EEF blog

Earlier this week we released our quarterly Credit Conditions Monitor, which looks at how the availability and cost of finance is changing for UK manufacturers.

This showed, encouragingly, that the availability of finance appears to be improving; including for the first time since our survey begain in 2007, the availabilty of finance on existing terms and conditions.

However a strong balance of companies (21%) are still saying the cost of finance is going up. This has risen from 2012q1 where the balance was 16%. The main driver of this deterioration appears to be fees and costs outside headline interest rates, which I personally think is a sign of weak competition in our SME bank lending market.

Today, the fourth installment of BDRC Continental's SME Finance Monitor has come out. Not too much fanfare these days, no press releases [update: there is a press release from BDRC but this is a step back from promotion of earlier editions of the SME Finance Monitor by interested stakeholders].

This is a big (5,000 companies), quarterly survey funded by - but independent of - the UK banks.

The SME Finance Monitor is a mine of information and greatly helps enrich the debate on access to finance. This is a debate that often become polarised between the financial community's view that banks aren't lending money because businesses don't want it (i.e. demand side factors) and some business groups that say the banks don't want to lend to SMEs because they're trying to shore up their own balance sheets but reducing their own borrowings to provide credit (i.e. supply side factors).

Of course, it's a bit of both.

But what this edition of the SME Finance Monitor shows does give some support that demand may be rising.

The overall appetite for new or renewed lending has risen from 2011q4 (16% of all SMEs v 14%).

The proportion of 'would-be seekers' of finance i.e. those who would like to borrow but aren't for some reason (e.g. discouraged by the response they think they might get from the banks) is up from 20% to 25%.

And still a fairly high number of companies that apply for a loan or an overdraft walk away with nothing (41% and 21% respectively).

But what's perhaps most concerning from the point of view of our sector is that manufacturers in particular seem to be disengaging with external finance providers.

The proportion of manufacturing companies having applied for a loan or overdraft in the past 12 months declined from 14% in 2011q1/q2 to just 7% in 2012q1.

Unfortunately I have heard this anecdotally too - companies saying they invest for the long term and can't rely on banks being there when they need them - and so instead relying solely on internal funds.

This is the sort of discouraged demand we definitely don't want; it holds back investment and growth.

Some important issues were raised at Wednesdays All Party Parliamentary Group on rebalancing sectorally. Speakers included EEF’s Chief Executive Terry Scuoler, Professor David Bailey from the University of Coventry, Dr Elizabeth Garnsey from the University of Cambridge and Lord Peter Mandelson. 

Together the panel provided a stimulating contribution to the debate on how the government can support the manufacturing sector and rebalancing. Some of the issues discussed included

• Raising capital intensity in the manufacturing sector through
  -   Recalibrating the financial model to improve access to finance with a particular focus on improving availability of finance for small and medium sized businesses. 
  -   Improving capital allowances to encourage more investment. 
• Focusing tax incentives and government support on high growth sectors, areas where the UK has a comparative advantage and exporting.
• Increasing commitment to building and maintaining our comparative advantage in knowledge, specialisation, innovation and skills. 
• Developing an intelligent focus on supply chains to improve the UKs ability to compete globally.
• Establishing a clear and pervasive commitment by the Government to a growth strategy with measurable indicators to track success.  

The top priority for the government should perhaps be the last item for two simple reasons

1. a clear plan for growth will lay the foundation from which the other issues can considered and actions implemented, and
2. a clear plan for growth will provide the business community with some measure of certainty in an environment plagued by uncertainty.

The downward adjustment to the second estimate of overall growth in the first quarter 2012 was disappointing to see. This was largely driven by weaker than previously estimated output in the construction and the non-manufacturing production sector. 

This headline figures does not tell the whole story and below this sits a more nuanced picture – there are some positive signs that confidence may tentatively be increasing in the economy but also signs that reinforce the challenges the UK faces.

So what do the underlying stats tell us?

Some of the interesting news includes:

• Business Investment grew by 3.6% in Q1 2012.  Within this manufacturing investment grew 5.2% and non-manufacturing grew 3.4%. 
• The net trade position deteriorated from a deficit of £4 billion in Q4 2011 to £4.4 billion in Q1 2012.

