Economics: Spent force

Most of the debate on spending in the UK concentrates on the
consumer and the government. The other major group, investment (technically
referred to as Gross Fixed Capital Formation, GFCF), was worth nearly £202bn and
accounted for almost 17% of GDP in 2005, but receives much less attention. There
is, however, probably more uncertainty about investment trends than other GDP
categories, as the Treasury’s latest survey of independent forecasts shows. The
most optimistic of the 43 organisations included in the monthly survey thought
that investment this year would rise by 5.6%, while the most pessimistic was
expecting a fall of 0.4% – which seems to suggest that nobody knows what is
going on. For its part, HM Treasury is expecting a 2% increase this year.

It is important to understand what investment means in economic terms.
Technically, it refers to any activity that adds to the capital stock of the
country. So the buying and selling of shares (and whole companies) is excluded
since this is merely a transfer of ownership of existing assets. It does,
however, include ‘dwellings’, 20% of the total, which, although primarily for
personal use, are capital goods. The other categories, as expected, are
machinery, transport equipment and building structures. The data records only
new investment and does not measure the value of the existing capital stock.

Helpfully, the government has created a sub-category within the overall GFCF
total of ‘Business Investment’. In 2005, businesses invested £112bn on a range
of new assets, largely by the private sector. (General government investment, of
around £20bn, is classified separately.) A little less than a quarter of total
Business Investment was by manufacturing and production industries and just 2.4%
by construction companies. Services accounted for the remaining 75%, with
distribution alone taking 13%.

Investment has failed to grow at a rate that would fill the gap in activity
left by a more fragile consumer sector. Measured in current prices, Business
Investment’s share of GDP fell to a 40-year low in 2005. Since investment in
buildings has risen in each of the last five years, it is spending on transport
equipment (down 13% by volume in three years) and machinery (virtually unchanged
for six years), that has weakened. The authoritative CBI Industrial Trends
Survey confirms this rather negative investment record and predicts little
improvement in the coming months.

There are two possible explanations for the subdued investment record over
the past few years at a time when the economy generally has been performing
quite robustly. The first is financial. Yet the official data for company
profitability shows that net rates of return (on capital) for private non-oil,
non-financial companies have been relatively stable, at around 12.5% for the
past three years (with services almost twice as high as manufacturing). Despite
the stability, the CBI survey results cite low rates of return as a key factor
limiting investment. The cost and availability of external finance do not seem
to be issues, although it does seem that shortages of internal finance are
holding back investment.

A second factor is business’s view of where the economy is going and here
sentiment, according to the CBI, remains in negative territory. And demand
uncertainty is the over-riding factor dampening investment intentions, cited by
more than half the respondents to the CBI survey. A similar proportion of
respondents claim to be working below capacity, while only 14% claim that their
present capacity is ‘less than adequate’ market conditions, therefore, suggest
that a surge in business investment is not on the horizon, other than in
financial services and North Sea oil companies, two sectors in which the growth
in capital expenditure has traditionally been buoyant.

While uncertainty about demand is apparent and an understandable reason for
holding off from investing, company finances are not really notably weaker than
most years since New Labour came to office. But perhaps companies now face
additional commitments, which are pushing capital spending down the priority
list. In particular, the ‘black holes’ in pension funds, estimated at £76bn,
have assumed a greater significance in corporate Britain. The new Pensions
Regulator’s mandate to close these funding gaps may force companies to choose
between investing in the future of their business and getting their pension
funds back into the black.

It was this sort of evidence that led many informed observers to criticise
the Chancellor’s Budget forecasts for this year and next, which showed a modest
pickup in investment this year and much stronger growth next. The idea that
investment and exports will lead the UK back to its trend rate of growth after
last year’s dip seems fanciful. If reliance instead is placed on consumer
spending, the existing imbalances in the economy will worsen. And the UK’s
long-term growth rate could slow if the capital base is weakened and the
productive potential reduced. Investment may be the smallest of the three big
spending groups, but it is by no means the least important.