Industry must do more than just blame the pound

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For UK profitability, the culprit is labour costs, which have risen by 17 per cent since 1995

For UK profitability, the culprit is labour costs, which have risen by 17 per cent since 1995

Football's coming home, perhaps, but manufacturing's rapidly heading for the exit. Britain's manufacturing output fell 3.0 per cent in July on a year-on-year basis. This represents the worst performance since the tail-end of the last recession in the early 1990s. To put the decline in context, the maximum decline in manufacturing output during the Asian crisis was only 1.8 per cent.

Even worse, the rate of decline in recent months has become faster and faster. On an annualised basis, manufacturing output is now down 7.3 per cent since the end of last year. If there is a crumb of comfort, it is that the UK is not the only country to be suffering. On an equivalent basis, there have been falls of 2.1 per cent in Germany, 5.6 per cent in the US and a truly staggering 20.9 per cent in Japan. As crumbs go, however, this one is pretty small – even in this comparison, the UK clearly has second division status.

For many, the explanation for Britain's manufacturing problems is simple. Production has fallen on two counts. First, Britain has simply been a victim of the global downswing. Second, Britain has, unusually, had to live with an overvalued currency. If only sterling had been weaker, the UK's manufacturers would be happier, healthier and more competitive. For manufacturers, a decline in sterling would be the equivalent of appointing Sven-Göran Eriksson as England's football coach.

Are these really, however, the only reasons behind Britain's manufacturing demise? The latest bout of manufacturing weakness has been associated with a deterioration in the global environment. Yet Britain's poor manufacturing performance has been going on for a lot longer than that.

The first chart shows the extent to which the level of manufacturing output has changed in four key industrial countries since the mid-1990s. The US has put in an exceptional performance, with an overall increase over the last six years approaching 30 per cent, even allowing for the decline in recent months. Interestingly, Germany has not been far behind, with an overall gain of over 20 per cent. The UK's performance, however, has been pitiful: over the whole period, the level of manufacturing output has been broadly unchanged, an experience only really matched by recession-hit Japan.

The second chart suggests – tentatively – that sterling may have played a part in manufacturing's poor performance. The chart shows movements in trade-weighted exchange rates for the same four countries. On this basis, it becomes easy to explain the UK's poor performance relative to Germany: put simply, sterling has risen against the currencies of its main trading partners whereas the Deutsche Mark – or, latterly, the euro – has tended to decline. Britain's loss has been Germany's gain.

There is one big problem. Sterling may have risen over the last six years but so too has the dollar. Yet, although British manufacturers have under-performed badly, US manufacturers have done very well – notwithstanding their latest problems. How is it that, for one country with exchange rate appreciation, manufacturing has failed whereas, for the other, manufacturing has, until recently, flourished?

Any examination of the impact of exchange rate movements is always fraught with difficulty. A rise in the exchange rate can mean a number of things. It can be policy induced – through, for example, high interest rates – in which case it may have a contractionary effect on activity. It can be a reflection of rapid capital inflows from abroad, in which case it may be an indication of expansionary effects on activity. It may simply reflect underlying relative out-performance in terms of productivity, in which case the rise in the exchange rate reflects a terms of trade improvement that raises domestic living standards. In other words, the "strong exchange rate bad, weak exchange rate good" mantra is far too simplistic.

One way to break the issue down lies in terms of pricing power. Could it be that US exporters, for example, have more pricing power than their competitors from Britain? Maybe US companies are simply in the right industries or, alternatively, they have more monopolistic pricing power. Sounds reasonable? In theory, yes, but the evidence provides no support whatsoever. US exporters have been just as constrained as their British cousins in terms of pricing power. Over the last five years, export prices have drifted lower in both countries. Deflationary pressures on pricing have been just as great in the US as they have in the UK.

So, if pricing is not the answer, what is? The culprit is costs – more specifically labour cost per unit of output. For British manufacturers, unit labour costs have risen by around 17 per cent since 1995. For the US, the equivalent costs have fallen by 4.6 per cent.

These differences have huge implications for profit margins. For an equivalent pricing experience, they imply that profit margins have been roughly stable for US manufacturers since the mid-1990s whereas, for the UK they have fallen sharply. Put simply, the cost structure of British manufacturing has led to a cumulative period of under-performance, which cannot be explained purely through movements in the exchange rate.

Of course, unit labour costs are an amalgam of wages and productivity (in this case, measured by output per hour worked). Splitting costs up into their constituent parts shows that manufacturers in Britain have been unable to compete with their American cousins on both counts: wage growth in the UK has been higher and productivity performance has been worse.

Whereas the dollar's strength appears to have acted as a "hair shirt" policy to force American producers to deliver productivity gains, sterling's strength appears to have been used as a cloak to hide underlying poor performance in terms of both cost control and innovation. This view is certainly borne out by the lack of private sector capital spending in the UK in recent years.

How did British companies get themselves into this position in the first place? There are many possible explanations, ranging from a lack of investment through to a lack of education, and a lack of flexible working practices through to a lack of decent infrastructure. However, it is also true that the squeeze in margins in the late 1990s came after a huge increase in profits, following sterling's ignominious exit from the ERM back in 1992. Could it simply be that companies got nicely fattened up by the windfall gains associated with sterling's ERM exit and forgot how to compete on the world stage?

Whatever the answer, sterling's strength is not the only reason for the demise of British manufacturing. It may have played a part but it cannot account for the poor performance on wages and productivity. Blaming sterling for all of manufacturing's woes is a bit like blaming Nick Barmby for England's inability to put more than two goals past Albania: he may have missed an open goal but he cannot be held entirely responsible for England's failure to thrash the opposition.

Stephen King is managing director of economics at HSBC.