The Spring Budget focuses on investing in infrastructure, skills and innovation to boost productivity growth, but this will only happen if it takes into account existing sectoral capabilities, writes Thomas Aubrey, CEO and founder of Credit Capital Advisory.
In his recent 2021 budget, the UK Chancellor set out a strategy to raise productivity growth through the government’s Build Back Better plan. The plan focuses on investing in three areas including infrastructure, skills and innovation, which is intended to boost the recovery through higher levels of competitiveness.
But increasing investment in these areas will materialise in higher productivity growth only if it helps firms in specific sectors develop a competitive advantage to sell their products or services. Hence, the returns to investment will be higher if its allocation takes into account existing sectoral capabilities.
For example, the computing and electronics sector is small in the UK compared to the US, China, South Korea and Taiwan, so expecting firms in this sector to be able suddenly to compete internationally as a result of more investment is unrealistic. An effective government strategy therefore needs to be targeted at sectors that already have sufficient capabilities to enable them to grow and export. Which sectors might have the capacity to grow must also take into account the adverse effects of Brexit and the negotiated Trade and Cooperation Agreement (TCA) between the UK and EU, which has increased trade frictions.
Countries that perform well in R&D intensive sectors are likely to have a greater share of labour employed in higher value-added jobs and hence faster productivity growth. Four high value sectors are assessed below to the extent that they might improve the UK’s jobs and productivity performance; however, each faces specific challenges requiring targeted interventions.
Pharmaceuticals is a high R&D intensity sector, which tends to result in greater innovation and a higher value added per capita. Prior to the COVID 19 pandemic the growth in gross value added (GVA) of the UK pharmaceuticals sector was beginning to slow relative to other leading countries. The table below shows that between 2002 and 2015 GVA growth in the UK lagged behind Germany and the United States, although it remained higher than France. However, the Brexit vote brought the sector to a standstill, largely due to the uncertainty it created.
Between 1997 and 2006 the UK pharmaceutical sector contributed positively to productivity growth whereas between 2010 and 2019 it made a negative contribution Interviews conducted with senior UK pharma personnel suggested that prior to the global pandemic the key focus of firms was on improving operational efficiencies of logistics and manufacturing capacity as well as seeking out optimal tax domiciles. This strategy appears to have been developed to partly offset the decline in R&D productivity and the expiration of key patents, which is one reason why the value added per hour of the sector fell between 2010-2019.
Despite this recent decline in relative competitive advantage, the UK sector has retained a highly skilled workforce as it has not seen a fall in its labour share. Hence when the global pandemic struck it was able to respond rapidly with new vaccine manufacturing plants, with value added per hour across the sector jumping 28% between Q3 2019 and Q3 2020. While the change of regulatory regime for UK firms to sell into the EU will create additional hurdles, if innovation supported by the government can drive new products, particularly in bio pharma, then opportunities are likely to expand.
The outlook in the UK for the aerospace sector, which is the most R&D intensive sector in the economy, looks far less rosy though. The UK dominated the aerospace sector in terms of innovation during the post war period including the world’s first commercial jet airliner.
Despite this technological lead, between 2002-2015 the UK aerospace sector entered a period of dramatic relative decline, its GVA growing far more slowly than for Germany and France, becoming negative since the Brexit vote. While the Trade and Cooperation Agreement (TCA) has an article on aviation safety, this will merely help facilitate the recognition of each side’s aviation safety certificates. Leading aerospace firms such as Rolls Royce had already decided to shift its home for design to Germany to avoid potential regulatory hurdles. The existence of different regulatory regimes may result in less future job growth in the UK.
While the outlook for the competitiveness of the domestic UK aerospace sector appears somewhat gloomy, the UK auto sector – which in the 1970s appeared to be in terminal decline – did manage to revive. This was mainly driven by the active policy of the Thatcher administration to incentivise Japanese firms to move production to the UK, taking advantage of its membership of the single market and customs union. Growth in the UK auto sector, which is a medium to high tech R&D intensive sector, over the period between 2002 and 2015 has been significant, even outperforming Japan. However, this moved into reverse as a result of the Brexit vote as the table shows.
The UK auto sector noted that the TCA is more about damage limitation than the potential to increase competitive advantage. The rules of origin related to future tariff free trade with the EU now require at least 40% of finished vehicles to originate in the EU and UK, rising to 55% in 2027. For electrical vehicles (EV) this is challenging given that batteries are largely imported.
To achieve scale in battery production will require the UK chemicals sector, which is also a medium to high tech R&D intensive sector, to be able to supply the right materials, particularly for anodes, cathodes and electrolyte additives where a significant chunk of the value lies. Further challenges lie in the recycling and reuse of batteries. Unfortunately, the chemicals sector in recent years has also been in relative decline and has been negatively affected by Brexit too.
Hence to address the EV opportunity and revive value added in the auto sector, the chemicals sector will require more targeted investment which will need to come via specific innovation support to build up the required capabilities. Such support from government is still no guarantee of success. But innovation policy necessarily involves taking risks.
These sectoral examples suggest that trying to drive up productivity growth will require more than just general investment in infrastructure, skills and innovation as set out by the government. Policy instead ought to focus on specific sectoral opportunities where some capabilities already exist, backed by appropriate levels of public investment and support.
Table: GVA international comparison 2002-2018