FEBRUARY 2008 - Ready Unlimited

Department for Business, Enterprise and Regulatory Reform. www.berr.gov.ukFirst published February 2008. © Crown copyright. BERR/Pub 8693/02/08/NP. URN 08/607

FEBRUARY 2008

Globalisation and the changing UK economy

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FEBRUARY 2008


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Contents

List of Tables and Figures IV

Foreword V

Executive Summary VII

1. The process of globalisation 11.1 Defining globalisation 1

1.2 Drivers of the latest wave of globalisation 2

1.3 Consequences of the latest wave of globalisation 5

2. The changing UK economy 132.1 Changes in output and employment shares 13

2.2 Export performance 16

2.3 Explaining the changing shape of the UK economy 18

3. The policy response to globalisation 333.1 Globalisation, trade openness and economic growth 33

References 49

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List of Tables and FiguresTable 1.1: Duties as a percentage of the value of manufactured goods 2

Table 1.2: Changes in transport and communications costs over theperiod 1930-1990 (1930=100, unless stated otherwise) 3

Table 1.3: Net financial flows to emerging market and developing countries 6

Table 2.1: Changes in sector shares of output – broad industry sectors 14

Table 2.2: Real estate, renting and business service sub-sectors 15

Table 2.3: Changes in sector shares of output – manufacturing in detail 15

Table 2.4: Growth in goods and services sector exports 16

Table 2.5: Qualifications of those employed in the UK manufacturing sector 24

Figure 1.1: Hourly manufacturing labour costs in 2004 4

Figure 1.2: Global exports of goods and services, percentage of global GDP 5

Figure 1.3: World stock of inward Foreign Direct Investment 6

Figure 1.4: Outsourcing and offshoring 7

Figure 1.5: Offshoring, total economy, 1995 and 2000 8

Figure 1.6: Manufacturing’s share of total output 9

Figure 1.7: International output comparisons 11

Figure 2.1: Changing relative services and goods prices, Jan 1996=100 19

Figure 2.2: Index of constant price manufacturing sector output over the period 1996–2006 (1996=100) 20

Figure 2.3: Occupational activity of workers in manufacturing, (000s) 23

Figure 2.4: The sectoral composition of output (% of total value added 2003) 27

Figure 2.5: Types of innovation activity by business service firms, 2005 28

Figure 2.6: Intangible investment as a percentage of output 29

Figure 2.7: Flow of net inward FDI in UK 30

Figure 2.8: UK international migration mid 1996–mid 2006 32

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Foreword Globalisation is changing the world’s economic landscape and the way we liveour lives. While globalisation, and the arguments that surround it, have ebbedand flowed for centuries, the wave of globalisation we are currentlyexperiencing is unique in terms of the speed and intensity of the political,economic, social and technological forces that have collided to create it. It hasunleashed a renewed wave of people, commerce and capital throughout theglobal economy and has powered the creation and transformation of markets,jobs and industries across the world, at ever increasing speeds.

This paper sets out how firms across the UK economy are taking advantage ofthe opportunities provided by globalisation in terms of new, rapidly-growingmarkets for producers and investors. It describes how many firms aresuccessfully responding to the challenge of low-wage competition by investingin innovation and skills in order to move up the value chain into morespecialised, high-quality goods and services.

The constant change that globalisation brings can create anxiety anduncertainty, as new technologies and methods of working appear to destroy jobsand skills almost overnight. The Government understands that this can bechallenging and daunting to workers who have to cope with a changing workenvironment and need to develop new skills. However, these are not reasons toturn our back on trade and revert to protectionist measures; the lesson of thefirst half of the twentieth century is that responding to economic uncertaintythrough protectionism only serves to undermine the process of innovation andeconomic growth, putting more pressure on jobs and living standards. TheGovernment has an important role to play in helping people to cope and toadjust to the changes brought by globalisation.

BERR’s role is to work with businesses to enable them to succeed in thischanging environment and help ensure that the benefits of globalisation are feltas widely as possible and across all regions. Key to this is ensuring thatindividuals develop the skills to enable them to adapt and prosper whateverfuture globalisation brings. For this reason the Government has set the UK theambition of being the world leader in skills by 2020. BERR is working as the voicefor business to ensure the concerns of business are understood throughoutGovernment on other priority areas such as planning, transport, innovation andtaxation. At the same time we remain committed to working with internationalpartners to open up trade and create opportunities for business both within theEU and beyond.

The Rt. Hon. John Hutton, Secretary of State for Business, Enterprise andRegulatory Reform, February 2008.

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VII

Executive SummaryGlobalisation is transforming the face of the global economy. This paper seeksto examine in more detail exactly what globalisation involves, how the UKeconomy is being transformed, in part in response to globalisation, and thepolicies that the Government is putting in place to best enable businesses tomaximise the opportunities and meet the challenges of globalisation.

In the first chapter of this paper we describe how globalisation has increased thefree flow of ideas, people, goods, services and capital across borders and hasincreased the integration of economies and societies.

While globalisation is not a new phenomenon, with waves of globalisationdating back to the 1800s, the current wave of globalisation is unique in bringingtogether the following three factors:

� The adoption by a large number of countries of more open economic policiesin the post-WWII era. This has increased international trade in goods andservices, and cross-border flows of both capital and labour.

� Rapid technical progress, particularly developments in the field ofInformation and Communications Technology (ICT). This has sharply loweredtransport and communications costs and has increased the tradability ofgoods and services.

� The emergence of developing, low-wage economies. The arrival of thesecountries on the world stage stems mainly from political and economicchanges – notably China’s accession to the WTO in 2001 and economicreform in India.

The consequences of the latest wave of globalisation can be observed mostclearly in the massive growth in cross-border trade in goods and service duringthe post-WWII era, with international trade in intermediate inputs and cross-border trade in services growing particularly strongly in the last decade or so.Similarly, international capital flows – particularly Foreign Direct Investment(FDI) – have also increased markedly in the post-WWII era. These figures have,in part, been driven by growth in global value chains, whereby firms locatedifferent parts of the production process in different countries according torelative cost structures, which has led to increased international trade inintermediate inputs. Part of this process is offshoring, which involves firmsselecting and holding on to the stages of the value chain that they consider toadd the most value, while relocating the firm’s remaining activities to foreigncountries or to third parties in foreign countries. While offshoring has had a highand often negative media profile, research suggests that it has not had aparticularly significant impact on employment structures in a large number ofdeveloped countries, and has often allowed firms to increase productivity, withthe bulk of demand continuing to be met domestically.

