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UK Economic OutlookMarch 2013

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Feature articles:•Outlookforthepublicfinancesandoptions fortheBudget•AttractingtheBRICs:pasttrendsandfutureprospects forinwardinvestmentintotheUK

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UK Economic Outlook March 2013 3

Highlights and key messages for business and public policy

• InourmainscenarioweprojectUKGDPgrowthofaround1%in2013asawhole, risingtoaround2%in2014.Thisassumesagradualrevivalintheglobaleconomy andnomajoraccidentsintheEurozone.

• AsourUKbusinessclimatemapinFigure1.1shows,thisgraduallyimprovingoutlookismirroredinmostUKregions,althoughthesunshinemaycomethroughabitmorestronglyinLondonandtheSouthEastthaninsomeotherpartsofthecountry.Theweathersymbolsinthemapalsotakeaccountofrecentemploymenttrendsineachregion. TheEurozoneoutlookremainsmuchmorestormy.

• RisksaroundgrowthinourmainscenarioarestillweightedtothedownsideatpresentgiventheongoingchallengesintheEurozoneandtherisksoffurtherglobalcommoditypriceshocks.WethereforerecommendthatbusinessesshouldstresstesttheirplansandvaluationsagainstanalternativescenarioinwhichtheUKlapsesbackintorecession.However,therearealsoupsidepossibilitiesiftheEurozonesituationcalmsdownfurtherandUKbusinessesgraduallybecomemoreconfidentaboutinvestingforgrowth.

• Weexpectrealconsumerspendinggrowthofaround1.2%in2013andaround1.9%in2014astheunemploymentratedriftsdownandinflationfallsbackgraduallynextyear(whileremainingabovetarget).Thisshouldeasebutnotentirelyeliminatetheseveresqueezeonrealhouseholdincomesseeninrecentyears.

• Companyfinancesremainrelativelyhealthy,particularlyforlargerservicesectorfirms, sothesecompaniesshouldbeabletoinvestmoreifcurrenteconomicuncertainties canbereducedovertime.However,thefocusofthisinvestmentmaybemorein fast-growingemergingmarketsthanintheUKorEurope.

• Consumerpriceinflation(CPI)islikelytoriseto3%ormoreintheshortterm,butshouldthenfallbackgraduallytowardsits2%targetleveloverthenexttwoyears.Butthereareclearupsideriskstoinflationfrompotentialfurtherglobalcommoditypriceshocks.

• Monetarypolicylookssettoremainverylooseforatleastthenextyear,butwillneedtobetightenedinthelongertermasandwhentheeconomyrecovers.Wedonotseeastrongcaseformorequantitativeeasinggivenpersistentabovetargetinflationandtherecentrelativeweaknessofthepound.

• Publicborrowingisprojectedtoovershootitstargetbyaround£8billioninthecurrentfinancialyearinourmainscenario,sotheChancellorwillhavelittleroomformanoeuvreinhisBudgeton20thMarch.Heshouldfocuswhatfirepowerhehasonmeasuresto boostinfrastructureinvestment,whilealsolayingthegroundworkforlongerterm supplysidereform.

Figure 1.1 – UK business climate map

Source: ONS, Eurostat, PwC analysis.Note: Eurozone employment rate is from 2012 Q3.

*This means no statistically significant change > 0.3%

Estimated average GDP growth in 2013 / Latest Employment rate (16-64)

UK outlook – cloudy but improving

Scotland

North West

Northern Ireland

North East

Wales

Yorkshire & Humberside69.80.6%

67.00.4%

67.70.5%

68.60.7%

70.21.0%

South West

East Midlands

74.71.0%

71.40.9%

South East

West Midlands

75.01.6%

London

East

74.80.9%

71.51.1%

Eurozone – still stormy

64.1-0.4%

70.70.9%

70.81.0% 70.31.3%

Increasing employment rate No change in the employment rate* Falling employment rate

• TheUKneedstoattractmoreinwardinvestmentfromtheBRICsandotherhighgrowthmarkets.OuranalysisshowsthattherehavebeensomeencouragingsignsofincreasedinvestmentfromChinaandIndiainrecentyears.ThishasscopetoincreasemuchfurtheriftheUKcanaddressweaknessesinareasliketransportinfrastructureandmakethe mostofstrengthssuchastheresearchcapabilitiesofourleadinguniversities.

Real GDP growth 1.1% 2.1%

Inflation (CPI) 2.8% 2.4%

2013 2014

Source: PwC main scenario projections

Table 1.1 – Key numbers

UK Economic Outlook March 20134

Contents

Section Page

1 Summary 05

2 UK economic prospects 08

• 2.1 Recentdevelopmentsandthepresentsituation 08• 2.2 Economicgrowthprospects 12• 2.3 Outlookforinflation 14• 2.4 Fiscalandmonetarypolicyoptions 14• 2.5 Summaryandconclusions 15

3 OutlookforthepublicfinancesandoptionsfortheBudget 16

• 3.1 Scenariosfortheeconomyandthepublicfinances 16• 3.2 Theoutlookforthepublicfinances 18• 3.3 ImplicationsfortheBudget 20• 3.4 Summaryandconclusions 20

4 AttractingtheBRICs:pasttrendsandfutureprospectsforinwardinvestmentintotheUK 21

• 4.1 GlobalandUKinwardinvestmenttrends(includingregionalanalysis) 21• 4.2 GrowingimportanceofChinaandIndia(includingTatacasestudy) 23• 4.3 HowattactiveistheUKasaninwardinvestmentlocation? 28• 4.4 Conclusions:futureprospectsforUKinwardinvestment 29

Appendices

AOutlookfortheglobaleconomy 33BUKeconomictrends:1979-2012 34

ContactsandServices 35


Recent developments

TheUKeconomycontractedby0.3%inthefourthquarterof2012,reversingthestrongreboundto1%growthinthethirdquarter,whichwasboostedbytheOlympicsandtherecoveryinoutputfollowingtheextraDiamondJubileebankholidayinJune.Servicesoutputgrewbyaround1%in2012,butmanufacturingoutputfellbyaround2%, constructionbyaround8%andNorthSeaoil andgasoutputbymorethan10%.Asaresult, overallGDPgrowthwasjust0.2%in2012,downfrom0.9%in2011and1.8%in2010.

Consumerspendingrecordedmodestreal growthofaround1%in2012,buttheEurozone crisisdampenedUKexportgrowthanddis- couragedsignificantnewbusinessinvestment.

Recentbusinesssurveyshavepresentedamixedpicture,butmostpointtomodestlypositiveunderlyinggrowthinQ12013ledbyservices.Labourmarketstatisticscontinue topointtoamuchstrongerpicturethan GDPestimates,withemploymentrising atahealthyrateduring2012andunemploymentfallingback.

TheeconomyremainsrelativelyfragilegiventhevolatileinternationalenvironmentwithcontinuinghighlevelsofuncertaintyaboutprospectsfortheEurozoneandgenerallyhighandvolatileglobalcommodityprices.Ontheotherhand,prospectsforgrowthbeyondEuropenowlooksomewhatmorepositivefor2013and2014becauseweexpecttheemergingmarketslowdownof2011-12tobegraduallyreversedduetopolicyeasinginthoseeconomies.

UKinflationfellbackto2.2%inSeptember,buthassincepickedupagainto2.7%inJanuary2013andlookssettoriseto3%ormoreinthesummer.Earningsgrowthremainsmuchlower,whichhasprolongedthesqueezeonrealhouseholdincomes.

Businessprofitabilityhasheldupreasonablywellinrecentyears,particularlyinlargeservicesectorcompanies.Thiscreatesthepotentialforafutureinvestmentrevivalasandwhenbusinessconfidencereturnson asustainedbasis.

Future prospects

Our main scenarioisforUKGDPtorise byaround1%in2013afterincreasingbyjust0.2%in2012asawhole.Weexpectagradualreturntotrendgrowthofaround2%in2014inourmainscenario(seeTable1.2).

AsshowninTable1.2,ourmainscenario forGDPgrowthin2013-14issimilartothe latestforecastsoftheOfficeforBudgetResponsibility(OBR).Ourviewissomewhat moreoptimisticthanthelatestconsensusprojectionsfor2014,butsimilarfor2013.

However,bothourmainscenarioandtheprojectionsofotherforecastersaresubjecttosignificantmarginsofuncertainty,asindicatedbythealternativeGDPgrowthscenariosshowninFigure1.2.

Weprojectconsumerspendinggrowthtopickuponlygraduallyin2013-14.Thisisduetosubduedprospectsforrealearningsgrowthandthedragfromhighhouseholddebtlevels.Butagradualdownwarddrift

1 – Summary

Projected % change on a year earlier

Figure 1.2 – Alternative UK GDP growth scenarios

-8

-6

-4

-2

0

2

4

6

Main Source: ONS, PwC scenariosStrong recoveryProlonged recession

Projections

Source: Office for Budget Responsibility (December 2012), HM Treasury survey of independent forecasts (average values in February 2013 survey)and PwC main scenario. Investment refers to total fixed investment by both business and government. CPI inflation rates are annual averages.

Indicator OBR forecasts Independent PwC(% real annual growth) (December 2012) forecasts Main scenario (February 2013) (March 2013) 2013 2014 2013 2014 2013 2014

GDP 1.2 2.1 1.0 1.6 1.1 2.1

Consumer spending 0.9 1.6 0.9 1.5 1.2 1.9

Fixed investment 2.1 8.1 2.2 4.7 1.5 4.8

CPI inflation 2.5 2.2 2.6 2.2 2.8 2.4

Table 1.2 – Summary of UK economic prospects

inunemploymentratesshouldprovidesomesupportforconsumerspendingandthesqueezeonrealincomesshouldeasein2013-14ascomparedtotheseveresqueezeexperiencedin2008-12(asillustratedinFigure1.3overleaf).

Fixedinvestmentgrowthremainserraticfromquartertoquarter,butshouldpickupspeedlaterin2013andinto2014giventhatcompanyfinancesappearrelativelyhealthyatpresent(atleastforlargefirms,particularlyintheservicessector).

*Excluding effect of Royal Mail Pension Fund transfer(all figures also exclude the impact of temporary financial transactions in line with usual Treasury and OBR practice)

Source: OBR central forecast (December 2012), PwC main scenario

Table 1.3 – Comparison of PwC and OBR public finance projections

2012/13 2013/14 2014/15 2015/16 2016/17 2017/18

PwC main scenario

Public sector net borrowing (£ bn) 117* 108 95 81 61 41

Public sector net borrowing (% GDP) 7.4% 6.6% 5.6% 4.6% 3.3% 2.1%

Cyclically adjusted current budget deficit (% GDP) 4.1% 3.0% 2.1% 1.5% 0.6% -0.2%

Public sector net debt (% GDP) 75% 77% 80% 81% 82% 80%

OBR forecast



Cyclically adjusted current budget deficit (% GDP) 3.6% 2.2% 1.4% 0.8% -0.4% -0.9%



However,investmentisstillbeingheldbackbytheoverhangofuncertaintyfromtheEurozonecrisisandthefactthat,wherebusinessesdodecidetoinvest,theymayfocusmoreonfastergrowingemergingmarkets.Nonetheless,replacementinvestmentwillstillberequiredintheUK, soweexpectsomepositiveupwardtrend inthisareain2013-14.

Inflationisexpectedtoriseintheshorttermduetohigherenergyprices,butshouldresumeitsgradualdeclinein2014.However,itnowseemslikelytoremainabovetargetforthenexttwoyearsevenassumingnofurthermajoradverseglobalcommoditypriceshocks.

Riskstogrowthremainsignificantandstillappeartobebiasedtothedownsideintheshortterm.Wethereforerecommendthatbusinessesshouldstresstesttheirplansagainsta‘prolongedrecession’scenarioinwhichGDPgrowthlapsesbackintonegativeterritoryduring2013andremainsveryweakin2014asshowninFigure1.2.Thisisnot themostlikelyscenario,butitcannotberuledoutatthisstagegiventhepossibility oftheEurozonecrisisflaringupagainandthefragilestateofUKconsumerand businessconfidence.

Atthesametime,therearealsosomeupsidepossibilities,whichcouldseeastrongerrecoveryoftheUKeconomytoagrowth rateofaround4%bytheendof2014.However,thiswouldbelikelytoprovokerisesininterestratesduringthecourseofnextyearinordertokeepinflationundercontrolinthemediumterminthismoreoptimisticscenario.

Insummary,ourmainscenarioisforaslowandprobablybumpyrecoveryintheUKeconomyoverthenexttwoyears,butconsiderableuncertaintiesremain.

Outlook for the public finances and options for the Budget

OurmainscenarioforthepublicfinancesissomewhatlessoptimisticthanthelatestOBRforecast(seeTable1.3),withpublicborrowingovershootingbyaround£8billionin2012/13andthestructural(i.e.cyclicallyadjusted)currentbudgetdeficitnotbeingeliminateduntil2017/18.Publicsectornetdebtmightpeakataround82%ofGDPin2016/17inthiscase(comparedtoapeak ofaround80%in2015/16inthelatest OBRforecast).

Average % change p.a.

Figure 1.3 – Real earnings squeeze expected to moderate in 2013-14

Source: ONS, Consensus forecasts for nominal earnings growth (Feb 2013), PwC main scenario for CPI inflation.

-2

-1

0

1

2

3

2013-2014(projected)

-0.2

2008-20122001-2007

2.3

-1.0


Attracting the BRICs: trends and prospects for inward investment in the UK

ForeignDirectInvestment(FDI)hashistoric-allybeendominatedbytheadvancedeconomies,buttheperiodsince2000hasseenasignificantriseintheFDIarisingfromemergingeconomies.In2011,emergingeconomiescontributedaround10%oftotalglobaloutwardFDIflows,upfromless than1%in2000.

