EEF blog

Reading all the commentary on the latest Irish sovereign debt crisis there’s a lot of wise words being bandied around the UK about why Ireland should never have joined the euro. Like Greece earlier in the year some even darkly foretell that Ireland may eventually have to leave the monetary union to resolve its economic malaise.

There’s three questions that come to mind in response to these views:
• Is the currency union to blame?
• Is it realistic for Ireland to pull out of the euro?
• What’s the impact of the eurozone stress on the UK and in particular our exporters to places like Ireland?

On the first, most commentators agree that Ireland enjoyed a sustained real economy boost before succumbing to a debt-fuelled property boom. Currency union kept interest rates down from what they otherwise might have been. This exacerbated the debt binge – but it’s at least questionable whether it caused it. And although export growth tapered off at around this time, Ireland has remained consistently and massively in trade surplus.

Similarly New Zealand has its own currency but it also had large increases in private debt fuelled by cheap credit at the same time. But in New Zealand’s case the monetary authority tightened the interest rate screws to dampen the inflation it saw in housing prices, loans were made more expensive but still the bubble continued. And by having higher interest rates the exchange rate jumped up as investors and then speculators piled into the Kiwi. New Zealand’s export sector was badly squeezed and NZ has consistently been in trade deficit. The level and volatility of the exchange rate is consistently cited as an issue for NZ exporters.

Similarly the UK has its own currency, so the vicious euro hasn’t wreaked its havoc here either. But just like Ireland and NZ, private debt in the UK soared during the credit boom. And just like Ireland, major banks in the UK have failed. Surely not to the same extent but Robert Peston points out the difference is one of scale not kind.

This is not to say that joining the euro was a great idea; it may be just as many are saying that it was a bad call and that if Ireland wasn't in the euro now, everything would be rosy. But clearly it's more complicated than simply having the euro = bad/not having the euro = good. There are costs and benefits of both options and the debate at the moment is a bit revisionist and one-sided.

I think that the banking sector is a much more significant factor than the currency union for explaining the current mess. The bad loans in the Irish banks represent a failure of regulation of the financial sector. Ireland has the misfortune of being more exposed than most and the Irish Government guaranteeing all the Irish banks’ debts.

So what now? Should Ireland dump the euro, restore the punt and devalue its way to prosperity? A recent BBC article showed the fallacy in this logic. If Ireland dumps the euro and looks to devalue its new currency immediately, the value of its euro-dominated debt will go through the roof. This greatly heightens the chance of default and, anticipating this, investors rapidly withdraw their capital from Ireland before the cross-over to the new currency. That would make a bad situation worse.

What does all this mean for the UK can be boiled down to impacts on demand for our exports and systemic impacts on our financial system.
The Govt’s attitude so far is illustrated by its willingness to participate in the ‘bailout’ of Ireland. But many of Mr Osborne’s Conservative colleagues have questioned why the UK is helping.

Both Cameron and Osborne have stressed the national interest angle, the interlacing of the economies etc. But what if another bailout is needed or, more likely to involve the UK perhaps, the EFSF proves insufficient faced with multiple bailouts. Where then does the interest lie?

The stability growth of the eurozone matters for UK exporters. It matters directly; without it demand for our exports will be lower as eurozone consumers confidence and consumption dips. Even in its parlous state, Ireland still accounts for 6% of UK exports and perhaps more surprisingly, since the end of the recession, Ireland has accounted for 4% of UK export growth.

A similar calculus is possible with other eurozone countries, such as Portgual, supposedly next in line. Although Portugal makes up a much smaller proportion of UK exports, its share of UK export growth, since the end of the recession, exceeds 1%, which is not trivial.

And the more bail outs there are, the more the systemic health of the banking system comes into considerations. I don’t think it’s beyond possibility that it could be in UK banks’ (and via their lending to businesses, the economy’s) interests to support further bailouts, or a replenishing of the EFSF, if the situation became severe enough. The involvement of the IMF in the bailouts already suggests the importance of these issues is wider than just Europe or the eurozone.

Today we've published our latest Access to Credit survey.

There's some good news: over the past quarter the proportion of companies reporting an increase in fees and interest rates on new or existing credit facilities has fallen.

The fact that fewer companies are seeing the costs of lending increase is good news for industry. But the the percentage of companies who actually saw their costs fall remains low.

Figure 1: Percentage of companies reporting a change in credit conditions in the last two months (click on image to enlarge)

Accessing finance is one of the biggest challenges currently facing manufacturers. This means that despite this quarter's improvement in credit conditions there is no room for complacency on this issue. Recent moves towards an agreement between banks, the government, and industry must therefore now be taken forward with action. Ways to improve access to finance include: greater competition between banks; alternatives to equity finance, such as mezzanine finance; and a restructuring of government-backed schemes into a single access portal.