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Nevertheless, the rise of low wage economies and associated growth in globalsupply chains have both contributed to a significant change in the compositionof most advanced economies’ structures in recent years. The rapid technologicalchanges and accompanying investment we have seen in manufacturing globallyhas facilitated strong productivity growth in the sector, resulting in falling pricesrelative to services and has facilitated a shift in the composition of both (currentprice) output and employment towards the services sector.

The current wave of globalisation has also changed the make up of the globaleconomy with, for example, China’s share of world output increasing from justover 2.6 per cent in 1980 to almost 5.5 per cent in 2006 and this is set to increasefurther according to International Monetary Fund (IMF) modelling. While this willprovide substantial potential opportunities for developed economies – with,amongst other things, new markets for their exporters and investors – it will alsoincrease the pressure on energy resources and the environment, withdeveloping economies expected to account for half of world energy demand by2012. Meeting the challenge of climate change, including reducing greenhousegas emissions, is clearly integral to how we manage internationally the ongoingprocess of globalisation.

Chapter 2 considers how the UK economy has been changing in recent years, inresponse to both developments in the global economy and domestic forces,such as population ageing and rising incomes. The chapter discusses how theUK economy has been able to take advantage of technological developmentswhich have made many services increasingly tradable and how the UK hasbecome a world leader in the growing export markets for many financial andbusiness services.

In common with many OECD economies, the UK has seen a fall in the share ofoutput measured in current prices accounted for by manufacturing. Part of thismay result from measurement difficulties associated with the increasinginteractions between manufacturing and service activities and subsequentoutsourcing and reclassification. The fall in the relative value of current pricemanufacturing output is also related to the global fall in the relative price ofmanufactured goods as producers all over the world have taken advantage ofimprovements in technology to lower costs and raise quality. Changes indomestic demand, in line with increased incomes and greater leisure time, havealso encouraged the more rapid expansion in some service sectors.

But the headline figure for the share of output accounted for by manufacturingalso hides the transformation that much of the sector has gone through in recentyears in response to both technological improvements and the emergence ofChina and India into the global economy. Within manufacturing, there has beena shift towards higher skilled professions, such as professional services andresearch and development, and in line with this an improvement in averagequalification levels. Case studies of the electronics and automotive sectors helpillustrate the changing role of the UK within increasingly global supply chains.


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Similarly, in services, we note the extent to which UK service providers haveundertaken different types of innovation – including through intangibleinvestment in areas such as training, R&D and branding – in order to raisequality and lower costs, enabling the UK to become global leaders in many,increasingly tradable services.

The chapter also considers the importance of FDI and engagement with multi-national enterprises (MNEs) in helping the UK raise productivity and competesuccessfully in the global economy. There is a growing economic literaturewhich points to the important role for FDI and MNEs in assisting productivitygrowth, both through a direct effect on investment, and more indirectly throughthe spread of technological know-how and management best practice. Similarly,the increased net inward migration into the UK in recent years is considered,with the positive impact such migration has had on economic growth in recentyears noted, alongside the possible positive impact on long-term productivitygrowth.

The final chapter considers the UK Government’s policy response toglobalisaton. Globalisation is creating tremendous opportunities for businessthrough the opening up of new markets, access to new technologies andcheaper products for consumers. Economic theory and evidence also points tothe strong relationship between increased trade and rising prosperity as well asthe dangers of retreating into protectionism. But globalisation also createschallenges for the UK economy. Globalisation puts UK firms and workers incompetition with those from across the globe and reinforces the need for UKfirms to continue to innovate and offer higher quality goods and services. Andinevitably, given the rapid pace of change that globalisation brings about, thereare rising fears that globalisation will undermine UK competitive advantagesand lead to job losses and insecurity. Not all people and places will be well-equipped to take advantage of the opportunities of globalisation.

The policy response to recent trends in globalisation, and the associatedopportunities and threats to the UK economy, has centred on three key priorityareas.

� Firstly, in recognition of the potential benefits to be derived fromglobalisation and greater openness, the UK is committed to reducinginternational barriers to trade. At the same time, we need to work withinternational partners to ensure that international institutions such as the IMFare fully equipped to provide the necessary direction and support to theongoing process of globalisation.


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� Secondly, the Government’s strategy of raising productivity through ensuringmacroeconomic stability and putting in place policies to strengthen theproductivity drivers (competition, investment, innovation, enterprise andskills) will also work to ensure that UK business is best placed to takeadvantage of the benefits of globalisation and compete effectively ininternational markets. In an increasingly competitive global economy, there isa renewed emphasis on having a world class risk-based regulatory regimewhich finds the right balance in supporting both competitiveness and widerobjectives.

� Thirdly, to ensure the benefits of globalisation are felt as widely as possible,the Government has a number of policies in place to help the UK economyadapt to its changing role in the global economy, as well as to reduce regionaleconomic performance differences and to protect the most vulnerableworkers through targeted labour market interventions.


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1. The process ofglobalisation

Globalisation is transforming the face of the global economy. But what exactlydoes globalisation involve? In this chapter we define what globalisation is,noting, first, that is not a recent phenomenon, with waves of globalisation datingback to the 1800s and, second, that it is about much more than the location ofproduction in low wage economies.

The second section discusses the various drivers of the current wave ofglobalisation. We identify three relatively recent developments in particular – theadoption of more open economic policies, increasing technological innovation,and the emergence of developing, low-wage economies on the world stage – ascentral to the current wave of globalisation.

Having discussed the driving forces behind the current wave of globalisation, wego on to note that these developments have facilitated greater cross-bordertrade in goods and services, foreign direct investment, and migration. Unlikeprevious episodes of globalisation, the latest wave is also very closelyassociated with the development of globally-distributed production systems.These so-called global supply chains reflect the increasingly global distributionof the various stages in the production process, in turn partly the result ofoffshoring.

1.1 Defining globalisation

Numerous definitions – both economic and non-economic – of globalisationexist, but according to one of the most oft-cited definitions, that of theInternational Monetary Fund (IMF), globalisation is “the process through whichan increasingly free flow of ideas, people, goods, services and capital leads tothe integration of economies and societies”.1 Globalisation is, thus, about muchmore than the location of production in low wage economies.

Globalisation is not a recent phenomenon; it is possible to trace waves ofglobalisation back to the 1800s. The period 1870-1913, for example, saw asignificant increase in international trade, accompanied by cross-border flows oflabour and capital. The current wave of globalisation, the pace and scale ofwhich are probably without precedent, started as early as the 1950s.

