Business Investment. UK GDP Growth and Main contributors

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1 GDP growth (%) Business Investment UK GDP Growth and Main contributors Outturn Forecast Private consumption Business investment Dwellings investment Government Change in inventories Net trade Source: OBR Business Investment Business investment, as well as making a direct contribution to GDP growth, can also raise productivity and increase the supply capacity of an economy. It is an important driver of the recovery where fiscal consolidation, weak export markets, subdued real income growth and household deleveraging are constraining other components of GDP. This chapter looks at what determines business investment, recent trends in the UK and Scotland, before turning to the prospects for such investment going forward. Why do businesses invest? Business investment decisions are dependent on the cost of internal or external capital (e.g. the interest rate) and the expected rate of return from the project. The former will be project-specific and affected by such factors as access to and the price of finance, and the cost of physical assets. The latter will be affected by factors such as demand, income levels and spending patterns. Ultimately a firm will choose to invest as long as the expected rate of return on an additional investment exceeds the cost of capital. However, expectations regarding the cost of capital and the rate of return also play a major role in determining the viability of an investment. For example, an expectation of muted economic growth may dampen estimated returns, with the result that for any given rate of interest planned investment will now be lower. This could be what

2 we have witnessed since the 2008 financial crisis as, despite record low interest rates, investment rates have remained low by historical standards reflecting an underlying lack of confidence in demand both globally and domestically. So in effect, the prevailing macroeconomic conditions and their effects on overall business and consumer confidence may inhibit a firm s investment plans translating into a lack of demand for finance. In its latest Trends in Lending publication (January 2013), the Bank of England reports that overall business demand for credit remained muted during Q4 2012, despite credit availability having increased overall. UK Business Investment Historic Trends Business investment in the UK accounts for approximately 56% of total Gross Fixed Capital Formation (a measure of total investment in an economy) with the remainder accounted for by investment in private sector dwellings (29%), by general government (14%) and by public corporations (1%). Business investment accounted for around 8% of annual GDP in As well as having a direct effect as a component of headline GDP, business investment can also provide a stimulus to the economy through multiplier effects, such as creating demand for the output of other areas in the economy, and in turn, creating jobs. The capital invested in new technology also increases the productive capacity in the economy and contributes to faster rates of trend growth in the long run. Business investment rates have been historically low in the UK in comparison to other advanced economies. For example, the UK has had an average annual business investment growth rate of 0.8% over the period , compared to an average growth rate of 1.9% in Germany, 2.3% in France and 1.5% in the US. 2 Among G7 nations since 2000, only Japan has had a lower rate of average growth in business investment. UK business investment as percentage of GDP was already on 1 Source: ONS National Accounts/ Scottish Government 2 Source: OECD

3 a declining trend prior to 2008, falling in nominal terms to 9.5% of GDP in 2007 from a high of 12.8% in UK Business Investment - trends since 2008 Business investment levels fell dramatically after the 2008/09 recession (as seen after previous recessions see chart below). As at Q3 2012, business investment remains 11.6% below pre-recession peak levels. Similar trends have been seen in other advanced economies; with business investment around 7% below prerecession peak in the US and Germany (as at Q2 2012). The drop in business investment was most pronounced in the manufacturing sector (manufacturing investment accounts for around 10% of business investment in the UK), where investment levels fell by 31% peak to trough and remain around 15% below pre-recession levels. The post-crisis trend in service sector investment has been broadly in line with the overall business investment rate, currently 11.2% below pre-recession peak. The reasons for the falls in business investment are two-fold: the impact of the financial crisis on the availability of finance and the impact of the resulting global recession on levels of confidence and demand. Firstly, availability of finance became difficult as banks increased capital buffers and reduced their exposure to wholesale funding markets. Five years after the financial crisis,

