EEF blog

Over the next month we'll be blogging on the economic issues that some policy makers may have filed away before settling down to watch the summer festival of sport. They should also keep in mind that some of the thorny questions around the state of our economy will still be there when they get back to the office.  Our summer reading list will help keep them in the picture. 

First off we'll keep the updates on the UK's economic vital signs coming - starting with the first manufacturing indicator of the month on 1st Aug. And we'll also be posting some thoughts on what type of economy we should be trying to build over the next couple of years.  To do this we'll be focusing on the things we do really well in the UK - some of which is being showcased to the world during this olympics period. And the areas where government and the private sector must do better. 

The growth challenge as we move into the second half of this year is still a big one.  While no one was expecting the UK economy to put in a particularly spectacular performance this year, even that doesn't seem to be going to plan.  We entered the year with a host of risks ahead of us - the eurozone crisis could come to a head with multiple exits, credit constraints for firms and households could intensify and one of the engines of global growth - the US or China - could sneeze.    

But although we haven't seen one of these major shocks materialise, the UK economy hasn't grown since the third quarter of last year.  

There are explanations; the eurozone crisis has been crushing confidence and the rest of the world isn't growing as fast as it was - not good for the investment or exports needed for better balanced growth; and the official GDP number crunchers have been plagued by one-off events in every quarter. In all likelihood we'll see growth come back in this current quarter as activity during the jubilee celebrations was displaced, rather than lost and all the olympics activity will provide a much needed boost.

Beyond that, however, the question of what needs to be done to get the recovery back on track still remains.  The Office for Budget Responsibility will inevitably be getting its red ink out as it updates its forecasts for the economy and the public finances for the Autumn Statement.  We'll be setting out some thoughts on what businesses and households will be expecting to hear in response on why we aren't where we need to be and what the economic plan is.     

UKTI put out their annual report today on the inward flow of FDI to the UK. We are still second in the world in terms of stocks of inward FDI - but have slipped to seventh in terms of flow (since 2007).

Much of this can be put down to the weakening economic situation here - nearly 1800 projects went ahead in 2008/09 and this is down to 1406 in 2011/12.

There are some bright spots though:

52,741 jobs created by inward FDI in 2011/12, up 26%;

£53.9 billion flowed into the UK in 2011, up 7%;

Number of new investment projects (rather than expansions or M&As) up.

If we focus on our sector in particular the story is also encouraging:

FDI in manufacturing in particular up 22%;

Advanced engineering saw the largest share of jobs created by inward investment (17,379, up 25%)

256 of 1406 inward investment projects were in manufacturing (18% c.f. manufacturing's share of the economy c10%).

China is moving up in terms of number of investment projects - now to third from 7th last year - and an increase in investment of 55%.

It's interesting to see the '7 reasons' that UKTI points to as important for investing in the UK. These include an 'unrivalled business environment', 'an internationally competitive tax environment', a 'world-class skills base', and 'Europe's strongest research and development environment'. UKTI at least seems very clear on the areas of focus for a thriving UK economy.

At first look the data paints a fairly bleak picture of the state of the economy…

The preliminary estimate of GDP shows the economy contracted by 0.7% in the second quarter of 2012.  The Index of Production (IoP) decreased 1.5% with manufacturing down 1.4% in Q2 compared to 2012 Q1.

The implied month on month contraction for the IoP is much starker – with total production contracting by 3.5% and manufacturing contracting by 4.4% in June.

… but it is difficult to take the figures at face value.

As noted in yesterday's blog, a contraction was anticipated but the scale of the impact from one-off events was difficult to predict.  Looking at manufacturing it is very unlikely that the 4.4% monthly drop in June manufacturing output implied by the figures gives a fair reflection of the underlying health of the sector.

The output figures don’t really fit with the sentiment we're picking up talking to members.  While they are more downbeat than they were a year earlier, the mood is definitely not as dismal as the Q2 and June figures imply.

