The UK is investing in a better class of boom
Monday 06 January 1997
Second, uncertainty about demand is becoming a less important constraint limiting investment. Business leaders need confidence in the durability of recovery in order to invest. This is inevitable given the high initial cost, the lengthy payback periods and the irreversible nature of most investment projects. In teams of easing uncertainties, the mix of growth can be as important as the absolute growth rate itself. History teaches us that business does not invest on the back of exports. In contrast, a little bit of life on the high street is far more effective at raising business confidence. Moreover, it would not need a fully fledged consumer boom to kick-start investment. Close to 4 per cent consumption growth in 1997 would give companies more than enough reason to invest.
Third, profit margins are high, as is the ratio of profits to GDP. Recently published data suggest that the core trading profits of industrial and commercial companies once again outpaced money GDP growth in 1996. Other official figures suggest that the net rate of return on capital employed is back above its long term average.
Fourth, survey evidence suggests that capacity usage is back at a late 1980s level. Unfortunately, official measures of the capital stock are highly dubious, since the asset lives used by the ONS statisticians are hopelessly unrealistic - they are way too long. More realistic assumptions suggest that growth in capacity has been significantly below GDP growth in this recovery and weaker than in any period other the heady 1980s recession. Companies have a need to invest, particularly in the service sector where spare capacity is fading fast.
There are also additional tail winds which will help keep investment strong beyond 1997. In particular, in the last two years the emphasis for many companies has been on merger and acquisition activity, share- buybacks and dividend payments. This has partly been the fashion, with UK corporates repeating the experience of the US, in many cases going into debt to finance these forms of financial engineering. However, it has also been prompted by the expectation that the shutters would come down post-election, under a Labour government. This has diverted resources away from investment. This will change after the election.
Not only could more bids be referred to the Monopolies and Mergers Commission under a Labour government, but the tax system could be used to skew more corporate activity towards investment. Indeed the current government has gone some way down this road by reducing the tax credits associated with dividend payments, share buybacks and special dividends. We would also not rule out an incoming Labour government enhancing capital allowances, albeit for a temporary period. This could have significantly more success than Norman Lamont's brief flirtation with enhancing capital allowances in 1992/93. Back then companies had little reason to invest. The situation today is very different.
At present, despite all the hype about the Private Finance Initiative (PFI), publicly sponsored investment is being a significant drag on total investment. After the election this is likely to change. An incoming Labour government would be keen to promote investment in areas like transport, health and education. Borrowing to invest would not threaten Gordon Brown's "Golden Rule". Also, by then, the PFI should be making a significant contribution to overall investment.
Another "non-economic" push to investment is the computer problems associated with the year 2000. The introduction of a single currency (whether the UK is involved or not) will also involve significant investment, as computer programmes are rewritten. Estimates involved vary enormously, but there is no doubting that spending on information technology will grow sharply in the next few years. This will coincide with business spending on software being included in the investment data for the first time. This could involve significant upward revisions to the published data, which as it is has probably under-recorded the investment recovery there has been to date.
But what about the head winds? Much will be made of a stronger pound and higher base rates denting investment. However, these head winds have to be put in context. True, exporters will be hit but strong export growth is never enough by itself to prompt an investment response in the whole economy. Sterling may hit manufacturing, but that sector accounts for not much more than 10 per cent of the investment undertaken in the UK economy.
All the strong currency will do is bias the investment recovery more towards services, the sector of the economy which does the lion's share of all investment anyway. We would expect the trends established in the 1980s to continue in the next few years, with particularly strong investment by finance, transport and communications companies (see chart).
Likewise, the likely rise in base rates has to be put in context. Finance is cheap and readily available, balance sheets are strong, GDP is accelerating, spare capacity in services is fading fast, the mix of growth has become more investment-friendly and companies have revealed that they are prepared to go into debt. It is very doubtful that a modest rise in base rates by historic standards will derail the investment recovery.
Few would argue against the notion that a strong investment recovery will improve the fortunes of the UK economy. However, a strong investment recovery will bring with it worries about overheating. Potentially, this could take one of two forms, rising inflation or a widening current account deficit. At present there is far more concern about inflation (which has been rising) than the current account (which is broadly in balance). This could change as we go through 1997. The experience of the late 1980s suggests that an investment boom is more likely to lead to a wider current account deficit than higher inflation. This could be further compounded by the strength of sterling, which may help obscure inflationary pressures in coming months, but hit net exports.
On balance, the main reason why a Lawson-style current account deficit should be avoided is a continued high rate of domestic savings. Despite the fall in the jobless total and a recovering housing market there are no signs yet of households using the economic improvement as an excuse to spend beyond their means.
In the long run savings and investment are closely correlated. Demography and uncertainty over pension provision mean that people will want to save more in the next decade. As such, a case can be made for arguing that the coming investment boom will go beyond a one-off cyclical increase.
David Owen is UK economist with Kleinwort Benson Securities.
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