Globalisation has the potential to benefit emerging countries, providing amechanism through which poverty can be reduced. The rapid growth of theseemerging economies also provides substantial potential opportunities fordeveloped economies – with new markets for exporters and investors, andcheaper, more diverse goods and services for consumers.

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1 Köhler, H. (2002).

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1.2 Drivers of the latest wave of globalisation

The current wave of globalisation has been driven and facilitated by severaldevelopments which have not previously occurred together. These are:

� The adoption of more open economic policies – which have increasedinternational trade in goods and services, and cross-border flows of bothcapital and labour;

� Technological progress – which has sharply lowered transport andcommunications costs and has increased the tradability of goods andservices; and

� The emergence of developing, low-wage economies on the world stage –which has been led by China and India.

We discuss the three main drivers of the latest wave of globalisation in moredetail below, beginning with the adoption of more open economic policies in thepost-WWII era.

The adoption of more open economic policies

The period since WWII has seen a series of reductions in the tariffs levied onmanufactured goods, thanks in large part to the General Agreement on Tradeand Tariffs (GATT) and, latterly, the World Trade Organisation (WTO). Table 1.1,below, indicates the scale of these tariff reductions on manufactured goods.

Table 1.1: Duties as a percentage of the value of manufactured goods1913 1950 1990 2004

Germany 20 26 5.9 3.6

Japan 30 25 5.3 3.9

Italy 18 25 5.9 3.6

United States 44 14 4.8 4.0

Source: Acocella (2005).

In addition to tariff reductions on manufactured goods, the post-WWII era hasseen the gradual lowering of non-tariff barriers as well. Reductions wereparticularly marked in the regional trading blocs formed after WWII, such as theEuropean Union (EU) and North American Free Trade Area (NAFTA). Finally, thegradual elimination of restrictions on Foreign Direct Investment (FDI) put inplace after WWII liberalised international capital movements.

TECHNOLOGICAL PROGRESS

Recent technological progress has driven the current wave of globalisationthrough four main channels: transactions costs; productivity; modularisation;and dissemination.


2


Technological progress, particularly developments in the field of Informationand Communications Technology (ICT), has had a very significant impact ontransactions costs. As Table 1.2 shows, in 1990, the cost of a three-minute phonecall between London and New York was roughly one-seventieth of what it wasin 1930; the cost of air passenger transport in 1990 was approximately one-sixthof what it was in 1930.

Table 1.2: Changes in transport and communications costs over theperiod 1930-1990 (1930=100, unless stated otherwise)

1930 1950 1960 1970 1990

Air transport costs per passenger mile 100 44 56 24 16

Cost of a three minute London-New York telephone call 100 22 19 13 1.4

Cost of using a satellite n/a n/a n/a 100 8

Source: Acocella (2005).

Even more recent developments – such as satellite and broadbandcommunications – have effectively increased the number of services it iseconomically feasible to trade. Here too there have also been significant costreductions – with the cost of using a satellite falling by 92 per cent between 1970and 1990.

But, beyond this, technological progress has also enabled the separation, orunbundling, of the production and consumption of information-intensive serviceactivities, such as Research and Development (R&D), inventory management,quality control, professional and technical services, banking and insurance, andgovernment administration. Now even services in which consumer-producerinteraction is very high can, in principle, be unbundled and traded acrossborders. Examples include remote education facilitated by onlinecommunication and multimedia systems, and the remote transmission ofmedical diagnostic services.

Additionally, technological progress has also made it possible to reduce thecomplexity of production. This has been done, in the main, through thedevelopment of production systems broken up into modules i.e.,modularisation. With complexity reduced, production develops a more distinctsupply chain, and modules can in some cases be outsourced, potentially to thebest global source of supply.2

Finally, technological progress has also facilitated the dissemination ofknowledge and technological progress and has made it vastly easier to benefitfrom spillovers from private investment in knowledge creation, such as R&D.Knowledge spillovers from R&D used to have a marked local bias, tending to


3

2 Modularisation does not lead automatically to outsourcing because in some cases it can create a greater need forinteraction, co-ordination and co-operation across workstreams.


arise within local clusters through, for example, labour market turnover.However, the latest analysis of the geography of patents citations, a proxymeasure of knowledge transfer, suggests that the local bias of knowledgespillovers has fallen over time compared to earlier studies, with the local bias inthe most ICT-intensive sectors all but disappeared.

THE EMERGENCE OF DEVELOPING, LOW-WAGE ECONOMIES ON THE WORLD

STAGE

For most of the post-WWII period, it was the major, developed economies (withthe notable exceptions of a few outward-looking countries, like Japan, SouthKorea, and certain other Asian economies) that increased their economiclinkages. Over the last decade or so, however, some highly populous, low-wagedeveloping economies have emerged onto the world stage. China and Indiahave been at the forefront of this movement, with both nations greatlyincreasing their shares of global output, trade and foreign direct investment inthe recent past.

Figure 1.1: Hourly manufacturing labour costs in 2004

Source: Estimates from BLS (2004); China and India from Oxford Economic Forecasting in Olsen, K. (2006), TheChanging Nature of Manufacturing in OECD Countries. Notes: (1) Estimates of Chinese labour compensation may beunderestimated as Chinese workers may benefit from various types of non-monetary compensation, includingsubsidised accommodation. (2) Trade-weighted estimates, as shown in BLS (2004).

The arrival of these countries on the world stage stems mainly from recenteconomic and political changes: economic reform in China, leading to itsaccession to the WTO in 2001 and, different, but nevertheless important,economic reform in India. But the rise of these countries has also been driven bythe adoption of open, liberal economic policies in other parts of the world and

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technological progress which has made it possible to manage remoteproduction far more effectively.

1.3 Consequences of the latest wave of globalisation

TRADE IN GOODS AND SERVICES, INTERNATIONAL FDI, AND MIGRATION

HAVE ALL INCREASED AND PRODUCTION IS INCREASINGLY ORGANISED

ALONG GLOBAL VALUE CHAINS

Cross-border trade in goods has taken off since WWII. This has been particularlytrue of the recent past, with the total value of goods exports rising from$5,398,671m in 1996 to $11,982,932m in 2006. While goods exports havehistorically accounted for the bulk of total exports, trade in services is nowincreasingly important, accounting for 19 per cent of total world exports in 2006.

