The bedrock of the UK economy

A new study categorically rejects the idea that manufacturing faces a declining role in the future. A strong manufacturing base, it argues, is fundamental to prosperity.

Manufacturing is in terminal decline. It is destined to form an ever-decreasing proportion of the UK economy. Perhaps design and R&D will continue to take place here while physical production is moved overseas, but in the main, the booming service sector will take up the slack.

So the conventional wisdom runs. But all these views are wrong. A new study by the Engineering Employers Federation and Warwick Manufacturing Group debunks these myths and concludes that:

1. Manufacturing is the key to a healthy trade balance

2. It is an engine of productivity and wealth creation

3. Because manufacturing is a big customer of a number of other sectors, an increase in manufacturing production has a bigger knock-on effect on the rest of the economy than an equivalent rise in any other sector

4. A decrease in manufacturing exports would need a threefold increase in services to compensate.

In other words, without a healthy manufacturing base the overall economy would be in much worse shape.

Nevertheless, manufacturing industry faces serious change. Deep-rooted problems in the fields of investment, innovation, R&D, skills and new technology need to be addressed if it is to achieve its full potential. Partly because of the prevailing economic conditions, the industry has become locked into a vicious circle of low margins leading to under-investment in skills, R&D and new technology, and under-use of innovative manufacturing techniques.

Below we examine some of the main findings of the study and look at the issues manufacturing must face up to if it is to play its full role in the modern UK economy.

The trade account

Manufacturing’s contribution to the trade account has plumetted from a surplus of £1.3bn in 1980 to a deficit of £29bn in 2000.

Nevertheless it still accounts for 62% of all exports, and a 5% decline in manufacturing exports would require an expansion in services of three times this amount to maintain the trade deficit at the same level.

Moreover, service sector exports are dominated by ‘old economy’ areas such as transport and travel. Telecommunications, computing and information services only amount to 5% of service exports, barely greater than engineering services such as consultancy.

Competition in services is set to intensify and improving productivity is more difficult than in manufacturing.

But since sterling started to rise in 1997 there has been a rapid acceleration of 18% annually in imports of intermediate goods (for example components which are not sold directly to a customer in their own right but to another company to incorporate into its own products). Production is being moved out of the UK to offset the strength of sterling, a worrying trend. ‘Even when sterling goes back to a more acceptable level this won’t come back,’ says EEF chief economist Stephen Radley.

The study set up a simple model of the trade account to examine what happens to the trade deficit if manufacturing grows at different rates until 2010. All the cases assumed the economy grows at its long-term annual rate of 2.25%, and in the first year all assumed manufacturing would grow by 0.5%. In the pessimistic scenario the annual rate of growth remains at 0.5%; in the middle forecast it expands by 1.5% annually; and in the optimistic case it grows at the same rate as the economy, 2.25%.

If manufacturing keeps pace, the deficit does not increase significantly compared with current levels, rising from £29m in 2000 to £38m in 2008. In the other scenarios a large and widening deficit develops, reaching £49m in the middle scenario and £60m in the pessimistic case.

‘This is not an unbelievably big deficit,’ says Radley. ‘It’s below the late 1980s’ level. But it would be permanent, not transient as it would if it were caused by a consumer boom.’

Given that manufacturing grew at only 0.5% annually for most of the 1990s, what are the prospects of reaching even the middle scenario? ‘The last 10 years have been pretty bad, with a major recession and two periods with an overvalued currency, so better than 0.5% seems OK. But to get to 1.5 to 2.5% the industry would need to seriously address the issues identified in the rest of the report,’ says Radley.

Productivity growth

Manufacturing productivity growth has outstripped the rest of the economy in every phase of the economic cycle since 1980, except between 1994-98.

The rapid growth in US productivity since 1995 shows what is possible. An earlier EEF study identified a range of factors to account for the US’s stronger performance, suggesting there is also significant potential to increase UK manufacturing productivity.

New technologies offer significant benefits but also pose a threat to competitiveness if UK manufacturers fail to invest in them as rapidly as other countries.The EEF and WMG identify a number of key areas for innovation in new technology.

Process technology such as sensors, rapid prototyping and nanotechnology offer reductions in costs and setup times, and quality and innovation improvements. System technologies including simulation technologies, control systems and software applications allow organisations to be more effective in planning, control, communication, innovation and learning.

E-business can improve co-ordination, co-operation and information — sharing across the supply chain.

Mass customisation – making bespoke products for individual customer needs in high volumes – would allow companies to escape from downward pressure on margins. But it also makes big demands on companies’ investment in technology, and the flexibility of their workforce and of their supply chains.

‘Mass customisation is double-edged,’ says Radley. ‘There are huge opportunities but it will make big demands on companies, their turnaround times and their relationship with their suppliers.’

To exploit these opportunities manufacturing will have to improve its investment record substantially, the report concludes. Lack of investment is the key underlying problem facing the sector. At the moment low profit margins are making it difficult to raise finance.

‘We have got economic stability at the moment – interest rates at a 30-year low, locked in lower inflation, and the cost of borrowing low. That could potentially count for a lot, but conditions are otherwise so uncertain a lot of companies think it may not be the right time to invest,’ says Radley.

‘Some companies have made a strategic decision to accept lower returns and wait for the recovery. As their technology comes up for replacement they are then making big decisions about whether to stay in the UK or move. This is particularly critical where companies are foreign owned.’

Spending on services

As manufacturing has focused increasingly on its core business and outsourced support operations it has become part of an ‘extended enterprise’, spending significantly on services. Almost a third of manufacturing purchasing goes on services.

Looking more closely, statistics show that this spending is heavily geared towards faster growing and high value added parts of the service sector, including banking, telecommunications and other business services.

An increase in output in any economic sector gives rise to a multiplier effect – in addition to the direct impact on production of an increase in demand, there is a knock-on effect on the wider economy through purchases of raw materials and services outside the sector concerned, and on the wages of workers in those sectors. Manufacturing’s multiplier is 1.72, so that a rise in demand for manufactured products by £1m results in growth of £1.72m in the overall economy. This is higher than most service industries though behind energy and construction.

Moreover, the combined effect of the multiplier and the size of the sector means that a percentage point rise in manufacturing has a larger absolute effect on the economy than the same rise in any other sector.

A 1% increase in manufacturing leaves the economy better off by £4.7bn, more than double the effect of financial services, the next biggest sector. Similarly any shrinkage in manufacturing will have a wider impact on the economy as a whole. It is important not to underestimate the links between manufacturing and other sectors, and the extent to which growth in services depends on a healthy manufacturing base.

Economic prosperity

Despite under-performing in investment and innovation, manufacturing remains a high-value added activity in the UK, contributing more to the economy than might be expected from its share of employment. There is significant potential to increase this contribution.

Gross value added per person employed in manufacturing remains higher than the economy average, particularly in the transport equipment and electrical/electronics sectors.

In addition, countries with relatively large manufacturing sectors tend to be more prosperous. Statistics from the OECD found a strong correlation between GDP per head and the size of the industrial sector for nine of 12 European countries.

The UK, with one of the smallest industrial sectors as a proportion of the economy, also had a smaller GDP per head than seven major industrial competitors and outscored only France and the smaller economies of Belgium, Denmark, Finland and the Netherlands.

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