UK manufacturing returns as flavour of the month

Manufacturing is back in fashion. In the last few weeks the City has been rediscovering British manufacturing companies as a favoured investment, with a number of brokers arguing for an increase in the weighting of manufacturers in investment portfolios.

At first sight this might seem odd, given that for the last six months or so the growth of manufacturing output has stalled, raising concerns about what is hopefully called a "growth pause", and which might turn into something worse.

But the task of investment analysts is to look forward, and they can see not only more growth in the autumn, but a manufacturing industry well fitted to take advantage of that.

That is the short term. There is a longer-term issue here, which is not so much whether manufacturing does well this year or next, but rather whether some kind of structural turning point has been reached. Might, for example, we see over the next decade a rebound similar to that which has taken place in the US in the last?

The background to this whole debate is pretty well known. A series of papers in the Economic Journal earlier this year highlighted the fact that overall manufacturing output had hardly grown between 1973 and 1992, with the result that employment in manufacturing fell by a third, and the share of manufacturing in GDP declined from 32 per cent to 21 per cent.

The authors differed as to how much this mattered, some arguing that this failure put a brake on the whole economy, while others believed that de-industrialisation was not in itself important, provided other aspects of the economy took up the slack.

Whatever view one takes on the importance, there does seem to have been some progress since 1979, for since then productivity has risen sharply (see the graph on the left). Output per head of the rest of the economy, on the other hand, did not grow any faster in the 1980s than it did in the 1960s and 1970s.

The result is some narrowing of the productivity gap between the UK and its competitors. In 1979 West German output per person per hour was 40 per cent higher than the UK; by 1989 the advantage was down to 17 per cent. That gap may have narrowed further since.

But how is manufacturing doing now? In the last six months, the period when output stopped growing, there have been renewed concerns: productivity has stopped rising, export volumes are falling, competitiveness is declining; and investment has collapsed.

All these facts are true, but as a recent paper by brokers ABN-Amro Hoare Govett shows, the big picture is more encouraging. Yes, it is correct that productivity has stopped rising, but that is a function of the halt in the rise of output. Last year, manufacturers over-estimated the strength of demand, and built up stocks when the demand failed to come through. (The build-up of stocks was much more serious in France and Germany and the adjustment to that is the main reason those two countries are back in recession.)

Either demand will pick up, or manufacturers will shed jobs: there is no evidence that the steady improvement in productivity will be reversed.

Exports? Yes, export volumes have been disappointing, but look at the middle graph, which explains why.

The problem is exports to the European Union, where the three biggest economies, Germany, France and Italy, all shrank in the final quarter of last year. Exports to the rest of the world have continued to grow steadily. Besides, if you take a longer view of UK manufacturing performance (right-hand graph) it is pretty clear that the dreadful deficit of the late 1980s is largely corrected.

Yes, there is still a deficit on trade in manufactures, which, since there is also a small current account deficit too, does suggest that there may still be some structural problem. But if so, at least the problem is more manageable than it was seven or eight years ago.

Finally, investment. Yes, it did collapse at the end of last year. But if you look at manufacturers' investment intentions as recorded by the CBI surveys, these show that investment is planned to continue at a high level.

London brokerage houses are interested in selling shares, and ABM-Amro Hoare Govett argues that from the point of view of equities, high-quality manufacturers are the "growth stocks" of the future. It is an interesting perception, and one which deserves to be taken seriously. If it is right, then there is more than an investment message here: there are policy messages too.

For example, if manufacturing is not going to continue shrinking there should be better job opportunities in the parts of the country where it is still an important employer. Arguably Britain did not make a mistake in downsizing industry too much; it simply downsized earlier than France or Germany, which are now having to do what we did a decade ago.

On the other hand, it could be argued that while success in manufacturing is wholly welcome, it is not so material to the whole of the economy as it was a generation ago. As a sector it is not much larger now than financial and business services, so policy should not be skewed to favour it at the expense of other sectors.

In any case, it looks as though we need not worry so much about helping manufacturing, for it is doing very well on its own.

I find this "either/or" debate rather too stark. The harsh truth remains that UK manufacturing, while vastly better than it was relative to the rest of Europe, remains less productive than that of the US or Japan. For the moment UK wage rates are low by European standards, and that, plus a climate designed to encourage inward investment, has attracted large amounts of foreign capital to the UK: some 40 per cent of the inward investment into the EU. But ultimately the prosperity of UK manufacturing will only be ensured if productivity is at least as good as the rest of Europe, for the real competitors are elsewhere. Being good by European standards is not good enough.

Furthermore, I don't see much evidence yet of a seismic shift in UK manufacturing analogous to that which took place in the US over the last decade. There has been useful and sustained incremental improvement, which has been reflected in a rerating on the market of UK manufacturing companies like GKN and British Aerospace. But the shift does not feel as dramatic as the revolution which took place in a number of US companies. And the revolution in US productivity probably reaches deeper down into the second and third division companies than it does here.

But the fact that there is not much evidence yet does not mean that a step-change is not occurring. Many aspects of the UK economy have become much closer to the US model in the last 15 years: our deregulated labour markets, which are at last starting to deliver lower unemployment without rising inflationary pressure; and our deregulated financial markets. It is perfectly possible that these changes are also affecting UK industry in the same way that they affected US. So it is quite possible that during the next 10 years the renaissance that we can just glimpse in manufacturing will spread much more widely.

If that is so, then it would be enormously encouraging in both social and economic terms. Some of the particular social problems of deindustrialisation - such as the shortage of jobs for middle-aged men - would at least not get any worse and might be partially reversed. And the endemic problem of the balance of payments - that whenever demand rises rapidly we tend disproportionately to suck in imports - would also recede. The next year or 18 months will be interesting, for we may catch a glimpse of things to come.