EEF blog

Last week’s disappointing PMI numbers said a lot about confidence at the start of 2011q4. Confidence is going down; not just in the UK but in the global economy.

How is falling confidence impacting on real activity for manufacturers?

The first place confidence spills over is into firms’ business decisions that have longer time horizons – investment and recruitment.

Manufacturers have longstanding issues finding the skilled employees they need. But it is also fair to say that the sector has not been a source of long-term employment growth for the economy overall. Neither of those things looks likely to change in the short term.

So focusing on investment, lower confidence means manufacturers see the future demand for their products as less bright – or at least more uncertain.

That goes against potential investment decisions for three reasons:

- potential for lower cashflow making it harder to service any external finance used to help finance investment;
- lower demand weakens the case for creating extra capacity;
- The value of retaining cash to help firms to cope during a downturn goes up;

On the last point we have an additional piece of evidence – earlier this year George Osborne claimed UK companies were sitting on cash worth 5% of GDP.

But last week’s data suggested falling confidence may be spilling over into more than just investment. Customer orders seem to be pulling back too – including those from outside of Europe.
How might that work?

Take China as an example. This is a country that relies on export demand to drive growth. Europe is a major market for the Chinese – in 2010 the EU accounted for 20.1% of China’s total exports.

The trade balance with the EU increased by a massive 39.5% in 2010 to return close to 2008 levels with a surplus of €108 billion.

If demand from Europe is lower, Chinese growth prospects are lower – unless they can find offsetting demand elsewhere to compensate.

So thinking about what all this means for Chinese companies that buy UK exports, it’s important to think about what kinds of goods we export to China.

One of our major exports is electrical machinery for example power generation equipment. Now some of this such as motors and variable speed drives go in to equipping Chinese factories, which for the same reasons as the UK, might be thinking now is the time to hold off on investments.

Vehicles, particularly luxury cars, are a growing export to China. If luxury cars are a purchase item of the wealthy, and the wealthy derive a relatively higher proportion of their income from capital (including owning Chinese factories) – then this is the sort of item that could suffer if Chinese export markets look weaker. This is my speculation only.

But despite all this there are reasons there’s still cause for optimism. These confidence impacts are not likely to be as severe in China as they are for the UK. China’s export exposure to the EU at 20% is still a way off the UK’s 50%+.

Later today Felicity’s going to talk more about these causes for optimism.

At the start of the year we identified four main challenges to growth over 2011: government cuts, access to finance, commodity prices, eurozone trainwreck.

This was also in the context of what we already knew to be weak consumer demand driven by reductions in real incomes, a weak housing market, and higher unemployment.

Domestic demand was undoubtedly weak and with the uncertain spillover impact of government cuts to come, the fear was it could become weaker.

The big shift since the start of the year has been the substantial weakening in external demand.

Though we might try to claim we had this risk in our sights, our flagging of the eurozone as a risk was more in the nature of an apocalyptic Lehman-scale financial markets meltdown. The sort of risk that was undoubtedly hugely negative but hard to be specific about.

While that unfortunate scenario could still yet materialise, the actual impact of the crisis that we are seeing, the generalised downward pressure on overall external demand is something we perhaps didn’t appreciate.

So how exactly is the eurozone crisis impacting on us?

Felicity has spoken about the three generalised impacts outlined by Mervyn King in May. But these generalised impacts hide a lot of complexity and specificity.

While the eurozone-wide challenges are the main threat to external demand, there’s actually a wide variety of challenges faced by the specific markets in Europe where we are now seeing weakness.

So with this in mind, we’re coming out in the next few days with a series of blogs on:

Specific challenges to eurozone countries that are key UK export markets;

The spillover of the crisis into external demand more generally via confidence impacts on markets outside of Europe;

Why in the medium term, we still have reason to be optimistic about the prospects for UK manufacturing, despite the impacts on Europe;

Why the UK cannot afford to take opportunity for granted and must compete hard to attract investment and drive growth.

Ah, the Eurozone, one minute you think the crisis is on the brink of resolution and the next a referendum has been called, stock prices have plummeted and the musical hopes of the Italian premier have been dashed.

Although the fact that the UK is not a member of the Eurozone has limited the extent to which we've been affected by the immediate impact of the sovereign debt crises, we are by no means immune. There are three key reasons what what happens in the Eurozone matters.