4 access to finance remains a barrier to investment for some firms particularly smaller enterprises. The chart below illustrates how bank lending in the UK has shrunk since Changes in Bank lending per region since 2009 Source Bank of England Secondly, falling demand and loss of confidence due to ongoing instability and fragility in the global recovery (particularly in the Euro Area) have impacted the manufacturing sector possibly resulting in the postponement of investment plans until macroeconomic conditions improve. This is likely to have contributed to the widely commented upon falls in productivity measures since the start of the crisis. More recent business investment data has been relatively encouraging with quarter on quarter growth improving through The ONS estimate that business investment increased by 5.1% during the year to Q Further, this increase comes during a period of declining headline GDP. However, provisional results for Q4 suggest that business investment contracted by 1.2%, highlighting the volatility in this data series. Business Investment in Scotland The trend in overall business investment in Scotland can be analysed from regional capital expenditure statistics. 3 As at 2010 (the most recent year for which data is available), net capital expenditure in the business economy 4 in Scotland was around 28% below its 2008 peak. The post-crisis trend to 2010 has been broadly similar to the UK trend UK capital expenditure was 24% below its Source: ONS/Scottish Government 3 The regional capital expenditure figures do not meet the ONS quality standards and, consequently, do not have National Statistics status 4 Coverage excludes certain areas such as parts of agriculture, financial and the public sector.

5 2008 peak in As can be seen from the chart, growth in capital expenditure in Scotland between 2003 and 2006 was fairly muted in comparison to the relatively steady growth rates enjoyed in the UK. However, Scotland saw a strong increase in growth over the period compared to the UK. Business Investment Prospects Despite picking up following the aftermath of the 2008 financial crisis, investment intentions have remained muted since The Office for Budget Responsibility (OBR) believes that UK business investment will remain subdued during 2013 due to a lack of confidence regarding the outlook for global and domestic demand, leading firms to postpone investment decisions. Further, it is possible that the recession has resulted in a significant amount of spare capacity, suggesting firms may be able to meet an upturn in demand by utilising existing resources. Survey indicators published by the Bank of England do not suggest the existence of a large amount of capacity. However, this may be explained by firms currently operating with a minimum workforce that cannot be reduced further for practical reasons but could easily absorb additional demand without hiring. There is also anecdotal evidence that firms have switched employees into activities associated with winning work, thereby understating the true level of capacity in the business sector and meaning these employees can be used when demand picks up without increasing employment. The OBR forecasts that business investment will grow by 4.9% during 2013 with more rapid growth expected over the medium term; it forecasts growth of 9.6% on average per annum between 2014 and There are signs to support the view that a recovery led by business investment may emerge this year. Firstly, firms are currently sitting on significant amounts of accumulated cash, so there appears to be plenty of funds available to be invested in capital projects. As the chart below shows, the UK corporate sector currently holds more than 300bn in deposits in UK banks. 5 It should be noted that mining and quarrying data is excluded from this analysis, if these figures were included the decrease in capital expenditure in Scotland since 2008 would be shallower than that in the UK.

6 Secondly, the Funding for Lending Scheme (FLS) was introduced in August in order to try and stimulate new lending to the private sector. FLS aims to increase the flow of new lending into the private sector by providing banks with access to capital at rates lower than those available on the market. Evidence from the first six months of the scheme shows that it has yet to have a significant impact on overall lending to businesses, with increased lending more apparent in the household mortgage market. However as the chart on page 36 highlights, there are indications that the availability of finance to the corporate sector has improved. Recent survey data from the Bank of England suggests that credit conditions are easing; its latest Credit Conditions Survey indicated that the availability of credit increased significantly in the final quarter of 2012 and that lenders expect the overall availability of credit to expand further during the next three months. 6 Finally, macroeconomic conditions softened somewhat at the tail end of 2012; the Euro Area crisis abated largely as a result of the ECB s announcement of the Outright Monetary Transactions programme and ECB President Mario Draghi s announcement to do whatever it takes to protect the currency zone. Partial agreement in the US over the fiscal cliff has also resulted in a positive market reaction with stock markets starting the year on a positive note. Indeed, the FTSE 100 enjoyed its strongest January since 1989 while the US S&P 500 recorded its strongest January since A continuation of this positive trend could lead to an upturn in confidence and expectations of increased returns to investment. However, maintaining stability and confidence in the Euro Area will be essential for private sector investment and growth. 6 Bank of England Credit Conditions Survey, Q FT, Bulls Charge ahead as stocks lift off, 8 February 2012

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