EEF blog

In 2010, in his ‘emergency budget’, George Osborne boldly set out the coalition’s plans for eliminating the structural deficit over the course of the parliament.

This fiscal plan, though tough, gave necessary signals to the market that the deficit would be reined in and removed a key source of uncertainty.

But now it is 2011 and the new challenge to the government is supporting growth - and that's what we need from Budget 2011. The Manufacturer runs a good summary piece on our submission.

2011 is the year the public sector cuts really start to bite and where private sector growth must take up the slack.

Just as we needed a Fiscal Mandate in 2010, in 2011, we now need a Growth Mandate. EEF's CE, Terry Scuoler outlines the Growth Mandate in today's Telegraph. It will signal that the government is serious about our business environment and helping the private sector deliver the growth we need.

The reality is that we need to see this commitment because manufacturers have a choice on where to invest and the smart money is on investing in an economy that offers a business environment that can compete with the best in the world. We need that economy to be the UK.

The Growth Mandate would set out priority areas for growth that the government would address and against which it will be measured. Like the Fiscal Mandate, the Growth Mandate should span the lifetime of a parliament. As the FT picks up we think each subsequent Budget and policy announcement showing further incremental progress.

This multi-year view must be taken. The fiscal mandate cannot be threatened so a big bang approach is not viable. But the barriers to growth must gradually and consistently be dismantled.

And like the fiscal mandate a long term view on the growth mandate will deliver a confidence dividend to businesses who will see the business environment progressively improving.

Each Budget should therefore report, relative to the last budget on the following measures:

• The change in total tax costs faced by businesses;
• Estimates of the net change in bank and non-bank external finance to non-financial companies;
• The change in total climate and environment policy costs faced by businesses;
• All new and withdrawn regulations, and the change in the total cost of all regulation;
• The change in the proportion of companies facing skills shortage and hard-to-fill vacancies; and
• The change in apprenticeship starts at each level.

The challenge is that this holds the government to account for delivering consistent progress.

But a growth mandate isn’t a replacement for action at Budget 2011. Instead, Budget 2011 offers the first opportunity for the government to take small steps forward to support growth – small steps that point to large ambitions.

We see four key areas, mentioned in the Independent, where progress needs to be shown:

- Tax;
- Access to finance;
- Skills; and
- Regulation.

On tax we need the government to appreciate that firms make decisions based on the basket of taxes they face, not just the headline rate. We need reform on the R&D tax credit and capital allowances that properly account for the costs manufacturers face. The environmental tax burden needs to be reduced. Any support we give for a Carbon Tax is conditional on reductions in other energy taxes.

Finance remains a problem for firms post crisis. We need the Independent Commission on Banking to deliver measures that not only make the banking system safer but also increase competition – because growing firms often get their first lending deals secured through banks looking to enter the market. We also need more alternative sources of finance – both non-bank debt and venture capital, critical funding for firms that aren’t ready for bank debt.

Future funding and demand for 14-19 diplomas needs to be reviewed with the aim of increasing support and improving delivery. And the government should introduce a pilot initiative through the Growth & Innovation Fund to support SME collaboration on industry placements

On regulation the government needs to match its rhetoric with action by reviewing the cumulative impact of thresholds for regulation and commit to further action on reform as appropriate. As scope for simplification of individual regulations has largely been exhausted, commitment to structural reform of entire regulatory domains is needed

All these examples provide initial opportunities for government action to support growth.

In 2011, George Osborne will deliver his second budget. We believe his challenge is to set the Growth Mandate for a private sector-led recovery.

Many firms get their break on a marginal loan deal from new banks trying to enter the market.

From an entrant bank’s perspective, riskier customers are the easiest to attract to build a profile and presence in the market as the incumbents have less incentive to hold on to these guys.

Time and again talking to members we were advised of foreign banks trying to break into the UK market in years gone by who provided them with finance early in their development.

I think we need to see more of this happening. Not only as an increase in the number of banking options serving our firms but as a spur to the banks already in the market.