Compare this with the 'great' recession in 2008/09 – there was only one month where we saw a larger month on month contraction, driven by a collapse in world trade, than what we have seen this June.  But the sentiment during those months was markedly worse than what we are seeing now.

So if sentiment is holding up, what could be driving this woeful June number?

The clearest culprit is the two bank holidays in June associated with the Diamond Jubilee.  The additional two days of holidays in June imply a loss of roughly ten percent of the working days in June.  We also know that some manufacturers went even further and shut their factories for the whole week of the Diamond Jubilee.  So it is not surprising, therefore, that output took a big hit in June. 

Previous Jubilees actually had a worse impact on output so June figures are not out of line with what should be expected

The ONS presents some telling statistics on the impact of the Diamond Jubilee compared to previous Jubilees and the story is not all bad.  On two other occasions – the Silver Jubilee in 1977 and the Golden Jubilee in 2002 – the May bank holiday moved to June and an additional bank holiday was added.  We can use these to provide a bit of a test of how bad things really are.

As shown in the chart below, each Jubilee had a severe impact on manufacturing production in June.  In fact, the impact in 2012 is not as marked as the previous two Jubilees.

This picture provides a bit of relief really - the UK economy has not reacted massively out of line with historical experiences and, in fact, may have come out somewhat better than it could have.  This also suggests the underlying picture is probably not as bad as the headline figures suggest.  

However, we have been struggling to get the recovery back on track and we need to see other activity indicators start to show that lost ground is being made up.  If this does not start to happen we will have greater cause for concern. 

The first estimate of UK GDP growth in the second quarter is released tomorrow.  The consensus view is that we will see a third consecutive quarter of falling output; a fall of 0.2% following a 0.3% contraction in the first three months of the year.

Activity indicators across manufacturing, construction and services in the UK all saw a marked weakening in May and June, with the manufacturing and construction PMI both dipping below the 50 no-change mark.  Offical index of production data have been extremely volatile in the past few months, with a 0.8% month-on-month fall in manufacturing output in April, followed by a strong rebound in May.  Plus the Jubliee holidays didn't bring the bounce in retail sales that might have been hoped for. And then there's the sharp drop in gloabl activity indicators, confirming that the health of under major markets is deteriortating under the pressure of the ongoing eurozone crisis.

On the face of it, this doesn't bode well for Q2 growth.  However, a few things to bear in mind.

- the additional bank holidays in June will push growth down, particulary if companies had extended shutdowns over the period.  This will have increased the number of working days lost.

- as ever, this is a first estimate and is a partical representation of activity

- given the one off events in the second quarter and the fact that next quarter is likely to see a bounce, not least because of the olympics, these statistics will not give a clear picture of the underlying health of the economy.

Indeed, more important is where we go from here.  Our recent forecast update suggests that while the Q2 GDP is unlikely to flatter the UK's economic performance, conditions could start to improve in the latter part of the year.  Although much of this depends on how events in the rest of the world evolve.  A bit more certainty and visibility about the state of the world economy could kick start stronger export performance and provide a much needed boost to companies planning investments.  All important cogs in the process of economic rebalancing. 

In the government’s recent Innovation White Paper they state that innovation will be the key driver of long-term sustainable growth.

So you would expect that the government’s Plan for Growth – which they describe as the “plan to put the UK on a path to sustainable, long-term economic growth .” – would be keenly focused on encouraging innovation.

But in the government’s four ambitions and the benchmarks for achieving these (you can see them here) neither innovation nor R&D is mentioned once. Actually, you have to get to page 28 before they detail support for innovation.

So how can we ensure that government policy is better-geared towards driving the kind of growth our economy needs?

We have been calling on the government to adopt a clearer, stronger strategy for growth for some time. We have suggested that the government aim to:

Increase the number of companies bringing new products and services to market.

