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News : UK Economy Last Updated: Jan 20, 2011 - 6:44 AM

UK manufacturing growing strongly -- service sector still fragile; Banking on exports for sustainable recovery
By Michael Hennigan, Founder and Editor of Finfacts
Jan 19, 2011 - 3:03 AM

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British Prime Minister David Cameron hosted a meeting of business ambassadors in Downing Street with Trade and Investment Minister Lord Green, former chairman of HSBC Bank, to discuss how the government can boost Britain’s export market, Jan 10, 2011.

The UK manufacturing sector has shown strength in recent months but service sector performance remains fragile. The UK government is banking on growing exports to support an sustainable recovery.

The British Chambers of Commerce’s latest Quarterly Economic Survey (QES), released last week, suggests that the UK economy has continued growing in the fourth quarter of 2010, but at a slower pace than in the second and third quarters. The survey, combining over 5,600 responses from businesses across the UK, paints a mixed picture of the economy. While the indicators point to a strong manufacturing sector, performance in the service sector is weaker, raising concerns about a sustainable recovery.

EEF, the UK manufacturers' association, says that last year the manufacturing sector outpaced expectations and the overall economy by expanding 3.8%. This year, another strong result is forecast with 3.5% growth for manufacturing compared to a solid if unspectacular 2.1% growth for the economy as a whole. In 2012 growth is forecast at 3% and 2.6% respectively.

This balanced growth is broadly based across all sectors with the top performers forecast to include mechanical engineering and metal products, which benefit from having high exposure to export markets where demand is likely to be strongest.

EEF chief economist Lee Hopley, said: “At the start of 2010, shell-shocked from the worst recession in 80 years, forecasters across the country were wary of predicting anything more than very modest growth. But manufacturing picked up the baton and delivered its best performance in sixteen years.

“Manufacturing now looks set to be at the heart of the rebalanced growth the economy needs with sectors most exposed to international markets likely to post the highest growth.”

On Tuesday, consumer prices in the UK were reported to have risen by 3.7% in December, boosted by rising prices for food, fuels and air transport. Consumer price inflation has been at 3% or more since January 2010, compared to the official target of 2%.

The British Chambers of Commerce (BCC) said over the next few months annual consumer price inflation will rise to 4% and probably higher, following the hike in the VAT rate this month to 20%.

David Kern, chief economist at the BCC said: "...our view remains the same - - raising rates at a time when fiscal policy is being tightened, while businesses and individuals are facing greater pressures, would be a mistake and should be avoided. The factors contributing to inflation at present are also adding to the squeeze on profits and disposable incomes. We believe that interest rates will have to increase later in the year, but it is critical that the MPC (Bank of England's Monetary Policy Committee) waits until the initial impact of the tough austerity measures have been absorbed."

As in other developed countries, export growth is seen as key to a sustainable recovery.

Source: Davy Research

Prime Minister David Cameron is spurring business to grow exports to offset up to 300,000 job losses in the public sector, following the implementation of the government’s £81bn program of of spending cuts.

Last week, the merchandise trade deficit was reported to have been at £8.7bn in November, mainly due to higher oil imports.

The deficit was £25.7bn in the three months to November - -  little changed from the previous months but £4.5bn higher than a year earlier.

Exports rose 10.3% in the three months to November compared with the same period in 2009, while imports increased 13.5%.

Conall MacCoille, economist at Davy Research in Dublin, says in a report this week that the sharp depreciation of sterling, following the collapse of Northern Rock in 2007, had been expected to help reduce the UK’s trade deficit.

He says that Figure 3 (above)  illustrates that in trade-weighted terms the depreciation in 2007 was even larger than in the period following the UK’s exit from the European Exchange Rate Mechanism (ERM) in 1992. Peak to trough, the nominal effective exchange rate fell by 27% between 2007 and 2009 compared with a decline of around 20% from 1990-1995. Following the UK’s exit from ERM, the trade deficit began to shrink, eventually moving into a small surplus in the mid-1990s. Conversely, the sharp appreciation of sterling from 1996 onwards led to a deterioration in the UK trade deficit. This time around, however, there has been little response with the trade deficit remaining close to 4% of GDP in the third quarter of 2010. Given that there had previously been a strong statistical relationship between the exchange rate and trade performance across many countries, the relatively poor performance of UK trade since 2007 is surprising.

MacCoille says over the past two decades, the UK’s goods export market share has been in secular decline, mainly due to the emergence of new competitors such as Eastern European economies, China and other developing countries.

Since 2007, however, this decline has stalled - - providing some evidence that the sterling depreciation has had a positive impact on UK export growth. That said, in the period following the UK’s depreciation in 1992, the UK gained market share in the traded goods market. So the sterling depreciation appears to have had less of a positive impact on the UK's goods export market share this time around.

Traded services, comprising around 40% of total exports, are particularly important for the UK. Since 1990 the UK has gained market share in the global traded services market, but this trend went into sharp reverse in 2007 - -  severely hurting aggregate UK export prospects. The rising importance of the traded services sector for the UK economy has been accompanied by increasing specialisation in the financial and business services sectors. Figure 5 illustrates that these sectors have doubled their share of UK exports over the past two decades. Together, these sectors accounted for 7.3% of UK GDP in 2008 and 62% of UK services exports in nominal terms.

Source: Davy Research

The report shows that UK import prices have increased by around 23% since 2007. It says surprisingly, export prices (in sterling) have risen by approximately the same amount so that the UK terms of trade have been broadly flat. That is, UK exporters have increased the price of their exports in sterling, so that their prices in foreign currency terms (e.g. euro) have remained constant. UK export volumes are unlikely to rise sharply because companies have taken the competitive gain from the sterling depreciation in the form of higher profit margins rather than attempting to cut their foreign-denominated prices and gain export market share.

Prospects for UK net trade in 2011

Most macroeconomic projections for UK GDP growth in 2011 are conditional on a sharp turnaround in trade performance

  • The outlook for UK growth remains highly uncertain. Most forecasts for 2011 GDP growth are based on a sharp improvement in UK trade performance next year.
  • On average, forecasters expect net trade to make a 0.5% contribution to GDP growth in 2011 (having detracted from growth in 2010).
  • The poor performance of UK net trade has been surprising given the competitive gain from the sharp sterling depreciation in 2007. Thus far, forecasters have provided little rationale for why this weakness should dissipate in 2011.

Net trade unlikely to pick up sufficiently strongly to offset fiscal adjustment; policy rates may remain at historic low for longer than expected

  • The UK's specialisation in traded financial and business services, a poorly performing sector, is likely to continue to act as a drag on export growth next year.
  • The Bank of England expects an improvement in UK net trade in 2011 in its central projections. But the November inflation report outlined the severe doubts of the Monetary Policy Committee (MPC) in this regard.
  • If the MPC's projections for GDP growth based on a turnaround in net trade are not realised, short-term interest rates may remain on hold at their current historic low of 0.5% for longer than the market might currently expect.

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