EEF blog

This week the Prime Minister – with several cabinet ministers and business representatives – went on a trade mission to India, with the hope of developing a new ‘special relationship’. This is part of a drive to promote exports following on from the Emergency Budget. It is clear that the UK will no longer be able to rely on government spending for growth: the OBR’s growth forecasts are dependent on business investment and exports picking up.

In light of the impending austerity measures hitting most of the UK’s main export market in Europe, and the likelihood of continuing suppressed demand in the US, it is only natural that the government has looked to India – with its economy forecast to grow by 8.2% this year – as somewhere to grow the UK’s exports.

In fact, India’s trade relationship with the UK is already worth £11.5bn per year, and announcements made during the trade mission have highlighted a £700m agreement between BAE Systems, Rolls Royce and Hindustan Aeronautics Limited to supply 57 Hawk Trainer Jets to India.

Despite all this, these figures must be put into context. This year to May, India has only accounted for 1.6% of the UK’s export market. As George Osborne has noted, the UK currently sells more to Ireland than it does to Brazil, Russia, India and China combined. As the Chancellor is aware, these markets are those with some of the greatest growth potential in the coming years.

Figure 1: Percentage of exports (by volume) to the UK's main trading partners

Source: HMRC 2010

Positively, in the five years between 2004 and 2009 the proportion of UK exports going to India more than doubled (it was only 0.7% in 2004). In addition there are several factors which count in favour of a strong trading relationship between the two countries.

India is already the biggest investor in Britain after the US, and Tata – an Indian company – is Britain’s largest manufacturer. Additionally, the two countries have a shared language which makes trading relationships simpler.

But increasing India’s demand for UK exports will not be an easy ride. Those markets where the UK has most to offer India – such as retail and banking – are burdened with significant barriers to entry for foreign companies. In addition, the UK will not be the only country looking to export to the high-growth nation. However, the UK’s Engineering and infrastructure development skills could become highly exportable to a growing, developing country.

Whatever the case, it is unlikely that exports to India alone will be enough to drive the UK’s growth. But it could be a move in the right direction. 

Probably everyone's had a chance to pore over the Committee of European Banking Supervisors' (CEBS') concise(!) summary of the European bank stress tests. But in case you missed it, here's a few thoughts from me.

Great news on Q2 GDP, manufacturing is right at the heart of a building UK recovery. While politicians from both sides are claiming credit for the result, commentators have been quick to hose down expectations, suggesting this may be as good as it gets this year at least.

Before we get carried away we should cast an eye over what's coming over the horizon. Felicity's noted the difficulty of government spending sustaining any support to the recovery - both directly and as a customer for the construction sector (a particular boost to today's figures). There's also a lot of uncertainty coming from our European neighbours. So the second half outlook and beyond is a lot more patchy.

European bank stress tests out tonight could be a key one for further developing a view on European sovereign debt risks. One scenario examined includes some kind of additional sovereign debt shock - the test results may say something about banks' exposure to this kind of risk. Chat on the radio this morning said the tests - and reporting of their results - were a tough one to get right; if the tests fail too many banks, there could be a panic but not enough and they'll be seen as not credible.

So the GDP figures for Q2 are out. And we’re surprised. Growth of 1.1% over the quarter is significant, and well above consensus expectations of 0.6%. Admittedly these are provisional figures, and subject to change, but this looks like great news for the economy.

Except… a quick look at where growth has come from: Construction; Business Services and Finance; and government spending. With recent cuts to capital budgets including Building Schools for the Future, and the dramatic planned cuts in government spending it’s difficult to see how this growth can be sustained.

On a positive note, manufacturing is also growing, which is great news. Hopefully this growth will help cushion industry against an uncertain global recovery.

The minutes from the most recent Monetary Policy Committe (MPC) meeting makes for interesting reading - and not just for egg-head economists like me, but for consumers and businesses as well.

Why should non-economist types care?

Well, whenever monetary policy is involved, it comes down to two things: prices and interest rates.

Where prices are headed matter for household budgets that are going to be stretched in the coming months and years and taxes go up and public spending (and jobs) are cut. Interest rates matter to home owners - for many, mortgage interest payments will have fallen over the last 18 months, providing a nice cushion as incomes stagnated or fell. Others will be wary of buying homes because they expect interest rates to go up - which may keep house prices and home building on hold for some time to come.

For businesses it's about credit conditions.

Troubles in Europe have rocked financial markets and made it costlier for banks to access the capital they need to underpin lending here in the UK. Market volatility and uncertain has pushed the pound around - volatility that makes manufacturers catious about pushing into new export markets. And prices matter too, as rising imported input and raw materials costs could undermine competitiveness, even as markets rebound.