Underpinning this, we have suggested two measures:

• Real business enterprise sector investment by businesses of all sizes in R&D returned to pre-recession peak by 2015
• 60% increase in the take-up of the SME R&D tax credit by 2015

Clear, measurable targets would help ensure government policy was focused on achieving a stronger, growing economy.

And even if we don’t have targets, our competitors do*.

• The Japanese government has set itself the target of increasing R&D expenditure to 4% of GDP by 2020
• Germany is committed to spending 3% of GDP on R&D by 2015
• In Sweden they already spend 4% of GDP on R&D

And it’s not just developed economies. Emerging economies are getting in on the act too:

• China expects to spend 2.2% of GDP on R&D by 2020
• Brazil aims to spend 2% of its GDP on R&D by 2020

In the UK R&D spend accounts for less than 2% of GDP.

While R&D intensity varies from sector to sector (in manufacturing it is about 4%, and rises to 15% for pharmaceuticals) lower R&D intensity puts the UK at a distinct disadvantage compared with our competitors.

These R&D targets include both government and business spending on R&D, but some of them have supplementary targets for business spend on R&D (for example, the Japanese government is targeting business spend on R&D of 2.7%). This is crucial, because the government has the ability to influence business spend on R&D through a series of policy levers. The government already recognises this fact; in the Innovation White Paper, they state that "government can be an important driver of innovation".

For this reason, we will be monitoring the government's progress against our ambitions anyway. The next data releases will be:

• Business invesment in R&D returned to pre-recession peak: November 2012
• 60% increase in the take-up of the SME R&D tax credit: October 2012

Last week the government announced the latest in its rolling series of interventions to improve access to finance for SMEs from the banking sector - the Funding for Lending Scheme.

It's another scheme, which luckily for the government, does not involve spending any additional money but rather using the 'strength of the balance sheet', a way of announcing initiatives without breaking the Fiscal Mandate the government has set for itself.

There's been several attempts from the government to improve access to finance, particularly for SMEs, in the banking sector since the onset of the financial crisis. But with a difficult external demand environment it's proving a tough nut to crack and I wouldn't bet on us being at the end of the road yet.

In the depths of the (first dip) of the recession in early 2009, the government announced the Enterprise Finance Guarantee (EFG). This is a revamped version of an older scheme, the Small Firms Loan Guarantee, and seeks to improve access to finance for firms that have run out of security to post with the banks. In return for a fee, the government guaranteed part of these SMEs' loans in the event of default, making lenders more willing to lend.

EFG suffered a little from poor communication from Whitehall and the banks' head offices to the bank branches that delivered it. Firms also mistakenly believed it would give them the ability to borrow without any security, rather than helping them access finance when they had insufficient security.

The scheme has been continued by the Coalition and as of end of March this year, over 15,000 loans worth over £1.5 billion had been drawn down.

Labour also sought to use its shareholdings in RBS and Lloyds to gain agreements from those banks to increase their lending to business. Alistair Darling tried this first on a net basis (net of repayments that is) for 2009/10 - but the targets were missed by a long margin; with RBS and Lloyds contracting their net lending by £41 billion rather than expanding it by £27 billion.

So for the 2010/11 year, Darling sought an agreement for these banks to expand gross lending by £90 billion. Then we had an election.

The coalition took gross lending further with its 'Project Merlin' agreement in February 2011. This sucked in all the major banks rather than just RBS and Lloyds but kept with the gross targets - despite Vince Cable panning the value of these prior to the election. HSBC, Barclays, Santander, RBS, and Lloyds agreed to lend £190 billion in 11/12 - £85 billion of which was to be to SMEs.

The overall target was achieved; the SME target was narrowly missed. But the gross target for lending was clearly missing the mark. Each bank seemed to have a different way of counting its contribution to the target. Some counted undrawn facilities, some counted unrequested extensions to existing facilities. Clearly this was not quite in the spirit of getting more funding into the real economy. And of course because lending has been contracting on a net basis since 2009, meeting these targets or not wasn't really suggesting expanding volumes of investment.