Sir John Vickers’ Independent Commission on Banking reports in September and is charged with improving the sustainability of the banking system.

These proposals – and more importantly the government’s response to them – must also increase competition in the banking sector by lowering barriers to entry and making it harder for incumbents to entrench their position.

The full effects of an enhanced competitive environment in the banking sector are only likely to be felt in the long run but will make a big difference.

The second thing that needs to happen is that more alternatives to bank finance need to sprout up and flourish. The pre-crisis glut of bank debt also helped choke off such alternatives – and helped distort expectations of returns.

To be fair to the banks, one of their Taskforce commitments goes towards addressing this by creating a Business Growth Fund. The BGF will provide finance for growing companies looking for £2-10 million – the growth capital gap identified in the last government’s Rowlands Review.

Crucially though, the BGF focuses on equity. The same Rowlands Review also identified SMEs’ aversion to equity finance as a behavioural barrier to getting finance for growth flowing.

The recommendation was to instead focus on mezzanine finance – a hybrid high return debt product that gets around the aversion to equity. This recommendation remains unaddressed.

Alternative finance doesn’t stop at mezzanine though. We need more private lending, more venture capital, and a readjustment of investors to the post credit boom environment. And we need a more sophisticated financial landscape that progresses firms along the different forms of finance appropriate to their stage of development.

Action here may require thinking from the government about how the tax system encourages – or doesn’t – these types of investors. It may require more fiscal resources than are necessarily available or it might mean moving some around. But it must be a medium term priority that should be addressed during this Parliament.

With little or no extra money however, the financial sector could seek a better understanding of the businesses they invest in. A common complaint I’ve heard is that banks don’t understand manufacturing. But it’s not just the banks.

In venture capital for example, the easy credit years allowed high leverage to do the work on generating high returns rather than relying on expert understanding of particular industries. This isn’t all VC funds – but for the sector overall.

There are encouraging signs on this. The banks Taskforce reinstated a forum for banks and firms to discuss finance. And the banks are determined to reach out to businesses through their network of mentors.

The latter is very much in the vein of how banks can help firms understand finance better and improve their chance of a successful loan application. Laudable but it is focused on improving understanding on the demand side.

It misses the converse idea of banks themselves learning more about business and therefore the risks and opportunities for different kinds of business – that would improve understanding on the supply side.

And what about funds under management? How many people in private equity funds or VC funds are manufacturing experts for example? Some perhaps but not enough. Consider the banks’ Business Growth Fund – what real activity business expertise is being brought to bear in the design of this fund. There’s an opportunity here.

Perhaps most frustrating and visible – but also correctable – is banks’ customer services. The Taskforce again commits to improve these for example through a new lending code, new lending principles, and a commitment to independent review of declined lending applications.

But letting the banks regulate their own adherence to higher standards may at best lack credibility and at worst be ineffective.

On business expertise and customer services, the Business Growth Fund and the (misguided) Merlin – banks have put their cards on the table. The government has a responsibility through its engagement with the Taskforce to drive the banks further and through the coming 'growth budget' to do what it can to further improve access to finance - and where it can't act now give a clear signal of future intentions.

Last week we were lukewarm about the Project Merlin announcement and how it will (not) help improve the flow of finance for businesses. I want to elaborate a little here on why and in a subsequent post on what I think needs to happen to really start making some progress.

In the previous decade leading up to the financial crisis, credit growth ran rampant as asset price bubbles and increasingly complex financial innovation fuelled debt driven growth. As we all know this has proven unsustainable.

The retrenchment that has followed the financial crisis and ensuing recession has been economy wide. Banks, firms, and consumers have all sought to wind back their own debt.

With the recovery still shaky, a key to future growth is to boost investment. This is a sustainable basis for growth and is part of the answer of rebalancing the economy.

But there are important factors holding back investment. First and foremost is the great uncertainty regarding demand.

