EEF blog

As recess draws to a close, policymakers need to start to tackle the thorny issues that still face our economy.   

Apart from the weather, summer has been a time to celebrate some of the successes of Britain – not just in sport but also as an industrial economy. However, today's statistics show the events of summer have not raised consumer confidence as expected and this could be risky as a pick up in consumption is expected provide some moderate support for growth in the second half of this year. 

Our summer reading list has discussed some of important issues that will contribute to a resurgence in growth in the short, medium and long term.

• We have discussed the need to stimulate innovation and continue to address the credit constraints businesses face. 
• A new model of growth needs to see investment and trade as key drivers – while the trade balance has not been improving, manufacturing investment has picked up in recent quarters and for some time now has been stronger than investment in the wider economy.
• We can also look to other countries that have seen some success in stimulating growth and supporting their productive sectors.

In the upcoming party conferences we want to see a big focus on getting the UK economy growing again with all parties having a clear and concrete commitment to raise growth akin to that of the fiscal mandate.

The coalition has made good inroads into getting the public finances back on track but in the absence of growth will they be able to achieve this goal?

Last week the public finance statistics showed public sector net borrowing, the key measure of the fiscal mandate, had increased in the year to July 2012 to £0.6 billion.

Clearly there is a tension between managing public finances and stimulating growth. But if conditions continue to worsen the government may be in a position where growth continues to lag and as a result are unable to meet the fiscal target.

The debate on our economy needs to change.  Keeping our fingers crossed that Europe will sort itself out and economic rebalancing will get back on track isn’t a plan for growth.  We need to start talking about what is most important for our economy – for us that’s the private sector investing, exporting and innovating – and how all parts of government can help companies do it.

A growing number of commentators are identifying infrastructure as the key to reviving the UK’s flagging economy. And for good reason, there is well-established evidence that spending on infrastructure offers one of the best returns on public investment.

During construction, infrastructure generates economic activity. Once complete, it can provide a wide range of benefits from a more mobile workforce and better access to export markets to making the UK a more attractive place for inward investment.

However, if the government wants to make investment in infrastructure the centrepiece of a renewed drive for growth, it needs to look beyond the headlines and received wisdom.

Anybody following the media debate might be forgiven for thinking that the only two infrastructure issues of any consequence are the heated debates about the need for more airport runway capacity in the South East and a bigger high speed rail network.

Whilst these are undoubtedly important issues for UK plc, it is far from clear that they are necessarily the most important ones from a growth perspective. Especially if a quick shot in the arm for the economy is the goal.  Both focus primarily on passenger, rather than freight, issues and either would be highly unlikely to start much this side of 2020.

But for manufacturing, which is well-positioned to provide the export and investment led growth that our economy desperately needs, issues such as the state of the UK’s road network are of at least equal importance.

Roads are fundamental to manufacturers’ ability to do business day in, day out. For most, the network is vital to accessing raw material, markets and the wider transport network. There’s little point, for example, in building a shiny new airport to the east of London if it’s not easily accessible by road.

In addition, many road improvement and maintenance projects can be got up and running relatively quickly and offer some of the best returns on investment. This makes them genuine candidates for economic stimulus measures.

If kick starting the economy whilst keeping to a tight budget is the objective, the government needs to focus its efforts on those infrastructure projects that can be implemented quickly and that offer the best returns on taxpayers’ money. This means paying as much attention to the state of our roads as it does to more glamorous issues such as new airports and high speed rail lines.

We put out our latest Credit Conditions Survey results today and spoke about it on Sky News - and there were some positive findings:

The balance of companies seeing an increase in the overall cost of credit falls to lowest level since 2007

Lower balance of companies reporting a rise in the cost of new borrowing

Improved responses on fees and rates on existing borrowing

Responses on availability of credit remain broadly stable

But we do also note some signs of more firms opting out of external finance altogether. This is a worry because we know from official statistics last week that our sector is bucking the economy's overall trend on investment - but it surely will be at a slower rate if its supported solely by internal finance.

Our survey started just after the financial crisis hit at the end of 2007. Since that time we have persistently had more companies say the cost of credit is increasing rather than decreasing and in general more companies saying the availability of finance is getting worse not better.

The availability balances started to turn more positive last year with the balance of companies finally switching to availability increasing. Since that time and again in this quarter's survey availability balances have been fairly stable.

On the cost side, the story has been pretty unrelentingly negative. Strong balances of companies have reported increases in the cost of credit - both in terms of interest rates but also fees and charges. 

As a result we have made numerous comments over the last 18 months that the cost of credit needs to come down - especially for SMEs - to help support the flow of finance for business investments.

So there is no doubt that the cost story in this quarter's survey is a positive - the lowest balance of companies (11.2%) reporting an increase. In particular the fall in the balance of companies reporting an increase in the cost of new lines of borrowing is encouraging (8.5% down from 13.2% last quarter).