ThecontributiontowardsthetotalstockofFDIintheUKfromtheBRICs(includingHongKong)hassimilarlybeenontherise

TheseprojectionsshowtheChancellorstillfacesaverytoughchallengeingettingthepublicfinancesbackundercontrolinthemediumterm.WewouldthereforeexpectaprudentBudgetthatisbroadlyfiscallyneutralinthemediumterm.However,thisstillleavessomescopefortaxreformsandareallocationofspendingtowardsinfrastructureinvestmentaimedatboostingthelong-termsupplysideperformance oftheeconomy.

overthepastdecade.Whilethesecountriesstillmakeuponly3.3%ofthetotalinwardUKFDIstock,thissharehastripledsince2001.IndiaandChinahavebeenthemaincontributorsamongsttheBRICcountries:Indiawasthe5thlargestFDIjobcreatorandChinathethirdbiggestprojectcontributor totheUKfortheyeartoMarch2012.

TheUK’skeystrengthsinattractinginwardinvestmentincludeaccesstoarelativelyflexiblelabourforce,worldclasstechnologyandwelldevelopedfinancialmarkets. ButtheUKalsohassomeweaknesses,includingarelativelyhighcostofliving

andpoorinfrastructurerelativetootherWesternEuropeaneconomies.

AmajoropportunityfortheUKliesinattractingfurtherinvestmentsfromfastgrowingeconomieslikeRussia,Mexico,SouthAfricaandtheMiddleEast,aswell asChinaandIndia.TheUKcouldalsoexploitfurtherthepotentialofitsworldclassuniversitiesinattractingmoreR&Dactivity.ButtheUKwillalsofacechallengesfromotherEuropeaneconomiessuchasPolandthatarebecomingincreasinglyattractive toforeigninvestors.


Key points

• UKGDProsebyjust0.2%in2012asawhole.Consumerspendingandbusinessinvestmentgrowthhaveremainedrelativelysubduedduetochallengingcreditconditionsandongoingeconomicuncertainty,whileexportsactuallyfellin2012dueprimarilytotheproblemsintheEurozone.Employmentgrowthhasbeenrelativelystrong,butthishasbeenoffsetbyacontinuingsqueezeonrealwages.

• Inflationremainedwellabovetargetat2.7%inJanuary2013duetoupwardpricepressuresfromrecentincreasesinuniversityfees,energyandtransportcostsaswellastherecentsterlingdepreciation.Weexpectinflationtorisefurtherto3%ormoreinQ32013,butthentofallbackverygraduallytowardsits2%targetin themedium-term.

• WeprojectgrowthfortheUKasawholetobearound1%in2013,pickingupgraduallytoaround2%in2014inourmainscenario.AsshowninFigure2.1, allregionsshouldreturntomodestgrowththisyear,ledbyLondonand theSouthEast.

• DownsiderisksemanatingfromtheEurozonehaveabatedsomewhatsincelastsummer,buttheseneverthelessremainsignificant.Businessesshouldthereforemakeappropriatecontingencyplansfortheseandotherkeyrisks (e.g.furtherglobalcommodityprice risesasgrowthpicksupagainin Chinain2013-14).

Introduction

Inthissectionwedescriberecentdevelop-mentsintheUKeconomyandreviewfutureprospects.Thediscussioncovers:

2.1Recentdevelopmentsandthe presentsituation

2.2Economicgrowthprospects:national, sectoralandregional

2.3Outlookforinflation

2.4Monetaryandfiscalpolicyoptions

2.5Summaryandconclusions

2.1 – Recent developments and the present situation

ThelatestUKGDPestimates,whichwerepublishedon27thFebruary,showthattheeconomygrewby0.2%overallin2012(revisedupfromapreliminaryestimateofzero).Realoutputfellby0.3%inthefinalquarterof2012relativetothepreviousquarterfollowinganunwindingofthetemporaryOlympicsboostinthethirdquarterandaparticularlylargedeclinein NorthSeaoilandgasoutputinQ42012.

Thisroundedoffayearin2012duringwhichtheUKeconomystruggledtogrow.However,itshouldbenotedthatnon-oilGDPdidnotactuallysuffera‘double-dip’recessionduringthisperiodwithtwosuccessivequartersoffallingoutput.ThisisincontrasttoheadlineGDP,whichwasdepressedbythefallofmorethan10%inNorthSeaoutput in2012,followingasimilarlylargedeclinein2011.Ingeneral,non-oiloutputprovidesabetterindicationoftheunderlyinggrowthtrendintheeconomy.

2 – UK Economic prospects

Source: ONS, Eurostat, PwC analysis.Note: Eurozone employment rate is from 2012 Q3.

*This means no statistically significant change > 0.3%

Increasing employment rate No change in the employment rate* Falling employment rate

Figure 2.1 – UK business climate map

Estimated average GDP growth in 2013 / Latest Employment rate (16-64)

UK outlook – cloudy but improving

Scotland

North West

Northern Ireland

North East

Wales

Yorkshire & Humberside69.80.6%

67.00.4%

67.70.5%

68.60.7%

70.21.0%

South West

East Midlands

74.71.0%

71.40.9%

South East

West Midlands

75.01.6%

London

East

74.80.9%

71.51.1%

Eurozone – still stormy

64.1-0.4%

70.70.9%

70.81.0% 70.31.3%

% change p.a.

Figure 2.2 – Growth in the expenditure components of GDP in both real and nominal terms in 2012

Source: ONS

-2

-1

0

1

2

3

4

5

GDPTotal importsTotal exportsDomestic demandGeneralgovernment

Fixedinvestment

Households

Real Nominal

1.0

3.8

1.4

2.1

2.6

2.0

1.2

2.6

-0.3

-1.1

2.0

1.4

0.2

1.5


LookingatGDPbyexpenditurecategory,Figure2.2showsthatgrowthratesin2012onbothreal(i.e.inflation-adjusted)andnominal(i.e.cash)terms.

Realconsumerspendinggrowthhasbeenweakinrecentyearsincomparisontopreviousrecoveries,havingbeensqueezedbyhighlevelsofinflation,weakearningsgrowth,andrelativelyhighsavingsrates inrecentyears.Fixedinvestmentgrowth alsoremainedrelativelysluggishin2012 asbusinesseswerereluctanttomakemajor newinvestmentsduetomuteddomesticdemandandongoinguncertaintysurrounding theEuropeanandglobaleconomicoutlook.Housebuildingandpublicsectorcapitalinvestmentalsoremainedsubduedin2012.Incontrast,generalgovernmentconsumption1continuedtogrowsurprisinglystronglyduring2012,butthisseemsunlikelytocontinueforlonggiventheongoing fiscalausterityprogramme.

Exportsactuallyfellbackin2012whileimportsincreased,sonettradeexertedasignificantdragongrowthlastyearaskeymarketsintheEurozoneweakened.Thisisevidentfromthefactthatrealdomesticdemandgrewby1.2%in2012,compared to0.2%overallrealGDPgrowth.

ItshouldbenotedthattheGDPdeflatormeasureofwholeeconomyinflationin2012wasonly1.4%–muchlowerthantheaverageheadlineCPIinflationof

2.8%.Thiswasdrivenprimarilybythenegativeinflationratesofothercategoriesofexpenditure,suchasgovernmentconsumption,exportsandimports,whichpartiallyoffsetthepriceincreasesinhouseholdexpenditure.ThisimpliesthatGDPgrowthincashtermsactuallyfellsharplyfrom3.4%in2011to1.5%in2012,whilethedeclineinrealGDPwasmuchmoremodest.

UKgrowthcontinuestobeledby theservicessector

TheservicessectorremainsthemainstayofUKeconomicgrowth,expandingbyaround1%inrealtermsin2012,withapositiveshowingfrommajorsub-sectorssuchasgovernmentservices,businessservices andfinance,anddistribution,hotels andrestaurants,asshowninFigure2.3. Theutilitiessectoralsoexperiencedastronger-than-expectedreboundduring thisperiod.

Otherpartsoftheeconomyhavelanguished:asnotedabove,outputintheminingandquarryingsectorfellbyaround10%in2012,reflectingamarkedfallinNorthSeaoilandgasproductionthatknocked0.2percentagepointsoffquarterlyGDPgrowthinthefinalquarterof2012alone.Themanufacturingsectorshowedsomesmallsignsofrallyingtowardstheendof2012,butitneverthelesscontractedbyjustunder2%in2012as a whole.

% change p.a.

Figure 2.3 – Sectoral output growth in 2012

Source: ONS

-12

-10

-8

-6

-4

-2

0

2

4

Mining & quarryingincl oil & gas

extraction

ConstructionManufacturingTransport, storage& comms

UtilitiesDistribution, hotels &

restaurants

Business services& finance

Government& other services

1.6 1.1 0.8 0.7

-0.1

-1.8

-8.2

-10.1

Index

Figure 2.4 – Purchasing Managers’ Indices of business activity

30

35

40

45

50

55

60

65

Above 50 indicatesrising activity levels

Manufacturing Source: CIPS/MarkitServices

1 As Figure 2.2 shows, it is puzzling that real government consumption growth (2.6%) is estimated to be higher than nominal growth (2%), which implies a negative inflation rate for the goods and services consumed by government in 2012. This does not seem particularly plausible, suggesting that real growth may be somewhat overestimated for government consumption, which made up just over a fifth of total UK GDP in 2012. Real government spending growth is notoriously difficult to measure due to the lack of market prices and methodologies continue to evolve, so we may well see major data revisions in this area in future years.


Thisissupportedbypurchasingmanagers’surveys(seeFigure2.4)whichshowactivityinthemanufacturingsectortohavebeendepressedformuchofthepastyear(andgenerallyweakerthanservices).Thesectorhasbeenaffectedbyweakdomesticdemandandthedeclineinnewexportordersfromkeyexternalmarkets,particularlythecrisis-hitEurozone.Theconstructionsectoralsoexperiencedalargefallinoutputofaround8%in2012,duetoongoingcutbacksinpublicspendingoninfrastructureandasluggishpropertymarket.

Consumerspendinggrowthremainssluggish

Theslowgrowthinconsumerspendinginrecentyearshasbeenduetoacombinationoffactors.Mostimportantly,realearningsgrowthhasremainedveryweak:realwages2 declinedbyaround1%onaveragebetween2008and2012,comparedtoaveragegrowthofover2%perannumduringthepre-crisisperiod3(seeFigure2.5).Asthechartshows,thesqueezeonrealincomeseasedbetweenSeptember2011andSeptember2012,buthasbeguntointensifyagaininrecentmonthsasinflationhaspickedupagain.

DespitehistoricallylowinterestratesbeingmaintainedbytheBankofEngland,thehouseholdsavingsratiohascontinuedtoclimbfrom6.6%in2011to7.3%duringtheyearto2012Q3,asconsumersremainedcautiousaboutspendingandborrowing.

Nonetheless,retailsalesvolumesincreasedby1.6%4onayear-on-yearbasisin2012,althoughtherewasasurprisedeclineinJanuary2013.Thiswaspartiallyduetopoorweatherconditionsinthatmonth,however,sowewillhavetowaitandseeifthisnegativetrendcontinues.Inanyevent,highstreetretailersremainunderseverepressurefromtheshiftofspendingtotheinternet(whichisincludedintheoverallretailsalesfigurequotedabove).

TheUKhousingmarkethasbeenbroadlyflat5 forthepasttwoandahalfyears,asshowninFigure2.6.Recentsmallhousepriceincreaseshavereversedsomeofthelossinhousevaluesduring2011andearly2012,butthegainsoverthepastyearhavelargelybeenconfinedtoLondonandtheSouthEast.NorthernIrelandcontinuestobearthebruntofthedownturn:housepricestheredeclinedbyalmost10%during2012ontopofearliersharpfalls.

Consumershavealsobeensqueezedbyhighandvolatileinflation,whichhasaveragedaround3.2%between2009and2012ontheCPImeasure(seeFigure2.10laterinthissection).Inflationhasmoderatedsincepeakingatover5%in2011Q3,butat2.7%inJanuary2013itremainswellabovetheBankofEngland’stargetrateof2%andyetfurtherabovethepre-crisis6averagerateof1.7%.Therenewedpick-upininflationsincelastSeptemberisduetoincreasesinuniversityfees,energyandtransportcosts,

% change on a year earlier

Figure 2.5 – Real earnings growth

-4

-3

-2

-1

0

1

2

3

4

5

Source: ONS (defined as average earnings growth less CPI inflation rate)

% change on a year earlier

Figure 2.6 – House price indices

-25

-20

-15

-10

-5

0

5

10

15

Nationwide Source: Halifax, NationwideHalifax

2 Regular earnings (excluding bonuses) adjusted for CPI inflation.3 Refers to the period from January 2001 to December 2007.4 Excluding sales of automotive fuel5 Based on house prices in cash terms – in real terms, house prices have been on a downward trend (in line with our projections in July 2011 and July 2012 special articles on this topic).6 Refers to the period from January 2001 to December 2007.


arestartingtoease:inparticular,theBankofEngland’ssurveyfor2012Q4reportedanincreaseintheavailabilityofcreditforhouseholdsinparticular.Mortgagelendingforhousepurchasesincreasedbyaround8%onayear-on-yearbasisin2012,whileunsecuredgrosslendingtoindividuals8roseby6.7%duringthesameperiod,albeitfrom alowbaseinbothcases.Lendersreported inthelatestBankofEnglandcreditconditions surveythattheFundingforLendingScheme(FLS)hashelpedtobringdownfundingcostsinrecentmonths.However,thishasyettofeedintoincreasedlendingtosmallandmedium-sizedbusinesses.

EquitymarketshavealsoralliedsinceearlyNovember2012,reflectinganimprovementininvestorsentimentovertheglobaleconomicrecovery(seeFigure2.8),althoughitisnotclearthatthiswillhavemuchimpactonneartermUKgrowth9.Marketscalmedsomewhatafteradealwasreachedattheeleventhhourtoavertthe‘fiscalcliff’in theUS,andtherehasbeensomeeasingoffearsovertheongoingsovereigndebtcrisisintheEurozone.ThisissupportedbyarecentCIPS/MarkitCompositePMIinFebruary2013showingsmallerdeclinesineconomicactivityintheEurozoneinearly2013thaninlate2012.Butitremainstobeseeniftheserelativelyfavourabletrendscanbesustainedand,aswesawwiththeItalianelectionresultsinFebruary,thepolitical andeconomicsituationintheEurozoneremainsvolatileandunpredictable.

aswellastheweaknessofsterlinginrecentmonths,whichhaspushedupimportprices.

