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Article14 Nov 2022

U.K. Comparison Unfair to EM Fiscal Discipline

A new report from Citi Research’s David Lubin, says that comparing the U.K.’s recent fiscal and monetary policy woes to emerging economies does a disservice to recent policy discipline across emerging economies.

Former US Treasury Secretary Larry Summers in late September described the UK as an ‘emerging market turning itself into a submerging market’.

The comment was made before the country’s latest change in leadership that saw Rishi Sunak installed in 10 Downing Street.

But Citi Research analysts argue is that it may be considered unfair to EM to think that ‘irresponsibly loose fiscal and monetary policy’ is a point of connection between today’s EM and the recent situation in the UK. In fact, they say policy discipline is, broadly speaking, a hallmark of many emerging economies these days.

The UK’s most fundamental structural problem, the analysts say, is its very low savings ratio, which at around 14% compares badly with almost everyone, including EM.

The UK savings ratio is super-low, so it’s very difficult for the economy to grow without generating a current account deficit…

© 2022 Citigroup Inc. No redistribution without Citigroup’s written permission.

Source: Citi Research

 

…and we’ve had a recent reminder within EM of how current account deficits can be associated with currency deprecation

© 2022 Citigroup Inc. No redistribution without Citigroup’s written permission.

Source: Citi Research

 

Since the flip side of a very low savings ratio is a persistent current account deficit, the UK’s dependence on external financing is perhaps the most obvious way of making the comparison between the UK and an emerging market.

Emerging markets crises in the past 40 years have almost always been the result of excessive dependence on external financing, and since the UK’s current account deficit currently exceeds 8% GDP-- a level which in an EM context would be considered exceptionally large--concerns about vulnerability are perfectly natural.

Indeed, the vulnerability of countries with large external financing needs is perfectly highlighted in the chart on the right above, which shows, for EM, the relationship between the trade-weighted exchange rate and the size of the current account deficit that’s not financed by (relatively stable) net FDI inflows.

This relationship is not constant: there are occasions when large current account deficits can be associated with appreciating currencies, for example when the deficit is a function of large capital inflows. But in an environment such as this one, where risk appetite globally is quite fragile, deficits and fx depreciation are natural companions.

The institutional problem in the UK was, Citi analysts say

  1. the finance minister’s decision to sack the head of the permanent civil service within the UK Treasury on his first day in office, and
  2. the failure of the government to back its 23 September ‘fiscal statement’ with any accompanying framework from the independent Office for Budget Responsibility.

Both these actions suggested an arbitrariness in policymaking and a disregard for the institutions of fiscal policy, which some might consider an ‘emerging markets-type problem’, in the sense that one of the reasons why, for example, sovereign rating agencies consider EM more risky than DM is existence of countries in EM which lack robust institutional frameworks for policymaking.  

Public debt in DM is higher than in most EMs and has also increased at a faster rate…

© 2022 Citigroup Inc. No redistribution without Citigroup’s written permission.

Source: Citi Research

 

.…leaving DM debt paths more vulnerable to higher real rates

© 2022 Citigroup Inc. No redistribution without Citigroup’s written permission.

Source: Citi Research

 

The weakness of the UK’s policy mix was that, against a background where the inflation-adjusted UK policy interest rate was exceptionally low, a fiscal expansion in an environment of weak external demand growth could only add to the UK’s external financing requirement with very little in the Bank of England’s monetary framework to attract the capital inflows necessary to finance the bigger deficit. Hence the sell-off in gilts and sterling.

For more information on this subject, and if you are a Velocity subscriber, please see Emerging Markets Economic Outlook & Strategy - Why EM isn’t the UK

Citi Global Insights (CGI) is Citi’s premier non-independent thought leadership curation. It is not investment research; however, it may contain thematic content previously expressed in an Independent Research report. For the full CGI disclosure, click here.

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