Firstly, what happens in Europe matters because Europe is our biggest export market. Given weak domestic demand, UK growth is dependent on export growth, which is being held back by ongoing weaknesses in the Euro area.

Europe buys around half of UK exports
Value of goods exports (2004 £m)

Secondly, what happens in Europe matters because of systemic risk

Back in May, Mervyn King gave evidence to the Treasury Select Committee, he said that crisis in Europe could lead to concerns about UK banks.

He said:

If, as their crisis evolves and develops, financial markets came to the view that these problems had not been tackled, there was no long-run plan for dealing with the need to regain competitiveness in these other countries, then of course the crisis could not only spread, but it would lead people to speculate, "Well, okay, here is a UK bank, which we are told has rather little exposure to Greece and we can see that, but we don't necessarily know all the exposures of the French and German banks to which the UK banks are themselves exposed". So trying to work out these other links is very hard to judge.

Finally, what happens in Europe matters, because no-one really knows how bad the outcome a disorderly default would look.

The crisis in Europe has knocked the confidence of households and investors around the world. If things were to escalate in Europe it is unclear what the impact of this would be. In the same Treasury Select Committee meeting King argued that:

Even knowing the mechanical links—a matrix of interconnections between banks—does not guarantee that there can't be a sudden loss of confidence in which those who fund banks decide to step back and say, "Look, we have no idea which European bank is exposed really to which other European bank, therefore we will just stop funding European banks". I think US banks and other national banks could be drawn in in those circumstances.

At the time King did not think this was the most likely scenario, but he also added "There is no alternative ultimately for dealing with the fundamental problems." Here's hoping Greece – and the rest of Europe – can deal with these.

The Germans are having a tough old time of it lately.

For months a coterie of southern European basket-cases have been pushing hard for them to sign on the dotted line re euro-bonds read Germans bailing out everyone else by standing behind their debts.

Then, in the weekend, German footy has taken a faecal turn with disgraceful behaviour at the Cologne v Schalke match.

And this week we have the news that the German economy only expanded by 0.2% in the second quarter.

So is it the end of the wirtshaftswunder (economic miracle)?

One cloud is well and truly within the gambit of the politicians to address – and I don’t mean the football.

That is the eurozone debacle that has lurched from train-wreck to train-wreck since the (first) decision to bail out Greece last year.

Were this to be resolved, it’s possible that Germany’s fortunes and those of the eurozone more generally could turn up. And there’s no doubt this is the schwerpunkt for Chancellor Merkel at the moment.

Sadly Ms Merkel’s summit with French President Nicolas Sarkozy this week, seemingly did not deliver.

Markets have been tripping over themselves to punish the heads of Europe’s two largest economies for failing to countenance eurobonds.

Yet you can understand Germany’s reluctance to get their hands dirty with southern European debt.

Speculation about the possibility of one or more eurozone members leaving the single currency has helped keep the euro low and therefore helped German exporters.

While a stronger Europe is certainly in Germany’s long term interests, at least in 2010 and the first quarter of this year, export growth in Germany powered impressive growth.

A more important factor is the impact Eurobonds could have on Germany’s cost of borrowing – it would increase. Again hardly a welcome development for the German economy and one the populace would feel is ill-deserved given Germany’s relative control over its finances.

A third factor has to be the bargaining aspect. As soon as Germany agrees to stand behind eurobonds the pressure comes off the peripheral European countries to reform rigidities holding back their economies.

Perhaps that’s why Germany is trying to drive reform in the direction it favours first before contemplating any Eurobond arrangement, starting with the announced intention this week for France and Germany to harmonize corporate tax rates.

The UK economy has stuttered along since the end of 2010.

2011q1 growth was weaker than many expected, including the OBR and the Bank of England, at 0.5%. Taking into account the 2010q4 contraction, the economy has been flat for six months.

Prospects for the second quarter look moderate, with modest growth set to continue.

Consumer spending weakness in the UK in 2011 so far, received a boost in April from the bank holidays and warm weather. This impact however is likely to be temporary. UK households are continuing to feel the squeeze on their disposable incomes from the VAT rise in January and strong food price inflation.

Investment intentions continue to be clouded by uncertainties. Demand uncertainties have been further complicated by volatile and (until very recently) increasing commodity prices - for many firms this makes sitting on cash the smart option right now.

