EEF blog

The UK commentariat has been wringing its hands about growth prospects following Tuesday’s poor first estimate for 2010q4 GDP (0.5% contraction). Perhaps it’s time to ease up on ‘the cuts’ and get jobs and growth going, the line goes – as if they are somehow perfect substitutes. S&P’s downgrade of Japan’s sovereign credit risk, noting the country ‘lacked a coherent strategy’ to manage down its debts, should be a reminder that even major economies cannot postpone putting their fiscal houses in order.

True, Japan’s forecast overall public debt level (110-200% of GDP depending on whether pension funds are included) is much higher than the UK’s (60.8% of GDP). But on the other hand its 2010/11 fiscal deficit is slightly less at 9.1% v our 10.0%. And for 2010 at least, Japan’s growth performance is actually forecast to be far superior to the UK’s at 4.3% v 1.7% (though further out Japan slips behind us and they also suffered a worse recession in 2009).

How much confidence do you think the markets gained on Japan’s fiscal plans when PM Naoto Kan’s response to a question on the downgrade was “I just came out of parliament and wasn’t aware, so please ask me about it later.”

If you’re thinking not much, you could be forgiven for drawing parallel’s to the Chancellor’s equally facile response to the UK’s GDP numbers.

“We will not be blown off course by bad weather,” said Osborne...except as many others have pointed out removing the estimated -0.5pp impact of the snow (which itself seems very large to me) doesn’t even get you back to the lowest forecast from economists prior to the announcement (0.2% overall growth).

And the UK wasn’t alone in facing terrible December weather. Faisal Islam has highlighted this week Germany’s continuing growth despite running out of grit and facing snow disruption, like Britain. Even if you swallow the snow story, why should that be an acceptable explanation? Isn’t it shocking that the snow can dent the UK economy so considerably – and following three cold winters in a row and an inability to stop the white stuff falling down again at some point – shouldn’t we be worried about it? So whether it was or wasn't 'just' the weather the government's response looks too weak to me.

The bottom line is that the starkness from lacking fiscal credibility is real and a lack of a credible plan has real costs. The Japanese will now pay more for their sovereign debt - and that means more in the way of cuts to real spending to get the deficit and debt back under control - not a situation we want to face.

But the government’s responsibilities don’t start and end with balancing the budget.

We need credibility on economic policy too. How are we going to generate the growth we need to not only offset the impact of fiscal austerity and but allow Britain to compete in the post financial-crisis world? So far the government doesn’t seem to have much of a story to tell. How are we going to boost innovation, start finance flowing properly to business, and enhance the business environment? How are we going to get unemployment down, just as the public sector prepares to lay off hundreds of thousands of workers? And how are we going to do all that with no public money to use?

A bad quarter’s data doesn’t mean it’s time to panic and throw away the fiscal plan. It would be folly to sacrifice our fiscal credibility as Japan should highlight. But it should be a kick in the pants for Osborne and co to get serious about growth and the economic credibility of the UK. There's a lot riding now on Budget 2011's Growth Review.

Today’s GDP figure, showed the economy contracted 0.5% compared with last quarter’s growth of 0.7%.

This is clearly not good news. However, following a recession, growth rates tend to be a bit bumpy. In the few years following the recession in the 1980s quarterly growth rates oscillated between -0.7% and 1.5%.

Up until Q3 growth coming out of the recession was faster than in the 1980s or 1990s. GDP is now 2.2% higher than it was at the end of the recession – weaker than in the 1980s – though stronger than the 1990s when this figure was 0.5%.

Figure 1: GDP index (first quarter post-recession = 100)

The sharp fall in activity should serve as a stark warning that growth and the recovery cannot be taken for granted.

But what we can see is that, manufacturing is growing. In fact, it grew by 1.4% over the quarter. Recent survey data (including the PMI, which reached a 16-year high) shows that strong growth rates look likely to continue. But, manufacturers – as with the rest of the economy – face a challenging 2011.

The pressure is now on the government for a decisive outcome from its growth review. The government needs to deliver concrete proposals to support sustainable, balanced growth through 2011.
 

Today the Department for Business is bringing together a large delegation of businesses and representative bodies, including EEF, to discuss what actions the government needs to take to support growth in manufacturing.  This is a key strand of the government's new approach to developing its policy agenda for growth over the course of this parliament. 

This is no small task - the challenge for government is to develop and implement a strategy for better balanced growth that not only steers our economy through the near term challenges, but also prepares the ground for sustainable growth in the long run.  With government relying more heavily than ever on the private sector to deliver growth, it needs to think more like the private sector as it puts together its policy agenda for growth. 

