Exports key to steady revival

BRITAIN'S exporters hold the fate of economic recovery in their hands. Their performance determines how quickly the economy can safely grow, before a widening trade gap torpedoes the pound and inflation takes off.

British exporters have seen their share of world markets shrink steadily for most of the post-war period. Between 1970 and 1984, our share of world manufactured exports dropped from more than 10.5 per cent to barely 7.5 per cent, but since then about one percentage point of market share has been regained. Will this improvement endure or is it merely a brief respite from inexorable decline?

An analysis to be published in Tuesday's Bank of England Quarterly Bulletin sheds some light. Some of the fall in market share between 1970 and 1985 can be explained by our tendency to export out-of-favour products to slowly growing countries. The opposite was true between 1985 and 1990. Demand for the goods that British manufacturers specialise in grew more rapidly than demand for globally traded manufactures as a whole, while spending grew more quickly in our traditional markets than in the rest of the world.

The trend for the 1990s will not be clear for years. Countries like Britain, which export relatively large amounts to the US, might be expected to have done badly when the US went into recession, and better since then, as the US recovered and Europe suffered. We may well do worse again from now on, as higher interest rates restrain growth in the US while Europe's recovery slowly strengthens.

However, these effects should be offset as British companies continue to target exports more towards Europe. With the growth of the single market over the past two decades, the proportion of British exports going to the rest of the European Union has risen from 35 to 53 per cent, while the share going to the US has fallen from 22 to 15 per cent. But our export market share cannot be explained entirely by the products we sell and the countries to which we sell them. They account for perhaps a sixth of the fall in market share between 1975 and 1980 and two-thirds of the rise in the subsequent five years. What explains the rest?

Competitiveness is the obvious contender - how do our exporters' prices and costs compare with those of their overseas rivals after adjusting for the impact of exchange rates? The Bank's study suggests that while competitiveness may help to explain the decline in market share before the mid-1980s, it does not explain the improvement in the late 1980s. After adjusting for exchange-rate changes, manufacturers' prices rose by 15 per cent relative to those of other leading industrial countries in the second half of the decade. This should have depressed our market share, although it is always possible that the rise in competitiveness in the early 1980s may have had a delayed effect.

Chris Dillow, at Nomura Research, argues that exchange-rate changes none the less help to explain the improvement in Britain's market share after 1985, although via a different route. He argues that exporters largely accept the prices set in overseas markets as a fait accompli, so the fall in the pound in 1986 would have raised their profitability and given them the confidence to establish themselves in fresh foreign markets by investing in overseas sales networks and the like.

Another possibility is that Britain suffered before the mid-1980s from the growing specialisation of international trade, for which our firms were ill-equipped and to which they were slow to react. International specialisation has seen most countries devote a growing share of their national income to imports. Countries increasingly concentrate on making what they are good at making - for both domestic and overseas consumption - while buying more of the other products they need from overseas.

World trade grows relatively quickly compared with world output when international specialisation is increasing. But in the 1980s, trade growth slowed relative to output growth. As Japan and the US both saw their share of world trade worsen during this period, it may be that the rise of bilateral trade barriers between the two nations was slowing the process of specialisation. Britain therefore gained, as the global marketplace became less dynamic but more predictable. This suggests that British exporters may do better still if the US/Japanese trade talks break down and US imposes sanctions. But they may lose out if the two nations reach agreement and pull down trade barriers.

The idea that a collapse of free trade offers Britain its best hope of sustaining its export revival is a pretty depressing one. Our underlying problem is the inability of our export sector to cope with growing international specialisation. This may be explained by the fact that our manufacturers have long devoted fewer resources to capital investment at equivalent stages of the economic cycle than their competitors in France, Germany, America and Japan.

Simon Wren-Lewis and his colleagues at Strathclyde University argue that the rise in British exporters' market share in the late 1980s can be explained by our relatively high cumulative investment at that time, relative to cumulative investment overseas. They argue that manufacturers probably invested in new types of product because this would have been more profitable than contesting export markets in which existing producers were already well entrenched.

But investment only grew as strongly as it did in Britain in the 1980s because industry had been so battered by recession and the high level of the pound early in the decade. Sharply higher capital spending was needed to meet the demands unleashed by the unsustainable boom that followed.

Although investment is likely to pick up during the rest of this year, it is hardly likely to match the pace of the mid-1980s. Investment has held up better during the last recession than in the previous one, but it has not risen any further as recovery has taken hold. Last week's quarterly industrial trends survey from the Confederation of British Industry found only 29 per cent of manufacturers expecting to raise their capital spending in the next 12 months, compared with 23 per cent expecting to cut it.

A muted pick-up in investment is unlikely to bring the benefits of product diversification described by Professor Wren-Lewis. A recent Bank of England survey of companies' investment appraisal techniques found that firms were much more likely to approve capital spending that cut production costs than riskier investments in new product development. The Bank found one firm in which the rate of return demanded on new product development was 10 percentage points higher than that demanded on investment in cost- saving production techniques - an alarming difference when the rates of return companies demand on average are around 20 per cent.

This suggests that a typically British cyclical pick-up in investment from now on is more likely to deepen the industrial base than widen it. Historically successful industries - such as pharmaceuticals and aerospace - will strengthen their position, but the range of products offered by UK plc is unlikely to widen very much. So economic recovery will still be constrained by the balance of payments. Our exporters will be slow to take advantage of new markets, while consumers will spend more of their income on imports as they tend to buy a wider range of products as they become richer.

This means that even if the improvement in Britain's manufacturing performance since the mid- 1980s is maintained, the economy is unlikely to be able to sustain growth much above 2 per cent a year for very long without a dangerous widening in the trade gap. This growth rate would be much too slow to keep unemployment falling. It would also further discourage investment, creating a vicious cycle as British products become increasingly unattractive compared with those of our competitors, further tightening the balance-of-payments constraint.

Boosting investment and exports is far from easy, especially as higher investment will worsen the trade position in the short term as components are bought in from abroad. The CBI suggested last week that long-term investments should face a lower rate of capital gains tax, which would reduce pressure on companies to use their profits for dividend payments instead of investment. Payment of dividends in the form of extra shares could be encouraged, while corporation tax could also be cut.

Most importantly, both the Government and the Bank of England need to convince chief executives that investment will not be endangered by sharp swings in growth and resurgent inflation. Loose talk of income tax cuts and Friday's disarray over interest rate policy do little to help.