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Productivity the key to a recasting of industry

The future for manufacturing in the developed world is brightening - but Britain must act quickly to make the most of the opportunities

The late 19th and early 20th centuries marked a “golden era” of manufacturing in the developed world that contributed to the largest increases in living standards in recorded history. This was initially fuelled by huge productivity improvements in agricultural production that allowed for significant migration of labour into the manufacturing sector. Manufacturing itself had already been transformed by the industrial revolution that began in the UK a century before. It was further transformed by mechanised mass production into a highly productive sector that offered rising wages with which to purchase the increasing variety of manufactured goods on offer. The result was an increase in manufacturing’s share of total output across the developed world through the first half of the 20th century.

As a result of manufacturing breakthroughs, the prices of a wide variety of goods have fallen, greatly benefiting consumers

Since then, the economic footprint of manufacturing has shrunk in relative terms in most of the rich nations. In some cases, the changes have been dramatic. At the same time, productivity gains within manufacturing have outpaced the economy as a whole, lowering the cost of manufactured goods and allowing labour to migrate to the service sector. At this stage of development, the share of manufacturing within an economy typically declines as growth in the service sector outpaces manufacturing, which may or may not be contracting itself.

So there is a sense in which manufacturing is a victim of its own success. The cost of manufactured goods relative to services has plummeted in the past 50 years, making an increasing variety of products more affordable and freeing households’ income for spending in other areas. This has led to saturation in some developed markets. In much the same way that agriculture can now provide for global food requirements with less than 5 per cent of global economic activity, manufacturing can satisfy global demand for goods despite accounting for less than 20 per cent of global output.

Despite its diminished footprint, manufacturing in the developed world continues to flourish mainly because these countries have the skills and technical know-how to support sophisticated high-value engineered products such as aerospace equipment and precision instruments. The growth of manufacturing in the emerging world has been driven much more by relatively unsophisticated manufacturing, in areas such as basic clothing and building materials.  In developed countries – where workers generally have greater technical expertise – low-skill parts of manufacturing such as these have become less important. Of course, as countries develop further, they begin to move up the value chain; China is perhaps the best example, having become an important producer of motor vehicles and with aspirations to move into aerospace.

25 years of change – and the UK slips

The past quarter century can be divided into two periods. During the 1990s, the developed world enjoyed the strongest and longest economic expansion for decades. By the middle of the decade annual growth in the US’s total output was well above 4 per cent, while in Western Europe it was almost 3 per cent.  While global trade was strong, manufacturing supply chains were still largely regional, with most activity occurring within the developed world. So even though the developed world’s share of global manufacturing slipped during this period, it remained at a commanding 70 per cent by the end of the decade.

This changed dramatically upon the accession of China into the World Trade Organisation at the end of 2001. Since then, its share of global manufacturing has more than doubled from 9 per cent to 23 per cent and it has become a central player across a broad spectrum of sectors. This has had ripple effects across other South-East Asian countries such as Indonesia, Thailand and Vietnam. As a result, emerging economies became more fully integrated into manufacturing value chains. This has essentially equalised the global manufacturing share of the developed and emerging world.

There are contrasts within the developed world in terms of the evolution of the manufacturing footprint over the past 25 years. Perhaps the most surprising observation is that, allowing for ups and downs related to the business cycle, in inflation-adjusted terms manufacturing has been remarkably stable across many countries. This provides welcome evidence that the secular decline in the manufacturing footprint has ended, and confirms that the declining share of world production is more a function of slow overall economic growth relative to the emerging world rather than a “disappearance” of manufacturing activity.

The UK is a notable exception to this rule. Manufacturing’s share of gross domestic product has continued to shrink. At about 10 per cent the proportion is among the lowest figures for this ratio in the developed world. Underlying this is the fact that UK manufacturing has not made gains in labour productivity in the same way as other developed countries.  From 2000 to 2010, labour productivity improved by 40 per cent in UK manufacturing, compared to 70 per cent in the US.

