Our forecast for the current account balance is constructed in a bottom-up way by forecasting its main component balances that cover cross-border flows of: trade in goods and services, investment income, transfers, and employee income.
The balance of nominal exports and nominal imports.
The balance of the income the UK generates on its overseas investments and the income it pays overseas investors who own UK-based assets.
The balance of various transfers to and from abroad.
The balance of employee compensation from abroad and employee income due abroad.
The trade balance is equal to the value of exports less the value of imports – covering both goods and services. Our forecasts for the value of exports and imports are built up by combining our forecasts for real exports and imports with our forecasts for the export and import deflators (measures of the price of exports and imports). The ratio of the export deflator to the import deflator is known as the ‘terms of trade’ – an indicator of how much a country can afford to import by selling a given volume of exports.
Income account balance
The income account balance is equal to the credits the UK generates on its overseas investments (‘assets’), less the debits it pays overseas investors who own UK-based assets (‘liabilities’). In order to construct these forecasts, we split both assets and liabilities into four groups:
- foreign direct investment (FDI)
- ‘other’ investment, including bank loans
Our approach to forecasting both credits and debits for these items involves two steps. We forecast the stock of each group of assets and liabilities and we forecast the associated average rate of return (calculated as the income flow divided by the stock). Taken together, these elements provide a forecast for the income credits from UK assets abroad and the income debits from UK-based assets held by overseas investors.
The change in the value of the stocks of assets and liabilities reflects both re-valuation effects and the net acquisition of those assets and liabilities. Our forecasts for revaluations include the effect of exchange rate movements on each of the four groups of assets and liabilities included in our income account forecast. For equities we also incorporate the effects of changes in world and domestic equity prices. The net acquisition of assets and liabilities is forecast using a number of behavioural equations in our macroeconomic model. These are typically linked to our forecasts for other balance sheet variables in the economic forecast. For example, UK holdings of foreign equities are partly determined by our forecast of households’ acquisition of equity, while holdings of debt are related to households’ acquisition of pension and insurance assets.
Rates of return
Forecasts for the rates of return on each group of assets and liabilities are informed by a number of factors. Rates of return on FDI are very difficult to model, so we draw on factors including the outlook for domestic profit margins, relative growth prospects in the UK and overseas, historical trends in relative rates of return and any specific factors, such as fines that UK-based firms pay in other countries (e.g. UK-based financial institutions paying fines in the US). Rates of return on equities are informed by our forecast for domestic equity returns (dividends relative to the stock of equity) and our assumptions about world equity prices. Rates of return on bonds are informed by our assumptions about domestic and world interest rates. Rates of return on ‘other’ assets and liabilities are generally modelled using a combination of domestic and world short-term interest rates, since most of these ‘other’ assets and liabilities are loans between financial institutions that typically pay these interest rates.
The UK makes and receives various transfers to and from international organisations. Our forecasts for these transfers are largely derived as part of our forecast for the public finances.
The employee income balance is a relatively small component of the current account and is equal to employee compensation from abroad less employee income due abroad. Employee compensation from abroad is assumed to grow in line with GDP growth in our major trading partners, while employee income due abroad is assumed to grow in line with UK compensation of employees.