With some justification the banks point out that they cannot control how much their SME customers pay down existing debt, making it hard to commit to a net target. But some banks clearly saw it as possible and pushed hard to expand lending on a net basis even though this was not part of Project Merlin.

The assessment of the Project Merlin targets did not receive quite the fanfare the government gave to the original launch. By this time its thinking had moved on and, in March this year, we were on the cusp of the National Loan Guarantee Scheme.

The National Loan Guarantee Scheme seemed to me to be the first time the government recognised that something needed to change in terms of the supply-side of access to finance. We'd been making noise about the cost and terms and conditions on finance all through 2011 on the back of our quarterly Credit Conditions Survey.

The banks and to a lesser extent the government had instead emphasised problems on the demand side. There are undoubtedly problems on the demand-side - weakness in markets, some lack of understanding of the right types of finance - but for us this was never the complete picture.

The NLGS allows banks to benefit from a government guarantee for tranches of their borrowing, allowing a one percentage point savings to be passed on to SME customers on the interest rate they pay on their lending. This is a slightly tricky idea for companies to get their head around because it's a 1pp cut on what they would otherwise have faced - not a 1pp cut on what they might be borrowing at now. Lending costs are going up for banks for a variety of other reasons that could swamp the impact of this cut.

Barely three months since the NLGS was announced and the government, this time with the Bank of England, has gone further with the Funding for Lending Scheme. Unlike previous interventions, the Funding for Lending scheme offers explicit incentives for increasing net lending. The Bank of England lends UK government gilts to banks in exchange for a fee. The fee is low so long as net lending expands - and progressively rises if net lending contracts - for each individual institution.

So that's a whirlwind tour through what the government has done so far to boost access to finance for SMEs. But with the rate of change you would hardly bet this is the end of the story.

We're putting our thoughts together at the moment on what the government needs to do to deliver a more sustainable improvement for SMEs. Different groups have bandied about the possibility of a new state-sponsored bank, perhaps focused on SMEs, perhaps to provide growth capital, or support innovation. Competition in banking is another focus of discussion. We'll be shortly putting forward on our thoughts in this space.

MPC members voted to hold the bank rate steady at 0.5% and to finance a further £50 billion of asset purchases that will take place over the next four months.  This decision brings the total quantity of quantitative easing to £375 billion. 

All nine members of the MPC voted to maintain the bank rate at 0.5%.  Seven members voted in favour of increasing the stock of asset purchases, with Spencer Dale and Ben Broadbent preferring to maintain the stock of asset purchases at £325 billion.

The fall in inflation to 2.4% announced yesterday was not unexpected by the MPC given reductions in oil and energy prices and the impact of the delay to fuel duty changes.

The Committee noted higher risks from weakening in global demand, outlook for GDP growth and export prospects.  While the reaction to the European council meeting has been generally positive and has led to improved market sentiment in Europe, there are increasing signs that the threat of disorderly resolution to the financial tensions in the euro area is affecting UK growth. The majority view was that upside risks to inflation had declined and the potential cost of greater stimulus was lower than the cost of providing too little. 

Economic developments over the month:

Financial markets

• The prevailing sentiment in financial markets remains one of caution and risk aversion.
• Some improvement in bank funding markets in continental Europe towards the end of the month.

The international economy

• Recent indicators continue to suggest a weak near-term outlook for global activity. 
• Composite Euro area PMI rose fractionally in June but remained consistent with contraction in the second quarter.
• Forward looking service sector business expectations suggest weak third quarter. 
• US manufacturing ISM index for June fell sharply indicating flat or declining output in the sector and the new orders index also contracted suggesting weakness could persist.
• Overall picture for emerging economies one of gradual reduction in the pace of growth. 
• Oil prices continued to decline for most of the month before picking up a little towards the end of June and early July.