While 2011q1 overall showed an improvement in the UK trade position relative to 2010q4, this appeared to have weakened at the end with ONS stats showing the deficit widening in March compared with February.

This was driven by a contraction in goods exports to countries outside the EU, with falls notably heavy in intermediate and capital goods exports. Some analysts fear that recent softness in commodity prices might indicate weaker activity in emerging markets.

This is particularly important for manufacturers as emerging markets are where they have seen strength in the recovery.

But on the flipside, more traditional UK markets in Europe, notably France and Germany, are powering ahead, with the Germans in particular showing strengthening domestic demand (and in impressive 1.5% q/q growth figure for 2011q1).

However, there are reasons to think the recovery in trade will revert to type in 2011q2. EU countries, with the possible exception of Germany, are unlikely to be able to sustain strong domestic demand recorded in q1.

And strength still remains in emerging markets. China beat expectations for retail sales growth in 2011q1 and with inflation also beating forecasts, pressure continues to build for an appreciation of the renminbi – a benefit to UK exporters.

For Asia more generally, BBVA (for example), sees continued strong growth in 2011, albeit moderated by high oil prices and supply disruption from Japan’s earthquake and tsunami.

In fact this supply disruption made it to the UK too, with UK outlets of Japanese-owned carmakers having some production restrictions.

This was perhaps part of the picture in April’s manufacturing PMI, which declined to a seventh month low, following January’s peak (though still very much in expansion territory).

How serious the Japanese impacts are remains to be seen, with some tentative indications that it may not be as serious as initially thought. What impacts we do see may be confined to the automotive sector in 2011q2.

The orders reading for the PMI underlined the contrast in strength between domestic and export markets. While this was already the case previously the difference, export market strength v domestic market weakness is becoming much more stark.

Export orders continue to be strong, particularly from emerging markets but also the U.S. and EU. But the domestic market appears to be weak and getting weaker.

Manufacturing powered through another strong quarter in 2011q1 and as my colleague Jeegar has noted is responsible for a larger share of the UK’s recovery than its share of the overall economy i.e. manufacturing punches above its weight.

We’ll be having a further think over the next few weeks about conditions for 2011q2 and coming to a view as to whether export strength will continue to deliver positive results for manufacturing and the wider economy.

Keep an eye out for our views early next month in the next edition of EEF’s Manufacturing Outlook.

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.

Ireland and Greece have been ‘bailed out’ of their financial woes. Commentators have turned their gaze to Portugal and Spain as the next dominoes in the eurozone sovereign debt saga.

But what does bailing out mean? And does getting a bail out mean you’ve sorted your debt problems? The answer has at least as much to do with growth prospects as it does state-backed financial assistance.

Paul Krugman in the NY Times notes that getting a bail out simply means getting a guaranteed line of credit at a cheaper rate than what the market will provide. It doesn’t mean countries are bailed out of their debts – they still have to pay them back. It doesn’t even mean a particularly cheap rate on debt, which would be a welcome respite for a country trying to manage down its bills. The Irish deal secures credit at 5.8% interest - more than what the markets were charging them as recently as September.

So what does getting a bailout really get you? In short, a bit of time. Time to put in place fiscal reforms to get deficits and ultimately debts down. But just as importantly time to get growth in the economy up.

The growth part is absolutely essential if the fiscal reforms are to stick.

Growth was the aspect highlighted in a Radio 4 interview with Alistair Darling last Friday, where he discussed the perilous prospects for the eurozone periphery.

Perilous indeed.

The Irish numbers don’t even look like they stack up numerically. Ireland is relying on 1.75% growth in GDP 2011 – a number that will flow through into its tax receipts forecast. At the same time they are planning a contractionary (is that a word?) drag from the government equal to 3% of GDP.

Market commentators don’t seem to think such growth is likely. Many predict growth to be flat or even negative in 2011. What then for the bailout, will it be enough? How much more pain can the Irish people take if it isn't?

One of the big claims regarding the eurozone periphery is that they’re uncompetitive because their costs are too high. Becoming more competitive is a path to higher growth. Sharing the euro means currency devaluation is ruled out as an option. That leaves so-called internal devaluation, a long, slow grind of suppressing wage and cost rises in the economy.

