Investment is key to business growth

It may be the smallest of the spending groups, but investment is still important to a healthy economy, warns Dennis Turner

Most of the debate on spending in the UK is centred around the consumer and the government. The other major group, investment – technically referred to as gross fixed capital formation (GFCF) – was worth nearly £202bn and accounted for 17 per cent of GDP in 2005.

However, there is probably more uncertainty about investment trends than other GDP categories, as the Treasury’s latest survey of independent forecasts shows. The most optimistic of the 43 organisations included in the monthly survey thought that investment this year would rise by 5.6 per cent, while the most pessimistic was expecting a fall of 0.4 per cent, which seems to suggest that nobody knows what is going on.

The government has created a sub-category within the overall GFCF total called ‘business investment’. In 2005, businesses invested £112bn on a range of new assets. A little less than a quarter of total business investment was by manufacturing industries and just 2.4 per cent by construction companies. Services accounted for the remaining 75 per cent, with distribution alone taking 13 per cent.

Measured in current prices, business investment’s share of GDP

fell to a 40-year low in 2005. Since investment in buildings has risen over the past five years, spending on transport equipment has weakened. The Confederation of British Industry (CBI) Industrial Trends Survey confirms this.

There are two possible explanations for the subdued investment record. The first is financial. Yet the official data for company profitability shows that net rates of return for private non-oil, non-financial companies have been relatively stable, at about 12.5 per cent for the past three years. Despite the stability, the CBI survey results cite low rates of return as a key factor limiting investment. The cost of external finance seems to be an issue, although it does not seem that shortages of internal finance are holding back investment.

A second factor is business’s view of where the economy is going. Here, sentiment remains in negative territory, says the CBI. And demand uncertainty is the over-riding factor dampening investment intentions.

While uncertainty about demand is apparent, and an understandable reason for holding off from investing, company finances are not really notably weaker than most years since New Labour came to office. But perhaps firms now face additional commitments that are pushing capital spending down the priority list. In particular, the ‘black holes’ in pension funds, estimated at £76bn, have assumed a greater significance in corporate UK. The new Pensions Regulator’s mandate to close these funding gaps may force firms to choose between investing in their business and getting their pension funds back into the black.

The idea that investment and exports will lead the UK back to its trend rate of growth after last year’s dip seems fanciful. If reliance instead is placed on consumer spending, the existing imbalances in the economy will worsen. The UK’s long-term growth rate could slow if the capital base is weakened. Investment may be the smallest of the three big spending groups, but it is by no means the least important.