Takingalongertermperspective,theweaknessofthepoundsincemid-2007alsohelpstoexplain7therelativelyhighinflationrateoverthisperiodintheUKincomparison totheEurozone,asFigure2.7illustrates. Therecould,ofcourse,alsobesomecausationintheoppositedirection,i.e.sterling’sweaknessisinpartareflectionofarelativelyhighactualandexpectedinflationrate.Nonetheless,aweakpoundclearlymakesimportsmoreexpensiveasoverseasproducersintheEurozoneandelsewherewilltendtoraisepricesinsterlingtermsinordertomaintainrevenuesintheirdomesticcurrencies.Thishascontinuedtoexertadragonrealconsumerspendinggrowthinrecentyears,slowingthepaceofrecovery.

However,othertrendspointtosomebrighterspotsonthehorizon.Businessinvestmentdidpickupmoderatelyduring2012,whichmadeupforsomeofthegroundlostsincethefinancialcrisis.Butitshouldbepointedoutthatthesegainshavebeenlimitedtotheutilities,miningandquarryingsectors,whicharecomparativelysmall,ratherthanto‘core’sectorssuchasservicesandmanufacturing.

Creditconstraintsmaybeoneexplanationforsubduedbusinessinvestment,particularlyforsmallercompanies,buttherehavebeensomesignsrecentlythatcreditconditions

/£ exchange rate, deviation from average

Figure 2.7 – Trends in Eurozone-UK inflation differential and the exchange rate

-3

-2

-1

0

1

2

3Eurozone-UK inflation differential %

-0.4

-0.3

-0.2

-0.1

-0.0

0.1

0.2

0.3

0.4

0.5

Source: Eurostat, Bank of England. *Deviation from 1999-2012 average.Note: negative inflation differential implies UK inflation is higher relative to Eurozone.

/£ exchange rates* HICP

Index (January 2007 = 100)

US

UK

Eurozone

Figure 2.8 – Equity market indices

40

50

60

70

80

90

100

110

120

Euronext 100 Source: Thomson ReutersFTSE 100 Dow Jones Industrial

7 See Andrew Sentance’s speech on Key issues for UK Monetary Policy, 26 April 2011 http://www.bankofengland.co.uk/publications/Documents/speeches/2011/speech493.pdf, and his recent blog post here: http://pwc.blogs.com/economics_in_business/2013/01/still-selling-england-by-the-pound.html 8 Excluding student loans.9 Based on our recent analysis of the historic relationship between stock market movements and real GDP growth, available here: http://www.pwc.co.uk/the-economy/publications/stock-markets-and-the-real-economy.jhtml


Labourmarketcontinuestoshow relativestrength

ContrarytoexpectationsgivenweakGDPgrowth,thelabourmarkethasremainedremarkablyresilientoverthepastyear.Employmentcontinuestostrengthendespite theweaktrendinoutput.Theunemployment ratedeclinedto7.9%inQ42012from8.5%duringthesamequarterin2011,andtheemploymentrateincreasedby1.1percentagepointsoverthesameperiod,thoughrecentsinglemonthestimatesforDecember201210suggestthatthisimprovementmaybebeginningtofade.Thepublicsectorworkforcehascontinuedtoshrink,butthiswasmorethanoffsetbystronggainsinprivatesectoremploymentduring2012.

EmploymentlevelsroseacrossmostUKregionsintheyeartoQ42012,withthelargestgainsinLondonandtheWestMidlands.However,theNorthEastandNorthernIrelandarestillsufferingdisproportionatelyfromtheeffectsofongoingpublicsectorjobcuts.

Itisimportanttonotethatmuchoftheincreaseinemploymentoverthepastyearhasbeenintheformofincreasedself-employment11.Thismayhelptoexplainrecenttrendsinproductivitygrowth,whichhasremainedsurprisinglyweaksincetheendofthe2008-9recession,particularlyintheservicessector.Thismaybeduetoacombinationofseveralfactors.First,lowerrealwageshaveallowedbusinessestoretainmorestaffthantheycouldhaveotherwise12.

Second,theinefficientallocationofcapitalduetothecreditcrunch,combinedwithrecent lowlevelsofinvestmentandthesubsequentdeclineinthecapital-labourratio,mayalso havenegativelyimpactedlabourproductivity. Thiscouldhaveseriousconsequencesfortheunderlyingsupplycapacityoftheeconomy,resultinginapermanentdownwardshiftintheeconomy’spotentialoutputlevel13.

2.2 – Economic growth prospects: national, sectoral and regional

WeexpectUKGDPgrowthtopickupgraduallythrough2013,averagingaround1%intheyearasawholeandrisingbacktoaroundits2%trendratein201414(seeTable2.1).

Ourprojectionsareslightlymoreoptimisticthantheaverageofotherindependentprojections,particularlyfor2014,butarebroadlyinlinewiththeOfficeforBudgetResponsibility’s(OBR)16revisedgrowthforecastsinDecember(seeTable2.2). TheyarealsobroadlyinlinewiththelatestBankofEnglandcentralviewonGDPgrowthintheirFebruary2013InflationReport.

Weexpectconsumerspendingtopickuplater in2013andinto2014.Thisisinlinewithourexpectationsofmoderatinginflationfrommid-2013onwards,whichshouldhelptoreducepressuresonrealdisposableincomes.Wealsoanticipateagradualriseinbusinessinvestmentasconfidencerevivesandcreditconditionseaseovertime.Netexportsshould alsohaveamuchlessnegativeimpactonGDP

Source: latest ONS estimates for 2012, PwC main scenario for 2013-14.

(% real annual growth unless stated otherwise) 2012 2013 2014

GDP 0.2 1.1 2.1

Consumer spending15 1.0 1.2 1.9

Government consumption 2.6 1.0 0.8

Fixed investment 1.4 1.5 4.8

Domestic demand 1.2 1.2 2.2

Net exports (contribution to GDP growth) -0.8 -0.1 -0.2

CPI inflation (%: annual average) 2.8 2.8 2.4

Table 2.1 – PwC main scenario for UK growth and inflation

Source: ONS, OBR, HM Treasury Survey of Independent Forecasts (average values in February 2013 survey).

(% real YoY growth unless stated otherwise) Actual or OBR forecasts Average latest (December 2012) independent estimates forecasts (Februry 2013)

Table 2.2 – Official and independent forecasts

2012 2013 2014 2013 2014

GDP 0.2 1.2 2.1 1.0 1.6

Manufacturing output -1.8 n/a n/a 0.3 1.9

Consumer spending 1.0 0.9 1.6 0.9 1.5

Fixed investment 1.4 2.1 8.1 2.2 4.7

Government consumption 2.6 -0.7 -1.4 -0.5 -1.3

Domestic demand 1.2 0.9 1.9 0.9 1.4

Exports -0.3 3.1 4.5 1.8 3.8

Imports 2.0 2.1 3.9 1.6 3.1

Current account (£ bn) -55 -21 -20 -45 -40

Unemployment claimant count (Q4, m) 1.59 1.69 1.67 1.59 1.56

10 See the ONS release Single Month Labour Force Survey Estimates, February 2013.11 See the ONS release Self-employed workers in the UK, February 2013.12 Even when demand is weak, businesses may wish to hold on to more workers than they can immediately fully utilise, either in anticipation of demand recovering, or because they are not able to reduce headcount further without shutting down certain operations altogether. 13 An in-depth analysis of the productivity puzzle can be found in the IFS Green Budget (February 2013), Chapter 3: The productivity puzzles.


‘debtceiling’inatimelymanner,anddisruptionstooilsupplyfrompoliticalinstabilityintheMiddleEast.TheseriskswouldnegativelyimpactUKbusinesses,damagingbusinessconfidenceandforcingcutbacksininvestmentandemployment,therebydepressingconsumerconfidenceandspending.Policywouldprobablybeloosenedfurtherinresponse,generatingbroadlyflatgrowthin2014,althougheventhiswouldnotbeguaranteedin suchascenario.

Althoughwedonotbelievethatthesealternativescenariosarethemostlikely outcomes,theycancertainlynotberuledout.Businessesshouldstresstesttheirbusinessplansagainstthe‘prolongedrecession’scenarioinparticular,given thatwestillseeriskstogrowthasbeingweightedtothedownsideatpresent.

Gradualupturninmajorindustry sectors in 2013-14

Althoughtheservicessectorsarelikelytocontinuetoleadgrowthin2013,weexpectactivityinthemanufacturingsectortopickuplaterintheyearandinto2014onthebackofimprovedeconomicprospectsintheEurozoneandbetterexportperformance.Thismaybeoffsetinpartbyafurthercontractioninoutputintheconstructionsectorin2013,butthesharpfallexperiencedinthatsectoroverthepastyearisunlikely

growthin2013-14thanin2012asglobalmacroeconomicconditionsgraduallyimproveinourmainscenario(seeAppendixAformoredetailsoftheseglobalprojections).

However,giventhatthereisconsiderableuncertaintyaroundfuturegrowthprospects,particularlyinlightoftheongoingEurozonecrisis,wewouldalsostresstheneedtolookatalternativeUKgrowthscenarios,asshowninFigure2.9.Thesecanbesummarised asfollows:

• Our‘strongrecovery’scenarioseesahealthyreboundinUKgrowthtoan averageofjustunder2%in2013,picking upfurthertoaround4%bytheendof2014.ThisscenarioassumesastrongerthanexpectedrecoveryintheEurozoneoverthenexttwoyears,providinga significantboosttoconsumerandbusiness confidenceintheUK.Thisincreasesbusinessinvestmentandconsumerspending,aswellasexternaldemand forUKexports.

• Our‘prolongedrecession’scenario,bycontrast,seesUKgrowthremainingstuckinnegativeterritoryduring2013onthebackoffurtheradverseshocksemanatingfromtheEurozone,includingaprotractedcreditcrunchresultingfromincreasingpressureonEuropeanbankstodeleverage.ThisscenariocouldalsoreflectfactorssuchasthefailureoftheUSgovernmenttorenegotiatethe


Figure 2.9 – Alternative UK GDP growth scenarios

-8

-6

-4

-2

0

2

4

6

Main Source: ONS, PwC analysisStrong recoveryProlonged recession

Projections

14 Like most forecasters, we have revised our projections downwards since the November 2012 issue of the UK Economic Outlook, following the disappointing GDP performance in Q4 2012 and signs of a slow start to 2013.15 We define this as household consumption expenditure not including consumption by not-for-profit institutions serving households, such as pension funds and life insurance companies.16 See the Office of Budget Responsibility’s Economic and Fiscal Outlook (November 2012).

toberepeatedthisyear.Jobcutsinthemanufacturingandconstructionsectorhavealsoslowedrecently,providingsomeindicationofanascentrecovery.

Inaddition,anincreaseinforeigndirectinvestment(FDI)couldprovideawelcomeboosttoflaggingproductivitygrowth. WeexploretheprospectsforinwardinvestmentfurtherinSection4below.

RegionsacrosstheUKshouldreturn tomodestgrowthin2013

Weprojectthatallregionswillreturntogrowthin2013inourmainscenario(seetheUKbusinessclimatemapinFigure2.1opposite).

LondonandtheSouthEastwillcontinuetoleadtheexpansion,butthereboundinmanufacturingshouldsupportregionsintheMidlandsandtheNorthofEnglandtowardstheendof2013andinto2014.However,NorthernIreland,theNorthEast,theNorthWestandWaleswillstillbeparticularlyexposedtofurtherroundsofpublicsectorspendingcuts.

Itshouldbeborneinmindthat,formostregions,wedonothaveanyactualoutput(GVA)databeyond2011,soanyprojectionsof thekindshowninFigure2.1aresubjecttowidemarginsofuncertaintyandshouldonlybetakenasillustrativeofbroaddirectionaltrends.


TheONSannouncedinJanuarytheoutcomeofitsconsultation17ontheproposedchangestotheRPIcalculation,butdecidedtomaintaintheexistingmethodologyusedtocalculateRPI.ThistookmarketparticipantsbysurpriseastherewereexpectationsthatchangestothemethodologywouldbringRPIcloserinlinewithCPIbyeliminatingtheso-called‘formulaeffect’.Instead,anewretailpriceindex(RPIJ)willbelaunchshortlythatwillmakethischange,butitremainstobeseenhowwidelyusedthisnewindexwillbeusedcomparedtoRPI,CPIorafurthernewvariantofCPIincludinghousingcosts(CPIH)tobelaunchedsoonaswell.Thisprofusionofinflationmeasuresispotentiallyconfusingforthepublicandbusiness,buttheONSwasclearlyreluctanttoabandonorsignificantlyaltertheexistingRPImeasuregiventhatthiswouldhavecreatedalargenumberoflosers(aswellaswinners)duetoRPI’scontinuedwidespreaduseincontractsandindexationformulae.

2.4 – Monetary and fiscal policy options

TheBankofEngland’sMonetaryPolicyCommittee(MPC)announcedinFebruarythatitwillcontinuetokeeppolicyratesat0.5%,andhasindicateditswillingnesstotolerateabovetargetinflationforthenextcoupleofyearsinordertotrytosupportgrowth.ThemajorityoftheMPCrejectedthecaseforfurtherincreasesinthesizeofitsassetpurchaseprogrammeinFebruary,

2.3 – Outlook for inflation

Inourmainscenario,weexpectinflationontheconsumerpriceindex(CPI)measure,whichiscurrentlyat2.7%intheyeartoJanuary2013,tocontinuerisingtoapeak inQ32013ofaround3%,aspriceshocksfromrecentincreasesinenergyandtransportcostsfilterthroughtheeconomy.WeexpectCPIinflationtomoderatethereafter,fallingverygraduallytowardsitstargetrateof2% bytheendof2014asshowninFigure2.10. Thisisbasedontheexpectationinourmain scenariothatagradualrevivalinproductivity shouldhelprestraingrowthindomestic costsandtemperinflationarypressures.