Growth in global exports of goods and services has, in fact, been so strong thatit has outpaced growth in world output in the recent past, leading to an increasein the ratio of global exports of goods and services to global GDP, as shownin Figure 1.2.

Figure 1.2: Global exports of goods and services, percentage ofglobal GDP

Source: IMF World Economic Outlook.

Mirroring this increase in cross-border trade in goods and services there hasbeen an increase in international capital flows since the Second World War –again, particularly in the more recent past. According to UNCTAD, there was amore than three-fold increase in the world’s stock of inward FDI, from$3,083,106m to $11,998,838m between 1996 and 2006, as Figure 1.3 shows.

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Figure 1.3: World stock of inward Foreign Direct Investment

Source: UNCTAD, Handbook of Statistics.

Not only has the total stock of inward FDI increased greatly, the direction andnature of FDI has also changed in the recent past. Developing and emergingeconomies are now far more important in terms of FDI inflows than they werepreviously, with significant amounts of capital flowing from capital-abundantindustrialised countries to a few developing countries, as Table 1.3 shows,helping build up the latter’s production and trade capabilities. In the very recentpast, a handful of developing countries have become significant sources of FDIin their own right – with FDI flowing from these countries back to developedeconomies.

Table 1.3: Net financial flows to emerging market and developingcountries3

$USbn Average Average

1993–1998 1999–2004 2005 2006

Net private capital flows 158.0 120.8 271.1 220.9

Net direct investment 110.0 174.0 262.7 258.3

Net portfolio investmenta 71.1 -14.2 23.3 -111.9

Other net investmentb -23.0 -39.6 -17.0 73.6

Net official flows 11.2 -22.1 -146.4 -165.8

Total net flows 169.2 98.7 124.7 55.2

Change in reserves -71.1 -237.1 -595.3 -754.2

Source: International Monetary Fund (IMF), World Economic Outlook Database, October 2007. Notes: (a) Includingportfolio debt and equity investment; (b) Including short- and long-term bank lending.

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3 IMF classification includes Israel and Korea, Singapore, Taiwan and Hong Kong, normally counted among theadvanced economies.


Looking at the nature of FDI flows in the recent past, it is clear that there hasbeen very rapid growth of FDI into the service sector since the 1990s, particularlyto developing countries’ service sectors. The share of services in the stock ofinward FDI in developing countries increased from 47 per cent in 1990 to 55 percent in 2002 thanks in large part to the rapid growth in the offshoring of services,and the opening of domestic financial activities.

Echoing greater trade in goods and services and FDI, migration – which has longbeen associated with globalisation – has also increased in the current round ofglobalisation. Migration flows have doubled since 1975 and around 3 per cent ofthe world’s population currently live outside their country of birth. Beyond this,the nature of migration has changed significantly, with temporary work-relatedand high-skilled migration accounting for an increasing share of migrationbetween OECD countries. Although migration is not central to the current waveof globalisation compared to previous episodes, some of its effects are stillimportant. For example, research suggests that migration flows have: supportedeconomic growth – particularly in the US; facilitated knowledge transfer –through, for example, the return of electronics engineers from the US to Indiaand China; and increased flows of remittances – which are important sources offunding for those developing countries which are not major recipients of privatecapital flows.

These figures – particularly the trade and FDI figures – have partly been drivenby the relatively recent emergence of global value chains – whereby firms locatedifferent parts of the production process in different countries according torelative cost structures. The development of global value chains has beenfacilitated by technological progress which has made it easier to supply servicesremotely, to modularise production activities and manage them remotely andhas resulted in a massive increase in cross-border trade in intermediates andbusiness services.

The emergence of global value chains is, in turn, associated with offshoring,which involves firms selecting and holding on to the stages in the value chainthat they consider to be ‘core’, whilst relocating the firm’s ‘non-core’ activities toforeign countries or to third parties in foreign countries.

Figure 1.4: Outsourcing and offshoring

Location

National International

Control Outsourced Domestic outsourcing International outsourcing

Insourced Domestic supply International insourcing

Source: Van Welsum, D. and Vickery, G. (2005).


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No official data on offshoring and global value chains exists, but the impact ofoffshoring on developed economies can be approximated using a proxy foroffshoring – the share of non-energy imported intermediate inputs in totalnon-energy intermediate inputs.4 A proxy measure of this type is reported inFigure 1.5.

Figure 1.5 shows that between 1995 and 2000, offshoring grew in almost allOECD countries, with significant increases in the sourcing of intermediatesabroad in a number of countries. Comparing OECD member states, it is clearthat, small increases between 1995 and 2000 notwithstanding, Japan and the USoffshore relatively little compared to other countries. It is also apparent thatsmaller countries like Ireland and Hungary) offshore quite a lot.

Figure 1.5: Offshoring, total economy, 1995 and 20005

Source: OECD, Input-Output Tables Database. Note: Australia 1995 and 1999; Canada 1997 and 2000; Greece 1995 and1999; Hungary 1998 and 2000; Norway 1995 and 2001; Portugal 1995 and 1999.

Despite having a high and often negative media profile in almost all OECDcountries, offshoring does not appear to have had a significant negativeeconomic impact on a large number of developed countries. Studies suggestthat there is not a significant link between offshoring and aggregate levels ofemployment. In most cases, the bulk of demand continues to be metdomestically. There are a number of reasons for this, including the fact that thedelivery of some services requires physical proximity to the customer,transactions costs are high, customer preferences, and competitive advantage.

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4 This can be derived from input-tables, which contain information on the value intermediate goods and servicesimported from elsewhere.

5 Calculated as the share of non-energy imported intermediates in total non-energy intermediate inputs.


PRODUCTIVITY-IMPROVING TECHNOLOGICAL PROGRESS HAS CHANGED THE

COMPOSITION OF MOST ADVANCED ECONOMIES’ OUTPUT AND EMPLOYMENT

Productivity-improving technological improvements have impacted on somedeveloped countries’ sectors (i.e., manufacturing) more than others (i.e.,personal services). This matters because it can be shown that, under certainassumptions, sectors which experience more rapid gains in productivity willexperience a fall in the relative price of their products, where price is determinedby marginal cost. Crucially, if the ensuing increase in demand is not sufficient tofully offset this fall in price the total value of output (i.e., price multiplied byquantity demanded) will fall and the sector’s share of total economy-wide outputmeasured in current prices will decline. This is the so-called Baumol effect,identified by William Baumol in the late 1960s.6

Relatively higher technology-driven productivity growth in developedeconomies’ manufacturing sectors compared to some service sectors, notablythe personal services sector, has led to a decline in the price of manufacturesrelative to services, and a decline in the manufacturing sector’s share of totaloutput measured in current prices in almost all developed economies. Thisphenomenon is illustrated in Figure 1.6 below. In several cases, these changeshave been accompanied by more-or-less equal and opposite growth in the shareof total output measured in current prices accounted for by the services sector.

