EEF blog

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.

In his column this morning, Allister Heath takes a look at whether the government is getting to grips with public spending and worries that "growth remains to weak for comfort." As he says:

"[The Chancellor] desperately needs more GDP growth.
 
Osborne’s mistake has been to rely too much on tax hikes, especially April’s job-destroying national insurance increase inherited from Labour, as well as January’s VAT increase, to protect spending. He hasn’t benefited politically from this choice...and the taxes are damaging growth.

Osborne is right on austerity (though not always on how to achieve it) – but wrong not to be deregulating the economy, cutting the most damaging taxes and truly making the UK open for business again."

Heath picks out the NICs and VAT rises as the primary drags on growth, but a note on corporate tax reform from the House of Commons Library filed last week picks out tax rise that's damaging for SMEs and manufacturing investment: the recent cuts to capital allowances.

The note quotes from the IFS, saying:

"the largest [negative] impact on those firms with capital-intensive operations – with long-lasting equipment and machinery – that currently benefit most from the capital allowances. This is likely to apply more to firms in the manufacturing sector..."

And from the HoL Economic Affairs Finance Bill Sub-Committee, which recommends post-implementation reviews to monitor the outcomes of the reforms, because:

"the package of reforms may be unbalanced across business sectors, disadvantaging small and medium-sized businesses and manufacturing..."

The government believes, that on the whole, it's corporate tax reforms will boost investment, including in manufacturing:

"The additional reductions in corporation tax rate and the extension of the short-life assets regime will help to increase further the levels of investment by business. We estimate that the overall effect of these measures will be to reduce the tax liabilities of the manufacturing sector by around £700 million by 2015."

Maybe, but the lack of private sector investment over the past year suggests Allister Heath might want to add capital allowances to his list of tax changes that are damaging to growth.

Anthony Hilton’s Evening Standard article, Let’s get real about manufacturing, suggests politicians – and the public – need to realise manufacturing cannot deliver the rebalancing the economy so desperately needs. Hilton claims the real rebalancing we need is a shift away from debt-fuelled consumption towards savings and investment.

While there is certainly truth in the need for a reappraisal of our debt-fuelled model of growth of the past decade, Hilton misses some important elements where manufacturing is very important.

Firstly exports. It is true that the UK, along with many other developed economies is going through a painful but necessary retrenchment in private consumption and government spending as people and governments learn to live within their means.

But this is not true for the world as a whole. Indeed there are parts of the world where consumption looks set to boom as aspiring and increasingly affluent middle classes emerge in developing economies like China and India.

This is a real opportunity for the UK. If we can export more goods and services to parts of the world that are looking to consume more, we can help drive our own economic growth. This is a key part of the rebalancing story.

So who does the exporting in the UK economy? Manufacturers punch way above their weight. 48% of total UK exports in 2010 came from the manufacturing sector. And we are seeing growth. Goods exports to China in 2011q1 were up 26% over 2010q1. This is admittedly off a small base but shows there is large potential.

Over a longer timeframe what drives an economy’s long run growth potential? Expansion of its technological frontier through investment in innovation.

How does manufacturing look here? Well manufacturing accounted for 71% of UK business R&D in 2008.

Finally what about Hilton’s warning to politicians not to devote ‘too much time to the pursuit of the impossible’?

Well our competitors are showing us what’s possible. Germany is booming on the back of its exports to China where it has a stronger foothold than the UK.

Our competitors take seriously the need to create the right business environment for manufacturing to succeed. It isn’t about ‘perversely damag[ing] those areas where we are competitive’.

It’s about our tax system reflecting the realities of modern capital investment to allow our manufacturers to keep reinvesting in modern technology.

It’s about making sure our world class financial sector actually supports the real economy as well as the inter-bank trade so that SMEs aren’t citing access to finance as a barrier to growth.

And it’s about having a demand-led skills system that delivers what the economy needs and produces a consistent pipeline of skilled young people.

Even if you support Hilton’s premise, it’s hard to see how addressing these areas would distort the economy. But it would mean getting real about manufacturing.

The recent run of manufacturing PMIs suggest that manufacturing is coming off the boil after nearly two years of solid growth.  The survey again highlights the weakness of the domestic market, reflecting the squeeze on households and government spending. 

However, as strong overseas demand has played a dominant role in the recovery of manufacturing, the softening in output growth reported across much of Europe and the BRIC economies could signal a choppier outlook for the rest of this year. 

The question is whether the positive trends in recruitment being reported across the sector give us cause to look through some of the external and temporary factors that will have dampened activity over the past couple of months and whether these indicators will simply begin to normalise after a strong rebound in the months ahead.

In the FT today, Peter Marsh reports that the government’s ‘rebalancing agenda’ has been criticised for being incoherent. This may be true. The term 'rebalancing' does seem to be used with a degree of abandon to refer alternately to regional, industrial or public/private balance, depending on which is most convenient at the time. While there is, in fact, rationale behind each of these uses we would point to two key elements of rebalancing.

As David Willets noted in a speech last year:

“Future growth has to be driven by business investment;
it needs to be export led”

In this speech Willets mentions the importance of innovation to drive both of these things.

But what exactly is innovation?