This is coincidental - not yet definitive - with government efforts to get the cost of credit down. The National Loan Guarantee Scheme was introduced in March and the new Funding for Lending Scheme took effect this month.

What remains to be done is targetting the creditworthy firms that have simply given up on accessing finance to support their investments - unfortunately companies that we hear from all too often.

A disturbing trend reinforced again in this quarter is the proportion of firms saying they don't need to borrow - despite manufacturing investment growing strongly. This has drifted up from the low 40s and at 50.5% is the equal highest proportion over the course of the survey. A slightly higher proportion of SMEs report themselves in this position (51.6%).

We need firms believing in our financial sector again - our economy needs every pound of investment it can get right now.

So while I think it's tentatively positive that the government's credit easing schemes MAY be having some impact on the cost of finance, what's important now is that the government makes a lot of noise about these schemes and strongly challenges banks and other providers to make clear to would-be borrowers what they can offer.

There's a lot riding on this - £80 billion isn't just going to borrow itself.

As trailed by other recent data releases, the latest GDP estimate for the second quarter was revised up to a contraction of 0.5%.  So the UK's economic performance wasn't quite as dire as the first cut of data suggested.

But as we said last month it's still difficult to take the figures at face value as the impact of additional bank holidays will have had a material impact on output across a number of sectors - inlcuding manufacturing. If activity has been displaced rather than lost - as was the case in previous Jubilee years - most of the ground lost in the second quarter should be made up in the third.

However, the second estimate provides a bit more detail on the components of growth and these are the areas we need to be watching closely. 

Trade and investment are what's needed for rebalancing the economy.  But growth across both components appears to be nowhere in sight, not just in the most recent quarter, but over much of the past year.

Th ongoing euorzone crisis and the slowdown in some emerging markets is casting a long shadow over the UK and this is being reflecting by the drag that net trade is having on economic growth.  Despite hopes that net trade would be a big contributor it has had a positive impact on growth in only five quarters since the end of the recession.

And there's been a similar trend with investment. It's not yet outwith the bounds of possibility that the Office for Budget Responsbility's March forecast of a 0.7% increase in business investment could materialise in 2012. But for the private sector to chalk up an increase of nearly 6.5% next year looks challenging given recent trends. 

Manufacturing does, however, seem to be bucking the investment trends. Capital expenditure across the sector rose more than 5% in the second quarter, pushing investment levels around 13% higher compared with a year ago. The strong focus on productivity, the need to replace machinery with the lastest technology and investment to support entry into new markets or supply chains are all likely to be playing a part in driving more postive investment trends across manufacturing.

So manufacturing investment is perhaps a glimmer of good news amongst data which is largely pointing underlying weaknesses across the economy. Regardless of the size of the rebound in Q3 it's clear that kick-starting the rebalancing process is going to need a fair bit more effort from policy makers.

One of the downside scenarios we've discussed this year for growth is if China were to encounter some sort of 'hard landing' whereby demand for UK exports fell away sharply.

This matters because even though only about 3% of our goods exports went to China in 2011, our goods exports to China in 2012q2 were 38% higher than 2010q2. Whereas our exports to the EU - accounting for over 50% of the total - have actually fallen over the same period.

So UK export growth is heavily dependent on the parts of the world that are growing, like China, to help offset the weakness in traditional markets in Europe that are struggling.

It's concerning then to read some economists talking about the prospects for a sharper slowdown in China increasing.

Our last Economic Prospects publication in July noted China's GDP expanded 9.2% in 2011 and we expected a 7.5% expansion this year.

Now some people are saying that growth in China has slowed to an annualised rate of just 6.5% with little prospect of much improvement until next year.

6.5% still sounds like a lot for us mired in a second recession but it represents a considerable slowdown for China and it means that Chinese demand for goods produced by the rest of the world is slowing.

The Chinese manufacturing sector is apparently very weak - this will have implications for UK manufacturers of mechanical equipment - machine tools and the like, investment goods used in factories. This sector had a strong 2011 but is already showing some weakness in 2012.

Why is this happening? According to Peter Redward of Redward Associates, it's because:

'The need for rapid infrastructure build-outs is beginning to drop away.'

And

'The availability of credit to small businesses is actually tightening again.'

Worryingly despite China's monetary and fiscal headroom to act to stimulate the economy (unlike, say, India), Redwood sees officials likely to stay their hand for fear of creating 'long-term impairments' on Chinese balance sheets - easy credit leading to bad investments or simply flowing through into property, which is already over-inflated.

Certainly one to watch in the second half of this year.

Innovation is crucial for growth, but in the UK spending on innovation has fallen since the start of the recession in 2008.