Figure 1.6: Manufacturing’s share of total output

Source: UNCTAD. Note: Pre-1990 data for Germany unavailable.

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6 Baumol, W. (1967).


A corollary of the Baumol effect is that if we assume that wages are set in aneconomy-wide labour market, sectors that experience more rapid gains inproductivity (and, consequently, experience relative price declines) will accountfor a smaller share of total employment in the same way that they will accountfor a smaller share of total output if the increase in demand is not sufficient tofully compensate for the price effect.

Internationally comparable data shows that, in keeping with the Baumol effect,manufacturing’s share of total employment has also fallen off in most advancedeconomies with, for example, manufacturing employment falling by around 3million in the US and by almost 3 million in Japan since 1997. Again, this hasbeen accompanied by more-or-less equal and opposite growth in the share oftotal employment accounted for by the services sector.7

THE BALANCE OF ECONOMIC POWER IN THE GLOBAL ECONOMY HAS

CHANGED

The entry of highly populous, low-wage economies onto the world stage haschanged the make up of the global economy, particularly in terms of countries’shares of total world output.

Between 1980 and 2006, China’s share of world output increased from just over2.6 per cent to almost 5.5 per cent. India’s rise over the same period was slightlyless impressive, but India’s share of world output nevertheless increased from1.5 per cent to over 1.8 per cent. Both countries have grown particularly stronglyin the recent past: both India and China’s shares of world output have risen year-on-year since 1994.

Over time, however, the process of economic development usually leads to anincrease in a country’s real exchange rate. This combined with rises in realwages means that differences in labour costs tend to narrow. Such a pattern isalready evident in the case of China, according to the World Bank, whereaverage wages, on an internationally comparable basis, have trebled in the lastdecade.


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7 The share of manufacturing employment in some major developing economies has also shrunk in recent years.Examples include China, Russia and Brazil. Alongside this, many of these countries have also seen rapid growth inmanufacturing output in recent years. This highlights the critical role of the differential productivity growth theory,a la Baumol (1967), in driving deindustrialisation in developing countries as well.


Figure 1.7: International output comparisons

Source: BERR calculations based on FCO/IMF modelling.

Notwithstanding, according to an IMF/FCO model, recent trends look set tocontinue for some time to come. In particular, Chinese output (and China’s shareof total global output) is set to increase markedly through to 2020, as Figure 1.7shows.

The continued rise of developing economies on the world stage will providesubstantial potential opportunities for already developed economies – with,amongst other things, new markets for their exporters and investors. But thecontinued rise of these developing economies will also increase the pressure onenergy resources, with developing economies expected to account for half ofworld energy demand by 2012. The continued rise of these developingeconomies will also increase the pressures on the environment, notably throughclimate change. Meeting the challenge of climate change, including reducinggreenhouse gas emissions, is clearly integral to how we manage internationallythe ongoing process of globalisation.

ChinaChina

IndiaUK

EU27excl. UK

USUS

RoWRoW

EU27excl. UK

India

UK

Total Output 2006

$US48.2 trillion

Total Output 2020

$US77.8 trillion


11


2. The changing UKeconomy

Chapter 1 examined the drivers of globalisation and how they are acting asforces for change in the global economy. This section considers how the UKeconomy has been changing in recent years, in response to both developmentsin the global economy and domestic forces such as population ageing and risingincomes.

The chapter discusses how the UK economy has been able to take advantage oftechnological developments which have made many services increasinglytradable and how the UK has become a world leader in the growing exportmarkets for many financial and business services.

While, in common with many OECD economies, the UK has seen a fall in theshare of output accounted for by manufacturing, this headline figure hides thetransformation that much of the sector has gone through in recent years inresponse to both technological improvements and the emergence of China andIndia into the global economy. Case studies of the electronics and automotivesectors help shed light on the changing role of the UK within increasingly globalsupply chains.

We highlight the importance of increasing investment in intangibles such asR&D, design and training, which also lies behind changes in both themanufacturing and service sectors.

2.1 Changes in output and employment shares

The UK economy has continued its long-term structural change during the pastten years with, broadly speaking, a continuing shift in terms of the shares ofoutput and employment from manufacturing towards services (although theshift away from manufacturing is more moderate in output terms than inemployment terms). As Table 2.1 illustrates, the growing prominence of servicesis underlined by the growing share of output and employment accounted for bythe wholesale and retail trade, financial intermediation, health and social work,education, other social and personal services, and hotels and restaurants.

13


Table 2.1: Changes in sector shares of output – broad industry sectors

Output (GVA) share (%) Ppt change in

share of output

2006 1996 1996–2006

Real estate, renting and business services 24.8 19.1 5.7

Manufacturing 13.2 21.1 -7.9

Wholesale and retail trade 12.1 11.6 0.5

Financial intermediation (excl. FISIM) 9.4 6.5 2.9

FISIM 5.0 3.3 1.7

Health and social work 7.3 6.4 0.9

Transport, storage and communications 7.2 7.8 -0.6

Construction 5.7 5.1 0.6

Education 5.6 5.4 0.2

Other social and personal services 5.4 4.3 1.1

Public administration and defence 5.1 5.8 -0.7

Hotels and restaurants 3.1 2.7 0.4

Mining and quarrying 2.4 2.9 -0.4

Electricity, gas and water 2.7 2.3 0.4

Agriculture, forestry and fishing 0.9 1.8 -0.8

Source: ONS Blue Book (including experimental output statistics). Note: FISIM = Financial intermediation services,independently measured.

Growth in real estate, renting and business services, which increased its outputshare by 5.7 percentage points over the period 1996-2006, has been central togrowth in services. In turn, growth in business services has been central togrowth in the broader real estate, renting and business services sector, as Table2.2 shows. Business services include a diverse range of activities, from thecreative and technical, such as advertising, legal services and computing, toindustrial cleaning and call centres. In the past two decades business serviceshave doubled their share of GDP from 7 to 14 per cent, and account for almost1.7 million jobs more jobs than previously.