However,thereisconsiderableuncertaintysurroundingourmainscenarioforinflation,asreflectedinthetwoalternativescenariosshowninFigure2.10:

• Inthe‘highinflation’scenario,thecombinationofsupply-sidepriceshocks suchasanincreaseinenergyandcommodity prices,andastronger-than-expectedreboundindemandpushesinflationtoaround3.5%overthisyearandthenext.

• Inthe‘lowinflation’scenario,weakgrowthindomesticdemand,combinedwithaworseningglobaloutlookandflaggingdemandforcommodities,aswellasthestrengtheningofthepoundowingtotheworseningsituationintheEurozonecausesinflationtofallbacktowardstargetayearearlierthanexpectedin2013Q4.


Figure 2.10 – Alternative UK inflation (CPI) scenarios

0

1

2

3

4

5

Main Source: ONS, PwC analysisLow inflation High inflation

Inflation target = 2%

Projections

17 National Statistician announces outcome of consultation on RPI, ONS website, 10 January 2013. 18 The minutes of the February 2013 MPC meeting indicate that three members of the committee, including the Governor, voted to increase the size of the Bank’s asset purchase programme by a further £25 billion to £400 billion. See the Bank of England Minutes of the Monetary Policy Committee meeting, 6 and 7 February 2013, and the Quarterly Inflation Report, February 2013. 19 For more analysis, see Andrew Sentance’s article Looking for the exit: Options for withdrawing monetary stimulus in the November 2012 edition of UK Economic Outlook: http://www.pwc.co.uk/the-economy/publications/uk-economic-outlook/long-term-export-trends-and-options-for-withdrawing-monetary-stimulus.jhtml

whichcurrentlystandsat£375billion,butit wasaclosevote18andfurthersuchquantitative easing(QE)cancertainlynotberuledoutifgrowthisslowerthanhopedduringthefirsthalf of 2013.

ThevalueoffurthermonetaryeasingviaQE is,however,highlydebatable.Therearereal concerns19thatcontinuedexceptionallyloosemonetarypolicyrisksdrivinginflationexpectationspermanentlyhigher,inpart throughaweakerpound,andthatlowinterest ratesaremerelydelayingtheinevitableunwindingofsomepoorlyperformingbusinesses.Thishamperstheefficientreallocationofcapitalandlabouracrossthe

economyandcouldexacerbatethedragonproductivitygrowthseeninrecentyears,sofurtherdelayingasustainablerecoveryin themediumterm.

MarkCarney,theincomingGovernoroftheBankofEngland,hasexpressedhissupportforflexibleinflationtargeting,andindicatedthatheisopentoadebateontheBankofEngland’sexistingremitofinflationtargeting.Onbalance,wethinkitisunlikelythattherewillbeasignificantchangeintheexistingmonetarypolicyframework.Nevertheless,itisimportantthattheMPCformulatesandcommunicatesaneffectivestrategyforreturningmonetarypolicytoa


moresustainablepathinthemediumterminordertoensurethatinflationexpectationsarenotpermanentlydestabilised.

Section3discussestheoutlookforthepublicfinancesandsomepossiblefiscalpolicyoptionsfortheChancellorinrelationtothe2013Budgetandbeyond.However,theseoptionsareclearlyheavilyconstrainedatpresent,withpublicborrowinglookingsettocomeinaround£8billionabovetargetin2012/13basedondataforthefirsttenmonthsofthefiscalyear.

2.5 – Summary and conclusions

TheUKeconomygrewby0.2%overallin2012.However,outputcontractedby0.3%inthefinalquarterof2012dueinlargeparttoanunwindingofthetemporaryOlympicsboostinthethirdquarter,reinforcedbyweakNorthSeaoilandgasoutput.Thisroundedoffayearofbumpybut,onaverage,verymodestgrowth.Consumerspendingandinvestmentbothremainrelativelyweakthisfaronfromthesevererecessionof2008-9.However,positivetrendsinlabourmarketactivityhintatapossiblerecoveryin the future.

OurmainscenarioisforagradualrecoverytoGDPgrowthofaround1%in2013,risingtoaneartrendrateofaround2%in2014.Amoderationininflationlaterin2013andthrough2014couldreducethesqueezeonhouseholdrealincomesandspending,althoughriskstoinflationremainweightedtotheupside.Agradualrevivalinbusinessconfidencecouldalsoboostinvestmentoverthenextyear,althoughthisisnotguaranteed.Netexportsmayalsorecover asrisksintheEurozonebecomelessacuteandtheglobalrecoverystrengthens,led byfastergrowingemergingeconomies.

Riskstogrowthremainweightedtothe downsideowingtotheeverpresentpossibility oftheEurozonecrisisflaringupagainand continuedhighandvolatileglobalcommodity prices.Difficult(ifgraduallyeasing)domestic creditconditionscombinedwithfurtherfiscal consolidationwillalsoweighonUKgrowthprospects,sobusinessesshouldstresstest theirplansagainstpossibledownsidescenariosandmakeappropriatecontingencyplans.

Overall,theroadtorecoverywillcontinuetobeslowandbumpy,butwearecautiouslyoptimisticthattheUKeconomywillgraduallyreturntogrowthin2013-14.


3 – Outlook for the public finances and options for the Budget

Key points

• ThisarticlepresentsupdatedprojectionsforthepublicfinancesandconsiderstheimplicationsfortheChancellor’soptionsintheMarch2013Budget.

• OurmainscenarioissomewhatlessoptimisticthanthelatestOBRforecast,withpublicborrowingovershootingbyaround£8billionin2012/13andthestructuralcurrentbudgetdeficitnotbeingeliminateduntil2017/18.Publicsectornetdebtmightpeakataround82%ofGDPin2016/17inthiscase.

• TheseprojectionsshowthattheChancellorstillfacesaverytoughchallengeingettingthepublicfinancesbackundercontrolinthemedium-term.WewouldthereforeexpectaprudentBudgetthatisbroadlyfiscallyneutralovertheperiodto2017/18.However,thisstillleavessomescopefortaxreformsandareallocationof spendingtowardsinfrastructureinvestment aimedatboostingthelong-termsupplysideperformanceoftheeconomy.

Introduction

Thecoalitiongovernmenthasaprimary‘fiscalmandate’ofeliminatingthestructuralcurrentbudgetdeficitbytheendofafiveyearforecasthorizon(currently2017/18)andasupplementarytargetthatrequirespublic

sectornetdebtasapercentageofGDP tobefallingby2015/16.Inpractice, theAutumnStatementsawtheChancellor admitthatthedebttargetwouldnotbemetuntil2016/17givenadownwardrevision inOBRgrowthprojections,whiletheausterityprogrammewillnowcontinueuntil(atleast)2017/18inordertomeetthefiscalmandatewithareasonablecomfortmargin.Despitethis,theUKhasrecentlylostitsAAAcreditratingwithMoody’s,indicatingthedifficultiesofmeetingthesefiscaltargetswhilegrowthremainssubdued.

Inthisarticleweuseourownmodelandscenariosfortheeconomytodeterminewhetherthegovernmentiscurrentlyon tracktomeetitstargetsforthepublicfinancesandthendiscusswhatthis meansfortheChancellor’soptionsfor theforthcomingBudget.Thediscussion isstructuredasfollows:

• Section3.1describesouralternativescenariosfortheeconomy,publicspendingandtaxreceipts.

• Section3.2presentstheresultsofouranalysisforpublicborrowinganddebt.

• Section3.3discussesimplicationsfor theChancellor’soptionsintheBudget.

1 Output gap estimates are highly uncertain given the unobservable nature of potential output, but our range of 2-4% of GDP for the extent to which actual output is below potential on average in 2012/13 encompasses the estimates of most other leading forecasters such as the OBR, OECD, IMF and European Commission.

Threealternativescenarios

ForouranalysisweusethreescenariosbasedonextendingthoseoutlinedinSection2above.Themainscenarioreflectstheoutcomeweconsidertobethemostlylikely,althoughboththepessimisticandoptimisticscenariosuseplausibleassumptionsandshouldbeconsideredasserious possibilities:

• Ourmain scenarioreflectswhatweconsidertobethemostlikelypathfortheeconomy.GDPgrowthremainsmodestataround1.4%in2013/14butthengraduallyrecovers.TrendrealGDPgrowthisassumedtobe1.5%perannumin2013/14and2%perannumthereafterandtheoutputgap1isassumedtostartfrom-3%ofGDPin2012/13anddeclinegraduallytoaround-1.7%ofGDPin2017/18(thesameassumptionasusedbytheOBRinitsDecember2012forecastand,forconsistency,inourother twoscenarios).

• Inthepessimistic scenariotheeconomystrugglestomoveoutofrecessionover thenextyear,withaverageGDPgrowth ofjust0.5%in2013/14.Trendgrowthinthemediumtermisjust1.5%andtheoutputgapisinitially-2%ofGDPin2012/13,implyinglimitedscopeforabovetrendnon-inflationarygrowthinthemediumterm.

3.1 – Scenarios for the economy and the public finances

The economy

Thefuturestateofthepublicfinanceswillbeheavilydependentontheperformanceoftheeconomy.InlinewithnormalTreasuryandOfficeforBudgetResponsibility(OBR)practicewetakeintoaccountthefactthatthesocalledcyclicaldeficit,causedbytherecessionpushingoutputbelowitslongtermpotentialtrendlevel(i.e.creatinganegative‘outputgap’),shouldbeeliminatedastheeconomyreturnstofullcapacityandthereforeislessofaworryforthepublicfinancesthantheunderlyingstructuraldeficitexcludingthesecyclicaleffects.

ThekeyvariablesfordeterminingthestructuraldeficitareunderlyingtrendGDPgrowthandhowfartheeconomyisfromfullcapacityatthestartoftheprojectionperiod(theoutputgap).Ifthereisalargerinitialnegativeoutputgap,thenthereismorescopefortheeconomytogrowatanabovetrendrateinfuturewithoutgeneratingundueinflationarypressures.Thusalargeroutputgapmeansthatthestructuraldeficitiscalculatedtobelowerforagivenleveloftheactualbudgetdeficitandthereforethatthegovernmentismorelikelytomeetitsprimaryfiscalmandateofeliminatingthestructuralbudgetdeficitby2016/17.



Figure 3.1 – Alternative real GDP growth projections

0

1

2

3

4

2017/182016/172015/162014/152013/142012/13

Source: ONS, PwC scenarios

Optimistic

Pessimistic

OBR forecast

Main scenario

OptimisticMain scenario Pessimistic

OBR forecast

*Excluding effect of Royal Mail Pension Fund transfer(all figures also exclude the impact of temporary financial transactions in line with usual Treasury and OBR practice).

Source: OBR central forecast (December 2012), PwC main scenario

Table 3.1 – Comparison of PwC and OBR public finance projections

2012/13 2013/14 2014/15 2015/16 2016/17 2017/18

PwC main scenario

Real GDP growth 0.2% 1.4% 2.2% 2.4% 2.5% 2.5%



Current budget deficit (% GDP) 6.2% 5.1% 4.1% 3.3% 2.1% 1.0%

Cyclically adjusted current budget deficit (% GDP) 4.1% 3.0% 2.1% 1.5% 0.6% -0.2%


OBR forecast

Real GDP growth 0.1% 1.5% 2.1% 2.4% 2.7% 2.8%



Current budget deficit (% GDP) 5.7% 4.6% 3.7% 2.9% 1.4% 0.4%

Cyclically adjusted budget deficit (% GDP) 3.6% 2.2% 1.4% 0.8% -0.4% -0.9%


• Theoptimistic scenarioreflectsaworldwherethereisaswiftandtimelyresolutiontotheEurozonecrisisandconfidencereturnsrapidlytoconsumersandbusinesses.Growthisaround2.2%in2013/14andacceleratesfurthertoaround3-3.5%inthethreeyearsto2017/18.Trendgrowthis2.5%andtheoutputgapisinitially-4%ofGDPin2012/13,soallowingplentyofroomfornon-inflationaryabovetrendgrowthinthemediumterm.

Atthemoment,risksappearweightedtothedownside,sothepessimisticscenarioappearsparticularlyrelevantintheshortterm,butrisksappearmorebalancedwhenamedium

termperspectiveistakenonfactorssuch asunderlyingtrendgrowth.

Howdooutscenarioscompare withOfficeofBudgetResponsibility(OBR)forecasts?

OurmainscenarioissimilartotheOBR’sDecember2012forecastsupto2015/16,asshowninFigure3.1below(althoughitshouldbenotedthattheOBRdidreduceitsgrowthforecastsmateriallyinDecembercomparedtoitsMarch2012forecasts).Butwearesomewhatlessoptimisticaboutmedium-termgrowth(2%vs2.2%)and thisisreflectedinslowergrowthinour mainscenariointhelasttwoyearsof theforecastperiod.

Lossofcapacityduringtherecession(e.g.duetoscrappingunder-utilisedassetsandlong-termunemploymentleadingtoskillserosionanddetachmentfromthelabourmarket)andpersistentlytightercreditconditionsthanpriortotherecessionmeanthatbothweandtheOBRthinkthattherewillbesignificantlylowertrendgrowth

overthecomingfiveyearsthanpriortotherecession.TheprojectedoutputgapinourmainscenarioattheendoftheprojectionperiodiscomparabletothatinthelatestOBRforecast.Inallscenarios,forconsistency withtheOBRassumptionsandprojections,weassumetheoutputgaptrendsbacktoaround1.7%ofGDPby2017/18.


Publicspendingandtaxreceipts

Weassumepublicspendingaccordingtoitscurrentplans2laidoutintheDecember2012AutumnStatementasidefromsomeadjustmentsforactualoutturnsinthecurrentyeartodate.Thestateofthepublicfinancesisthereforelargelydrivenbygrowthinreceiptsandtheresponsivenessoftaxrevenuestogrowth.Toreflectthiswevarytheelasticityoftheresponseofrevenuestoincreasesinincome,spendingandprofits.Taxrevenuesareassumedtobelesselastic inourpessimisticscenarioandmoreelasticinouroptimisticscenario.

