The relative importance of the banking sector s contribution to the balance of payments current account

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1 The relative importance of the banking sector s contribution to the balance of payments current account Andrew Grice Tel This is the third in a series of articles examining the banking sector s contribution to the balance of payments. An article in August 1998 described the Bank of England s collection and compilation systems against a background of recent changes to implement new international standards. An article in January 1999 provided a detailed breakdown of the banking sector s current account. This article examines the banking sector's relative importance to the balance of payments current account. Overview This article examines the contribution made by the banking sector to the balance of payments current account 1 and to the current account balance over a tenyear period. The data used in this analysis are sourced from the Office for National Statistics 1998 Pink Book balance of payments accounts. The data used in the previous article, 2 were compiled from the Bank of England s own statistical survey system. Although based on the same data sources there are differences between the two sets of data, the cause and magnitude of which were discussed in the previous article (see pp.9-1). However common trends are still seen in both sets of data. The article examines the banking sector s contribution to each relevant component of the current account separately (banking contribution to trade in services and investment income) and examines trends. Table A provides a summary of the components which make up the banking sector contribution to the balance of payment accounts. The banking sector s contribution to the balance of payments current account (Charts 1 & 2) From 1987 until 1993, the banking sector contributed a net deficit to the current account (Chart 1). This was initially due to the net deficit on the banking sector s portfolio income, and from 199 to an increasing net deficit on its other income. From 1994 the banking sector contributed a net surplus to the current account. This was because of a general decrease in the net deficit on other income and rapid growth in the portfolio income net surplus. It was fairly low due to exceptional reasons in 1995 (the losses at Barings Brothers & Company Ltd 3 ); however, the general trend in this second period was for continued growth in the banking sector net surplus. In terms of the overall BoP current account, the most influential component, in terms of size, was trade in goods (Chart 2). This had consistently been in deficit since the early 198s and between 1987 and 1993 was the determining factor behind the size of the current account deficit. As the trade in goods deficit decreased between 1989 and 1991, so the current account deficit also decreased. Between 1993 and 1997, the link between the current account deficit and the trade in goods balance appears to have been broken. Trade in services and net income have made increasingly positive contributions in this period. From 1992 this account switched from providing a net deficit to providing an increasingly large net surplus. By 1997 the current account showed a large surplus for the only time in this period. Table A - Banking sector contribution to the balance of payments current account millions Service earnings Net direct investment income Net portfolio investment income Net other Income Banking sector contribution UK BoP current account The current account is made up of four accounts trade in goods, trade in services, investment income and current transfers. Banking data contributes to the investment income and trade in services accounts. 2 See Monetary and Financial Statistics; January 1999 pp Hereafter referred to as Barings Bank. 1

2 Chart 1 Components of the banking sector contribution to the current account series Banks' Net Direct Investment Income (Credits +ve) Banks' Net Other Investment Income (Credits +ve) Banking Sector contribution to the Current Account Banks' Net Portfolio Investment Income (Credits +ve) Banks' Net Service Earnings Chart 2 : The BoP current account : contribution of the banking sector Trade in Goods Net Current Transfers Banking Sector contribution to the Current Account Trade in Services Net Income Current Account Balance 2