Rebalancing is about achieving two things: internal balance (a balance between consumption and investment); and external balance (a balance between exports and imports). Today’s GDP and investment figures allow us to look a little closer at which way the scales of economic balance are tipping: 

Investment:
It seems progress towards an internal balance stalled a little in 2010q3: business investment fell by 0.2% over the third quarter. However, business investment was 2.6% higher than in the same quarter a year ago. A similar picture can be seen for manufacturing: although investment fell by 2.0% over the quarter it is 1.0% higher than in the third quarter of 2009.

Trade:
There is some good news on the external balance: the contribution to growth of net exports was 0.4%, which is an improvement on the last quarter, when net trade had no impact on growth, and the three earlier quarters when net trade had a negative impact on growth.

I wrote last week about the GIB and possibilities for removing it from the public sector balance sheet if the Government found that unpalatable.

I was trying to stress the importance of scale and why establishing an institution that could leverage additional funding from capital markets may be important if the GIB is to achieve the quantity of investments being discussed.

To maximise its leverage of such sources, the GIB needs to be adequately capitalised. The Government’s £1 billion is too little but realistically it can’t put in much more (asset sales excepted) in its current fiscal position. The bond holding I discussed last week was about funds for investment. So how could we attract private equity in to capitalise the GIB to allow this leverage in the first place?

The problem is that the GIB is not going to generate a high enough return, at least initially. Private equity investors will be put off by having to wait 10-20 years for a decent return, rightly suspicious that the Government will encourage low, no, or negative profits to support its public policy aims.

That’s where bribery or force might have to come in. How could the government encourage or coerce private investors to provide equity to get the GIB capitalised?
The GIB Commission discussed possible compulsory siphoning off of parts of the Bank Levy or auction proceeds from emission permits. But really this is just another way of increasing Government expenditure on the GIB as this funding is currently destined for the consolidated fund. What’s more it would potentially be inefficient if the hypothecation is ‘hard’ i.e. spending is actually determined by the fluctuating flow of the revenue.

Another way could be to provide a tax rebate inversely related to the regulated price of carbon.

For the private sector to properly incorporate climate change considerations into its decision-making the externality needs to be fully internalised, all gases, all sectors. To smooth the costs of adjustment, maintain UK competitiveness, and for straight out political expediency the Government may understandably not wish to jump to this solution either right away or unilaterally.
So the Government could estimate the difference between the price they put on carbon and the higher average cost of abatement if all gases and sectors were included. This difference could then be used to calculate a rebate for equity investments in the green bank.

As the climate regime strengthened and extended, approaching the ideal, the case for government support for green investment would become progressively weaker. Thus the tax rebate would reduce, approaching zero as the cost of carbon becomes fully internalised in the economy.

So, for example if there was a carbon tax of £5/tonne CO2e and the estimated all gases, all sectors average abatement cost was £10/tonne, then the cost is 50% internalised. Equity investors in the GIB would then be eligible to make 50% of their investment tax deductible. This would be an immediate and sizeable return for investors that might encourage them to contemplate on what may seem an otherwise long and risky proposition.

Unfortunately this re-emphasises the symbiosis already event between a coherent climate and energy policy and the GIB. The tangle of different Government regulations and taxes striking at a price on carbon is complex, too complex to calculate a single price and create a rebate scheme as described above.

The Government needs to consolidate this landscape into a consistent and predictable carbon price. This is essential not just for contemplating back of the envelope schemes like I've just outlined but, much more fundamentally, to reduce and eventually eliminate the regulatory/political uncertainty which is the real barrier to major green investment. Without action here the GIB will not succeed.

How well prepared are UK manufacturers for the next challenge of turning their investments in productivity and competitiveness over the past decade into transformational growth in the next?

To answer this question and to understand the current state of British industry, our new report - The Shape of British Industry - Growing from strong foundations - draws on a survey of 300 manufacturers as well as in-depth discussions with dozens of businesses.

What comes out is a picture of an industry starting from strength, but cautious about growth. Having weathered the recession, UK manufacturing emerges as an innovative, diverse and globally engaged sector. Firms have continued to boost productivity and competitiveness, even if they have struggled to deliver profits or meet their ambitions. According to our new report there's both good and bad news.

Chart 1 - SMEs less likely to turn productivity boost into profits or growth
% balance with increase in productivity, profits and meeting growth objectives

There is, however, one striking feature: the UK, has relatively fewer large manufacturers – those employing more than 250 people – than our closest competitors.

