Not out of the woods yet

Posted on 8 Jan 2010 by The Manufacturer

EEF's Jeegar Kakkad makes an ecomonic forecast for 2010 and says exchange rate volatility is chief among manufacturers' concerns

In 2010, the UK economy faces a daunting rebuilding task. 2010 is set to be just as uncertain as 2009.

Working capital
The recovery is likely to place as many strains on cash flow and working capital as did the recession.

Much like the recovery, the UK’s banking system is still fragile. Most banks are desperately trying to rebuild their balance sheets and profits, but this often comes at the expense of lending. Manufacturers looking to tap into growing export markets will be concerned whether they have or can get the working capital necessary to fulfil their new orders.

Will banks begin to extend their healthier balance sheets by providing the short-term financing these companies need? Or will manufacturers struggle to meet demand – and potentially go to the wall – because banks are reluctant to lend?

Insolvencies tend to rise after recessions as businesses struggle to cope with the demands of the recovery. If that trend holds in 2010, a lack of working capital from banks could be to blame for more business failures, further job losses and a weaker than expected recovery.

Will consumers bed down for the winter?
Although the High Street is happy about a strong Christmas shopping season, it could have come at the expense of sales in the first few weeks of 2010.

In the wake of a tough recession, households have been building up savings and paying down their debt. And although unemployment hasn’t hit the highs many expected, the prospect of a jobless recovery and future tax rises could keep consumers cautious through the rest of 2010, as well.

If, however, the labour market continues to build on the improvements seen towards the end of 2009, households will feel they need to save less, driving a stronger-than expected recovery. But the cold weather is likely to keep consumers at home and out of the shops.

Can global growth drive domestic growth?
What happens in the rest of the world will play a big part in the UK’s economic performance in 2010 and also that of manufacturing. Sustained recoveries in China and the US, coupled with a weak pound, could kick start world trade and boost UK exports.

In emerging Asian economies the impact of the global recession was not as pronounced as initially expected. But the Chinese government will need to curtail lending to keep its economy from overheating in 2010. In the US, the prospect of a jobless recovery is keeping consumers and businesses cautious. And the rest of the world is being adversely by growing tensions between the renminbi and the dollar.

Indeed, over the past year we’ve seen some sharp movements in sterling. This volatility has proved costly for UK manufacturers, raising margins and costs rather than orders. An EEF survey shows that further exchange rate volatility is manufacturers’ biggest concern for 2010 as it is a potential barrier to increasing export sales.

An export-led recovery on the back of a weaker exchange rate is, therefore, not assured.

Threading a needle at the Bank
In 2009, the Bank of England pushed monetary policy a long way from normal.

A sluggish recovery will mean that interest rates will remain low throughout 2010. Consequently, the most difficult decision for the Old Lady now is how to begin unwinding its £200bn quantitative easing programme while ensuring businesses have the working capital they need. But reversing quantitative easing means selling government bonds to financial markets already wary of buying them.

The Bank of England will have to strike a very delicate balance between rolling back its unconventional stimulus and not undermining an already fragile recovery.

It’s the election, stupid.
Financial markets, already worried about how the UK will fare in a stormy 2010, are also worried about the public finances and the prospect of a hung parliament or a minority government.

Any new government will need to set a credible plan to address the perilous state of public finances. But a hung parliament or a minority government will find it very difficult to push through the necessary tough reforms.

That means that sterling is being buffeted about by investors second guessing the outcome of the election. Consequently, financial markets are beginning to shy away from UK government bonds.

If this continues or if the UK’s credit rating falls, it could raise interest rates for businesses and households and complicate the Bank’s decisions on when to unwind quantitative easing. The market’s belief that the UK economy is still shaky is self-reinforcing, helping the UK economy get off to a rocky start to 2010.

So, yes, the election will centre on the economy and public finances. But the outlook for the economy in 2010 is very much about the election as well.

Any reasons to be cheerful?
Manufacturers went into the recession in better shape than in the past – more competitive and productive and with a broader reach into global markets. They also adjusted quickly to difficult economic circumstances – controlling costs; holding onto skills and working closely across their supply chains.

If the global economy doesn’t fall foul of the risks outlined and returns to better health this year UK manufacturers stand ready to benefit.

Jeegar Kakkad is the senior economist at EEF, the manufacturers’ organisation