Productivity gains are especially important to industrial competitiveness in the developed world – where unit labour costs are already likely to be higher than in emerging markets.

It follows that if manufacturers in such nations can make themselves more productive, their commercial performance will be better – which will keep the overall level of manufacturing in the economy fairly high. This is what has happened in Japan and Germany, where industrial productivity has been ahead of Britain’s, and the proportion of manufacturing in output has not fallen as fast.

A second reason for a falling UK share is higher power prices than in other parts of the developed world. Unsurprisingly, this has hit power-intensive sectors such as steel and basic chemicals particularly hard. It has had an impact – albeit not so severe – in other parts of manufacturing which also are relatively heavy users of energy. In contrast, the US did not ratify the Kyoto protocol affecting regulations over carbon dioxide emissions. This means it has avoided implementing measures to reduce carbon dioxide emissions that have in other countries pushed up energy prices. Moreover, the recent shale oil and shale gas boom has driven US energy prices even lower, providing support to energy-intensive industries there.

The UK should do well in an improved climate – but still needs to raise its game

Looking ahead, the developed world’s share of global manufacturing output is likely to continue to decline, though at a slower pace than in the past quarter century. This reflects the fact that the significant structural change in global manufacturing supply chains that began in earnest in the early 2000s has largely played itself out. China’s manufacturing footprint (as a proportion of the country’s total output) has stabilised and may in fact decline slightly as the government attempts to rebalance economic growth towards consumption and away from investment. Developed countries continue to have considerable competitive advantages in high-end manufactured products, demand for which is increasing in the emerging world.

Manufacturing is far from disappearing in the developed nations, even though growth prospects in other parts of the world are stronger.

The performance of individual economies within the developed world will vary. In new forecasts by Oxford Economics and Haver Analytics, the US stands out as having a positive manufacturing future. Benefiting from a confluence of low energy prices, further productivity gains and favourable demographics, US manufacturing is stronger than it has been in a decade. The small increase likely in the footprint of manufacturing within the US economy is expected over the next decade to keep the US’s share of world manufacturing output steady at roughly 18 per cent of the total.

Most other industrialised countries are expected to see their share of global manufacturing continue to fall, particularly Japan and Germany. (The figures for these projections are calculated on an inflation adjusted basis with output numbers pegged to 2010 dollars.) Each of them is expected to lose a further 1-2 percentage points of share by 2025, driven in part by energy cost pressures, but accentuated by slow growth in domestic markets due to stagnant or falling populations. British manufacturing on the other hand is projected to be fairly resilient. While it currently has the lowest share of global manufacturing among the major developed countries (having fallen behind France during the 1990s) it is not expected to fall much further.  From accounting for 2.1 per cent of world manufacturing output now, the country’s share will decline by 2025 – but by less than 0.5 percentage point, to 1.7 per cent. In comparison with the declines of the past three decades, this is fairly minor. 

Helping this trend is the UK’s strength in two key parts of manufacturing – cars and aerospace. Since the financial crisis, Britain has become an important platform for automotive production destined for continental Europe, with companies such as Germany’s BMW stepping up investments in their UK plants. Other makers of luxury cars such as Jaguar Land Rover and Bentley have seen higher demand for their vehicles in new markets in Asia led by China. Furthermore, the UK has a key role in aerospace supply chains, which is projected to be one of the fastest-growing sectors for the next decade.

However there remain areas of concern in other sectors such as chemicals and fabricated metal products that are expected to be adversely affected by relatively high energy prices. An important conclusion is that Britain needs to address its problems in productivity – which may be rooted in relatively low investment in high-tech machinery as well as a poorly trained workforce hit by a shortage of top end engineering skills – if it is to make the most of what could be a promising period for rich-world manufacturing in the coming decade.

A version of this article will be published as an Oxford Economics research note.