14


Table 2.2: Real estate, renting and business service sub-sectors


share of output

2006 1996 1996–2006

Real estate, renting and business Services 24.8 19.1 5.7

Of which: Business services 14.8 9.2 5.7

Of which: Computer related 3.2 1.5 1.6

Research and development 0.5 0.3 0.2

Other business activities 11.1 7.3 3.8

Source: ONS Blue Book (including experimental output statistics).

In line with the falling share of manufacturing in total output, almost allmanufacturing sub-sectors (the exception being wood and wood products) sawtheir shares of total UK output decline over the same period, as shown below.

Table 2.3: Changes in sector shares of output – manufacturing in detail


share of output

2006 1996 1996–2006

Food, beverages and tobacco 2.0 2.9 -0.9

Textiles and textile products 0.3 1.0 -0.7

Leather and leather products 0.0 0.1 -0.1

Wood and wood products 0.3 0.3 0.0

Pulp, paper and paper products 1.7 2.6 -1.0

Coke, petroleum and nuclear fuel 0.2 0.4 -0.1

Chemicals and man-made fibres 1.5 2.3 -0.8

Rubber and plastic products 0.8 1.0 -0.3

Non-metal mineral products 0.5 0.8 -0.2

Basic metals and metal products 1.4 2.4 -0.9

Machinery and equipment n.e.c. 1.1 1.8 -0.7

Electrical and optical equipment 1.3 2.6 -1.4

Transport equipment 1.4 2.1 -0.6

Manufacturing n.e.c. 0.6 0.8 -0.2

Source: ONS Blue Book. Note: ‘n.e.c.’ = not elsewhere classified.


15


2.2 Export performance

Table 2.4 illustrates how the UK has benefited in terms of higher exports fromthe rapid growth in world trade outlined in chapter 1. The UK has seenimpressive growth in many service sector exports. Financial services and otherbusiness services in particular have become significant contributors to overallUK export volumes in recent years. While other countries have also benefitedfrom the technological changes that have allowed increased trade in services,UK performance has been particularly strong. According to the IMF, the UK wasresponsible for 8.7 per cent of service exports in 2004, compared with Germany’s6.6 per cent share and France’s 5.1 per cent share. The UK is the global marketleader in financial services exports (24.4 per cent of world exports) and computerservices (13.7 per cent of world exports).

Table 2.4: Growth in goods and services sector exports

Service Good Growth Percentage share of Change in share

1996–2006 total exports 2006 of total exports

(%) (%) 1996–2006 (%)

Computer and information Services 495 1.8 1.3

Communications services 303 1.2 0.7

Construction services 280 0.2 0.1

Financial services 246 7.7 4.0

Non-oil fuels 224 0.6 0.3

Personal, cultural and recreational Services 162 0.5 0.3

Other business services 151 9.4 3.2

Oil 112 6.3 1.4

Basic materials 76 1.3 0.1

Royalties and license fees 74 2.0 0.1

Government services 62 0.6 0.0

Transportation services 53 4.5 -0.3

Finished manufactured goods 46 37.2 -4.7

Semi-manufactured goods 44 17.6 -2.5

Travel services 34 5.0 -1.1

Insurance services 33 1.0 -0.2

Food, beverages, tobacco -2 3.0 -2.0

Unspecified goods -33 0.4 -0.5

Total services 115 33.7 8.0

Total goods 47 66.3 -8.0

Source: ONS Pink Book.


16


It is also noticeable that export volumes increased significantly in recent years inmany goods sectors. An examination of commodity exports at a more detailedlevel shows that the UK has a strong trade record in a number of smaller, morespecialised manufacturing sectors. These tend to be sectors providing lowvolume, high-technology, specialised or innovative products which may betailored to a specific consumer need. Examples include cultural items (art andprinted materials), pharmaceuticals, aircraft components, certain chemicals(particularly pharmaceutical) and instruments.

Europe remains the most important market for UK exporters, accounting for 56per cent of total trade and 63 per cent of British goods exports in 2006. Theaverage value of goods exported per firm is higher for EU exports (£4.9m) thanfor non-EU exports (£1.0m).8 However, the great majority of exporters trade withnon-EU markets. Of the approximately 70,000 UK firms who exported goods in2007, 65,100 exported outside the EU, and 16,700 within the EU9 (some firmsexport both within and outside the EU, hence these do not sum to the total).

Studies suggest that exporting has a positive effect on the UK economy.Exporters and MNEs tend to have above average productivity, and as theyexpand, average UK productivity rises. Exporting also acts as a stimulus tocompetition, which encourages innovation and drives up productivity. Analysisof the Community Innovation Survey (CIS4) indicates that exporters tend to bemore active in R&D than other firms: approximately 26 per cent of UKestablishments export but when only manufacturing firms which are R&D activeare considered, this rises to 72 per cent.10 Other positive effects on UKproductivity from exporting arise from increased access to new ideas andtechnologies and exposure to superior organisational skills which may be directthrough exposure to overseas markets or inward investors or indirect viaknowledge spillovers.

Although there are benefits from participating in international markets, barriersexist to doing so and Government support aims to assist firms in overcomingthem. Analysis suggests that such support is best focused on: strengtheningsocial networks which underpin international trade and investment flows;providing access to information and advice which the private sector alone willnot or cannot provide both to inward investors and UK firms seeking to export;and strengthening the internationalisation capabilities of innovative and high-growth businesses which would not otherwise fulfill their potential withoutexploiting overseas opportunities.11

A sub-set of SMEs, referred to as ‘born globals’ fall into this group of firms.These firms tend to be knowledge-intensive or knowledge-based and their


17

8 HMRC UK Regional Trade in Goods Statistics, 2007Q3 (data for 2007 is provisional).

9 HMRC UK Regional Trade in Goods Statistics, 2007Q3 (data for 2007 is provisional).

10 Harris, R. and Cher Li, Q. (2006).

11 DTI Economics Paper No 18 sets out in more detail the economic benefits for the UK of increased international tradeand investment, the evidence on market failure and the cost-effectiveness of Government intervention.


products are so specialised that there is a limited domestic market for them.They thus have to target the global market to obtain sufficient scale to benefitfrom R&D and innovation.12 These young and innovative SME exporterscontribute crucially to the flexibility which allows the economy to respond toeconomic shocks and changes to the UK’s comparative advantage. In time, someof these dynamic SMEs and ‘born globals’ of today will become the large firmsin profitable mature sectors of the future.