The growth in business investment is a sign that UK companies are starting to increase confidence. It is early days yet but does this signal the beginning of the long-anticipated recovery of investment?  Forecasters have been predicting investment levels to pick up for a while but at the same time the precise timing of this recovery has been continually pushed out. 

Manufacturing investment has continued to show stronger growth than non-manufacturing investment. With the exception of Q2 2010, growth in manufacturing investment has remained stronger than other sectors since late 2009.

The deterioration in the net trade position in the first quarter was a result of both higher imports and slightly lower exports. Lower exports to the EU are worrying but not entirely surprising given current events and weak growth in the Eurozone but it is comforting to see exports to non-EU countries continuing to grow. 

Ongoing challenges face UK companies, from difficulties accessing finance to the intensification of strains in the UK’s major export markets in Europe. Despite the positive business investment stats, the process of rebalancing still has a long way to go.

Yesterday’s inflation figures presented some good news for the MPC. CPI came in at a lower-than-expected rate of 3% meaning – for the first time in this Parliament – that the Governor of the Bank of England did not have to write a letter to the Chancellor of the Exchequer.

CPI inflation is now at its lowest level since February 2010, but it remains well above target, and has been for over two years. 

Yet this morning’s MPC minutes hint that increased monetary easing is more likely than an increase in interest rates any time soon. As with last month, all committee members voted to maintain the stock of asset purchases at £325bn with the exception of David Miles, who voted in favour of a £25bn extension to the scheme.

So given the high level of inflation why is more monetary easing on the table?

The UK economy is still weak. As with last week’s Inflation Report, the MPC’s minutes noted the significant risks to growth associated with the economic turmoil in the Eurozone. Similar points were highlighted yesterday, when the IMF released its review of the UK policy mix. In fact, the IMF argued that weak growth and limited underlying inflationary pressure suggest further monetary easing is required. 

Our own forecasts suggest that growth is likely to be weak, and inflation should fall back to target early next year. However, we now expect inflation to return to target later than we previously forecast, due to the increased outlook for oil and commodity prices: upside risks to inflation remain.

As King pointed out during the press release for the Inflation Report, the amount of spare capacity in the economy is difficult to predict, and will be affected by tight credit conditions and economic uncertainty, yet it is precisely this spare capacity that is expected to keep domestic price pressures under control.

Other upside risks to inflation noted in today’s minutes:

-         developments in global prices, such as for commodities

-         growth in domestic costs

-         degree to which companies seek to restore margins

The minutes also noted some downwards risk to inflation:

-         weak economic activity might result in inflation falling materially below 2% in the medium term

-         demand growth might be weaker than expected

Today in the news there's been a lot of talk about BDO's new report Manufacturing the Future, which, amongst other things notes that only 25% of the manufacturing companies surveyed think the government is adopting the right strategies to support and develop UK manufacturing.

That might be puzzling to some in the government who with some justification might point to the current rate of corporation tax, now just 24% and scheduled to fall further to 22% by 2014/15.

But if ever there was devil in the detail then this is surely an example. What we hear a lot from our members is how (at least for the initial changes) the government paid for this cut to corporation tax by reducing the Annual Investment Allowance and the main write-down allowance for capital allowances.

Respectively these have been reduced to £25,000 (from £100,000) and 18% (from 20%) with effect from April 2012.

The big concern with this is the impact it has on SMEs cashflow. These firms are not beneficiaries of the cuts to the headline rate of corporation tax and they often have fewer sources of external finance than larger companies - cashflow is an essential driver of their investment.

If this doesn't make much sense, consider the following example for how capital allowances work and why for some companies current government policy might not be seen as particularly supportive:

 Now compare this example with what was in place prior to April this year:

Trade figures released this morning showed that the UK’s trade in goods deficit was unchanged between February and March.

While exports to Europe were flat over the month, reflecting challenging economic conditions in the region, exports to non-EU countries continue to look strong. Non-EU markets are providing a real boost to exporters: once again, hitting a record level in March.

EEF’s recent export survey showed that even amid the economic turmoil we saw last year, nearly 65% of companies surveyed saw an increase in total export sales in the last twelve months. The focus of exporters is predominately geared towards emerging markets, where manufacturers expect to see strong growth in the next five years. As domestic and traditional markets remain weak, 45% of companies said they were more interested in exporting to new markets than they were a year ago.