Manufacturers have rebounded strongly in the past year but they face an extraordinary degree of uncertainty: the impact of spending cuts on consumer spending threatens domestic demand and eurozone sovereign debt worries threaten demand from Europe, still by far our most important export destination.

On top of this surging commodity prices put a major squeeze on manufacturers costs. How far can these be passed through?

Access to finance is also holding back investment. The problem is most acute for fast-growing SMEs with limited collateral and often a degree of innovation. Exactly the sort of companies we want to help drive the recovery.

Crucially compared with the other challenges, access to finance is potentially able to be improved by positive action.

Banks have pledged to lend more in gross terms. As an intention this is positive. As a substantive commitment it’s nearly worthless.

As Vince Cable said in March 2010, it is ‘perfectly possible for banks to achieve a gross lending target while withdrawing capital from [SMEs]’.

This is because the banks know many firms are paying down debt and so with this in mind they can make available loans in the knowledge that their net position may be to withdraw credit from the economy.

Why would they want to do this? Because the banks need to deleverage themselves and reduce the average riskiness of their portfolios. Both those desires suggest lower net lending from the banks is in their interests even if viable proposals are seeking finance for growth.

The Coalition Agreement picks up this net v gross issue too. Under banking reform section it notes ‘We agree that ensuring the flow of credit to viable SMEs is essential for supporting growth and should be a core priority for the new government...This will include consideration of…use of net lending targets’. (my emphasis)

But of course Merlin has only delivered a gross target. If target is even the right word.

Because as the Merlin agreement itself makes plain, the banks' position is that lending will be ‘subject to normal commercial objectives’ (1.5), further that even these gross lending targets go beyond the banks' expectations of demand (1.3.2), and that the ‘committed lending capacity…is materially higher than…revised expectations [for what will be delivered] for 2011’ (1.3.3).

Banks are after all businesses themselves looking to maximise profits. How could they justify lending to their shareholders that didn't deliver the highest possible profit? They see the current flow of finance as consistent with their criteria. Demand that meets these criteria will be met; that which doesn’t will not.

Firms that are not getting the finance they seek are missing out because they’re not suitable to lend to.

That’s not to say the banks are totally oblivious to the need for action or the causes for a potential mismatch in demand in supply. Their Taskforce commitments included a number of worthy objectives such as reaching out via a mentor network, starting refinancing discussions earlier, being more transparent on their lending principles, and establishing better data on lending.

But the fact remains that the signatories to Merlin are all powerful members of a banking sector that can largely set its own terms. Profit maximisation for them does not equal welfare maximisation for the economy. The competitive forces aren’t there to drive more lending even though viable unmet demand exists.

The banks have been clear on what they'll do and it is incumbent on the government to respond on behalf of the rest of us to bridge to gap to what the economy needs. Merlin's box of tricks unfortunately leaves us far from enchanted.

Yesterday, following on from the MPC's Inflation Report, we got into a debate on twitter with Tom Brammar, MD of FT Tilt about the path of interest rates.

Below is a transcript of the debate:

Back in July 2009 EEF Published Manufacturing Our Future. In this we commented that:

“Just as today’s internet giants began life with one computer in a garage, advances in design and digital manufacturing mean that tomorrow’s manufacturing multinationals will start from equally humble beginnings.”

And an article in this week’s economist suggests that 3D printing could be just the technological advance that drives advances in tomorrow’s manufacturing:

“As with computing in the late 70s it [3D printing] is currently the preserve of hobbyists and workers in a few academic and industrial niches. But like computing before it, 3D printing is spreading fast as the technology improves and costs fall.”

In fact, 3D printing could be a real game-changer for industry

“By reducing the barriers to entry for manufacturing [it should] promote innovation. If you can design a shape on a computer, you can turn it into an object. You can print a dozen, see if there is a market for them, and print 50 more if there is, modifying the design using feedback from early users. This will be a boon to inventors and start-ups, because trying out new products will become less risky and expensive.”