So if business were running the growth review how might it approach the task?

1. Leading from the front.  Firstly the CEO would take ownership, show leadership and ensure all his top team were pulling in the same direction.  The CEO would instil a culture change with all parts of the business focused on the growth objectives and their role in achieving it. 
   
2. Long-term vision.  The starting point is a clear sense of direction; a vision that sets out the company's ambitions for the next five years and good understanding of what the company is trying to achieve and clearly identified growth opportunities.
   
3. Invest.  Clearly defined growth objectives will drive investment in the parts of the business that can capitalise on those opportunities and drive growth.  Inevitably, this will go hand in hand with decisions on where to reduce costs and refocus efforts.
   
4. Engage the supply chain.  Recognising that supply chains are only as strong as their weakest link, business will communicates strategy and opportunities through the supply chain.  Success will depend on the supply chain investing and innovating alongside.
   
5. Never be satisfied.  Business recognise that there is no such thing as sustainable competitive advantage - achieving the vision requires continual evaluation of decisions - both the company's and what competitors and customers are doing. 

So, against the approach the private sector might take the government's record to date is encouraging.  It is thinking differently with cabinet-level engagement in the review.   There are also the makings of a shared objective in achieving economic growth that is more balanced across the country and between industries - although there hasn't always been consistency about what this will look like in practice. 

The initial engagement that is taking place today is also a good start, but this will need to be maintained if the private sector - those companies that will be central to driving growth - have the confidence to invest and grow.  But finally, government needs to cement this process - make it part of the government's DNA, not just in this parliament, but beyond. 

Data released today showed CPI annual inflation hit 3.7% in the year to December, well above the Bank of England’s target rate of 2.0%. But it is not so much current inflation, as prospects for future inflation, that will be worrying the Bank.

There are certainly cost pressures in manufacturing: input prices are well and truly on the up. As we noted last week, commodity prices are putting pressure on firms. The Producer Price Index revealed that average input prices for manufactured goods rose 12.5% in the year to December. Oil prices accounted for a fair proportion of this rise, but imported metals prices were also up significantly, by 24.2% over the year. Even excluding more erratic items, costs were up by 8.8%.

Output prices are also rising, though they have failed to keep pace with input prices: the average output price for home sales of manufactured goods was up 4.2% in the year to December.

This discrepancy will be putting pressure on companies’ margins (though there are other factors to consider such as export prices and wages), and it is therefore not surprising that in EEF’s last Business Trends survey we saw a jump in the number of companies planning to put up prices, both in the UK and abroad.

What does this mean for broader inflation?

Obviously UK-manufactured goods do not make up the entirety of the basket of goods and services consumed by a UK household which are used to calculate. Goods consumption makes up about half of the weighting in the CPI, and although it is impossible to separate out UK-produced consumption from this, it is fair to assume that there will be similar price pressures on imported goods.

Figure 1: CPI inflation (annual % change)

Given strong growth in emerging economies, input-price pressures seem unlikely to abate. If commodities prices rise at the same rate that they did in 2010, we forecast that CPI inflation in the UK will remain above 3% for all of 2011 and above target for all of 2012. Today’s inflation outturn suggests this is not implausible.

The Bank of England is right to hold back on rate rises, worried as it is about the impact that spending cuts will have on economic growth, but the uncertainty inflation causes is not good for growth either. Our forecasts suggest that with higher commodity-price-fuelled inflation, manufacturing output growth would be reduced.

At EEF, we do our best not to get caught up in the circumstances of individual companies - it's the breadth of manufacturing that matters, and in most cases, we're not close enough to the details of a particular company to comment credibly on their issues.

Yet there is a story on the cover of the FT today about a plastic electronics company that got its start in Cambridge, but is headquartered in the US, bases production in Germany and has now received over £400 million in investment from a state-backed Russian company.

Unfortanetly this is an all-too-familiar story - a new technology is created in the UK, but is financed and produced outside the UK. That means the value of innovation - the jobs, the profits and the growth - aren't captured in the UK, but by our competitors instead.

In these instances, the policy debate becomes about what the UK government should or shouldn't be doing to support innovative, growing companies: in other words, should the state take stakes in innovative companies?

This was the starting point for Lord Mandelson's industrial activism and is the basis for Science Minister David Willets comment in the FT:

...there was "no way" any UK government agency would invest £400 million into a technology company to help its expansion. "Plastic Logic is a fantastic company which has developed its intellectual property in the UK and will continue to have deep roots here."

But this is the right answer to the wrong question.

