Risk of investor flight from the UK

The conditions under which investor flight might happen for the UK is something we have discussed in our recent A2 lessons on exchange rates and macroeconomic policy and it forms the basis for a short article in the Financial Times today…

“As the Bank of England prepares to crank up the printing presses to expand the money supply, the risks have rarely been higher. Critically, the health of the British economy may now rest on international investors who hold about £200bn ($286bn) – or a third – of UK debt in the form of gilts. If these investors, including the Chinese and Japanese governments, Middle Eastern sovereign wealth funds and an array of international pension and life insurance funds, pull out of Britain, the government has a serious problem.”

“It would mean the yield required to make government debt sufficiently attractive to investors would probably have to increase markedly which, combined with the spiralling amount of debt that needs funding, could take financing costs to unsustainable levels.”

There is some important economics here linked to the sustainability of the twin-deficits - namely the (ballooning) government fiscal deficit and also the persistent deficit on the current account of the balance of payments.

(1) If overseas investors take flight and withdraw their portfolio investment from the UK - what will this do to the sterling exchange rate?

(2) What impact might investor flight have on the interest rate needed to attract people to purchase new issues of government debt? Consider the second round effects of this too.

(3) Should the UK government consider setting up its own sovereign wealth fund? How might this be done?

The sterling trade weighted index seems to have stabilised after the dramatic depreciation in the second half of last year.

More here from the article

Sterling trade-weighted index and UK base rates (chart)
Sterling_Index_Interest_Rates.ppt