This raises the question, how can we encourage more innovation, and more innovation in the UK?

As with most activity, the main reason companies choose to innovate – and choose to innovate in a certain place – is because of the opportunities available in that marketplace. Fundamentally, it’s about demand.

Mariana Mazzucato made this point in an article recently: arguing that technological and market opportunities are the main reasons companies will choose to locate in one place over another. She also mentions the importance of public funding for innovation. This can be key, as it signals government's committment to supporting innovative companies and technologies.

Below are a couple of examples of how competitor economies support innovation:

US policy recognises that government can boost demand through its procurement practices.

Mazzucato mentions the US organisations Defense Advanced Research Projects Agency and the National Institutes of Health, public sector bodies which are both actively engaged in procuring innovative goods and services. These act as a major spur for innovation in the US.

German policy provides an example that public funding through grants can boost innovation, especially when access to credit is tight.

Government can also provide an important spur to innovation through grants. In Germany R&D spending actually rose through the recession and the German grants schemes (ZIM and Thematic R&D) are credited with supporting this.

Importantly, both schemes are quite generous, both in terms of the total budget, and the amount available to individual companies. Grants are often also useful as they provide upfront funding for innovative projects, which companies can often struggle to finance.

This week the Bank of England released its Agents' summary of business conditions for August. This is a report based on the Bank's network of agents around the UK who go out and talk to businesses in their area to add to the Bank's intelligence about what's happening in the real economy.

Given ongoing weakness in the eurozone and recent disappointing economic data (GDP for q2 in particular), it's perhaps not surprising that the summary paints a picture of some gloom with demand weakening both at home and abroad.

A couple of interesting points I took out of this month's edition:

Credit conditions

Credit conditions remain polarised between, basically, large firms or firms that don't really need any cash and smaller firms that lack track records, security - or who banks really don't want to lend to as they continue to seek to shrink their balance sheets.

It will be interesting to see what the next SME Finance Monitor says next month about credit conditions for SMEs. While we can't do anything about firms not wanting to borrow given the weak demand outlook, it's worrying that (as the agents' summary notes) some creditworthy firms are still put off approaching their banks for finance.

I think cost is part of the picture, so the latest incarnation of 'credit easing' - Funding for Lending - will hopefully stir companies to approach their banks again to support their investment. But a lower cost has only got a chance of influencing firm behaviour if firms are still engaged with finance providers - I fear many no longer are following bad experiences in recent years.

Capacity utilisation

Despite firms reporting a moderation in export growth, exporting firms are still reporting that they are operating at close to full capacity. This is a story backed up sectorally, for example in the automotive sector, where capacity constraints for some major firms with high export concentration (85%) are being reached. But persistent weakness in Europe and fears that this weakness may be spreading to other markets, including strong-growing emerging markets, may test this strength in the second half of the year.

The flipside of this export story is what's happening domestically where firms that are focused on domestic markets report a degree of slack in capacity. Ironically, domestic demand has potentially a better story in the near future than export demand. While there's no suggestion consumption is about to surge, the drift down in inflation (despite last month's tick-up) should start to relieve the pressure on real incomes endured for several years by domestic consumers.

On the back of cracking success at the Olympic Games, now is a great time to ponder what else Great Britain does well. 

The Olympics opening ceremony celebrated the industrial revolution, which began in the UK and saw huge steps forward in the development of technology, the manufacturing sector and other industries.  It had a profound impact on daily life and the living standards that people across society enjoy. 

Britain remains an important manufacturing nation and the manufacturing sector is a vital part of the economy…

• 10% of the country’s GVA is generated by the manufacturing sector
• Approximately 2.5 million people are employed in manufacturing
• Half of the UK's exports are manufactured goods
• The manufacturing sector contributes over 70% of business R&D spending
• The UK is the world’s 9th largest manufacturer

The British manufacturing sector continues to generate new, innovative and ground-breaking products and services... 

• The Make it in Great Britain exhibition at the Science Museum showcases some excellent examples of the range and success of British manufacturing. A few weeks ago the EEF economics team visited the Exhibition and would highly recommend it to others. 
• This recent Telegraph photo gallery also celebrates great British inventions.  

As the UK gears up for recovery, the manufacturing sector must be a key part of that plan

The manufacturing sector has been hard hit by the uncertainty in the economic environment but manufacturers are not idle.  Many of our members continue to invest, are looking for growth opportunities in new markets and are focused on developing new products and services to keep ahead of competition.  The government needs to be encouraging more of this type of activity so UK manufacturing remains competitive.

Over the past couple of weeks our summer reading list has discussed some of the areas that policymakers should be thinking about.  These include the need to boost innovation and support UK companies to export, as well as looking at the success of some of our competitor nations.