Chart 2 - UK has relatively fewer larger manufacturers,
Number of manufcturers with 250+ employees (US figure is for firms with 500+ employees), and large companies as % of total manufacturers

The twin dynamics that could drive growth in manufacturing are large companies creating markets for a dynamic, diverse supply chain and innovative, agile suppliers attracting large, mobile multinationals to the UK. The danger for manufacturing and the economy is that the lack of larger companies could slow this dynamic, leading to a hollowing out of supply chains and placing a cap on future growth

After a deep recession in which the economy shrunk by 6%, a manufacturing-led recovery has helped drive a year of good economic news. Exports to developing economies are booming and the private sector is slowly creating jobs again. But with public sector cuts looming and a currency war threatening to derail the global economy, we cannot take this growth for granted.

Generating long-term, sustainable growth will require the private sector and government to work together to build on the strengths of sectors – such as manufacturing – that are essential to tackling our future challenges, such as global security, demographic change and climate change. Government, therefore, has a big part to play in providing the right framework that will support and catalyse private sector investment and business growth.

As the Prime Minister stated in his speech on growth, this will mean more than government getting out of the way.

Instead it will need to be clear about what its role is in generating and supporting growth.

The previous government’s preferred approach was overly focused on industrial champions. The current government’s attention to start-ups and young businesses is helpful, but is in danger of swinging too far in the opposite direction.

Yet growth is not a big or small issue. It is about providing sufficient demand to sustain a dynamic and diverse supply network. It is about big businesses with the capacity to drive innovation and productivity down supply chains. And it is about growing bigger businesses with the scale and muscle to invest in tackling our long-term economic challenges.

Prior to the recession, manufacturers’ investments in innovation, their collaboration and their agility were paying dividends. But knocked off their plans for growth during the recession, many companies are now justifiably cautious about investing in growth until they gain greater certainty over the economic and business environment.

Growing more, larger manufacturers is, in part, about continuing to attract new ones to the UK. But it is also about ensuring small and medium-sized manufacturers overcome barriers that constrain them.

The limited availability of affordable finance traps some young and small companies in a Catch-22: unable to get the necessary finance, their ability to plan for growth is constrained, yet unable to demonstrate clear ambitions for growth, some firms find it difficult to get the appropriate finance. If they do manage to grow, these firms would be caught in the thicket of tax and red tape that helps make mid-sized cautious about planning to become truly global in scale.

Chart 13 Tax and regulation are major concerns for mid-size firms
% balance of companies citing UK strengths by company size

The Prime Minister has challenged industry to commit “to create and innovate; to invest and grow; to develop and break boundaries”.

This report shows that manufacturers are already rising to the challenge, but it also sets out where both manufacturers as well as government must make better progress if we are to grow a generation of bigger manufacturers.

Maintaining momentum behind the recovery is crucial. But not all economic growth is equal: imbalanced and unsustainable growth can leave a terrible legacy, as the recent financial crisis and recession have shown.

To ensure our economy can pay its own way in the future, the UK does not need a handful of bigger manufacturers, we need hundreds of them.

As we blogged about back in September, over the last decade productivity in manufacturing has grown at nearly double the rate of the whole economy.

In fact, in the five years between 2002 and 2007 manufacturing productivity consistently grew at around 5% a year, roughly in line with growth rates in the US.

Figure 1: Average annualised productivity growth, 2002 – 2007
 

Since the recession ended manufacturing productivity growth has been even more impressive. In the last year productivity grew by 7.9%, compared with 2.0% in the economy as a whole.

We should be ambitious about the contribution manufacturing can make to the economy.

Companies used the recession as an opportunity to boost their productivity. Now is the time to build on this. As EEF’s State of British Industry report (to be released on Monday) will show, the challenge now is capitalising on this productivity growth to drive transformational growth in the next decade.

The government is expected to release its growth strategy on Monday. The government must take this opportunity to provide the kind of framework that will support and catalyse growth in manufacturing.

The Spending Review announced £1 billion of Government funding plus ‘significant’ proceeds from the sale of assets to capitalise the Green Investment Bank (GIB). Details as to how the GIB will work are to be announced in the Spring. By itself this ain’t going to be enough.

Ernst and Young estimate the GIB would need to be capitalised to the tune of £4-6 billion to 2015 to meet the UK’s climate and energy goals. To be sure, funding alone won’t be enough from the Government in the absence of a coherent and stable climate and energy policy regime.

Forget about £ for capitalisation, the GIB’s funding issues appear even more fundamental. The £4-6 billion is supposed to help unlock investment of £250-450 billion to 2025, compared with a current expectation of only £50-80 billion. Where’s the extra money going to come from? Realistically it has to be the private sector. The Government’s modest £1 billion (so far) reflects the steep challenge of bringing the public finances under control. Fair enough.