3 The contribution of the banking sector to individual components of the current account Chart 3 - Contribution of the banking sector to the total trade in services income series Banking Sector Net Service Earnings Other Net Service Earnings Total Net Service Earnings This relationship is further demonstrated when comparing the contribution of the banking sector (dotted line in Chart 2) to the overall current account balance (solid line). From 1992 there is a strong correlation between the current account balance and the banking sector contribution. The net surplus of the banking sector had the effect of pulling up the net deficit of the current account and by 1997 there was a current account net surplus. Prior to 1992, the deficit of the banking sector had the effect of increasing the current account deficit, but in this period the trade in goods deficit was more influential. Service earnings (Chart 3) Banks service earnings 4 were relatively stable at just under 2bn per year over the last ten years (see Chart 3). The total service earnings account has seen rapid growth since 1994, mainly due to the remaining domestic sectors 5. The main drivers of growth over the last ten years were securities dealers, insurance, other business, travel and transport services, with growth over the last three years due to engineering, other miscellaneous business and information technology services. For further information on the composition of banks service earning, refer to the Bank of England 1998 Statistical Abstract, Table 11 (on p.121). Direct investment income (Charts 4 & 5) An earlier article 6 describes the directional principle of direct investment used here. In Chart 4 banking sector net direct investment income credits are compared to debits and a subtractive process (subtracting debits from credits) is used to show the net position. This also applies to Charts 6 and 8. For all other Charts in this article an additive process (adding together all components to find the net position) is used. It should be noted that the majority of UK banks are foreign owned. Usually banking sector direct investment income produced a net deficit in the UK balance of payments, as seen in and The payments made by UK-based banks to their non-resident parents exceeded the payments received by UK parent banks from their investments abroad. However, for the years 1989 to 1992, there were negative inward debits (that is in effect a credit) partially offset by negative credits (in effect a debit) on outward income. This led to a banking sector net surplus. The increase in the net deficit in 1995 was, in part, due to the losses of Barings Bank abroad (which caused a large fall in the net outward income for that year as funds were sent from the UK to cover them). 4 See Monetary and Financial Statistics; January 1999 p.6 for further discussion about the split between the measured and estimated service earnings of banks and recording of data on a gross/net basis. There are service charges indistinguishably included within interest income on borrowings and lendings which are not captured in these data known as Financial Intermediation Services Indirectly Measured (FISIM). The Office for National Statistics will be carrying out further research work into this area. 5 Within this article banking sector data is compared to the data of the remaining domestic sectors combined. Examples of institutions included within these remaining domestic sectors are insurance companies, non-financial corporations, financial intermediaries and the household sector. For ease of reference, I have referred to this group on the Charts as the other sector. Details of these sectors are given in the 1998 Pink Book. 6 Monetary and Financial Statistics; January 1999 p.7 and p.11. 3

4 Why has there been such growth in the inward debits series? There was increasing globalisation during the 199s with significant acquisitions by non-residents of UK banks, which contributed to the growth in this series. This is reflected subsequently in the growth in the inward debits series, as these entities have, at least since 1992, been profitable (and were profitable before they were purchased). The contribution of the banking sector, compared to the remaining domestic sectors, to the overall direct investment income account was limited because its net balance was quite small. As Chart 5 shows, the effect of the banking sector on the total net direct investment income balance in the 199s was to reduce the net surplus. This was most apparent in However, the main drivers behind the total net direct investment income surplus are the remaining domestic sectors. Chart 4 - Net direct investment income of the banking sector - Pink Book 98 basis Outward Direct Investment Income Credits (+ve) Inward Direct Investment Income Debits (+ve) Net Direct Investment Income (Credits +ve) Chart 5 - Contribution of the banking sector to the total direct investment income series Banking Sector Net Direct Investment Income (Credits +) Other Net Direct Investment Income (Credits +) Total Net Direct Investment Income 4

5 Portfolio investment income (Charts 6 & 7) Portfolio income credits received by banks grew very slowly from 1987 until 1991 but then grew rapidly to Correspondingly the debits paid by banks rose rapidly from 1987 until 1989, then fell from 199 until 1993, before rising again to Banks net income on the portfolio investment account from 1987 until 1991 was in deficit net income leaving the United Kingdom as the debits that banks paid on their own portfolio investment liabilities exceeded the income they received on their holdings. This possibly reflected the large amount of high yielding money market instruments they issued over the period with this issuance declining from From 1992 there was a second trend: the rapid growth in income that banks received on their holdings of portfolio investments, which was driven by those institutions that absorbed their securities dealers and other businesses into their banking operations. However, banks portfolio investment income data in this second period also include banks earnings on certain financial derivatives interest rate swaps 7 which increased the size of banks net surplus from their portfolio investments. Their relative impact was greatest in the years 1992 and 1994, where what would have been a modest surplus for this account was augmented by the inclusion of these flows. Between 1995 and 1997 other factors led to an increase in the surplus on this account. Banks began to switch into portfolio investments that would provide higher yields. Chart 7 shows the importance of the contribution of the banking sector to this account, comparing banking sector net credits or debits against the remaining domestic sectors net debits. In the late 198s, the banking sector net deficit was matched by that of the other domestic sectors leading to an overall portfolio income net deficit. From 1992, the growth in the net surplus of the banking sector was only partially countered by the increase in the size of the net deficit of the remaining domestic sectors. Thus the net portfolio investment income deficit in 1989 became an overall net surplus by After 1994 the size of the net deficit contributed by remaining domestic sectors rose. However the banking sector surplus remained fairly constant, leading to a continued but smaller net surplus on the total portfolio income account. In 1997 there was a fall in the net deficit of the remaining domestic sectors, which led to the overall net surplus rising to 2.5bn. One factor which could have driven the growth of portfolio investment flows into the UK was the divergence in yields between the UK and those European economies which were about to enter the single currency this became more pronounced during 1996 and As yields on UK investments were comparatively higher than European yields, so demand for UK securities increased, leading to more issuance, and more interest payments to non-residents. Chart 6 : Net portfolio investment income of the banking sector - Pink Book 98 basis Outward Portfolio Investment Income - Credits Inward Portfolio Investment Income - Debits Net Portfolio Investment Income (Credits +ve) o/w banks' net earnings on Interest Rate Swaps 7 See Monetary and Financial Statistics; January 1999 p. 11 for further discussion about international standards covering the treatment of this item. 5