2.3 Explaining the changing shape of the UK economy

CLASSIFICATION AND OUTSOURCING

Part of the shift in the value added shares from manufacturing to services is dueto measurement difficulties. Increasingly, firms do not consider themselves to bein ‘services’ or ‘manufacturing’ but providing solutions for customers thatinvolve a combination of products and services. Manufacturing firms oftenprovide both a physical product and an accompanying or complementaryservice. Similarly, service industries and functions are becoming moreindustrialised due to technological developments (e.g., ICT). The question is howfirms that are changing their orientation report their business activity to theOffice for National Statistics (ONS). If a firm that was previously focusedprimarily on manufacturing but had a small but significant service activity (e.g.,a small retailing presence) chose to focus solely on services and changes itsreporting from wholly manufacturing to wholly services then the officialstatistics would overstate the switch away from manufacturing. While ONSattempt to overcome such problems by allowing reporting units below the levelof the firm, there remains some uncertainty around the data. BERR analysisshows that between 1998 and 2006 firms switching classification frommanufacturers to service providers accounted for 120,000 jobs more than thosefirms switching the other way. This figure, which accounts for around 10 per centof the fall in manufacturing employment during the period, represents an upperbound for the number manufacturing job losses which might be overstated byofficial statistics due to reclassification issues.

In addition to reclassification, there is a second, related, issue aroundmanufacturing outsourcing service activities (such as cleaning) that wouldpreviously have been carried out in-house. However, while research suggestsoutsourcing of this nature has been an important trend in the UK, evidencesuggests that most outsourcing from manufacturing to services took placebetween 1984 and 1990, prior to the period under consideration.13


18

12 Harris, R. and Cher Li, Q. (2007).

13 For example, Abramovsky, L. and Griffiths, R. (2007).


CHANGING RELATIVE PRICES

The shift towards services also reflects the decline in the average price ofmanufactured goods relative to services (Figure 2.1). This shift in relative priceshas occurred both as a result of global improvements in manufacturingproductivity driven by improvements in technology and related investment andas a result of the increased involvement of low-wage economies inmanufacturing rather than tradable services.14 As Figure 2.2 shows, the real(constant price) output of UK manufacturing (the value of output measured in1996 prices) has actually increased over the last 10 years. As discussed inchapter 1, there has been a trend towards manufacturing falling as a share ofoverall output in nearly all OECD economies over the last 10 years.

Figure 2.1: Changing relative services and goods prices, Jan 1996=100

Source: ONS.

80

90

100

110

120

130

140

150

160

Sep

–07

May

–07

Jan

–07

Sep

–06

May

–06

Jan

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Sep

–05

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–05

Sep

–04

May

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–04

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–03

May

–03

Jan

–03

Sep

–02

May

–02

Jan

–02

Sep

–01

May

–01

Jan

–01

Sep

–00

May

–00

Jan

–00

Sep

–99

May

–99

Jan

–99

Sep

–98

May

–98

Jan

–98

Sep

–97

May

–97

Jan

–97

Sep

–96

May

–96

Jan

–96

All goods CPI inflation All services CPI inflation


19

14 This phenomenon of falling manufacturing relative prices is also driving the improvement in the terms of trade theUK has observed in recent years.


Figure 2.2: Index of constant price manufacturing sector output overthe period 1996–2006 (1996=100)

Source: ONS; forecasts for 2007 and 2008 manufacturing sector output from HMT.

CHANGING DOMESTIC DEMAND

Changes in domestic demand also have an important part to play in explainingthe ongoing changes in the structure of the UK economy. Key features of thetwentieth century were rising real incomes and increasing leisure time.Spending on consumer durables, travel and communications have grownsignificantly in the recent past, with spending on recreation and cultureincreasing by 683 per cent between 1971 and 2004 – including a 540 per centincrease in foreign holidays taken by UK residents. Thus, the shift towardssectors such as hotel and restaurants, personal services and retailing observedin Table 2.1 can be viewed as part of this continuing trend.

Looking forwards, population ageing, alongside rising real incomes, is likely tohave a significant impact on demand for certain goods and services. Purelytaking into account the changing age distribution of the UK population and thedifferent patterns of consumption undertaken by people of different ages, therewill be an increase in demand for housing, energy and health. At the same time,there will be a significant fall in demand for education and more moderate fallsin demand for entertainment – although rising incomes are likely to offset fallsin demand for the latter two categories driven by demographics.

Both the UK and the global economy are likely to see rising demand forenvironmental goods and services (EGS) in the coming years due to bothincreased demand for environmental standards arising from growing realincomes and a growing international consensus regarding the economic casefor action to reduce carbon emissions in response to climate change.

99

100

101

102

103

104

105

106

107

2008200720062005200420032002200120001999199819971996


20


BERR and DEFRA estimate15 that the UK EGS market will grow by 42 per centbetween 2005 and 2010, rising in value from £25bn to £34bn over the period.By 2015, the ESG market is expected to be worth £46bn. The sector is expectedto increase from 2.0 per cent of GVA in 2005 to 3.8 per cent of 2005 GVA by 2015.Particular sub-sectors driving this growth are expected to be energymanagement (£2bn in 1995, rising to £7bn by 2015), renewable energy (£1bn,rising to £8bn) and waste management (£8bn in 1995, rising to £17bn by 2015).

Global demand for environmental services is also expected to grow over thecoming years, with BERR and DEFRA estimating that the global market will growby approximately 33 per cent between 2005 and 2015 (from $600bn in 2005 tojust under $800bn by 2015). Opportunities exist in many of the new EU MemberStates, as well as emerging markets, in basic environmental infrastructures,such as water supply and waste management as these countries either continueto industrialise or need to clean up the legacy of previous industrialisation.

INCREASING TRADE OPENNESS AND THE CHANGING UK ECONOMY

While measurement difficulties around reclassification and outsourcing,technology-driven changes in relative prices and changing domestic demand allplay a part in explaining the changing structure of the UK economy, the changesin the UK economy have undoubtedly come in response, at least in part, to thechanging global economy.

As described in chapter 1, increasingly global value chains allow intermediateproducts to be sourced from abroad, leading to increased exports and importsof both intermediate inputs and final outputs. Such activity, whereby firms tradeinternationally within the supply chain, is often referred to as offshoring, and theextent to which it has affected a couple of leading UK sectors is considered indetail in Box 1. However, the fact that non-energy imported intermediate inputsas a share of total non-energy intermediate inputs was stable for the UK between1995 and 2000, as shown in Figure 1.5 in chapter 1 suggests that the increase inoffshoring has been limited and/or a very recent phenomenon. This, despite thestrong evidence that increased outsourcing (domestic trade in intermediates)has taken place in the UK, with intermediate consumption within manufacturingindustries in the UK increasing by almost 40 per cent between 1992 and 2004.The greatest proportion of these intermediate inputs come from themanufacturing sector itself – highlighting how production processes arebecoming increasingly fragmented.