And 3D printing really could be open to anyone. An exciting example of this is the RepRap project which was showcased at NESTA’s recent personal manufacturing seminar. RepRap have developed a replicating 3D printer that prints about 50% of its own parts, with the other parts are easy to obtain from a hardware shop or online. RepRap has a website called Thingiverse, where you can download designs that others have created to print on your printer.

With costs of 3D printing falling (the Economist notes that a 3D printer now costs less than a laser printer did in 1985) the potential for a paradigm shift in how we produce is really here. Open-source designs combined with simple production methods could lead to a form of modern manufacturing which combines elements of mass- and bespoke-production.
 

Today’s announcement of lending targets with the major banks have not gone far enough to address the fundamental issues facing businesses looking to access finance for growth.

While there are some helpful measures, especially Bank of England scrutiny of the targets, we have had lending agreements in the past and they have either been missed (net targets in 2009) or met (gross targets 2010) without material alleviation in the access problems faced by SMEs. Also, as in the past, the targets will prove to be unenforceable.

The announcement also fails to address the flaws that we see as still remaining:

• a lack of competition in the banking sector;
• more alternative sources of finance aside from banks, both debt and equity.
• a need for greater transparency in lending decisions;
• and better real business knowledge in the financial sector.

Competition is important both in terms of the service business customers receive and also lending decisions going forward. Many new companies have had their first big break from a bank looking to enter the market.

Alternative sources of finance have in many cases been choked off by the era of cheap credit leading up to the financial crisis. Private lending, mezzanine debt finance, venture capital, and private equity all need to be boosted to help the economy grow.

Transparency on the lending principles applied and adhered to by banks - and a credible way for monitoring banks sticking to this are important to strengthen the relationships between banks and SME business customers. This is a two way relationship and banks promises to address customer relations in their Taskforce report was welcome. Firms need to respond too by making sure they give their relationship with the bank the attention it needs.

Better knowledge of how businesses, like manufacturing, work should improve both the substance and the perception of how banks, fund managers, and investors decide to inject capital. Again it is encouraging to hear that many banks are looking to build their in-house expertise of the UK manufacturing sector.

Today’s trade figures showed that the deficit on trade in goods rose to £9.2bn. This is high. This is very high. In fact it’s the highest nominal deficit on record. 

But should this be seen as a sign of weakness in the UK economy?

An article in today’s Investors’ Chronicle suggests that this is to do with export weakness:

“the bad weather… might have left some of our exports temporarily stranded on the M20”

But a closer look at the statistics suggests that this is not the case. Exports are growing strongly. In 2010 total goods exports grew by 16.9%. This is the strongest growth in goods exports since 1977. In the five years before the recession the average growth rate of exports was 3.8%.

The problem is – as far as net trade is concerned – that imports are growing even more quickly. This is not good for our trade balance, and it suggests the economy is not moving towards a better balance. But, as we have previously argued, import growth does suggest that domestic demand is still relatively strong. And as the Investors’ Chronicle article notes, with a globalised supply chain increased exports require increased imports of parts from overseas.

However, the same Investors’ Chronicle article continues to lambast the UK’s export position:

"Last year, the UK exported twice as much to Ireland as it did to China (£16.9bn vs £7.6bn). And it exported more to Italy or Spain than to China too. Our export effort, then, is directed at those who aren't in a position to buy more anyway."

Yes, our exports tend to go to Europe (don’t underestimate the importance trade relationships and geographical proximity), but our “export effort” is decidedly more global. In 2010 our exports to China grew by 41%, considerably more than growth in exports to Ireland (6%), Italy (6%) or Spain (7%).

The article’s author is right that today’s figures do not suggest the economy is rebalancing. But they are not all bad. Crucially, the impressive growth of both exports and imports shows that there has been a significant rebound in economic activity since the recession ended.

The question now, is now is what can we do to spur on export growth at a faster rate? Let’s see what the Business Secretary’s White Paper on trade tells us today.