6 Chart 7 - Contribution of the banking sector to the total portfolio investment income series Banking Sector Net Portfolio Investment Income (Credits +ve) Other Net Portfolio Investment Income (Credits +ve) Total Net Portfolio Investment Income Other income: previously called other investment income (Charts 8, 9 & 1) These data show the income banks have received on their lendings, and income paid on their deposits. In addition, there were associated flows - such as trade finance. The gross flows of the banking sector are very large in absolute terms between 3bn and 6bn in the 199s - compared with the size of gross exports and imports of all goods in 1997 ( 172bn and 184bn). These data are the principal component of the entire investment income account. The credits and debits series have been closely aligned and have similar movements over time. Credits exceeded debits in 1987 and 1988 after which the size of both gross series began to increase with the debits series growing more rapidly than the credits series, leading to a net deficit which amounted to 8.3bn in It should be noted that small percentage fluctuations in the gross flows could have a very significant impact on the measured current balance. From 1992 until 1994, both gross series decreased, with debits falling more rapidly than credits, leading to a reduction in the size of the net deficit. In 1995 both the credits and debits series grew by 8bn. The credits series then remained relatively unchanged but the debits series fell by 3bn over the next two years, which reduced the size of the banking sector other income net deficit to 2.4bn by While there were net income payments to non-residents who deposited or lent funds to the UK banking sector, these funds were available for lending onwards domestically, or to purchase portfolio investments. Two possible causes of this rapid growth in the other income credits and debits series are explored on Chart 9. One factor is that a change in the income series is related to a change in the levels 8 series that underlie them (ie if the size of a deposit doubled, ceteris paribus, the size of the income from that deposit would also double). A second cause is that a change in interest rates are affecting these series if interest rates rise a borrower would have to make higher interest payments on their outstanding loans. Chart 1 gives a better indication of how the change in the size of the banking sector net deficit affected the other income account. From 1992 both the banking sector and the remaining domestic sectors recorded a net deficit. The banking sector initially drove the performance of the other income account. However as the net deficit of the banking sector narrowed after 1995, so the remaining domestic sectors began to play an increasingly important role. By 1997, the net deficit of these sectors exceeded that of the banking sector. 8 For more detailed analysis of these trends, refer to the February 1999 Bank of England Quarterly Bulletin article The external balance sheet of the United Kingdom: recent developments pp

7 Chart 8 - Net other incom e of the banking sector - Pink Book 98 basis Other Income Credits (+ve) O ther Incom e D ebits (C redits +ve) Net Other Income (Credits +ve) Chart 9 : Reasons for the g rowth in banks other income 1 9 lhs - Assets and Liabilties rhs - Income mn Y ear Other Investm ent - Banks' Assets (lhs) Other Investment - Banks' Liabilities (lhs) Other Investment Income Credits (rhs) Other Investment Income - Debits (rhs) UK Base Interest Rate (% x 3 on rhs) [dashed line] Chart 1 - Contribution of the banking sector to the total other income series Banking Sector Net Other Income (Credits +) Other Net Other Income (Credits +) Total Net Other Income 7

8 Contribution of the banking sector to the total income account (Chart 11) The banking sector s various contributions to the separate income accounts have been described above. Chart 11 summarises these contributions. The income accounts include two other smaller accounts, compensation of employees, and earnings on reserve assets, to which banks do not contribute. The banking sector net deficit was broadly offset from 1987 until 1993 by the remaining domestic sectors net surplus. As the banking sector deficit increased in 199 and 1991, due to increasing portfolio and other income deficits, this was only partially offset by an increase in the net surplus of the remaining domestic sectors. This lead to a net deficit on the income account for the only time in this period. From 1994, while the remaining domestic sectors continued to provide a net surplus to the overall income account balance, the banking sector also provided a net surplus thus driving the overall surplus still higher. This Chart shows the growing importance of the income account to the United Kingdom, contributing a net surplus of 12.2bn to the economy in Chart 11 - Contribution of the banking sector to the total income account Banking sector total income Other total Income Total income 8