BothforsimplicityandforconsistencywiththeTreasuryandOBR’snormalpractice,weexcludefromthepublicdebtstatisticstheimpactofthepublicsectorbanktakeoversandofthebankrecapitalisationmeasures.Suchtransactionscreatepublicassetstosetagainstincreasedpublicdebt,withthepotentialbeingthereforthetaxpayertomakeeithergainsorlossesontheseinvestmentsinthelongerterm.Itshouldberecognisedthatthesebankingtransactionsdo,therefore,introduceanadditionalelementofuncertaintyintothelong-termstateofthepublicfinances.

Wealsoexcludefromourpublicborrowingfigurestheone-offimpactin2012/13ofthetransferofRoyalMailPensionFundassetsandliabilitiestocentralgovernment,sincethistransferisessentiallyneutral

fromtheperspectiveofthepublicsectorasawhole.Wedo,however,takeaccountoftheeffects(usingthesameassumptionsastheOBR)ofthetransferofAssetPurchaseFund(APF)couponpaymentsbacktotheTreasury,whichreducesborrowingformostoftheforecastperiod,althoughitmaybebroadlyneutralinthelongertermastheassetpurchaseprogrammeisunwoundandpotentialcapitallossesarerealisedthatwillbecoveredbyTreasuryunderagreementspreviouslyreachedwiththeBankofEngland.Wealsoallowforaone-offcapitalgainof£2.3billionfromthe4Gspectrumsale;thiswaslowerthantheOBRassumptionthatthiswouldraise£3.5billion,althoughthedifferenceisnotmacroeconomicallysignificant.

3.2 – The outlook for the public finances

Basedontheassumptionsoutlinedabove,ourmainscenarioforthepublicfinancesisassummarisedinTable3.1,whichalsoshowsthelatestOBRforecastforcomparison.

ThistableshowsthattheoverallprofileofthepublicfinancesinourmainscenarioisbroadlysimilartothatinthelatestOBRforecast,butsomewhatlessoptimisticineveryyear.Inbothcases,thestructural(i.e.cyclically-adjusted)currentbudgetdeficitfallsgraduallyovertime,butisnoteliminateduntil2017/18inourmain

2 In practice, the challenge of achieving the scale of real spending cuts planned should not be underestimated, but for the purposes of this analysis we assume that the spending plans can be delivered. 3 This is the difference between total receipts and total public spending (including capital investment).4 The gap between spending and receipts, cyclically adjusted and excluding capital spending.

scenario,whichisstilljustinlinewiththeGovernment’sfiscalmandatebutwithalmostnomarginforerrorandoneyear laterthanintheOBRprojections.

Thenetpublicsectordebtstockrisestoapeakofaround82%in2016/17andthengraduallydeclines,whichagainisoneyearlaterthaninthelatestOBRprojectionsandtwoyearslaterthanspecifiedintheGovernment’soriginaldebttarget.However,thelatterwasalwaysratherarbitraryandtheChancellorwassensiblenottosticktorigidlytothistargetintheAutumnStatement.

Anysuchprojectionsaresubjecttomanyuncertainties,however,asdiscussedinmoredetailbelowinrelationtoouralternativescenarios.ThishighlevelofuncertaintyisimportantinassessingtheChancellor’spolicyoptionsfortheBudget.

Publicsectorborrowing

Ongoingcutstogovernmentspendingmeanthatpublicsectornetborrowing(PSNB)3 fallsinallofourscenarios.Basedonthelatestavailabledata,itappearsthattotalborrowingforthecurrentfinancialyearissettoovershootbyaround£8billiontheOBRforecastofaround£109billion,duetotaxreceiptsbeingbelowplannedlevels(particularlyforcorporationtaxandVAT,reflectingweakerthanexpectedeconomicgrowth).SpendingisprojectedtobesimilartoOBRprojectionsandweassume

thiscontinuesinfutureyears,sothatanydeviationsfromtheOBRprojectionsare duetovariationsintaxrevenue(asidefromanyrelativelysmalleffectsoninterestpaymentsifgovernmentdebtvaries betweenscenarios).

InourmainscenarioweprojectPSNBtofallonslightlyto£108billionin2013/14givenrelativelyslowgrowthinthatyear,butthentodeclinesteadilytoaround2%ofGDP(£41bn)by2017/18,whichissomewhathigherthantheOBR’scentralforecastof1.6%ofGDP(£31bn)inthatsameyear.However,ouralternativescenariosshowarangeforthePSNBin2017/18ofbetween4%of GDPandaroundzero,whichillustrates theconsiderableuncertaintiesinvolvedinanysuchmediumtermfiscalprojections (seeFigure3.2).

Thegovernment’sfiscalmandaterequiresthestructuralcurrentbudgetdeficit4tohavebeeneliminatedbytheendofarollingfiveyearforecasthorizon,whichiscurrently2017/18.Underourmainscenariothisisachieved,althoughaprojectedstructuralcurrentbudgetsurplusof0.2%ofGDPin2017/18istinyrelativetotherangeunderourotherscenariosasshowninFigure3.3.Onlyslightlylowertrendgrowththaninourmainscenariowouldleadtothegovernmentfailingtomeetitstarget.Thissuggeststhatthefiscalstanceneedstoremainprudent intheforthcomingMarch2013Budget.


Figure 3.3 – Cyclically-adjusted current budget deficit projections (% of GDP)

% of GDP

Pessimistic

Optimistic

Main scenario

OBR forecast

-3

-2

-1

0

1

2

3

4

5

6

2017/182016/172015/162014/152013/142012/13


PessimisticOBR forecast Optimistic

Main scenario

% of GDP

Figure 3.2 – Alternative public sector net borrowing projections (% of GDP)

Pessimistic

Optimistic

Main scenario

OBR forecast

-1

0

1

2

3

4

5

6

7

8

2017/182016/172015/162014/152013/142012/13

Pessimistic

Source: ONS, PwC scenariosOBR forecast OptimisticMain scenario

Figure 3.4 – Alternative public sector net debt projections (% of GDP)

% of GDP

Pessimistic

Optimistic

Main scenario

OBR forecast

55

60

65

70

75

80

85

90

95

2017/182016/172015/162014/152013/142012/13


PessimisticOBR forecast Optimistic

Main scenario

Anotherwayoflookingatthisistonote thattheprobabilityofthegovernmentmeetingitsfiscalmandateonthebasis ofourrangeofprojections(andpastforecastingerrors)wouldonlybearound52%giventheuncertaintiesinvolvedinlookingaheadto2017/185.

Publicdebt

Thenetdebtstockattheendof2012was70.7%ofGDP(around£1.1trillion)excludingtemporaryfinancialtransactions.Underourmainscenariothedebtstockwillcontinuetorise,peakingataround82%ofGDPin2016/17,butwillthenfallbackto justover80%in2017/18.Thisdebtprofile

issimilartobutslightlyhigherthanthatforthelatestOBRforecast(withbothprojectionsbeingsignificantlyhigherthanearlierOBRforecastsduetohigherborrowingrequirementsarisingfrom lowerprojectedeconomicgrowth).

AsshowninFigure3.4,theuncertaintiesaroundthismainscenarioareconsiderable.Ifourpessimisticscenarioweretooccur,thenpublicdebtwouldbearound90%ofGDPby2017/18andstillonarisingtrend.Underthisscenariodecisiveactionwouldeventuallybeneededtobringdebtundercontrol,butnotuntillaterinthedecadegiventhatearlyactioncouldbe

5 Based on past forecasting errors for Treasury budget deficit projections looking five years ahead.


counterproductiveinfurtherworseningtheshort-termrecessionseeninthisscenario.Underouroptimisticscenario,bycontrast,thedebtratiopeaksearlierandfallsfasteraswouldbeexpectedwithastrongergrowthoutlook.Incurrentcircumstances,however,thisscenarioisnotsomethingthegovernmentcanrelyupon.

3.3 – Implications for the Budget

Theanalysisabovemakesclearthatthepublicfinanceoutlookremainsdifficult,sotheBudgetwillneedtobeaprudentone.However,therecouldpotentiallybesomelimitedroomfortemporarycarefullytargetedfiscalstimulusnow,offsetbymoretighteninglaterasandwhentherecoveryisstronger.Businessesandconsumersaresavingandnotspending.Stimulusbythegovernmentmightservetoboostconfidenceintherecoveryandencouragespendingandinvestment.However,thisstimuluswouldneedtobewelltargetedandmight,forexample,befocusedonboostingcapitalspendingintheshort-termoverandabovethelimitedincreasealreadyannounced intheAutumnStatement.

Increasingcapitalspendingcouldbearguedforonthebasisofsupportingtheeconomyintheshort-termwhileboostingtheUK’sinfrastructureinareasliketransportandhousinginthelongerterm.Theimpactofaone-offincreaseinplannedcapitalspending

ofaround,say,£5-10billionin2013/14and2014/15wouldbeminimalformediumtermtargetsforthestructuralcurrentbudgetdeficit,giventhatthelatteraredefinednetofcapitalspending(therewouldbeanincreaseindebtinterestspending,butthiswouldbeverysmall).Thedebtlevelwouldbeincreasedbutthepathofdebtwouldnotbealteredgreatly,withthedebttoGDPratiostilltendingtofallafter2016/17inourmainscenarioevenwithanadditionalone-offcapitalspendingboostof£10billionin2013/14.

Othermeasureswithmodestfiscalcoststosupportthelong-termdevelopmentofthesupplysideoftheeconomyshouldalsobeconsideredintheBudget.Policyoptions inthisareamightinclude:

• Tax policy:developingalongertermstrategyforpersonalandindirecttaxofthekindthathasimprovedthecorporatetaxregimeinrecentyears;thismightincludelookingtoreducesometaxes thatareparticularlyeconomicallyinefficient(airpassengerdutymight beoneexample)whileincreasingtaxes onimmobilefactorsofproductionsuch aslandinthemediumterm.

• Smarter regulation:forexample,introducingasunsetclausewherebyallregulationsarerepealedafter,say,20yearsunlesstherearestrongarguments tothecontrary.

• Investmentinskills:businesses,government,schoolsanduniversitiesworkingtogethertoensurethatcoursesandcurriculaareorientedmoretowhatisrequiredtomakeyoungpeopleemployableinaglobalised,highlycompetitiveeconomicenvironment.

• Localisation:followingtherecommendationsoftheHeseltineReviewindelegatingmorebudgetsandresponsibilitiestolocalenterprisepartnershipsandsimilarbodiestodriveforwardgrowthinlocalareas.Thiswillincludeeffortstoharnessthepowerof UKresearchuniversitiestolinkupbetterwithbusinessesinhi-techmanufacturingandpromotinggreenfieldinwardinvestmentwithpositivespillovereffects (asdiscussedfurtherinSection4opposite).

Realisticallythough,therearelimitstowhattheChancellorcandointheshorttermtoboosteconomicgrowthgiventhefiscalconstraintshefaces.Expectationsshould notbesettoohigh.

3.4 – Summary and conclusions

InourmainscenariothebudgetdeficitwillovershootlatestOBRforecastsbyaround£8billionin2012/13,butshoulddeclinesteadilyinthemediumterm.Thestructuralcurrentbudgetdeficitwouldbeeliminatedby2017/18inourmainscenario,assumingthegovernmentstickstoitstoughspendingplansgoingforward,butonlywithaverysmallmarginforerrorrelativetotheuncertaintiesinvolved.

Thepublicdebtstockrisestoapeakofaround82%ofGDPin2016/17inourmainscenario,butshouldthenstarttofallbackgraduallyinlateryears.OuroutlookissomewhatmorepessimisticthantheOBR’sDecember2012forecasts,althoughthedifferencesarenotthatlargerelativeto theuncertaintiessurroundinganysuch fiscalprojections.

Clearlythereisnoroomforcomplacencyontheoutlookforthepublicfinances.Therecould,however,beroomforalimitedone-offincreaseinplanningcapitalspendingin2013/14tosupporttheeconomyandimproveUKinfrastructureinthelongertermorothersupplysidemeasureswithmodestfiscalcoststhatcanberecoupedinlateryears.ThefocusoftheBudgetshouldinanyeventbeonreformsaimedatboostingthesupplysideoftheeconomy,whileretaining aprudentmediumtermfiscalstance.


Key points

• ForeignDirectInvestment(FDI)hashistoricallybeendominatedbytheadvancedeconomies,buttheperiod since2000hasseenasignificantrisein FDIarisingfromemergingeconomies. In2011,emergingeconomiescontributedaround10%oftotalglobaloutwardinvestmentflows,upfromlessthan 1%in2000.

• ThecontributiontowardsthetotalstockofFDIintheUKfromtheBRICs(includingHongKong)hassimilarlybeenontheriseoverthelasttenyears.Whilethesecountriesstillmakeuponly3.3%ofthetotalinwardFDIstock,thissharehastripledsince2001.IndiaandChinahavebeenthemaincontributorsamongsttheBRICcountries.Indiawasthe5thlargestFDIjobcreatorandChinathethirdbiggestprojectcontributortotheUKfortheyeartoMarch2012.

• TheUK’skeystrengthsinattractinginward investmentincludeaccesstoarelativelyflexiblelabourforce,worldclasstechnology andwelldevelopedfinancialmarkets.ButtheUKalsohassomeweaknesses,includingarelativelyhighcostoflivingandpoorinfrastructurerelativetootherWesternEuropeaneconomies.

• AmajoropportunityfortheUKliesinattractingfurtherinvestmentsfromfastgrowingeconomieslikeRussia,Mexico,SouthAfricaandtheMiddleEast,aswellasChinaandIndia.TheUKcouldalsoexploitfurtherthepotentialofitsworldclassuniversitiesinattractingmoreR&D.ThemainthreatscouldbeotherEuropeaneconomieslikePolandthatarebecomingincreasinglyattractivetoforeigninvestors.

Introduction

Inthepreviousissueofthisreport,welookedatprospectsforUKexportstotheBRICs.Thepresentarticleexaminesanotheraspectofthisglobaleconomicpowershift:risinginwardinvestmenttotheUKfromemergingeconomies,particularlyChinaandIndia.WesetthisinthecontextofanoverallassessmentofpasttrendsandfutureprospectsforUKinwardinvestment.

Thediscussionisorganisedasfollows:

4.1GlobalandUKinwardinvestmenttrends(includingregionalanalysis)

4.2GrowingimportanceofChinaand India(includingTatacasestudy)

4.3HowattractiveistheUKasaninwardinvestmentlocation?

