The country is at a crossroads and it's unclear whether Boris Johnson’s government can overcome the challenges ahead.

UK economy

In February 2020, the UK prime minister, Boris Johnson, delivered a speech at the Old Royal Naval College in London. In it, he offered a vision of the country’s future beyond the EU: global in nature and built on Britain championing free trade and open markets. His choice of location — the baroque splendour of the Royal Navy’s former training academy — was telling, many thought. For the prime minister’s critics, it smacked of the imperial nostalgia permeating his administration; for his supporters, it underscored the country’s need to tap into its maritime, internationalist instincts to secure its future. 

In the intervening months, the devastation wrought by the Covid-19 pandemic has focused minds on the UK’s immediate problems. The country is grappling with an economic contraction of –11.2% for 2020 — its worst slump in 300 years. Unemployment is spiking and poverty levels are rising sharply. “The UK has been among the worst affected economies. This is no surprise, given the longer and more severe nature of its national shutdowns,” says James Smith, developed markets economist at ING. 

Yet, as the UK moves into 2021, the realities of the country’s exit from the EU will come to the fore. As a jolting geopolitical moment, it is likely to retrain national attention to Britain’s longer-term future. How will the country recover from the pandemic? And will its economic outlook be one of swashbuckling globalism, as envisioned by Mr Johnson, or will the country descend into parochial isolationism and irrelevance? 

Divining the future 

Reading the UK’s tea leaves is not easy. For one, the country is facing a daunting series of challenges. Economically, the pandemic continues to leave deep scars across the wider business landscape, while the government is now saddled with astronomical levels of debt. This unprecedented crisis will exacerbate long-term weaknesses in the economy, including low productivity and investment levels. 

The UK has been among the worst affected economies [by Covid-19]. This is no surprise, given the longer and more severe nature of its national shutdowns

James Smith, ING

Moreover, as Britain has cut itself off from its main trading partner, sectors of the economy that were relatively unaffected by the pandemic, such as agriculture, will be exposed to new costs. Moving forward, the UK will, at best, enjoy a wafer-thin trading arrangement with reduced access to the European Single Market. And, if transnational headaches of this nature were insufficient, separatist sentiments are growing on the country’s geographical fringes, throwing up a potential challenge to the UK’s long-term political integrity. 

These difficulties, however, are only one side of the coin. The country boasts an array of underlying strengths that point to a brighter economic future. To start with, the UK’s demographic outlook is more favourable than most developed market peers. Based on current trends, the UK’s population will surpass that of Germany’s before 2050, according to projections from the European Environment Agency. If it is true that demography is destiny, then much of the rest of continental Europe is in trouble. Populations, from Italy and Spain in the west to Poland and the Czech Republic in the east, are both ageing and shrinking quickly. 

On the Brexit front, the UK’s dominant financial services industry has remained relatively untouched. A recent analysis by the Financial Times found that international banks have only marginally reduced their staff headcount in the City of London, while asset managers and UK banks have increased their total number of personnel since 2015. Meanwhile, London’s global share of daily foreign exchange transactions had increased to 43% at the end of 2019, up from 37% 2016, according to data from the Bank for International Settlements. The City’s status as a hub of international finance and commerce shows little sign of diminishing, for now. 

In the near term, however, the single biggest boost to the UK economy is likely to stem from China’s decision to impose a national security law on Hong Kong, effectively pulling the territory entirely within Beijing’s political and security orbit. That Mr Johnson’s government acted quickly to offer a path to citizenship to some three million British national overseas (BNO) citizens at least chimes with the globalist narrative he expounds. A December 2020 survey conducted by Hongkongers in Britain, an expatriate group, indicates that about 600,000 citizens of the territory could make the move to the UK within the first two years of the scheme opening up in January 2021. 

Elixir of growth

One analyst at a European think tank, speaking on the condition of anonymity, described this scenario as one of the most meaningful, if under-appreciated developments likely to shape the UK’s political economy in years. Most BNO passport holders are university educated and relatively wealthy. Their impact on the British economy could be profound, giving it a much-needed boost of dynamism and expertise. In doing so, their arrival may offer a small contribution to one of the country’s gravest economic ills: low productivity. 

