Mark Carney's Testimony to House of Lords Highlights Risk to Current Account Deficit via Brexit

The Bank of England's Governor Mark Carney has given evidence to the House of Lords Economic Affairs Committee and his comments on the vulnerability of the UK's current account caught our attention.

The highlight of the testimony surrounded, as expected, the upcoming EU referendum. 

It was undoubtedly a pro-EU tone that came through with Carney doubling-down on how important the European Union is to the UK from a trade perspective.

In his view, a vote to leave Europe would extend uncertainty about the outlook, particularly regarding exports. "It’s virtually impossible to refute, the degree of integration with the rest of the European Union would be reduced," says Carney.

The impact of the EU referendum is already being felt, notes the Governor, citing sterling as having fallen more than 10% since the start of the year and the cost of buying protection against sterling weakness as having risen considerably.

A vote to leave could have significant implications for the exchange rate and other asset prices, “such as rising rising risk premia which, all else being equal, would impact negatively on productivity."

Current Account Deficit is Major Threat

We said ahead of the appearance that it is Carney's views on the current account deficit that we would find most interesting from the perspective of the UK currency.

The UK's current account deficit (difference between money coming in from exports and that going out to pay for imports) is at an historic high, at more than 7% of GDP.

Carney says it is safe to say it is running consistently around a rate of 5% and this is, "remarkably high for an advanced economy."

Carney's views are unequivocal that it would become more expensive to fund the deficit as foreign investor inflows dry up in the event of an EU exit from the Eurozone.

The UK economy would have to pay for the closing of the current account deficit by suffering slower growth in the economy.

Previously...

The appearance of the UK's most important independent financial policy setter comes at an interesting time from both a global and domestic perspective.

A look at the topics the Governor and Lords will be covering:

• What risks are there to remaining in the European Union?
• What risk does China pose to the UK economy?
• Is the housing market still the biggest medium-term risk to the UK economy?
• How important is membership of the European Union to London’s status as a leading international finance centre?
• Are banks now too complex to fail?
• When will inflation return to target?
• Are any further changes to banking regulation required as a result of the revelations in the ‘Panama Papers’?
• To what extent is the historically large current account deficit a concern?

The appearance is therefore likely to be the fundamental highlight of the week for the British pound.

Of significance to us will be Carney’s take on inflation and the UK current account.

It is the UK’s gaping current account deficit that leaves the British pound exposed to significant downside risks in light of the EU referendum.

In short the UK imports more than it exports, a scenario that typically places downside pressure on a currency.

However, GBP remains supported by a large flow of foreign investor capital which is coming into Britain to take advantage of numerous investor opportunities.

Were this compensating flow of currency to dry up due to the UK voting to leave the EU then the British pound could fall significantly further and reflect the reality of the current account.

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What Carney has to say about how vulnerable the pound and UK economy is to the trade deficit is will be of great interest to us.

Inflation is meanwhile the economic indicator the Bank of England are most concerned with as it is their mandate to keep inflation stable at around 2%.

With inflation barely above 0% the Bank has had to keep interest rates at record lows for an extended period. It is the promise of higher interest rates in the future that could see the pound move higher and recover from its malaise.

Rising inflation would see the Bank need to raise rates in order to cap price rises.

The most recent economic stats from the ONS show inflation ticking higher faster than economists had expected.

What does Carney make of this trend, will prices rise faster than anticipated. How does this bear on interest rate policy?

Any suggestions that inflation is turning higher could well see the British pound catch a bid.

Last week, as expected the BoE Monetary Policy Committee voted unanimously to maintain Bank rate at 0.5% and the stock of purchased assets at £375bn.

Markets continue to believe the Bank will only raise rates for the first time in 2020.

However, there are some analysts who believe this could happen as soon as this year.

"Our view is that price pressures will reassert themselves forcing the BoE to hike in Q4 2016, on the assumption that a Leave vote following the EU Referendum does not materialise. While there are risks to our view of a BoE hike in Q4 2016, the risks are of it being out by two quarters, as opposed to two years," says Renuka Fernandez, economist at TD Securities in London.

On the issue of the referendum, interestingly, there was a little more discussion around the risks surrounding the EU Referendum at last week’s MPC decision.

The Bank notes that there was evidence of uncertainty weighing on activity with decisions on capital expenditure and commercial property transactions being postponed till after the outcome of the vote is known.

Will Carney expand on this? If he is shown to be more pro-EU we could see the pound rise.

However, in light of the fall-out from his apparent pro-EU stance in March we would expect his words on the matter to be incredibly guarded.