UK: A broken adjustment mechanism - HSBC
Research Team at HSBC, suggests that the UK has a very large current account (C/A) deficit and this structural weakness will come under immense pressure because of the forthcoming major political and economic changes.
Key Quotes
“Many hope that the decline in GBP seen so far will be enough to cause the C/A deficit to correct substantially. We find that GBP will need to fall further, and remain weak for a long time, in order to create significant improvements to the UK's structural position.
A country needs capital inflows in order to fund a C/A deficit. To be clear, we are most definitely not arguing that the UK will suffer a true current account crisis. However, the UK’s C/A deficit is now in focus and the market is likely to demand at least some adjustment. It is not plausible that a large enough adjustment will come via the trade channel with GBP at its current level. Therefore, it is clear to us that a substantive and prolonged fall in GBP will be needed. This will also help other, smaller, components of the C/A to cause a material improvement. A much weaker GBP will also have the beneficial effect of making UK assets cheaper to foreign investors and should help to stimulate capital inflows.
In our view, GBP is the main part of the adjustment mechanism but the adjustment is not over yet. We still see GBP-USD at 1.25 by the end of Q3 and 1.20 by year-end. However, we now see GBP weakness extending into 2017 and we now forecast GBP-USD at 1.10 by end-2017. This aligns with our economist’s view that the Bank of England will ease even further, cutting rates by 15bp in November and expanding QE in February next year.
The UK's decision to leave the EU has put the focus of attention sharply on GBP's structural imbalances. With a current account deficit comparable to the size of the most vulnerable emerging market economies, and a political outlook plagued with uncertainty, the pressure is on GBP to weaken. The UK's structural weakness will come under immense pressure because of the major political and economic challenges ahead. In this report, we delve deeper into the various channels of the current account and financial account to see how exactly a weaker currency can help the rebalancing process. Our conclusion is simple: GBP must weaken further and notably so.”