So, private sources: Bonds, deposits, potentially equity to support the GIB; plus direct debt or equity through co-financing. The GIB Commission, which published its report in July, discusses most of these. Let’s look at just one – bonds. The GIBC suggested that issuing bonds was the major way the GIB could draw in funding from major institutional investors like pension funds or insurance companies – perhaps the majority.

But issuing bonds means in addition to holding assets, the GIB would also have liabilities – just like a real bank. Majority ownership along with any Government conditions of control on the GIB would indicate the Government controls ‘general corporate policy’. The problem is that these liabilities will then be counted in Public Sector Net Debt (PSND), which the Government is publicly committed to have falling by 2015/16. PSND is defined as financial liabilities less liquid assets.

The GIBC is at least partly alive to the issue, noting that all the GIB’s investment decisions would be made independently from the Government. Unfortunately, with majority ownership, that is unlikely to be enough.

There are ways around this. The Government could pledge to sell a majority of its shares by the end of the Parliament (thus not hurting its debt goals). The problem with this is that the GIB might be a couple of years away from investing, longer before it issues bonds, and much longer still until investment returns that might attract private buyers starting rolling in.

Another idea would be to devolve the Government’s shareholding to individual taxpayers, again by the end of the Parliament, perhaps with a further restriction of say 5 years on on-selling. This ‘green shareholding’ could even help build popular enthusiasm for the GIB.

A third idea could be setting the GIB up to only issue third-party guarantees, much in the way the Government does currently with the Enterprise Finance Guarantee (EFG). To my knowledge, EFG-backed loans do not add to Public Sector Net Debt (PSND). Rather only the expected cost of the guarantees shows up, as government expenditure, which in excess of revenue leads to the flow of Public Sector Net Borrowing (PSNB). Only this small flow, not the whole value of loans, adds to the stock of PSND. PSNB is defined as the difference between total expenditure and receipts or equivalently the change in net financial liabilities.

The question remains though, whether dropping majority ownership will be enough to lose the GIB from the Government’s accounts, or, in the case of the guarantee option whether the GIB will be able to meet its mission. That’s because the Government wants the GIB to pursue an ambitious, largely public (at least for now), aim – financing green investments with sub-market risk-return profiles.

Could the Government force the GIB to retain this mission without a majority ownership and without falling within the definition of influencing ‘general corporate policy’?

And if the Government gave guarantees only, will that allow enough green investment? It might make finance for green investments available that isn’t there currently – but perhaps at a price that chokes off demand for such finance.

If all these fixes fail or are unacceptable to the Government e.g. because it doesn’t want to do things ‘off balance sheet’ – what then? It seems to me that keeping the GIB in the public sector, even if it issues bonds, will cause a hit on PSND – but it’s much less clear what the impact will be on PSNB. That’s because at the same time as creating financial liabilities (bonds) it would be creating financial assets (giving out loans and guarantees).

The Government’s major fiscal goal is to eliminate the structural fiscal deficit (the structural element of PSNB) over the course of the Parliament. For PSND, the goal is only that this will be falling by 2015/16. Given the PSND hit would likely come before 2015/16, this should still be achievable.

Whatever option the Government ultimately goes for it needs to keep in mind the scale of the investment challenge it is trying to address.

A currency war is on hold – though it depends on the performance of the US Economy

 “The prospect of a full blown trade war is unlikely; it benefits nobody” … “it is not in China's interest to provoke the US”
World_First

Additionally, currency intervention… “May go off US agenda if QE2 works/economy grows” … “I suspect that a war will be averted”
JeffreyPeel

“The G20 is split - Washington consensus is dead. But sanity may prevail. No-one really wants no-win #cwars or #fx wars”
JeffreyPeel

Chinese currency depreciation is not win-win

JohnPullin asked “What will be effects on scarcity of raw materials including strategic metals?”

“that is defintely one of the aces up China's sleeve and should we see supply concerns come to the fore then the pressure will rise”
World_First

“If the West achieves its objectives re. Chinese revaluation may mean more expensive input costs”… “may be good for US steel and other traded goods though - China hasn't all aces”
JeffreyPeel

For UK manufacturers the largest impact of currency wars is likely to be price volatility

We asked whether the UK would “be collateral damage from fx volatility?”

“you have a point. To an extent it depends how much the Chinese are prepared to pump-prime and how much US resists”
JeffreyPeel

“we are advising manufacturing clients to hedge at these GBP levels to negate volatility and lock in profit”
World_First

Or, as we put it on twitter: "currency war is on hold as QE2 gets going & eurozone distracts markets. But..." "QE2 could go down like the Titanic if it hits China's raw materials iceberg." "So for now, UK manufacturers have little to worry about, except maybe protecting themselves from #fx volatility."