Sunday, October 16, 2016
Uncertainty to choke off business investment
Posted by David Smith at 09:00 AM
Category: David Smith's other articles


My regular column is available to subscribers on This is an excerpt.

What is the biggest risk to Britain’s economy over the next couple of years? Anybody watching sterling’s gyrations in recent days might conclude that, as on so many occasions in the past, it is the exchange rate, itself the product of the government’s uncertain steps towards the Brexit door.

The pound’s performance is, however, merely the canary in the coalmine, a symptom of a wider uncertainty. Its average value, its trade-weighted index, fell to an all-time low last week. Its volatility adds to that uncertainty; for businesses, individuals and for the government. Whether or not a downward adjustment in sterling was needed, which is debatable, the process itself is unsettling.

When it comes to being unsettled, there are three central risks to growth over the next couple of years. They are that, in an atmosphere of uncertainty, businesses will be very cautious about investing, that a similar caution will affect recruitment, and that the inflationary impact of sterling’s fall will squeeze real incomes and consumer spending, more than offsetting any beneficial effect on exports. After that, the risks will centre on the nature of Britain’s new relationships both with the European Union and the rest of the world, including trade and migration.

Let me this week take just the first of those risks; business investment. If you were looking for an explanation of Britain’s poor productivity performance, business investment would be high on the list. It has been lower, over time, than most of our competitors. Some but not all of that reflects the larger decline in manufacturing, which is more investment-heavy than other sectors.

On the most recent official figures, business investment surprised on the upside in the second quarter, rising by 1%, though it was nevertheless down on a year earlier, and its rise mainly reflected additional spending on transport equipment; cars, vans and lorries.

Overall, business investment is 7% higher than it was before the global financial crisis hit the economy, similar to the rise in the overall economy; gross domestic product. It has, however, been a very patchy recovery. It has fallen in nine of the 28 quarters since the economy hit its recession low point in the middle of 2009. The normal post-recession exuberance of business investment was missing, not least because of the difficulties of raising finance.

What about now? The past is another country and March this year seems very different indeed. At the time of George Osborne’s last budget the Office for Budget Responsibility (OBR) predicted a 2.6% rise in business investment this year and a 6.1% increase next year.

The OBR is currently running through the numbers for the chancellor’s November 23 autumn statement, and they will make interesting reading. In the meantime we have a new forecast, to be published this week, from the Ernst & Young (EY) Item Club, which uses the Treasury’s model of the economy. It predicts that business investment will drop by 1.5% this year and by 2.3% next year. Some other independent forecasters are significantly gloomier about the outlook for business investment. The fall predicted by the EY Item Club, and the difference between it and the rise predicted by the OBR in March, is however almost enough on its own to account for the expected drop in overall economic growth next year from more than 2% to less than 1%.

Before the referendum a big concern was whether Britain could maintain her appeal as a magnet for foreign direct investment in the event of a vote to leave. That remains a big concern, particularly now that leaving the single market looks increasingly likely, if not certain. There will still be some investment flowing into Britain, not least to snap up what, thanks to sterling, are bargain-basement assets. But the loss of appeal is real.

Foreign businesses do not, however, operate in a vacuum. The concerns they have are shared by many domestic businesses, some of which need to be in the single market, some of which are just concerned about an uncertain future.
Fears of a drop in investment are not just forecasters’ guesswork. Investment intentions have weakened since the referendum. The Bank of England’s regional agents, who regularly survey firms in their areas, record what are known as agents’ scores across a range of measures of business activity. Its latest reading showed that these scores for investment intentions have dropped to their weakest since the financial crisis. The “animal spirits”, to use Keynes’s expression, have dropped.

The British Chambers of Commerce, in its latest quarterly survey, published a few days ago, recorded an eight-point drop in manufacturers’ investment intentions and, perhaps as worryingly, a 12-point decline in plans to invest in training by service-sector firms.

Worries over investment were at the top of the Bank’s concerns when it chose to cut interest rates in August, and why it may yet do so again, though probably not this year.

Ben Broadbent, one of its deputy governors, set this out very clearly in a recent speech. Investment decisions are, as he put it, “at least to some degree – irreversible. Once made, they can’t be easily or costlessly unmade.” They are also closely correlated with uncertainty.

The Bank’s own index of economic uncertainty has, Broadbent demonstrated, been closely correlated with business investment during the past three decades. Even when firms go ahead with investment during periods of uncertainty, they are only likely to do so when the rate of return is high; uncertainty raises the investment “hurdle”. Uncertainty also makes businesses more likely to employ temporary workers rather than take on new permanent staff.

Broadbent also made two points directly relevant to post-referendum Britain.
The first was that the longer-lasting the investment, the more that business will want greater certainty than currently exists on Britain’s future trading relationships. The second was that the flow of new investment matters more than the flow.

As he put it: “A lack of clarity about the UK’s future trading relationships needn’t result in visible, headline-grabbing closures of productive capacity. The effect is likely to be more insidious: decisions to expand, that might otherwise have been taken, are delayed.”

What can be done to maintain investment in this time of uncertainty? Philip Hammond is being pressured to announce some short-term measures to help firms overcome their doubts. The annual investment allowance, currently £200,000, was raised to £500,000 from April 2014 to the end of 2015 and was associated with generally stronger investment. Whether the same trick could work again remains to be seen. The priority is to put an end to the uncertainty, and that may not be in the chancellor’s gift.