 In recent years, the rate of productivity growth in the country has been quite poor

Barret Kupelian, PwC

If the UK is to look confidently to its future, addressing this issue will be vital. “In advanced economies like the UK, productivity is the elixir of growth,” says Barret Kupelian, senior consultant economist at PwC UK. “Before the global financial crisis, the UK and the US were the absolute stars in terms of productivity among the G7 economies. Now, if you take a look at what has happened in the UK since the crisis, that picture has changed quite a lot. In recent years, the rate of productivity growth in the country has been quite poor,” says Mr Kupelian. 

Today, Britain is among the worst-performing advanced economies in terms of its productivity metrics. On a current-price gross domestic product (GDP) per hour worked basis, British productivity was 26.2% lower than Germany, 22.8% lower than France, 10.5% lower than Italy and 16.3% lower than the wider G7 group of economies, according to 2016 figures from the Office for National Statistics. As Mr Kupelian notes, various theories have been put forward to account for this yawning gap: “One of the explanations for the UK’s low productivity growth is that the financial system was disrupted during the 2008 crisis, so a key channel of credit allocation to the economy was disturbed.”

In a 2015 interview, Andy Haldane, the Bank of England’s chief economist, noted that British companies’ tendency to lavish shareholders with dividend payouts, rather than reinvest their profits, was leading to a trend in which businesses were “eating themselves”. This explanation aligns with the fact that investment levels in the UK remain extremely low, contributing to the country’s poor productivity numbers. This has not been helped by the years of political paralysis following the country’s decision to leave the EU in 2016. 

“If you look at non-government investment levels in the UK, they have been very low. The UK has one of the lowest investment to GDP ratios of any Organisation for Economic Co-operation and Development (OECD) economy. So there is something that is clearly not working well,” says Mr Kupelian. 

Developing investment

Boosting investment and productivity in the UK will take time. It will also require policy certainty for businesses, along with an operating environment which favours and rewards innovation and research and development (R&D), two vital ingredients underpinning productivity growth. The British government has a sizeable role to play here, particularly in fostering the kind of national culture that places these ideals at the front and centre of economic development. So far, the agenda being pushed by the current administration is a step in the right direction.

In July 2020, the UK government published its Research and Development Roadmap. In it, the government committed to increase public spending on R&D to £22bn ($30bn) per year by 2024/2025 and to push total public investment in R&D to 2.4% by 2027. If this goal is reached, it would mark a sizeable improvement from the UK’s current position where just 1.7% of GDP is invested in R&D. This compares unfavourably with many developed market peers: the OECD country average in 2018 was 2.4%, while star performers such as Germany, Japan and Israel, spent 3.1%, 3.2% and 4.8% respectively. 

burch

Felicity Burch, CBI

“The current government has, I think, made some really big steps forward in terms of an R&D roadmap. The introduction of the target around the UK spending 2.4% of GDP on R&D, coupled with some multi-year commitments in the spending review, are evidence of this. I am relatively optimistic,” says Felicity Burch, director of innovation and digital at the Confederation of British Industry (CBI). 

“If you put yourself in the shoes of a business that is thinking about R&D investment, having a government that consistently talks up the value of R&D is going to make you feel more optimistic about it,” she says. 

Beyond cutting-edge R&D, UK businesses need to do more to adopt innovative solutions that are already in the open market. To this end, the Covid-19 pandemic has helped, as a growing number of companies have deployed digital solutions to ameliorate the efficiency of their operations. In a report titled ‘Building a world-class innovation and digital economy’, published in June 2020, the CBI notes that the pandemic has increased business appetite for innovation adoption among UK businesses, while referencing research from the consultancy McKinsey, estimating that 55% of labour productivity growth will stem from companies adopting existing best practices. 