However, challenges remain for UK manufacturers. It is still the case that around half of all UK exports go to Europe. With news this morning that the region narrowly missed a return to technical recession, and a Greek exit looking increasingly likely, the economic situation on the other side of the Channel will remain a challenge for UK companies.

Similarly, exporting to emerging markets is not easy. There are specific barriers to entry into most new export markets, from business practice or language differences to exchange rates or poor credit protection; or a lack of knowledge about specific markets.

But UK manufacturers are ambitious, and are putting the foundations in place to continue the growth in exports to new markets that we have seen throughout the recovery so far.

Recently there have been a number of reports and articles saying companies are holding back on investment and are sitting on piles of cash totalling £750 billion.  A couple of questions need to be asked and answered before this figure is continued to be used.   

Firstly, is it true? 

Non-financial companies in the UK did hold £750 billion in currency and deposits in 2011.  Total currency and deposits have more than doubled since 2002.  This figure comes from the Government’s economic accounts and shows that currency and deposits held on the balance sheets of non-financial corporations has been increasing and growing fast since 2002. 

Crucially, not all this money is available to spend on investment in the UK 

There are a few more relevant facts that need to be understood about this number:

1. Most of the growth occurred in deposits held with foreign banks.  The ONS and OBR think a minimum of 20% (and most likely more) of overseas deposits are held by financial companies and are therefore funds that are not held by companies for investment.
2. Non-financial companies include UK owned corporations, foreign controlled corporations and public corporations.  Public and foreign corporations are likely to be subject to a different set of investment decisions – they may have more investment options overseas and may be influenced by the investment environment in the UK relative to opportunities elsewhere.

So, how much cash might be available for investment in the UK?

It is hard to say but (very) rough estimates suggest cash available for investment is likely to be less than £660 billion and could be as low as £400 billion – a significantly lower amount from the headline number.   

• Upper bound scenario: Adjusting only for cash held by financial institutions would reduce cash reserves by £90 billion.
• Lower bound scenario: Assuming all deposits prior to 2002 were held by non-financial institutions, had these deposits grown in line with domestic deposits since 2002 cash reserves could be up to £350 billion lower.

Is it only happening in the UK?

UK companies are not the only ones increasing cash on balance sheets.  Manufacturers worldwide have been increasing their cash reserves over the past five years. 

Sourced from: WEF report on the future of manufacturing

A recent report by Standard and Poor’s suggested this trend is the result of “companies … strengthening balance sheets and liquidity in order to counter any systematic shocks or contagion”.  

So, are businesses really sitting on piles of cash? 

Maybe – the more important question is why?  Higher cash on balance sheets suggests companies are reacting to the economic challenges they continue to face, including the aftermath of the financial crisis and the weak and uncertain demand outlook.   More cash on their balance sheets places them in a more secure position to react to changes in the current economic climate.  Investing all of this cash may not necessarily be the right move for all.   

Perhaps a better question might be: How do we address the long-standing underinvestment in the UKs economy?

2011 was a record year.  Goods exporters sold more than ever before to markets including Hong Kong, China, Brazil, India, Malaysia, Pakistan, South Africa, Singapore, Thailand, Taiwan, Russia....

EEF's latest research, in partnership with RBS, suggests that this is no one off.  UK manufacturers are going with the grain of global growth; a focus on multiple emerging markets supported solid growth in orders over the past year even as dark clouds settled over Europe and more companies expect to see stronger growth coming from these markets over the next five years. 

In other positive export news:

• Manufacturers are more likely to export (55% of all companies compared with 31% in the economy as a whole) and across EEF members around two-fifths are export intensive companies, with half of more of their sales to overseas customers; 
• Nearly 65% of our survey respondents reported an increase in total export sales over the past 12 months, with nearly a fifth seeing growth of more than 20%;
• Forty-five per cent of respondents report being more interested in exporting to new markets compared with 12 months ago;
• In the next 12 months, India and South East Asia are the front-runners for growth, with just over 30% of those surveyed expecting to see orders growth;
• Looking beyond this year China is expected to leapfrog the other markets with almost half expecting strong Chinese demand to be a driving force behind export sales within five years.

This is important - particularly now - for rebalancing our economy.  The decade preceding the financial crisis spending by households and government were dominant components of UK economic growth. Overleveraged households and ballooning public sector deficits have necessarily reduced the contribution that both sectors will make to growth in the coming years.  This has put tradable and investment intensive sectors in the spotlight as the primary drivers of economic expansion.