Even if government did have the cash to invest in 100 such companies, the UK government shouldn't be taking these stakes - it leads to a picking winners approach that isn't likely to deliver value for taxpayers' money.

So what are the right questions? There are two that spring to mind:

1. Why do companies like Plastic Logic leave the UK in the first place?
2. What does it say about the UK's business environment that start-up after start-up finds it easier to create jobs and grow by expanding overseas?

These are harder questions to answer than whether government should simply splash cash around.

Just because a company develops IP in the UK, doesn't mean that the innovation is complete. Once a company proven that a new technology can work, they need to prove it is commercially viable. Put simply, innovation doesn't stop with the first prototype. It keeps going as companies try to prove they can produce the technology quickly, to cost and to scale. Otherwise the market will look elsewhere.

The UK is a great place for companies beginning to innovate, but problem for the UK is that we don't have a business environment that supports the costly and relatively risky, but complete process of innovation.

Russia has to use state-controlled companies to make investments because it doesn't have an entrepreneur-friendly business environment. That's fine - that's the decision Russia is making to remain competitive in the global economy.

But if the UK isn't going to compete on state-backed finance (and we don't think it should), then it needs to compete on the business environment - through substantive reforms to the tax system, by moving beyond bank-bashing to increase lending through greater competition in the finance sector, by actually getting rid of regulations and improving adult apprenticeships.  Because we don't have a competitive business environment, the UK's innovations are being bought by the highest bidder.

While some of this is going on because of the government's Growth Review, the challenge for government is to ask the right questions - about how to keep the value of innovation in the UK - as it consults with businesses on how to support growth.

On Monday we published Economic Prospects, 2011: detailing our views on what the year ahead is likely to hold for manufacturing. Over the last few days we’ve set out what we think are likely to be the biggest challenges for manufacturing in the coming year. These include: Eurozone instability; commodity price inflation; and access to finance. The fourth challenge is the likely impact of government spending cuts.

In 2011 government spending will fall substantially and manufacturers are concerned about the impact of this. Nearly one fifth of manufacturers expect to see a direct loss of orders. In addition, 40% of companies expect to see a loss of orders through their supply chains. It is not only lost orders that are a concern: a quarter of manufacturers surveyed were worried about cuts to business support programmes.

There is some good news too: one in six companies expect that the government’s spending cuts will make the business environment clearer, and a few saw new market opportunities arising from a change in spending focus. What is more, 45% of manufacturers thought that reducing the deficit would improve market confidence in the UK economy.

We've blogged in the last couple of days about access to finance and commodity prices. The third of our four forces to watch in 2011 is the eurozone crisis. Will it get worse, will it pass over, or will it be much like 2010, muddling through with a bailout or two for weak peripheral countries but no major collapse? And what will be the consequences for the UK?

2011 has kicked off in a very similar fashion to 2010 with the Guardian reporting heightened nerves regarding Portugal's growth prospects - a familiar sound to what preceded the Irish bailout late last year. How will this impact on exports to the eurozone?

Our Economic Prospects report out yesterday shows that a testing 2010 did see exports to struggling eurozone economies go backwards. In fact, exports to many other eurozone countries went backwards too, including France and the Netherlands - not usually listed with the sovereign debt basket cases. The one notable exception was Germany where the share of UK export growth was similar to Germany's share of UK total exports.

One of the PM's favourite rallying calls to action is that we export more to Ireland than all the BRICs combined. True maybe but on the other hand exporters are fast remedying that through strong growth to these key markets. So despite lacklustre demand from Europe, UK exports grew strongly overall with demand from key emerging markets more than compensating. With growth prospects for Europe and emerging markets continuing to show a divergent story in 2011, much the same pattern could repeat itself.

 That's not to say that Europe's prospects aren't still very important for the UK economy. In its December meeting minutes the MPC talks about three generalised impacts from the sovereign crisis in order of impact: a reduction in exports to stricken markets, a generalised loss of confidence, and a systemic failure transmitted through the financial system. So far we've only really seen the first impact - and this has been offset to a degree by a strong Germany.

If on the other hand confidence were to start to fall and the eurozone's prospects for holding the euro together were to weaken considerably there is a possibility the pound could start appreciating considerably. Because such a large stock of UK trade still goes to and comes from Europe this is likely to reduce exports to and increase imports from Europe. The contribution from net trade to growth would be considerably reduced. We model one such scenario in Economic Prospects with a 10% appreciation against our central forecast, which in the short run drastically reduces the much sought after boost to growth from net trade.

So even the eurozone storm has so far failed to seriously impact on the UK, it is a key one to keep watching in 2011.