A fear that still haunts the markets

There are two main areas where conventional wisdom has misread the British recovery: the fact that unemployment should have started to fall early in the expansion, instead of lagging the economy by 18 months or more; and the way rapid consumer-led growth has not yet led to a significant widening of the current account deficit.

Now that it seems pretty clear that consumption growth will level out (witness, for example, yesterday's evidence of flat retail sales), it is worth focusing on the second proposition and asking: is it possible that the next stage of the recovery could be accompanied by a narrowing, or even the elimination, of the current account deficit?

In fact, it is not only wholly possible that we will move back into current account surplus during the course of next year but, making some not too wild assumptions, a surplus is actually probable - though most people in the markets would be surprised by such an assertion.

The central argument can be quickly stated. A consumption-led expansion in Britain always sucks in imports because British consumers like to buy foreign goods. This has sometimes been attributed to the extent to which British producers have withdrawn from many markets, so that all products in some areas are made abroad.

But explanations on those lines do not explain why British producers withdrew in the first place. I suspect it has more to do with the open distribution system, the desire to experiment, and the individualistic streak among Britons.

However, consumption growth is slowing and while it will creep up in the months ahead, it is hard to see it growing faster than output. Exports, on the other hand, will follow the growth of markets.

We may or may not slightly increase market share over the years, but not on a month-by-month basis. Some 60 per cent of our merchandise trade exports goes to other EU countries, so the overall export figure is heavily influenced by growth in Continental Europe. Provided the Continental recovery continues (even at a slower pace than during the second quarter) export growth will continue.

We have already seen something of this. That strong growth in export markets, plus early signs of the pause in consumption, showed in the second quarter trade figures, when the volume of exports rose at an annual rate of 10 per cent while that of imports was flat. As a result there was a sharp narrowing of the deficit. But the trend only becomes significant if it is sustained. Many dismissed the figures as a blip.

A recent paper by the economic team at CS First Boston suggested the reverse: that there was substantial momentum behind the narrowing of the trade gap, and that if it were to remain at the levels of the second quarter or improve a little, rising invisible earnings would bring the current account to balance or small surplus during the course of 1995.

Invisible earnings are invariably tough to pin down - the figures are always revised, usually upward, and we have a decent breakdown of figures only for 1983. But the rise in investment income in particular last year was quite remarkable. Portfolio investment income in 1993 was pounds 8.2bn, up from pounds 6.8bn the previous year. If that rise has been sustained through 1994 and into 1995, one does not need a much better trade performance to see a small current account surplus.

And what then? What would be the perception in the financial markets were the current account to move into surplus?

Markets are always hunting for surprises and this would be a big one. But the current account position of countries, provided it is within plus or minus 1 per cent of GDP, is not a particularly powerful determinant of market movements, even on the market most directly affected, the foreign exchanges. So a current account surplus would not of itself lead to a boom in sterling.

It might, however, be an important constituent part of a more general rehabilitation of Britain as a secure haven for money. Suppose, for example, a current account surplus were combined with a sharp narrowing of the public sector borrowing requirement, perhaps to pounds 20bn, and the pulling back of inflation to the bottom end of the target range.

Then one could see a reward come in a narrowing of the gap between the yield on long gilts and long-dated US and German securities. Looking perhaps to the back- end of next year, one could see the basis for the next boom in gilts.

This may all seem a long way off. But a sniff of a current account surplus would remove the lingering fear that still haunts the market: if every previous British recovery has run into the buffers of a sterling crisis, why should this one be different?