Lower costs or even decreasing costs, could lead to lower inflation or deflation. Good for competitiveness maybe – except that will also make the cost of these countries’ debts higher in real terms, potentially necessitating further cuts.

So is that bailout really buying just another strap in the debt-growth straitjacket? And it seems to be tightening in.

As European leaders hammer out a deal on a permanent stability mechanism, they would be well to keep a close on their temporary fixes. Some ideas for boosting growth need to emerge for the periphery and soon. And if the periphery can't sort that out, maybe the core needs to think about it too - after all they're standing behind the bailouts. All this seems to be pointing to closer fiscal/political integration as the only sustainable way out.

Whitehall bureaucrats supposedly working up a Plan B for stimulating growth if the UK economy heads south would be wise to pay close attention.

Yesterday, EEF published the results of our Q4 Business Trends Survey.

The headline messages were that the manufacturing recovery was powering ahead, with two mechanical equipment and metal producsts coming out of our survey as two of the strongest performing sectors.

Today, National Statistics has published the October Index of Production - the official account of what's happened to output. Here are the headline results:

• Output grew by 0.6% in October, and was up 5.8% from October 2009.
• Growth was broad-based, with 10 of 13 manufacturing sectors showing growth.
• Mechanical equipment and metal products were the two strongest performing sectors.
• But output remains 9.4% down from pre-recession levels.

So yes, manufacturing continues to power ahead. But the challenge is maintaining that momentum into 2011, so that manufacturing can continue to drive the broader economic recovery.

2011 won't be an easy ride - the EU crisis is still in full swing and the rebalancing of the US-China economic dynamic will only begin in earnest next year as China's new five year plan begins in March.

The government's Growth Review, which was launched last week, will hopefully take a look across government to see where it can reform policies that are currently blocking growth, and where it implement new ones to support ambitious manufacturing companies planning for growth.

Last week I noted the low likelihood of Ireland or other distressed PIIGS leaving the euro. Investors would take flight, debt would balloon, default would be likely. The converse of this situation is what if Germany chose to leave the euro? Stephanie Flanders notes that this could make economic sense for both Germany and everyone else.

Germany’s new deutschemark (DM) would likely rise relative to the euro. Therefore there would be no big jump in the value of German Government debt, in fact the opposite, euro-denominated debt would be worth less in terms of DM. Commentators on the German economy claim that their dynamic economy is the main driver of their strong export performance, not the euro. Dumping the euro would certainly test that assertion. Assuming they're right a higher currency would not cripple exports.

And for everyone left in the euro, there would likely be a small gain in the competitiveness of their exports. The relative strength of the new DM compared with the euro should see German consuming more imports from their neighbours. This would help them with the export-led growth they need to climb out of their respective sties.

But I don’t think this will happen.

Whether they want to admit it or not, a lower euro vis-à-vis a theoretical DM does benefit Germany’s export sector, even if we assume that internal dynamism is more important. A lack of currency fluctuation for exporters, particularly small exporters, inside the eurozone is also highly beneficial.

Even contemplation alone of exiting the euro may threaten stellar German business and consumer confidence, which at the moment seems to be sailing straight through the sovereign debt crisis storm. Uncertainty about the impact would be a negative force, even if calculations suggested a net benefit.

And while a fall in the value of euro-denominated debt may benefit the German Government it would be at the expense of many bondholders in the German private sector.

Convincing as all this is, in the long run I think the strongest motivation for Germany to stick with the euro is political economy. Germany is the biggest eurozone economy and the strongest – its bunds are the reference against which peripheral euro members’ widening bond yields are measured.

It means Germany has the biggest say in how institutions in the EU are being designed to deal with the current crisis – but also how they should be designed to put the system onto a stable and sustainable footing. You might argue they’re not doing a great job of that – but they are having a big influence. And if things come right - and even if they don't - that influence is likely to be felt for many years.

Other countries looking for a bailout need to lobby Germany. It’s the biggest donor to these deals. Using this lever the Germans can press for policy reform in their interests. They may not have succeeded in getting Ireland to push up its corporation tax rate – but they got this sacred cow on the table for discussion.

As the biggest player in the EU, the augmentation of institutions along German lines surely is seen as an opportunity by German politicians to increase their power. So for example future sanctions on fiscal recalcitrant behaviour aren’t going to hurt Germany given its record – and look who’s pushing this issue? Germany.

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.