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Can knowledge based industries keep driving UK growth?

Economics Weekly: Economic Research and Analysis--
Can knowledge based industries keep driving UK growth?


How important is manufacturing?
What is to be made of the continued decline in the share of the UK economy that is accounted for by the manufacturing sector? In the last few years, the manufacturing sector has been in and out of recession. It is currently in recession - in the first half of 2005, output fell by 1% in Q1 and by 0.3% in Q2. Yet the whole economy in the UK continues to expand and employment to grow. In this weekly, we look at the key sectors that are currently driving economic growth. This is important because of what conclusions we can draw from them about the sustainability of UK growth over the next few years, and so the likely path of interest rates and the exchange rate. Recent figures for intra industry activity, known as input output tables, give us a good basis from which to look at some longer term trends in different industrial sectors in the UK.

Manufacturing is lagging behind…
Chart A shows the divergent path of services and manufacturing in the last few decades, but particularly after 1995. It shows that the fall in the share of manufacturing is not a recent trend but a persistent long term one, no doubt partly reflecting competition from producers in the rest of the world. However, in the last few years the gap has widened at a faster pace. The chart shows this has been partly due to a flattening off of the pace of growth in manufacturing but also acceleration in the growth rate of services. In 1999, manufacturing’s contribution to total gross value added in the economy dropped below 20%, so a cumulative fall of 5% to 14.9% has occurred since then. That is set against the 8 years it took for manufacturing’s share of the economy to fall by 1%, from 21% in 1992 to just under 20% in 1999.

Clearly something has occurred in the last five years to make this acceleration happen. The finger points to a strong sterling exchange rate and slow growth in the UK’s EU export market, which have both hit UK exports. Other factors are likely to include fast growth in consumer demand in the UK (based on a strong housing market and low interest rates) and intense competition from low cost China. This combination boosted service industries but did little for manufacturing.

...but is still expanding
But it is important to note that manufacturing is not shrinking in absolute terms. As table 1 shows, in terms of current prices, the value added in manufacturing has risen by a total of 28% over the period 1992 to 2003. But value added has risen even faster in some other industries, notably business and financial services where growth was 137% in the period. Wholesale and retailing value added also grew rapidly, by 94% in the period. Construction, boosted in the last five years by the housing market boom, has seen a rise of 103% in its value added. Education, health and social work industries, dominated by the public sector but not exclusively so (fast expanding private nursing homes are also in the total), rose by 92%. Public administration expanded by 33%. Growth in private service industry has therefore been faster on average than growth in public services over the period. This means that while the share of manufacturing in value added has fallen, its gross total value has actually risen. Chart B shows that manufacturing is not alone is seeing a decline in its share of the economy; falls also occurred in agriculture, mining, energy, the public sector and transport and communications.

In terms of employment, services have expanded sufficiently to mean that the loss of jobs from manufacturing has been offset. All of the top five fastest growth sectors since 1992 have been in the services sector (computer services, other business services, insurance and business services, recreational services and real estate). The biggest fallers have been in manufacturing (man-made fibres, metals, insulated wires and cables, leather goods, and textiles). Moreover, given the size of the private services sector, over the period 1992 to 2003, it is private services that accounts for the bulk of the rise in employment during this period.

Knowledge sectors win out
However, there are also some other features of the UK economy that its latest input output tables also imply that are worth mentioning. With service activities being more sheltered from international competition, it is not surprising that profit margins and profits are generally higher in services industries than in manufacturing ones. As a result, investment is therefore higher in services, both in growth terms and in absolute terms due to its size and higher profits. But perhaps that is to be expected since services firms do not face the same intense global competitive pressure as manufacturing firms, partly due to world trade treaties that have opened up global manufacturing trade much more than trade in services.

However, the employment picture matches that of the output share profile: manufacturing employment is falling but services employment is rising. In the last decade, 5 of the fastest growing sectors have been in services and 5 of the slowest have been in manufacturing. But what this means is that the UK is shifting from industries where it is not competitive and losing jobs to where it is competitive and gaining jobs. That actually implies an economy that is flexible and adaptable. So long as it remains so in future, there seems little reason why the loss of activities in manufacturing that can be done more cheaply elsewhere cannot continue to be offset by expansion in services industries where the UK seems to have some advantage. But within this broad framework, it is clear that manufacturing is still very important in generating value. In 2004, manufacturing exports amounted to £158bn, some 55% of total goods and services exports that year.

Conclusion
Competition from lower cost producers in the rest of the world is likely to continue and to intensify, so the trend of manufacturing’s relative decline is unlikely to change. The real test for the UK therefore, assuming that it remains an open economy, is to sustain growth in the key services industries where it seems to have a comparative advantage. Low interest rates, flexible labour laws, low regulation and a competitive tax regime seem the best way of achieving this aim. Moreover, it does not have to be the case that the 5 percentage fall in manufacturing's share of the economy in last few years will continue at the pace seen in the last five years, partly because the higher valued added parts of UK manufacturing can also benefit from the increase in global trade currently taking place. After all, UK manufacturing exports last year were worth £158bn, the biggest share of total goods and services exports. Not bad for industry that is supposedly disappearing fast.

UK economic outlook
This week in the UK, it will not be data that attracts the most interest but the MPC meeting. After the mostly good data of the last 4 weeks, the MPC is expected to leave rates on hold, with the 5:4 vote implying that rates may remain on hold for some time. There are increasing signs that the UK manufacturing activity may show a modest recovery in Q3 from recession in the first half of the year. Based on the PMI’s, there is a chance that output may have risen modestly, partly based on a recovery in export demand. The services PMI continues to indicate that this sector is expanding by about 0.8% a quarter, and is the key driver of economic growth.

Trevor Williams, Chief Economist
trevor.williams@lloydstsb.co.uk
www.lloydstsbfinancialmarkets.com
Lloyds TSB Bank,
Financial Markets
Division,
Faryners House,
25 Monument,
London EC3R 8BQ
Switchboard:
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  • POTENTIAL PRICE RISK: HIGH Tue-- 08:30 GMT GB- CPI top tier confirmation of Inflation.

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