David Willets notes that:

Innovation covers “a broad range of activities” and is “more than research and development, vital though that is. Knowledge transfer, design, branding and customer insight all matter”

He is right. Innovation is broad. But it is also targeted. Companies innovate as a response to competitive pressure. Innovation is commercially driven. And this is why it is so broad, competitive pressures do not just apply to products. Developing new processes or marketing techniques is equally innovative, and equally important to maintaining a competitive edge.

So innovation is commercially-targeted development of any or all elements of a business. And Willets is right, it's crucial for growth. Or, for that matter, rebalancing.

Last Friday, FT Alphaville wrote up a Kevin Gaynor (from Nomura) comment that pinpointed mid-2001 as the starting point for the recent crisis.

As Gaynor states:

"Looking back it now seems that a fundamental shift happened in mid 2001 to the commodity and currency world, a shift which has been ongoing since and that has affected the global supply side inflation picture around dramatically.

This shift has not been analyzed before as far as I’m aware, but in fact, it appears to have dominated asset returns over the period. The US Dollar measured against its broad index shifted from being in a quasi permanent appreciation since the breakup of Bretton Woods, into a depreciating phase which is still going on today.

The CRB index, which had been in a broad cycle since the 1960s, shifted into a turbo charged increase phase. Not surprisingly, the basic materials and oil and gas components of the global equity index shifted into a major bull phase at the same time and have together been the two best performing sectors over the period."

But if he's right, the question is why did dollar and commodity markets experienced a structural shift in mid-2001?

Commenting on the FT Alphaville post, my answer was that the Bush tax cuts and the September 11 attacks resulted in a massive fiscal earthquake:

"Two fundamental global economic pivot points in mid-2001 were the US passing the first Bush tax cuts and the September 11 attacks.

It's why the US fiscal position shifted from the 2001 projection of $889 billion annual surplus in 2011 to a $1,480 billion deficit forecast this year by the CBO for 2011. A $2.3 trillion swing in the deficit for 2011.

The impact on net indebtedness? Instead of a surplus of $2.3 trillion, it has a net debt of $10.4 trillion - a $12.7 trillion swing in a decade."

The rest of the FT Alphaville post and the comments are worth reading because they flag up the rather stark implications for global rebalancing.

According to official data, manufacturing output grew by a modest 0.2% in March. Output was up by 1.1% on the quarter - which was no snow-bounce, as output was up 1.1% in q4 as well.

Another solid quarter of growth, however, means that UK manufacturing is the biggest source of growth in the economy. Manufacturing accounts for around 13% of the economy. But according to official statistics, it has accounted for 33% of the economic recovery.

Manufacturing is punching above its weight, and the economy is benefiting in terms of jobs and investment.

Share of GDP
 
Source: ONS & EEF

Share of growth since the recovery ended

Source: ONS & EEF

While a meek February and March are cause for concern, manufacturing output is still 8.5% below its pre-recession peak, leaving plenty of fuel in the tank drive growth in the coming months.

So today's GDP estimate of 0.5% growth in the first quarter was, well, expected.

To certain degree, it won't set hearts and minds racing about the strength of the recovery. Nor will it send the markets to panic stations about a double dip.

Manufacturing remains the strong point of the recovery, with 1.1% growth in the first quarter. The service sector rebounded from the snow by growing by 0.9%.

But while we've avoided a return to recession, 0.5% growth won't settle nerves about the rest of 2011. As Joe Grice, Chief Economist at the Office for National Statistics says:

"Abstracting from the snow, we have an economy on a plateau."

Worryingly for the economy, that's plateau, as in stagnant growth...as in stagflation. The Monetary Policy Committee may feel justified in its stance on holding tight on interest rates, but it will worry about the underlying health of the economy: strong service sector growth in q1 is likely a rebound in activity from the snow. As FT Alphaville bearishly notes:

"Plateau isn't the word we would use of course. More stagnation, flat-lining, stalling in mid-air, that kind of thing. The ONS also called growth in Q1 2011 'essentially an arithmetic effect' which seems even more devastating."

What worries us here at EEF isn't necessarily what today's data says about where the economy is now, but what it says about the economy for the rest of the year. The UK will face some stiff economic challenges in the coming months:

• Fiscal austerity has begun (we've seen roughly the equivalent of 1.5% GDP cut back in the past 12 months) and will begin to weigh on the economy through the rest of this year.
• There appears to be no respite in rising oil and commodity prices.
• Supply chain disruptions from the Japanese earthquake will only begin to affect output in this quarter.
• The euro-zone crisis will only get worse unless Greece, Ireland and Portugal begin to restructure their debts (which will be painful enough).

The recovery could probably withstand a shock from any of these on their own. But the risk is that they combine to create a perfect storm that keeps the economy trapped on the plateau...or even worse, forces an economic retreat back down the hill.

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.

Rebalancing is about achieving two things: internal balance (a balance between consumption and investment); and external balance (a balance between exports and imports). Today’s GDP and investment figures allow us to look a little closer at which way the scales of economic balance are tipping: 

Investment:
It seems progress towards an internal balance stalled a little in 2010q3: business investment fell by 0.2% over the third quarter. However, business investment was 2.6% higher than in the same quarter a year ago. A similar picture can be seen for manufacturing: although investment fell by 2.0% over the quarter it is 1.0% higher than in the third quarter of 2009.

Trade:
There is some good news on the external balance: the contribution to growth of net exports was 0.4%, which is an improvement on the last quarter, when net trade had no impact on growth, and the three earlier quarters when net trade had a negative impact on growth.