4.4Conclusions:futureprospectsfor UKinwardinvestment

AsummaryofkeyacademicstudiesonthedriversandimpactofFDIisprovidedin theAnnex.

4.1 – Global and UK inward investment trends

FDIcanbeoftwomaintypes:greenfieldinvestmentswhichprovidefreshcapitaland additionaljobs;andmergersandacquisitions(M&A)whichisapurchase/saleofexistingequity.Theofficialinwardinvestment flowdatafromsourcessuchasUNCTADortheONScanbequitevolatileduetothe M&Acomponentaslargeacquisitionscanhaveadisproportionateeffectonannual FDIflowsandalsobecauseequityvalues areaffectedbyvolatilestockmarketpricevariations.Inthisarticle,wethereforeputmostweightondataongreenfieldinvestmentsandemploymentcreation,

4 – Attracting the BRICs: past trends and future prospects for inward investment into the UK

butwedoalsolookattheofficialdata withappropriatecaveats.

OnekeycaveattohighlightisthattherecanbesignificantdistortionsintheofficialdatarelatingtotheultimateoriginoftheFDI.Theofficialanalysisofinwardinvestmentisbasedonthecountryofownershipoftheimmediateparentcompany,ratherthanthecountryofthefinalultimateparent.Thereforeifinvestmentischannelledthroughholdingcompaniesinacountrywithataxadvantageousregime,asisoftenthecase,theflowofinvestmentfromtherealcountryoforiginisunderstated.Weneedtobear thisinmindinthediscussionthatfollows.

FDI outflow as % of global total

G7

E7

1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

Figure 4.1 – FDI outflows as share of the global total – G7 vs E7

0

10

20

30

40

50

60

70

80

G7 Source: UNCTAD, FDI/TNC database (www.unctad.org/fdistatistics).G7: Canada, France, Germany, Italy, Japan, UK, US

E7: Brazil, China, India, Indonesia, Mexico, Russia, Turkey

E7


Globaltrends:beginningofareversal indirection

GlobalFDIflowsrose16%inUSdollartermsin2011,surpassingthe2005-2007pre-crisislevelforthefirsttime.FDIhas traditionallyflowedfromadvancedeconomiestoemergingeconomies.However,inthelasttenyears,theshareoftotalFDIoutflowsfromadvancedeconomieshasbeenonadownwardtrend,whilethatfromemergingeconomieshasbeenrising,albeitfromalowbase(seeFigure4.1foranillustrationofthisfortheG7andE7groupsofeconomies,butnotingthedatacaveatsmadeabove).

ArecentPwCpaper1showsthattheroleshavealreadyreversedasfarasdealsare concerned,withEmergingMarketcompanies alreadyinvestingmoreinmaturemarketcompaniessince2008thanviceversa (seeFigure4.2).

ThisispotentiallygoodnewsforadvancedeconomiessuchastheUK:aninjectionofinvestmentfromthecash-richemergingeconomiescouldprovideamuchneededboosttoUKgrowthandemployment.ButFigure4.2coverstotaldealflowstoarangeofadvancedeconomies,soweneedtolookmorespecificallyatrelevantdataforFDIflowsintotheUK.

UKinwardinvestmenttrends

ThetotalaccumulatedFDIstockintheUKhas beenrisingsince1997withablipafterthefinancialcrisisbuthasseenarecoverysincethen(seeFigure4.3).AnnualFDIinflowsaremuchmorevariable,dueinparticulartotheinfluenceoffluctuationsinM&Aactivity asnotedabove.

Significanceofgreenfieldinvestments

Asmentionedabove,greenfieldinvestmentsaretypicallymoreimportantforacountry’sgrowththanM&Adealssincetheyleadtoincreasedemploymentandproductivecapacity.Overthelastfiveyears,greenfieldinvestmentshavemadeupthemajorityoftheFDIflowstotheUKbecauseworldwideM&Aactivitydeclinedafterthefinancialcrisisin2007(Figure4.4).

FDIinUKregions

Thepotentialbenefitsfrominwardinvestment(forexample,aboosttooutputandemploymentwhichisrelativelyquickworking,aswellasbenefitstoproductivitythroughaccesstoexternaloriginR&Dandmanagementpractices)alsoapplyattheregionallevel.Itisthereforeinteresting toconsidertheregionaldistributionofinwardinvestmentwithintheUK,assummarisedinTable4.1intermsofthenumberofjobscreated.

Note: Deals included are completed, disclosed deals where the final share acquired was >20%Source: PwC analysis using Dealogic

USUK

GermanyAustralia

JapanCanada

$151 bn

Figure 4.2 – The flow of M&A investment from ‘Emerging’ to ‘Mature’ markets has beengreater than the flow in the opposite direction over the past five years (2008-12)

‘Mature’Economies

$161 bn

‘Emerging’Markets

ChinaIndiaMiddle EastRussiaBrazil

US$ billions

Figure 4.3 – UK inward FDI stock and annual flows at constant 2011 prices

Source: UNCTAD, FDI/TNC database (www.unctad.org/fdistatistics).

0

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400

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800

1,000

1,200

1,400

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Flow Stock

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

1 ‘Resetting the Compass: How High Growth Market Buyers move M&A in a new direction’, PwC, March 2013.


Note*: Not all new and safeguarded jobs could be attributed to a specific UK region.The % shares relate only to those which could be attributed (in 2005/6 24,200 could not be attributed and in 2011/12 17,955).

Source: UKTI.

Jobs % of UK Jobs % of UK Regional GVA as % 2005/06 Total 2011/12 Total* of UK Total (excluding ex-region and continental shelf) 2011

East Midlands 4,525 6.9 4,375 4.6 6.1

East of England 4,546 6.9 5,663 6.0 8.5

London 6,752 10.3 15,150 16.0 21.1

North East 5,775 8.8 10,679 11.3 3.1

North West 6,803 10.4 15,430 16.3 9.2

South East 6,343 9.7 5,561 5.9 14.3

South West 3,925 6.0 2,948 3.1 7.6

West Midlands 10,300 15.7 14,254 15.1 7.1

Yorkshire & Humber 4,499 6.9 3,700 3.9 6.8

Northern Ireland 4,079 6.2 1,480 1.6 2.2

Scotland 2,915 4.4 12,610 13.3 8.1

Wales 5,204 7.9 2,854 3.0 3.5

Table 4.1 – Distribution of jobs (new and safeguarded) related to FDI by UK region

ThedatainTable4.1showthattheEnglishregionsoutsideofthe‘GreaterSouthEast’(i.e.theregionsotherthanSouthEast,LondonandEastofEngland)succeededinattractingarelativelyhighshareofthetotalemploymentrelatedtoFDI.ThiswashigherthantheirshareofUKgrossvalueadded(GVA)inboth2005/6and2011/12.Similarly,thethreedevolvednationsattractedadisproportionateshareofinwardinvestment,nodoubtinpartreflectingfavourablegovernmentpolicyregimesfortheseterritories.ThismayprovidesomesupportfortheseeconomiesrelativetoLondonandtheSouthEast.

4.2 – Growing importance of China and India

TheUSandWesternEuropehavetraditionallybeenthebiggestinvestorsintheUKandindeedcontinuetobeso.However,overthelasttenyears,FDIfromtheemergingeconomieshasbeenrisingrapidly.TheFDIstockfrommainlandChinahasincreased14foldinthelast10years,whileFDIstockfromIndiahasincreased16fold,albeitfromalowbase.Incomparison,theFDIstockfromtheUS,FranceandGermanyhaslessthandoubledoverthistimeperiod,albeitfrom amuchhigherbase(seeFigure4.5).

%

Figure 4.4 – Value of Greenfield projects as a % of total inward FDI to the UK (2004-2011)

Source: UNCTAD, based on information from the Financial Times Ltd, fDi Markets.

0

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60

70

80

20112010200920082007200620052004

£ billions

Figure 4.5 – UK FDI total stock, current prices

Source: and, ONS.

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50

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250

BRIC, incl. Hong KongJapanGermanyFranceUSA

2001 2011


TheBRICsincludingHongKongstillaccountforonlyamodest3.3%ofthetotalFDIstockintheUK.However,thissharehastripledfrom1.1%in2001.Furthermore,thetrueshareoftheBRICsislikelytobehigherthantheofficialdatasuggestbecause,asnotedabove,someoftheFDIfromthesecountrieswillberoutedthroughtaxadvantageouslocationsandsonotcapturedbytheofficialdataascomingfromtheBRICs.

Unfortunatelythereisnowaytopindownhowlargethisdistortionis,butwecangetsomeideabylookingatalternativedatasources.Inparticular,UKTIdatashowthatChinaandIndiahavealreadybeeninstrumentalincreatingorsafeguardingasignificantnumberofjobsthroughFDIprojectsinthelasttenyears,consistentlyfiguringinthetopteninwardinvestors whenmeasuredonthisbasis.

AsshowninFigure4.6,thenumberofjobscreatedorsafeguardedbyIndianFDIprojectshasgoneupfrom316in2002-03 to5,454in2011-12.OtherUKTIdatashow thatChinawasresponsibleforthethirdhighestnumberofFDIprojectsin2011-12 ofallcountries.

TheUKinwardinvestmentstockfromChinaandIndiahasbeenbuildingupintheUKoverthelasttenyears,withparticularlyrapidgrowthininvestmentsfromIndiasince2007(seeFigure4.7).Thisvaluemeasureis,however,heavilyinfluencedbyafewlarge

transactionssuchasTata’sacquisition ofJaguarin2008.

Focusinginsteadonlyongreenfieldinvestmentsandexpansions,wefindthatretailbankinghasbeenthetopsectorforinwardinvestmentsfrombothChinaandIndia(seeTables4.2and4.3).Themainreasonsbehindthisare:Londonbeingoneofthelargestandmostefficientfinancialcentresintheworld;ChineseandIndianbanksneedingtocatertotheneedsofthegrowingdiasporafromtheirhomecountries;andclustereffects.AsotherIndianandChinesecompaniessetupshopintheUK,retailbanksfromthesecountriesareattractedtoservicethem.

TheothertwoindustrysectorsthathaveattractedsignificantinvestmentfrombothChinaandIndiaareAutomobilesandLightUtilityvehicles.ThishighlightsthehighqualityengineeringanddesigncapabilitiesthattheUKoffersincertainspecialisedmanufacturingniches(seealsotheTatacasestudyinBox4.1furtherbelow).

Theprofileofinvestmentsbythetwocountriesdiffer,however,inthatIndiahasmadesignificantinvestmentsinthefossilfuelelectricpowersector,whileChinahasinvestedmoreingreenenergysectorssuchassolarandbiomass.Chinesecompanieshaverespondedheretothevariousrenewableenergyincentivesofferedby theUKgovernment.

Current £ millions

Figure 4.7 – Foreign Direct Investment position by China and India in the UK, Stock

Source: and, ONS.

0

500

1,000

1,500

2,000

2,500

3,000

3,500

4,000

China India

2002 2003 2004 2005 2006 2007 2008 2009 20102001

Jobs are defined as ‘New and Safeguarded jobs’

Figure 4.6 – Top countries for jobs creation through FDI projects in the UK since 2002

Source: Inward Investment Reports 2002-03 to 2011-12, UKTINote: Years are from April to March.

0

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2003-04 2004-05 2005-06 2006-07 2007-08 2008-09 2009-10 2010-11 2011-122002-03

China India GermanyJapan France US


Chinahasalsoestablishedalargerpresenceinthetelecommunicationssector,whileIndiahasbeenmoreprominentintheIT andcomputerprogrammingsector,where ithaswellknowndomesticstrengths.

ThemostprominentIndianinwardinvestortotheUKhasbeentheTataGroup,whichwe discussinmoredetailinBox4.1.Wewouldseethisasapossiblemodelforotheremergingmarketmultinationalstofollow infutureyears,althoughdetailedstrategieswillclearlyvaryfromcompanytocompany.

Source: Fdi market intelligence from the Financial Tmes Ltd., PwC analysis.

Sub-sector Total capital Jobs Capital invested invested created as % of total (US$ millions) from China in this period

Retail banking 358.6 721 15.2

Solar electric power 310.1 73 13.1

Automobiles 266.9 1,064 11.3

Communiations equipment 193.9 1,036 8.2

Bio mass power 156.3 6 6.6

Light trucks & utility vehicles 96.4 172 4.1

Insurance 83.7 44 3.5

Clothing & clothing accessories 74.2 568 3.1

Computer & peripheral equipment 59.9 235 2.5

Other petroleum & coal products 59.6 56 2.5

Table 4.2 – Top 10 sectors for China’s FDI flow into the UK (2003-2012), by total capital invested

Source: Fdi market intelligence from the Financial Tmes Ltd., PwC analysis.

Sub-sector Total capital Jobs Capital invested invested created as % of total (US$ millions) from India in this period

Retail banking 1,463.7 1,264 17.6

Light trucks & utility vehicles 1,354.7 2,655 16.3

Custom computer programming services 840.2 2,544 10.1

Fossil fuel electric power 794.1 30 9.6

Motor vehicle gasoline engines & engine parts 581.4 850 7.0

Automobiles 434.1 1446 5.2

Steel products 413.7 2,,087 5.0

Corporate & investment banking 253.8 330 3.1

Schools, colleges, universities & professional schools 248.3 94 3.0

Performing arts, spectator sports & related 204.9 212 2.5

Table 4.3 – Top 10 sectors for India’s FDI flow into the UK (2003-2012), by total capital invested


TataGroupisanIndianmultinational conglomeratecompanywhichrunsmorethan90companiesinsevenmainbusinesssectors:chemicals,communicationsandIT, consumerproducts,energy,engineering,materialsandservices.Tata’sfirstentryintotheUKwasin1907whenTataLimitedwasestablishedinLondontobeTatagroup’srepresentativeinEurope.AsofOctober2012,theTatagroupwasoperating19companiesintheUK,employingabout50,000people andoperatedhereinalltheaboveareasofbusinessotherthanenergy.Tataisanexampleofanemergingmarketcompanybeing successfulacrossbusinesssectorsintheUK.Otherthanmergersandacquisitions,thegrouphasalsomadegreenfieldinvestmentsasdetailedinTable4.1.1.