Money, credit, demand and output

• GDP estimate unchanged but contribution to growth from trade, business investment and consumer spending were revised down and offset by an increase in government spending.
• Business survey indicators of activity have been weak. 
• The announcement of the Funding for Lending Scheme and the Banks activation of its ECTR facility are expected to provide a potentially significant stimulus to economic activity.

Supply, costs and prices

• CPI had fallen to 2.8% in May (though has since fallen further to 2.4% in June)
• CPI likely to be lower than expected in the near-term given low oil and energy prices and postponement of the fuel duty changes. 
• Private sector productivity had continued to fall despite a three month on three month rise in employment of 166,000 in April.
  

After last week’s trade figures, we blogged about the fact that goods exports to non-EU countries exceeded goods exports to EU countries in May. This is only the second time this has happened, and suggests that UK exporters are really making inroads in faster-growing economies outside of Europe.

As an article in the Telegraph has pointed out today, the growth in exports to the BRIC economies has been particularly notable. In 2005 the BRIC economies received 3.9% of UK goods exports. In the first quarter of 2012, this figure was 8.1%.

And another point worth noting. Goods exports to Ireland accounted for 5.7% of UK exports in Q1 2012. The UK exports more goods to the BRICs than it does to Ireland.

Out at another couple of companies this week talking about tax. These were large companies, one in specialty chemicals, one in aerospace.

First thing that comes through loud and clear is that if we think big cuts to the headline rate of corporate tax are going to radically ramp up investment from big manufacturers we need to think again.

Other business drivers such as being close to markets, following OEM customers, and the supply of skilled labour were seen as much more important to determining where investments are being made. Highlights the importance of coordinated action across multiple areas to support growth.

However, tax IS an important secondary consideration.

One company told me the signalling effect of cutting the headline rate shouldn't be underestimated. It gives company's a sense that the government is moving in the right direction. The more confidence companies have this direction will be maintained the stronger this impact will be rather than the precise change per se.

Another company said that tax is an important 'tie-breaker' when locations are similar in terms of other characteristics e.g. some of our European competitors.

But we also discussed the importance of other parts of the tax system.

Sourcing is also influenced by tax. The scrapping of industrial building allowances (finally ending last fiscal year 11/12) meant one company wouldn't build anymore factories here - it would lease them instead - is that what the government wants?

Another company was fired up about the R&D tax credits and Patent Box. The credit compared favourably with other countries, notably the U.S., and is widely known amongst the large corporates. The Patent Box was also seen as a positive...though would it encourage the development of more patented technology in the UK was less clear.

Tax compliance and administration is an age old tax complaint. The mentality of the tax authorities was noted as being unhelpful - assumption seems to be that default position for companies was to avoid tax. Many attempts to curb avoidance were catch-all and created cost for companies that are compliant without catching the real tax avoiders.

HMRC's large company service with its 'customer relationship managers' was seen as positive; all the quality of CRMs is seen as variable and the benefit needs to be kept in perspective - if the tax legislation is still horrendously complex, the CRM can't do much.

Last week UNCTAD released their World Investment Report 2012.

UK Inward and outward Foreign Direct Investment (FDI) flows increased in 2011. UK inward FDI increased slightly in 2011, rising to 15.6% of gross fixed capital formation (GFCF). Outward FDI almost tripled to over $100 billion and 31% of GFCF, rising from 12% in 2010.  Outward FDI is now much closer to the annual pre-crisis average seen from 2005 to 2007 in both $ terms and % of GFCF, inward FDI remains well below the pre-crisis level and is more in line with other developed economies.

 
 
We might start to see more inward investment as the UK is becoming more attractive as a place to invest. Transnational Corporation (TNC) executives ranked the UK 6th equal with Australia as a top investment destination for the period 2012-2014, up from 13th in 2011.  The top five ranked countries were China, the US, India, Indonesia and Brazil. 

Manufacturers globally have the strongest investment plans.  60% of Manufacturing TNCs indicated they plan to increase FDI expenditure in 2012 from their 2011 levels compared to 45% in the Primary sector and 43% in Services.