Over the last couple of weeks we posted an “alternative medals table” which illustrated, among other things, the breadth of locations that UK manufacturers export to. This reflects the highly interconnected nature of modern manufacturing.

And it is not just manufacturers' customers who are overseas. The vast majority of manufacturers have overseas suppliers too. In the last three years nearly a third of UK manufacturers increased the number of overseas suppliers they used.

There are, of course, advantages to using overseas suppliers, but with more complex supply chains comes more vulnerability. Recent events such as the Japanese tsunami highlighted this – globally the automotive sector was badly hit – but it is not just ‘acts of god’ that can disrupt supply chains. Many manufacturers also experienced significant disruption as a result of the last global downturn, and the macroeconomic environment remains a concern.

Supplier failures and supplier disruption have real business implications, such as loss of orders, quality failures, or damaging relationships with customers.

One manufacturer we spoke to said that the inability of a major supplier to return to pre-recession production levels in response to higher demand meant the company was unable to respond with the speed and quality their customers expected.

However, manufacturers are not sitting back. In the last two years only 6% of companies said they had taken no action to improve supply chains. Many manufacturers proactively manage risk, with around one third of companies saying they view monitoring supply chains as business critical.

One method manufacturers are using to improve supply chain performance is increased collaboration with suppliers.

One company we spoke to said that not only did this improve quality, reduce prices and lead times but it also meant that they had better visibility of potential problems, such as capacity constraints. Another manufacturer said that increasing collaboration has enabled them to get things “right first time”, improving delivery times and reducing costs.

Some manufacturers are also looking to source components from more than one supplier

Multiple sourcing increases supply chain resilience, but it is not straightforward. Often inputs are complicated and each supplier will need to meet precisely the same standards. Companies who source successfully from more than one supplier often also have long-term collaborative relationships with these suppliers.
 
Another method of improving supply chain performance is to bring production back in house, or increase the use of local suppliers.

Our survey showed that two fifths of companies were bringing some production back in house, and one quarter increased their use of local suppliers.

A company we spoke to said that bringing production in house had taken two years of preparation, including hiring and training additional employees, but they had seen benefits through cost savings, quality improvement, and reduced lead times. However there can be disadvantages to bringing production in house. Another manufacturer commented that this had necessitated an extension to their factory, which eats into margins.

The results of actions to improve supply chain performance pay dividends for companies: two fifths of companies saw improved customer satisfaction and decreased costs.

Working with supply chains will be key to manufacturers’ ability to deal with any future disruptions that come along.

Trade data out today and it's not a pretty picture for 2012q2.

The deficit in trade in goods (ex oil) increased more than £2.5 billion in 2012q2 compared with 2012q1, with the overall trade deficit increasing by more than £3 billion. This doesn't bode for rebalancing our economy towards generating more growth from trade.

Our gold, silver, and bronze medal export destinations of Germany, the U.S., and France each saw falls of around £400-500 million in exports in 2012q2 (but conversely imports from Germany and the U.S. actually rose slightly).

More positively our gold medal export destination for growth, South Korea, saw UK exports continue to increase (by over £350 million) in 2012q2. China, our silver medal growth destination, was largely static.

So what to make of all this?

As we noted in our press comment, it's important not to get too worked up given the one-off factors in 2012q2 especially the Jubilee holidays but also the weather.

But on the other hand 2012q3 will need to see a serious bounce back to avoid the conclusion that rebalancing is off track.

What is the government's role in promoting exports as part of focusing *110%* on growth?

Three noteworthy mentions:

Strategic goal of doubling exports to £1 trillion by 2020

UKTI support for exporters

UKEF - finance products for exporting

The government's goal to get exports to £1 trillion was announced around the time of Budget 2012. It certainly is ambitious...requiring similar export growth to that seen in fast-growing export countries like South Korea every year up to 2020. But it is an important - and measurable - benchmark by which the government can hold its more detailed export promotion activities to account.

UK Trade and Investment is an effective government agency providing a range of services to promote UK exporters (and inward investment into the UK). Services include the Overseas Market Introduction Service that is a vital route into new markets - especially for companies new to exporting.

Then there is the recently renamed UK Export Finance agency. This agency is charged with making it easier for firms to trade by providing finance products to improve the cashflow and migitate the risk of trading with overseas customers.

While the intent of both agencies is good, the awareness of the support they offer is not so good - especially for the little-known UK Export Finance.

That's another reason the government's events at Lancaster House during the Olympics have been important - not just for highlighting opportunities to overseas investors and customers - but also to hopefully raise the profile of what support is avaiable to UK companies.

The challenge is how to build on this momentum and keep increasing awareness - this is where the government needs to think carefully about its near-universal ban on promotional/marketing spend. Is it really worth saving a few £ million on marketing spend if we're relying on trade delivering £ billions more in growth to drive the UK recovery?