NowwelookatsomeofthemajorTatagroupacquisitionsandinvestmentsintheUK. Wediscussthemaindriversbehindthem andtheoutcomesoftheinvestments.

4.1 – Tata Motors - JLR acquisition in 2008

TataMotorswasIndia’sthirdlargest car-maker,butwasstrugglingwithapoorimageandrisingrawmaterialcosts.

Keydrivers/motives:

• Tatagainsaccesstoworld-classengineeringcapability,askilledworkforce,excellentR&Dfacilitiesandefficientmanufacturingplants.

• Tatagetstheopportunitytoexpanditspresenceintheglobalpassengercarmarketthroughawellknownbrand andbeinapositiontocompetewithinternationalplayers2.

• FordhadnevermanagedtomakemoneyfromitsinvestmentinJaguar,butTatawastryingtodoso.

Outcomes:

• TataturnedaroundthelossmakingJaguar.Attheendofthe2012fiscalyear3,JaguarLandRoverposteda27%jump inretailsales,to306,000vehicles,becomingtheprimarydriverofgrowthandprofitforTataMotors.4

• JLRisamajorexportrevenuegeneratorfortheUKwith80%percentoftheirvehiclesexportedto180countries.5

• Adecadeago,JLRsoldjust110carsinChina6butin2012,Tatasold71,940carsfromitsJLRarm,makingChinaTata JLR’sbiggestcarmarket,aheadofthe UK,theUS,RussiaandGermany.7

1 fDi Markets tracks Greenfield and Expansion investments. It tracks all new projects and expansions of existing investments. Joint ventures are only included where they lead to a new physical (Greenfield) operation. Mergers & acquisitions (M&A) and other equity investments are not tracked. Every project included has to create new direct jobs and capital investment. 2 http://www.uk.tata.com3 Financial year from April to March. 4 “Tata Motors Finds Success in Jaguar Land Rover”, The New York Times 30/08/2012.5 http://newsroom.jaguarlandrover.com 6 Data from Tata JLR.

Source: Fdi market intelligence1.

Company Projects Capital Invested Jobs (USD million) created

Tata Motors, including by Jaguar Land Rover (JLR) 13 2,936 5,829

Tata Consultancy Services 6 550 1,709

Tata Steel, including by Corus 11 462 2,265

Other Subsidiaries 8 102 250

Total 38 4,050 10,053

Table 4.1.1 – Greenfield and expansion investments made in the UK by Tata subsidiariessince January 2003

Box 4.1 – Case Study: Tata Group’s investments in the UK

• InNovember2011,TataMotorsannounced1,000newjobsataLandRoverplantinSolihullboostedby risingdemandforSUVs.8

Reasonsforsuccess

• Theacquisitionwasendorsedbytradeunionsandsupportedbyexistingstaff.

• TatamaintainedcordialrelationswithFordandcontinuedtoseeksupport fromthem.

• Thecompanyhasintroducednewmodelstocatertodemandandhasexploredandbeensuccessfulinemergingmarkets likeRussiaandChina.

4.2 – Tata Steel’s Corus acquisition in 2007

TataSteelwastheworld’smostprofitablesteelcompanyandlocatedinAsia’sfastgrowingmarketswithaccesstolowcost rawmaterials.Corushadmorethana 50%marketshareintheUKandwas wellpositionedinEurope,especiallyin thehighvalueautomotive,packaging andconstructionmarkets.

Keydrivers/motives:

• Coruswastryingtokeepitsproductioncostsundercontrolandwasonthelookoutforsourcesofironore.


7 “Tata’s JLR to add 800 new UK jobs on soaring China demand”, Reuters.com 14.01.2013.8 fdimarkets.com, Financial Times.9 “Tata Steel: 600 Welsh jobs cut, mainly at Port Talbot”, BBC News Wales 23.11.12.10 “Tata Steel cuts 900 jobs to reduce UK costs”, ft.com 23.11.12.11 Fdi market intelligence.12 www.tataglobalbeverages.com

• TatahadastrongretailanddistributionnetworkinIndiaandSouthEastAsia.ThisacquisitionwouldgivetheEuropeanmanufactureraninroadintotheemergingAsianmarkets,wherethedemandforvalue-addedsteelproductswasgrowing.ItwouldalsogiveTataaccesstohigh-endEuropeanmarkets.

• Therewouldbetechnologytransferandcross-fertilizationofR&Dcapabilitiesbetweenthetwocompaniesthatspecialisedindifferentareasofthe valuechain.

Outcomes:

• TataSteelhasfacedachallengingtimewithdwindlingdemandinEuropeasaresultoftheEurozonecrisisaswellasinChinaandIndiaduetoslowinggrowth.Bytheendof2012,demandforsteelinEuropehaddroppedby25%since2007andwasexpectedtofallfurther9.

• Ithashadtocutjobs(900in2012)andadoptothercostreductionstrategiesinordertostaycompetitive10.

Strategic response

TataSteelhasaimedtostaycompetitive inthefaceofatougheconomicenvironmentby:

• Introducingrestructuringstrategiessuchasupgradingfacilitiestoimprovetheirdeliveryperformance,whilemanagingoutputatlevelsappropriatetomarketconditions

• Continuedfaithinthelocalworkforceas aresultofwhichtheyhaveinvestedinblastfurnacesasarestructuringdecision,whichinturnhascreatednewjobs.

• Governmentsupport:theirGreenfieldprojectin2008wassupportedbytheWelshAssemblyGovernment11.

• Infrastructure,logisticsandskilledworkforce:TheirwindturbineGreenfieldprojectwaspossibleduetothesefactors.

4.3 – Other major Tata subsidiaries

TataConsultancyServices(TCS)hasbeenamajorcontributortotheUKeconomy:TCShasanetworkofofficesintheUKandIreland,thefirstofwhichopenedin1975,andnowemploys4,800professionals.IthasalsoestablishedaninnovationhubinPeterboroughwhichencouragescollaborationsbetweencustomers,academics,globalalliancepartners,start-upsandventurecapitalists.TCShassomemajorgovernmentclientsintheUKincludingNEST,CardiffCityCouncil,andTheBig

LotteryFund.TataConsultancyServiceshasbeencertifiedasoneofBritain’sTopEmployers2012bytheCRFInstituteandhasalsowontheprestigiousSupplyChainProjectoftheYearin2012,forimplementingamajortransformationprogrammeforTheCo-operativeGroup’sfoodbusiness.Further,TCSisinvolvedinboostingUKgraduateemploymentprospectsbysupportingtheStudyIndiaProgramme2012.

TataGlobalBeverages’acquisitionofthe Tetleybrandin2000hasalsobeensuccessfulwithTetleycurrentlybeingthemarketleaderinboththeUKandCanadaandhavinga27%shareoftheUK’s teamarket.Tetleycontributedto39% ofthetotalsalesofTataGlobalBeverages in201212.

LessonsfortheUKtoinvitemoreinwardinvestmentfromChina/India:TatainvestedintheUKnotjustbecauseoftheattractionofthebrandandengineeringcapabilities,butalsobecauseitwasveryfamiliarwiththeBritishregulatoryandlegalsystem,havinghadapresenceheresince1907. Also,ithadaffiliationswithuniversitiesviaaChairattheUniversityofCambridge.Asexplainedabove,factorssuchasaskilledworkforce,worldclasstechnicalcapabilities

andgovernmentsupporthaveattractedinvestmentbyTataintheUK.

Inturn,theUKeconomyhasbenefitedsignificantlythroughincreasedemploymentandexportsaswellasthebusinessskillsoftheTatagroup,whichhaveenabledittoturnaroundsomelossmakingproducts.TheUKeconomyalsobenefitedfromTata’sinjectionofcapitalintoinnovativeprojectsandtheircollaborationwithlocalcompaniesanduniversities.Soithasbeena‘win-win’experienceforboththeUKandTata.


4.3 – How attractive is the UK as an inward investment location?

ToassessfutureprospectsforUKinwardinvestment,wefirstneedtoassessthecountry’sstrengthsandweaknessesasadestinationforFDI.Wecandothiswithreferencetothegeneral‘push’and‘pull’factorsthattheacademicliterature(seeAnnex)hasidentifiedasbeingimportantindrivingFDIflows.Notallofthesestudiesagreeonwhichfactorsaremostimportant,butTable4.4providesachecklistofthevariablesthataregenerallyseenashavingthegreatestimpactonFDIinflowstoanadvancedeconomysuchastheUK.

CompetitivepositionoftheUK

AnumberofrecentreportsprovideinsightastohowtheUKmightrankonthesekindsoffactors.Table4.5showsthreesuchindices usingdifferentcriteriatoarriveattheirrankings (seefootnotesbelowformoredetails).

TheUKhasbeenfallinginsomeoftheserankings,mostnotablytheUNCTADindexonpotentialFDIattractiveness.However,ithasheldupbetterrecentlyontheWEFGlobalCompetitivenessIndex,whichcoversawiderrangeoffactors.ButtheUKfacesincreasingcompetitionfromemergingeconomieswithmuchstrongergrowthpotentialaswellassomeotherEuropeaneconomiessuchasPolandthatarerising uptherankings.

OurownassessmentoftheUK’sstrengthsandweaknessesasadestinationforinwardinvestment,togetherwiththepotentialopportunitiesandthreatsthattheUKfaces,issummarisedintheSWOTanalysis inFigure4.8.

TheUK’skeystrengthsinattractinginvest-mentfromemergingcountriesincludeitsrelativelyflexiblelabourforce,highqualitytechnicalcapabilitiesandrenownedglobalbrands.Inordertostaycompetitive,theUKgovernmenthasalreadytakenstepsinrecentyearstowardsmakingitstaxregimemoreinvestorfriendlybycuttingthecorporatetaxrateandsomeothermeasuresasdetailed inTable4.6.

However,theUKneedstoimproveitsinfrastructuretokeepupwithcompetitionfromkeycompetitorslikeGermanyandFrance.OtherEuropeancountrieslikePolandarealsointensifyingeffortstobecomemoreattractivetoinwardinvestorsfromthefastgrowingemergingeconomies.

TheUKneedstoexploitfurtheropportunitiessuchasusingitsworldclassuniversitiestoattractmoreR&Dprojectsanddeployingitsexpertiseincuttingedgelowcarbontechnologiestohelpfirmsfromemergingeconomiesachievetheirgreenobjectives.Londoncanalsouseitsreputationasaworldclassfinancialcentretoattractfurtherinvestmentfrom,forexample,Chinese

Table 4.4 – Push and pull factors for inward investment in advanced economies such as the UK

Push factors

• Economic development and globalisation• Bilateral trade• Low quality infrastructure, high cost of skilled labour, rigid labour laws and high tax rates in the home economy• Increased access to global networks and markets • Access to world class technology or capabilities• Access to well developed capital and financial markets

Pull factors

• Market size • Skilled workforce and labour productivity • Trade and financial openness • Tax incentives and low-cost funding • Labour market and goods market efficiency• Agglomeration of FDI and clustering of activities• Cultural links• Ease of laws and regulations related to starting and operating a business• Government assistance• Geographical distance

Source: UNCTAD, World Bank, World Economic Forum (WEF).

Indices Ranking

UNCTAD FDI potential index2 UK is placed in 16th position in 2011. The UK’s ranking has fallen from 3rd in 1990 and 5th in 2000, having been overtaken by emerging economies such as China, India, Russia, Turkey, Mexico, Indonesia and Argentina.

World Bank Doing Business Index3 This index places the UK in 7th position in 2011-12 behind the US, Denmark and Norway among others.

WEF Global Competitiveness Index, 2006-20124 This index places UK in the 8th position in 2012-13, and its position has slightly improved since 2007-08. However it is behind countries such as the US, Germany, Sweden and Finland.

Table 4.5 – Position of UK on three key indices of relevance to FDI inflows

2 FDI potential determinants in the UNCTAD index are: market attractiveness, availability of low-cost labour and skills, presence of natural resources and enabling infrastructure. 3 Weighted index of performance in areas such as ease of starting a business, employing workers, enforcing contracts, resolving insolvency, getting credit, registering property, protecting investors and paying taxes.4 Weighted index of country performance along dimensions such as infrastructure, macroeconomic environment, health and education, goods and labour market efficiency, financial market development, technological readiness, market size, business sophistication and innovation.

economicstabilitycomparedtotheEurozoneareacouldhelpitattractfurtherinvestmentfromcountriessuchasRussia,whichgenerally considertheUKtobeasafehaven.

sovereignwealthandprivateequityfunds(andsimilarcapital-richbodiesinotheremergingeconomiessuchasRussiaandtheMiddleEast).Finally,theUK’srelative


Breakdown of components of average annual growth in real GDP, 2011-50

Figure 4.9 – Emerging economies show a much higher average real growth in GDP over 2011-50 compared to the advanced economies

%

Source: , PwC (January 2013):www.pwc.com/en_GX/gx/world-2050/the-brics-and-beyond-prospects-challenges-and-opportunities.jhtml

-1

0

1

2

3

4

5

6

7

Average growth in GDP per capita Average population growth GDP growth

Source: Assessment by PwC tax experts.

Table 4.6 – Strengths and weaknesses of the tax regime in the UK

Strengths• Lowest corporate tax rate (21% from April 2014) of any major western economy• No dividend withholding tax• Exemption from capital gains tax on substantial shareholdings• No tax on foreign dividends remitted to the UK• UK can be used as a hub for ‘European single company’ structures• Sensibly targeted Controlled Foreign Company (CFC) rules• One of the best treaty networks• Leverage to acquire shareholdings attracts interest deductions• R&D tax credits • Patent box 10% rate

Weaknesses• High personal tax rates• High VAT rates• Low capital allowances• Uncertainty around application of anti-avoidance measures• European Financial Transaction Tax (FTT) could have implications for the City as it potentially affects all transactions in securities from the EU countries adopting this measure, even if this is not formally adopted by the UK• Limited advance clearances

A closer look at tax

Table4.6looksatthecomparativestrengthsandweaknessesofthetaxregimeinUKinmoredetail(basedonthejudgementofPwCtaxexperts).TheUKisnowrelativelycompetitiveduetoitslowcorporatetaxrateandincentivesprovidedtoforeigninvestmentsaroundR&Dcreditsandthe

PatentBox.However,theUKstillhasrelativelyhighpersonaltaxandVATrates,whichcouldactasadeterrenttosomeinwardinvestors.Uncertaintyastoevolvinganti-avoidanceregimeshasalsobecomemoreofafactorrecentlygiventhepoliticalandmediafocusonthisissue.