“I think productivity and R&D are very closely linked. But in particular, innovation adoption has even more profound implications for productivity. So this will be even more crucial. It’s important to remember that the productivity impact isn’t always about cutting-edge research, but also about businesses adopting innovative solutions that are already out there. When it comes to innovation adoption, the UK has historically been a long way behind the top performers,” says Ms Burch. 

It will take time before increased spending on R&D, as well as faster innovation adoption by Britain’s private sector, delivers tangible benefits for the wider economy. Nevertheless, for Ms Burch, the UK is starting this journey from a position of relative strength: “The UK is a world-leading innovation nation. We have some of the most innovative businesses in the world and we have some of the top-performing universities in the world. The UK is very good at this. The problem is we haven’t done enough of it. And we haven’t done enough of it in enough parts of the country.”

A new trading future 

In the coming years, as Britain contends with the realities of life outside of the EU, it must grapple with its status as an independent trading nation. The country’s future trading trajectory will have important implications for the development of its private sector, not least because vibrant, export-oriented businesses tend to increase economic growth, productivity and local and regional development. 

GwynneMaster

Gwynne Master, Lloyds Bank

Given the importance of the government’s levelling up agenda for the UK, coupled with the trading vision articulated by Mr Johnson during his February speech in London, the success of British trade on the world stage will be a vital component of its future prosperity. The current administration has articulated a vision of boosting British exports from 30% of GDP to 35%, though it has given no time frame in which it plans to achieve this. It is hoped that much of this growth will occur with emerging economies in Asia, Africa and Latin America, as the UK looks to diversify its trade connections away from the EU. 

Encouragingly, there are early signs of success on this front. A recent study published by Lloyds Bank, in partnership with the Aston Business School, analysing 340,000 quarterly export transactions from 26,000 UK exporters, has thrown a light on the degree to which trade diversion away from Europe by Britain’s exporters has already occurred since the 2016 referendum result. Export growth value towards EU countries have since fallen by 8.7% per year since, equal to £50bn in export value that has been channelled elsewhere, largely to Brazil, Russia, India, China and the Commonwealth nations. 

The study also found that a third of all British exporters, along with a sixth of businesses generally, were planning further expansion beyond the EU in the coming years. “The data is uplifting because it shows British businesses are putting down new trading footprints around the world,” says Gwynne Master, managing director of global trade at Lloyds Bank. “Some of the biggest shifts that we have seen in terms of trade diversion has come from micro-exporters. As much as 46% of new export growth to non-EU markets was driven by this business segment,” says Ms Master. 

To accelerate Britain’s trade goals, Lloyds Bank has launched a digital trade offering for the country’s businesses, whether they are clients of the bank or not. “In order to help Britain’s economic recovery, we have a tool called the International Trade Portal (ITP) which has been made available to all UK companies. Businesses want to know which markets are the best fit for their products, who their potential buyers and suppliers are, the kind of duties and taxes they will encounter in specific markets, as well as the kind of country risk they are likely to face. The ITP can answer all of these questions,” says Ms Master. 

Yet, Mr Johnson’s vision of the UK as a global trading nation, harnessing opportunities across the oceans, will not be achieved easily. For one, the UK is now an independent mid-tier economy mixing in a multi-polar world, full of rising and established economic giants. Creating and maintaining favourable trade agreements with the most important economies will incur sizeable costs for the country, and its private sector, in one form or another. The UK’s ambitions must be tempered by the fact that, in 2020, it is an archipelago of 67 million people in a world of 7.5 billion. 

The future of the British economy, with its mix of strengths and weaknesses, still hangs in the balance. Much will depend on the government solving a range of problems, from low investment and low productivity, to improving the country’s hard and soft infrastructure. Above all, policy certainty and long-term thinking will help in this regard. For its many and obvious flaws, the current administration is at least presenting a narrative of its priorities that fit with this agenda. The challenge, however, will be translating this broad vision into meaningful outcomes. That will require a mix of hard policy choices and technocratic excellence, both of which have been in short supply in recent years. 

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