Is recession the only way for UK plc to escape from the strong pound?

British businesses feel caught between falling profit margins and rising pressure to invest in information technology
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The Independent Online

UK Plc is unhappy. The pound is too strong. Customers are unwilling to pay higher prices. Yet in a tight jobs market employees want higher bonuses. Raw materials, especially energy, are becoming much more expensive. And then there is the New Economy out there, which means investing money in new technologies and markets.

The unhappiness has spilt over into the political arena. Last week, both Gordon Brown and Eddie George had to face their critics in industry at the annual conference of the British Chambers of Commerce. Many business people present at the conference believed that interest rates are too high, helping keep the exchange rate painfully strong. Many also agreed with the consensus among City analysts that the Budget has, if anything, made matters worse. A little help for high-technology start-ups does not offset the combined burden of the pound's strength and additional red tape.

Certainly, the figures suggest that the economic environment is getting tougher for companies outside the financial and North Sea sectors. Profit margins on domestic sales have drifted slightly lower from a peak of 26 per cent in mid-1997; but margins on export business have nosedived from a similar level to just under 5 per cent at the end of last year. Export business is at its least profitable since the mid-1970s.

Total profits did increase through 1999, particularly in manufacturing, but they did not grow as much as the economy as a whole. So their share in national income has dropped sharply through 1999, as the chart shows.

Often in the past a declining profit share has been an early signal of economic downturn, warning of forthcoming reductions in employment and investment as companies cut back to retrench financially.

However, so far British companies have continued to step up their investment, leaving them with a huge financial deficit. The corporate sector was £21bn in the red in 1999 according to official figures, up from a £5.5bn deficit in 1997 and £9bn in 1998. As a share of GDP, the financial gap is at its widest since the late 1980s when it reflected the investment boom ahead of the last recession.

This shortfall reflects the squeeze between slow growth in profits on the one hand and a 6.4 per cent increase in business investment last year on the other.

"It is a tough environment for business," said Richard Iley, UK economist at ABN Amro. "Despite the strength of the currency and their lack of pricing power, companies have continued to invest."

This was not defensive investment so much as staking a presence in the New Economy, he argued. "They feel an imperative to invest, The component of spending which includes information technology and software has been growing very rapidly."

But he added: "The financial deficit is a worrying symptom. The recovery is becoming increasingly stretched."

Most economists - including those at the Treasury - are forecasting more of the same this year. For example, Goldman Sachs predicts a 4.7 per cent rise in corporate investment spending, compared with a 3.3 per cent rise in profits. "Business investment growth may weaken in 2000 as companies strive to improve their financial position," according to economist David Walton.

Robert Barrie at CSFB says there is no hard landing in prospect. Even so, he argues: "Before long the corporate sector is likely to seek to restore profits and cashflow." If prices can not be raised, that means cuts in jobs and investment.

Last month's Budget Red Book noted, optimistically: "Company rates of return are high relative to the cost of capital, the buoyant stock market has tended to lower the cost of equity finance and corporate income gearing (the ratio of debt service costs to corporate income) remains low."

However, it went on: "[Companies'] net borrowing is estimated at around 2 per cent of GDP in 1990 and is forecast to rise to around 3 per cent of GDP in 2000." That implies a deficit closer to £30bn this year. The corporate deficit was worse in the late 1980s, but that is not an entirely encouraging precedent.

The Treasury's economists opted to conclude that companies will slow their increases in investment enough for the financial deficit to narrow slowly. That implies the economy's growth will slow from around 3 per cent this year to 2.5 per cent, or close to trend, next year. The alternative scenario suggested in the Red Book is faster growth in investment and the economy as a whole, and a growing corporate financial deficit. Yet it if this does occur, it is likely there would be an even bigger retrenchment in investment spending the following year, unless there were an unexpected recovery in profits growth.

This could certainly happen. Profits of non-oil, non-financial companies fell 2 per cent in 1999 and most economists expect a recovery this year. Goldmans predicts a rise of around 3 per cent. In particular, a steep fall in the value of the pound could make an enormous difference, boosting exporters' profit margins substantially.

Unfortunately, there is even a downside to this upbeat scenario. Eddie George made it plain in a recent speech that a sudden decline in the exchange rate would almost certainly spell higher interest rates, saying the downward pressure on inflation exerted by the strong pound had left loan costs lower than they would otherwise have been. A big trade deficit triggering a sterling devaluation is in fact the classic way for a British economic upturn to come to an end, forcing a vigorous policy response to prevent a surge in inflation from going too far.

The alternative of slow retrenchment by the business sector looks a more appealing exit from the current corporate financial imbalance, which, along with the household sector financial deficit is reflected in the yawning trade gap. But either way, it is not surprising businesses are unhappy. However unfairly, they blame Gordon Brown and Eddie George for getting them into this position in the first place.

d.coyle@independent.co.uk

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