Source: PwC assessment

Figure 4.8 – SWOT analysis of the UK as a destination for inward investment

Source: Assessment by PwC tax experts

Strengths• Labour relations and workforce flexibility • World class R&D• World class financial centre and capital markets• Investor friendly policies• Tax regime-low corporate tax rate (further details in Table 4.6)• High quality production and manufacturing facilities• Access to high end European markets• Quality brands• Hub for commercial innovation and creative industries

Weaknesses

Opportunities Threats

• Low quality infrastructure relative to other Western European economies• High cost of living• Weak economic outlook relative to emerging economies• High cost of labour relative to emerging economies• High personal tax and VAT rates (further details in Table 4.6)

Internal• Relative economic and political stability compared to some countries in the Eurozone such as Greece and Spain • Education sector • Green technology

External• Attracting investment from Chinese private equity firms to partner with local equity investors.• Gulf states, Mexico and South Africa which have already made some investments here

• Developed countries rich in natural resources, notably Australia, Canada and the US, which attract more FDI in oil and gas, particularly for unconventional fossil fuels, shale oil and gas and minerals• Emerging countries like China and India as well as other Eastern European countries like Poland who have higher growth potential, lower cost bases and are increasingly offering improved quality• Well known engineering capabilities of countries like Germany• Greater cultural and social links between some South West African and Latin American countries, and other Western European countries like Portugal and Spain


4.4 – Conclusions: future prospects for UK inward investment

TheBRICsstillaccountforonlyamodestshareofthetotalUKinwardinvestmentstock(3.3%in2011),butthisproportionhastripledoverthepastdecadeandisprobablyunderstatedduetodatadistortions.

Indiahasbeenthebiggestinwardinvestor intheUKoftheBRICsduetotheactivities ofcompaniessuchasTata,butChinais alsobeginningtobecomeasignificant

investorintheUKinareaslikebanking,telecommunicationsandrenewableenergy.RussianinvestorsalsotendtoseeLondon asanattractive‘safehaven’location,althoughinvestmentfromBrazilhasbeenlesssignificantsofar.

WewouldexpectFDIflowstotheUKfromemergingeconomiestocontinuegrowingrelativelyrapidlyinthefuture.ThisreflectsthecurrentlylowbaseofFDIfromtheseeconomiesandthefactthattheyare

expectedtogrowatamuchfasterpacerelativetotheadvancedeconomiesover thenextfewdecades,astheresultsofourrecent‘Worldin2050’studymakeclear (seeFigure4.9).

TheUKhasbenefitedfromitsopennesstoinwardinvestmentinthepast.Tostaycompetitiveinthefuture,itwillneedtotargetfastgrowingeconomiesandkeysectorswhereitscapabilitiesarestrongestsuchasthoseidentifiedbytheUKTI:Life

Sciences,LowCarbon,AdvancedEngineering, ICT,FinancialServices,CreativeIndustries,Defence&SecurityandEnergy.Bydevelopingstrengthsintheseareasthroughtop-notchtechnologyandimprovedinfrastructure,theUKcanenhanceitsstatusasapreferreddestinationforinwardinvestmentbyemergingeconomiesinthefuture.ThisinturncouldprovideasignificantboosttoUKgrowthandemploymentinthemedium tolongrun.


The author analysed patterns in data on FDI outflows for 56 developing countries from 1996 to 2010. Using panel data methods, the results indicate that the country’s level of economic development, globalisation, political risk and science and technology investments all contribute to outward FDI.

Das, K. (2013) , Journal of Applied

Economic Research 7:1, pp. 93-116

SummaryReference

The authors conclude that business opportunities – as represented by the size and growth potential of markets – are the most powerful determinants of FDI. Governments can also attract FDI in the short run by creating an enabling investment climate as measured by factors such as the quality of its laws and regulations and the efficiency of its bureaucracy.

Hornberger, K., Battat, J. and Kusek, P. (2011)

Viewpoint No. 67803, World Bank

The authors analysed FDI data from 57 source and host countries between 2000 and 2005. Using a Tobit model, the authors find that variables such as distance, cultural factors, source country GDP and the bilateral exchange rate have an impact on cross-border FDI. Source countries also tend to invest directly in host countries with higher R&D spending (as a share of GDP), those with natural resource abundance, and those with a better pool of educated workers and that have higher degree of trade openness.

Hattari, R. and Rajan, R. (2010) , Oxford Development Studies

Vol. 38 No. 4

The authors analysed the distribution of FDI projects across NUTS1 regions in the UK from 1985 to 2005. Using a GMM estimation method, they find that location factors (per capita income, distance and knowledge), costs (availability of skilled and unskilled labour) and prospects (growth and risk factors), and agglomeration (lagged regional share of FDI) are significant in explaining FDI location across regions. Higher regional grants lead to higher FDI shares, allowing for differences in grant rates and regional FDI competition.

Jones, J. and Wren, C. (2008) ,

SERC Discussion Paper 13

Main drivers of foreign direct investment

The author analysed outward FDI patterns from 13 developing economies from 1980 to 2002. Using panel data techniques, the author found that greater trade links and higher levels of inward FDI are associated with higher levels of outward FDI. Push factors include low quality infrastructure, high cost of skilled labour, rigid labour laws and high tax rates in the home economy.

Banga, R. (2007) , Chapter 7 in UNESCAP (2007)

, United Nations

Wesummarisesomekeyacademic studieson:

• themaindriversofFDI;and

• thepotentialimpactofFDIonthehosteconomy.

Theseresultshaveinformedthediscussion inthemaintextofthisarticle.

Annex – Key academic studies on FDI drivers and impacts


Impact of foreign direct investment

The authors studied FDI patterns in 30 OECD countries between 1990 and 2004. Using a dynamic panel data regression method, the authors show that FDI has a significant impact on economic growth: foreign capital complements domestic capital and contributes to both investment and the growth rate of output.

Bhattarai, K. and Ghatak, S. (2010) , Economics Discussion Paper,

2010/5, Kingston University, Department of Economics, London, UK

The authors studied the effects of different types of UK inward and outward FDI on domestic productivity and on the demand for skilled and unskilled labour at the industry level. They found that technology differences matter much more than labour cost differences in terms of the effects of inward FDI: acquiring technology through inward investment increases the demand for skilled labour, decreases demand for unskilled labour and produces positive spillovers on domestic productivity. There is scope for inward investment to generate employment for unskilled workers, but only where this is motivated by low labour costs. Furthermore, such FDI generates little in the form of spillovers.

Driffield, N., Love, J. and Taylor, K. (2008)

, Working Papers 2008001, The University of Sheffield, Department of Economics

Using an industry-level panel data set, the authors found that foreign-owned firms have a significant positive effect on the level of technical efficiency in domestic firms. There is evidence of significant intra-industry and inter-industry spillovers from inward investment. The findings are robust even when other factors such as imports and domestic R&D expenditures are allowed for. Inward investment appears to be a much more important source of technical progress than foreign trade.

Hubert, F. and Pain, N (2001) ,

Scottish Journal of Political Economy, Vol. 48 (2), May 2001

In their consideration of recent UK growth performance and in making recommendations for improvement, McKinsey noted that multinational enterprises represent only 2% of firms in the UK by number, but deliver about 80% of total UK business R&D.

McKinsey (November 2010) , McKinsey Global

Institute, London

The World Bank noted how FDI had been instrumental in raising product quality, productivity and management practices in many businesses in Central and Eastern Europe (e.g. the impact of Volkswagen on Skoda). In contrast, as north western European origin FDI was now being diverted towards the east the decreased scale of FDI going into southern Europe was one explanation for a slowdown in productivity growth in the peripheral Eurozone economies prior to the crisis of recent years.

World Bank (January 2012) , World Bank,

Washington DC

SummaryReference


Source: Latest PwC main scenario for 2013-14; IMF for GDP shares in 2012 at market exchange rates (MERs),which are generally more relevant for business purposes than shares based on GDP at PPPs.

Country Share of GDP growth (%) Consumer price World GDP inflation (%) (%: 2012) 2013 2014 2013 2014

United States 21.7 2.0 2.8 1.9 2.2

Canada 2.5 1.9 2.4 1.8 2.0

Germany 5.1 0.4 1.6 1.6 1.9

France 4.0 0.2 1.1 1.4 1.6

United Kingdom 3.5 1.1 2.1 2.8 2.4

Italy 3.2 -1.2 0.5 1.9 1.8

Spain 2.1 -1.1 0.4 2.6 1.8

Netherlands 1.2 -0.5 1.0 2.4 2.0

Greece 0.4 -4.2 -1.0 -0.3 -0.5

Portugal 0.3 -1.7 0.8 0.8 1.6

Ireland 0.3 0.8 2.0 0.7 1.1

China 10.5 8.0 8.0 3.4 3.2

Japan 8.4 1.0 1.1 0.3 1.5

India 2.4 6.0 6.9 6.6 7.0

Australia 2.1 2.5 3.0 2.9 2.8

South Korea 1.6 2.9 3.2 2.3 2.8

Indonesia 1.2 6.1 6.2 5.1 5.2

Saudi Arabia 0.8 4.0 3.9 4.7 4.2

Russia 2.7 3.8 4.1 5.7 6.1

Turkey 1.1 3.9 3.9 7.1 5.5

Poland 0.7 1.9 2.6 2.9 3.1

Brazil 3.6 3.0 3.9 5.7 5.8

Mexico 1.7 3.6 4.0 3.6 3.5

Argentina 0.6 3.0 2.5 11.0 11.1

South Africa 0.6 2.9 4.0 5.3 5.2

Table A.1 – Global economic prospects

Appendix A – Outlook for the global economy

TableA.1presentsourlatestmainscenarioprojectionsforaselectionofeconomiesacross theworld.MosteconomiesintheEurozoneshowagradualrecoveryin2013,withtheoutlookfurtherimprovingin2014.

Theemergingeconomiesshowstronggrowthin2013aswellas2014.TheseprojectionsarenowupdatedmonthlyinourGlobalEconomyWatchpublication,whichcanbefound at www.pwc.co.uk/economic-services/global-economy-watch/gew-projections.jhtml

Source: Latest PwC main scenario projections.

Country Share of GDP growth (%) Consumer price World GDP inflation (%) (%: 2012) 2013 2014 2013 2014

World (PPP) 3.2 3.8

World (market rates) 100% 2.5 3.2 4.9 5.1

Eurozone 18.8% -0.4 1.0 1.7 1.7


Appendix B – UK economic trends: 1979 – 2012

Source: ONS, Bank of England

* Pre-1997 data estimated** Public Sector Net Borrowing (calendar years)*** Peak-to-peak for GDP relative to trend

Average over economic cycles***

1979 - 1989 2.7 3.9 0.9 7.9 12.2 -0.2 2.5

1989 - 2000 2.7 3.2 0.8 3.6 7.8 -1.4 2.9

2000 - 2007 3.0 3.2 0.0 2.8 4.7 -2.2 2.2

Annual GDP Household Manufacturing Inflation 3 Month Current PSNB**averages growth expenditure output (CPI*) interest rate account (% of GDP) growth growth (% annual balance average) (% of GDP)

1979 2.8 5.0 -0.2 13.7 -0.5 4.71980 -2.0 0.1 -8.6 16.6 0.8 4.31981 -1.3 0.0 -6.1 13.9 1.9 3.41982 2.2 1.2 -0.1 12.3 0.8 2.61983 3.8 4.6 2.1 10.1 0.4 3.41984 2.9 2.8 3.7 10.0 -0.4 3.71985 3.9 4.3 2.9 12.2 -0.2 2.81986 4.3 7.1 1.4 10.9 -0.9 2.21987 5.2 6.2 4.8 9.7 -1.7 1.51988 5.6 8.4 7.3 10.4 -4.1 -0.81989 2.6 3.9 4.0 5.2 13.9 -4.9 -0.81990 1.8 2.4 -0.1 7.0 14.8 -3.8 0.71991 -1.8 -2.4 -5.0 7.5 11.5 -1.8 3.01992 0.9 1.5 -0.1 4.3 9.6 -2.1 6.51993 3.1 4.0 1.5 2.5 5.9 -1.9 7.81994 4.6 3.2 4.7 2.0 5.5 -1.0 6.61995 3.2 2.0 1.5 2.6 6.7 -1.4 5.31996 3.1 4.9 0.6 2.5 6.0 -0.9 3.71997 3.9 4.8 2.3 1.8 6.8 -0.1 1.91998 3.5 4.3 0.8 1.6 7.3 -0.4 -0.11999 3.2 5.2 0.8 1.3 5.4 -2.7 -1.32000 4.2 5.3 2.4 0.8 6.1 -2.9 -1.72001 2.9 3.9 -1.6 1.2 5.0 -2.3 -0.82002 2.4 4.1 -2.6 1.3 4.0 -2.1 1.82003 3.8 3.7 -0.2 1.4 3.7 -1.7 3.02004 2.9 3.3 2.1 1.3 4.6 -2.1 3.12005 2.8 2.7 -0.1 2.1 4.7 -2.1 3.32006 2.6 1.6 1.8 2.3 4.8 -2.9 2.42007 3.6 2.8 0.9 2.3 6.0 -2.3 2.52008 -1.0 -1.6 -2.5 3.6 5.5 -1.0 4.82009 -4.0 -3.0 -9.7 2.2 1.1 -1.3 11.12010 1.8 1.3 3.9 3.3 0.7 -2.5 10.12011 0.9 -1.3 2.0 4.5 0.9 -1.3 8.02012 0.2 1.0 -1.8 2.8 0.8 -3.6 (est.) 8.3


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