign debt position.