So why the interest in the MPC?

Well, the MPC is split on where they think the economy is. Some, like the Governor Mervyn King, think that economy has enough room to expand (called spare capacity by us boffins) to stamp out any inflationary pressures.

A second, cautious camp is concerned about rising inflation expectations - because prices have been rising, people come to expect them to continue to rise, which in turn pushes prices up, either through higher wage demands or through stronger demand or by passing costs on to customers.

A third (and small group of one) want to start raising rates now beacuse of the risks that inflation would continue to persist far above the 2% target.

For businesses and households, the prospect of either future (and sooner) rate rises or further inflationary pressure comes down to a key call on the economy: is there spare capacity in the economy (in businesses and in the labour market) to let the economy expand and grow without creating problems for inflation.

Like much in economics, there's unfortnately no single definition or measure of spare capacity. For economists, it comes down to your view of the world and what you hear from businesses.

What we're hearing is a worrying word - shortages.

Shortages - in skills and in raw materials - implies little or no spare capacity. And that puts us in the middle cautious camp. Inflation's has proved a persistent problem despite a series of temporary price pressures. But while fiscal consolidation remains on tough track, the MPC should still be worried about the health of the recovery.

That means keeping rates and QE on hold for now, but raises the prospects of interest rates going up sooner rather than later.

Today, the government launched the Office of Tax Simplification to help reduce the growing complexity of the UK's tax regime.

The OTS will do what it says on the tin - simplify the tax system - by looking at two key areas.

First, it'll conduct a wholesale review of small business taxation - including tackling the tricky IR35 that allows people to set up their own companies inorder to minimise NI contributions and income tax, while paying themselves in dividends. But hopefully it will also look at how to tax smaller businesses on a cash flow basis - something that would strip out enourmous amounts of complexity.

Second, the OTS will take a good hard look at the 400 plus reliefs and allowanes that permeate the tax system. The OTS will be looking to scrap obscure, anachronistic or narrow reliefs in an effort to make a modest beginning in paring back the masses of tax law.

The OTS is a good innovation - given the need to improve the competitiveness and predictability of our tax system, the OTS is likely to have a really important role in simplifying the vast stock of complex tax code.

By focusing first on small businesses, the OTS has an opportunity to strip away the administrative and compliance burdens they currently face.

The key test will be the OTS’s ability to work effectively with business to make substantial and visible progress in reducing complexity and enhancing competitiveness.

But more importantly, the OTS should ensure that simplification isn't an ends, but a means to improving the competitiveness and predictibility of the tax system.

Cynics might question the value of yet another independent 'Office' based out of the Treasury. Business will be hoping that the OTS gets to work as soon as possible.

As if the government didn't have enough on its plate with the economy, there is another area crying out for decisive leadership - energy policy. The UK faces an unprecedented combination of energy challenges over the next decade. 

Chief amongst them are replacing a significant proportion of our energy infrastructure, managing the risks associated with increasing reliance on imported natural gas and making dramatic cuts in carbon emissions.

To meet these challenges we will need hundreds billions of pounds worth of investment in a wide range of infrastructure and technologies, from upgrades to the grid and new gas storage facilities to renewable energy and nuclear power. And government has a crucial role to play - ensuring that the UK is an attractive place to invest and safeguarding the interests of energy consumers, who will ultimately pick up the sizeable bill. 

Unfortunately the energy policy inherited from the last government is no longer fit for purpose. It was forged in an era when the UK was self-sufficient in fossil fuels, had a lavish margin of spare power generation capacity and more benign economic times meant the cost of subsidising renewable energy was subjected to limited scrutiny. A new strategic direction is needed based on setting clearer responsibilities for long-term energy security and a more flexible approach to meeting environmental objectives in which the focus is on cutting emissions rather than setting arbitrary technology-specific targets.  

The government will need to move quickly. The regulator believes that the timescales required to secure finance, mobilise supply chains and deliver infrastructure mean that the energy industry will start making far-reaching and long-lasting investment decisions within the next couple of years. This leaves a very limited window of opportunity to implement new policies and institute market reforms in time to influence its decisions.

Energy is not an esoteric area of interest and importance only to technocrats in their ivory towers. Getting energy policy right matters.   It is integral to most aspects of modern life from transport and communications to the lighting, heating and cooling of our buildings.   It is also important to manufacturing and, by extension, the government's aspiration to rebalance the economy. For many manufacturers considering where to invest as the economy recovers, the security and competitiveness of energy supplies will be an important factor.  

The need for strong and decisive leadership on energy is why EEF published its "Energy Action" yesterday. In this document we set out the key actions we believe the government needs to take, and by when, to get energy policy back on track.