Manufacturers ambition and ability to capture growth opportunities in fast growing markets will also be important in meeting the government's target of doubling UK exports by 2020.  Our survey, and the official statistics, would suggest that manufacturing is in good shape for the challenge.  However, the journey from export strategy to success is not straigntforward.  Our research identifies a range of perceived barriers to exporting to unfamiliar emerging markets, which may hold back internal decision making to push ahead with export strategies. There are also some real, but surmountable, hurdles.

Barriers to entry may be in-country, such as business practice or language differences; finance related such as exchange rates or poor credit protection; or awareness related, with many companies saying they have a lack of knowledge about the opportunities out there for their business. Some of these barriers are perception issues but many are also rooted in the reality of exporting to these markets.

Our research provides some optimism that there are foundations to build on the growth in exports to new markets that we have seen through the recovery so far. We have got the ambition of many manufacturers, we also need to ensure that is matched with quality market information and support and good UK engagement in removing trade barriers

Ever wondered how important manufacturing is to the economy?  This recent report from WEF says that

For every $1 of manufacturing value add in the US, $1.40 of value is added in other sectors.

It’s called the multiplier effect

In addition to creating value through output directly, manufacturing induces production and value creation in other sectors of the economy.  For example, the development of a new manufactured product could lead to the development of a service associated with the product leading to job creation.  Higher demand for manufactured goods could also higher investment and greater innovation in other sectors of the economy as they seek to capitalise on demand opportunities. 

Of all sectors, manufacturing had the highest multiplier and so the biggest positive effect on production and value-creation in other sectors. 

It should therefore not be surprising that manufacturing has been reducing as a share of the global economy.  The multiplier effect means that other sectors in the economy will be growing if manufacturing grows.  If manufacturers are actively improving efficiency to lower prices of manufactured goods at the same time, then manufacturing should be declining as a proportion of the economy. 

So…what has been happening with manufacturing output in the UK?
 
… given this, it is vital that the conditions for continued and more sustained growth in manufacturing are right.

One of the ambitions the government has set out in its little-known ‘Plan for Growth’ is to create the most competitive tax system in the G20. This is a laudable aim.

And though the government does emphasise its bold cuts to the headline corporate rate as being the centrepiece of meeting this ambition, we now from references in other tax consultations (e.g. on the R&D tax credit) that the government recognises there is more to competitive tax policy than cutting one tax.

This year, we are going through a process of refreshing our tax policy positions after a successful 2011 campaigning year (we pushed for the lengthening of the short-life asset definition for capital allowances to eight years and for the R&D tax credit to be payable ‘above-the-line’).

When thinking about the UK corporate tax environment, we’ve found it useful to think about the tax system in terms of how it confronts different groups of companies.

At the moment we're dividing companies up as follows:

• Start-ups;
• Fast-growing SMEs;
• Mid-sized businesses looking to go public; and
• Multinationals.

These companies face similar growth challenges related to their point in the growth cycle and likely also have similar issues with the tax system – whether that means the tax system is creating an undue burden for them or not supporting them sufficiently.

So I just thought I might list out some of the issues we think are important to creating the most competitive tax system in the G20 from the perspective of these different groups to signal the sorts of issues we’ll be looking into over the year.

Start-ups

• Tax incentives for investors to provide start-ups with finance, like the new Seed Enterprise Investment Scheme
• The relevance of incentives to encourage corporate investors to invest in small companies, like the discounted corporate venturing scheme.

Fast-growing SMEs

• The administrative difficulties companies have coping with VAT requirements and NICs/PAYE.
• Allowing more companies to account for their corporate tax liability on a cash basis, as the government has just started for businesses with annual turnover up to £77,000.

Mid-sized businesses looking to go public

• Capital allowances and how they encourage investment.
• The challenges larger mid-sized businesses have complying with the government’s controlled foreign company regime.

Multinationals

• The definitions of expenditure used for the R&D tax credit
• How companies can make best use of the government’s new ‘patent box’.

These are the sorts of issues we think need to be addressed in the UK if we are truly going to have the most competitive tax system in the G20. As our tax work progresses we'll be sharpening up our recommendations for the government on tax if it's going to meet its Plan for Growth ambition.