A Two Speed Story

Services and Manufacturing in the UK - at Moneyweek.com - the best of the international financial media

Over the past 25 years, the UK services and manufacturing sectors have diverged dramatically. Their average rates of profitability drifted apart, and the share of manufacturing output in the economy has fallen steadily while that of services has risen. The services sector's share of UK GDP has now risen to 75% while the share of manufacturing has fallen to 15% half of what it was 30 years ago. While the manufacturing sector is often described as being in a state of structural decline, the services sector continues to drive UK GDP growth. Will this trend persist?

In a recent report (Services and Manufacturing: A Tale of Two Sectors, V Pillonca and D Miles, July 14, 2005), we addressed the question of whether the UK would essentially become a service economy. To answer this question we analyse two key measures of profitability for each sector: the rate of return on capital and profit margins. The real rate of return on capital is a broad measure of return on investment. In 1Q 2005, the real rate of return on capital in services was 2.9 times that in manufacturing (17.5% compared with 6.0%).

If differences in the rate of return on new capital investment between the sectors reflect even in diluted form the differences between average rates of return on existing capital, then there is, on average, little incentive to invest in manufacturing relative to services.

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Profit Margins in Services and Manufacturing Have Diverged. We next look at a fundamental measure of profitability and a key driver of the rate of return on capital the price over cost mark up or margins, the percentage difference between firms' output prices and input costs.

Margins in manufacturing have remained under pressure in recent quarters, while in the service sector they have been close to their long-term average. The fact that margins moved slightly below their long-term average in services in recent years while the rate of return on capital has not implies that services firms have compensated for lower margins with greater sales. The recent robust output growth in the services sector may partly reflect an attempt on the part of firms to maintain market share, slightly to the detriment of margins. But falls in manufacturers' margins have been accompanied by contemporaneous and persistent falls in output growth and market share. Despite the low rate of return on capital in manufacturing, there has been no apparent recovery in manufacturers' margins.

Our statistical models highlight the different dynamics of margins in the two sectors. Mark-ups tend to revert to their long-term mean more quickly in services than in manufacturing. But crucially that long-term mean is higher in services than in manufacturing. Our models project that manufacturing margins will remain under pressure as input price inflation rises faster than manufacturing output prices.

Comparative disadvantages and a high exchange rate have hurt the manufacturing sector. Producers of most manufactured goods are more open to overseas competition than suppliers of services, and more exposed to currency fluctuations. The relative decline in manufacturing mark-ups (or profit margins) reflects the needs of UK firms to reduce their margins in an effort to compete internationally. The evidence is consistent with the idea that many manufacturing firms need to set prices to compete with overseas producers and absorb adverse currency and cost movements. Since sterling appreciated strongly at the end of the 1990s, downward pressures on the margins of UK manufacturers have likely intensified.

From the second half of 1996 to the start of 2000, the Bank of England's broad effective exchange rate index rose by over 31%. From 1996 to 2000, mark-ups in manufacturing fell by 26% whereas in the services sector they rose by 10%. The exchange rate has remained at a level that makes the traded goods sector struggle.

One strong piece of evidence for this is that the balance of trade in goods has deteriorated markedly in recent years, whereas there is a surplus in services. The trade deficit rose to 5% of GDP in 1Q 2005 from a deficit of approximately 4% in 2003. In April 2005, the UK was running a goods deficit of £4.8 billion, compared with the £1.4 billion surplus in services.

Outlook and conclusionsThe downturn of the manufacturing sector is not transient, or cyclical it is predominantly structural. Our models suggest that the downturn in manufacturing margins cannot be explained by cyclical forces. Rather, it is largely explained by structural phenomena and what has now become a persistently high exchange rate. We conclude that the output share and employment share of manufacturing are likely to fall further.

The services sector is more sheltered from the international competition of intensely-traded homogeneous goods. Manufacturers often price to market to retain market share, and are vulnerable to movement in the exchange rates, which can never be hedged fully.

On the basis of this evidence, we recently revised down our forecasts for manufacturing. We now forecast manufacturing output to be flat in 2005 and to grow by 1.7%Y in 2006, compared with our previous estimates of 0.9%Y for 2005 and 2.0%Y for 2006.

By Vladimir Pillonca (London) and David Miles (LondonEconomists, Morgan StanleAs published on The Global Economic Foru