Since 2000 there has been concern at a developing trend for service jobs tomove offshore. However, whilst the pace of service offshoring has increasedsince 2000, evidence suggests that the number of jobs being moved as a resultof restructuring16 or offshoring has been limited. Even in the occupationsregarded as most vulnerable to offshoring – IT and contact centres –


21

15 DTI/DEFRA (2006).

16 Rüdiger, K. (2007).


employment growth over the period 2001 to 2004 was three times the overall UKemployment growth.17

There are reasons for expecting service offshoring to increase in the future.Whilst manufacturing offshoring is relatively mature, service offshoring is still arecent development. As with manufacturing, service providers are likely tocontinue to extend their use of global value chains to increase their efficiency.But there is likely to be a limit to this process. The costs and benefits ofoffshoring can be finely balanced and many employers are likely to seek to retainjobs onshore, especially as the cost of offshore locations rises. Many activities,requiring a wide range of skills and capabilities, either must be or are bestdelivered locally.

Whilst it is sometimes assumed that offshoring has a negative impact on theeconomy, the potential impact of offshoring on domestic employment andeconomic activity is uncertain. Jobs that move overseas are lost. But, the netimpact depends on how quickly people adjust and find new jobs and whetheroffshoring firms expand their home employment as a result of their improvedefficiency. Analysis so far suggests that offshoring hasn’t had a negative impacton overall UK employment.18 Studies also show no clear pattern as to howoffshoring affects productivity, with much depending on both sector and firm-specific characteristics.19

The UK has also been a beneficiary of offshoring by overseas companies. In2006, the UK was the second-largest recipient of FDI inflows globally and is asubstantial exporter of the services – business, financial, computing, informationand communications – that are most frequently offshored.

A wider academic debate remains ongoing regarding the relative importance ofincreased trade and improvements in technology in explaining the decline in theshare of manufacturing in many OECD economies. The seminal paper indisentangling the impact of trade from ‘internal factors’ was Rowthorn and Wells(1987), later updated in Rowthorn and Ramaswamy (1999), and Boulhol andFontagné (2007). Their main result was that trade with developing countries wasresponsible for less than a fifth of the relative decline of manufacturingemployment in the advanced economies (confirmed by Boulhol and Fontagné).Similarly, Hine and Wright (1998) found a limited impact of imports on UKemployment: around 6 per cent of job losses in the manufacturing sector overan earlier period (1981-91).

Whether as a result of increased trade or improvements in technology, it isundoubtedly the case that UK companies, particularly those engaged in


22

17 Heckley, G. (2005).

18 Hijzen, A. and Swaim, P. (2007).

19 Olsen, K. (2006).


relatively high-volume, low-skilled activities, have had to adapt and respond inrecent years in order to remain competitive and take advantage of theopportunities created by globalisation, namely larger export markets, cheaperinputs, and improved access to technology.

Within manufacturing, there have been tremendous efforts to shift towardshigh-technology, high-skilled areas where low-wage economies are less able tocompete. While the overall fall in manufacturing employment has been welldocumented, within the sector, there has been a shift towards higher-skilledoccupations. Figure 2.3 shows that the majority of job losses have occurredamongst production occupations, with higher-skilled occupations, includingR&D and development, professional support and logistics and distribution,consequently now representing a much larger proportion of employment (R&Dand development employment actually increased in absolute terms between1994 and 2006).

Figure 2.3: Occupational activity of workers in manufacturing, (000s)

Source: ONS Labour Force Survey, 4 quarter averages.

Similarly, as Table 2.5 shows, qualifications data also point to considerableupskilling, with an increasing share of those working in the sector now holdingNVQ3 qualifications and the number of employees with degrees almostdoubling between 1994 and 2006.

0

500

1,000

1,500

2,000

2,500

3,000

3,500

4,000

4,500

5,000

20061994

6.1%

10.2%

10.0%

16.3%

2.5%

Production

54.9%

50.1%

3.6%18.6%

9.4%11.5%7.0%

Logistics, distribution Sales and Marketing Support services, trades

Support services, professional R&D, development


23


Table 2.5: Qualifications of those employed in the UK manufacturingsector

Proportion with NVQ level Proportion with degree

3 qualifications and above (%) or equivalent qualifications (%)

1994 2006 1994 2006

Production; support services, trades; Logistics and distribution 42.0 48.0 4.8 8.7

R&D, development; support services, professional; Sales and marketing 55.1 64.1 19.8 31.7

All employed in manufacturing 45.5 53.4 8.9 16.4

Source: ONS, Labour force survey, 4 quarter averages.

The picture of manufacturing increasingly focusing on more specialised, highervalue added areas, serving a more fragmented, global supply chain, is illustratedby case studies of the UK electronics and automotive industries (Box 1). The casestudies consider how the industries have adapted to remain competitive in thenew global supply chain through, for example, focusing on areas such asproduct development, design and systems integration, drawing on the UK’sworld-class academic research base.

BOX 1: CASE STUDIES – THE UK’S ELECTRONICS AND AUTOMOTIVE

INDUSTRIES

The restructuring of the UK’s electronics and automotive industries in recentyears helps illustrate how UK industry is continuing to respond to thechallenges and opportunities of globalisation.

The UK electronics manufacturing industry20, despite experiencing a declinein output since the peak of the global ICT boom in 2000, remains the fifth-largest in the world, accounting for 7 per cent of manufacturing GVA in 2006,and 6 per cent of manufacturing employment. Similarly, the UK’s automotivesector continues to employ around 180,000 people and accounted for 6 percent of manufacturing GVA in 2006. Both sectors have transformedthemselves in recent years in order to command a place in a global valuechain which has been increasingly influenced by both the entry of low-wagecompetition and technological change which has changed the nature of theproduction process and facilitated the fragmentation of the supply chain.

The global electronics sector, in particular, has been transformed by theincreased separation of activities into modules which, in turn, has been madepossible by rapid progress in standardisation, and in the development ofinterfaces for both production stages and components, based upon commonprotocols. The outsourcing to low-wage economies of electronic hardware,particularly components, is especially attractive given the high value-to-bulkratios for these goods.


24

20 As defined by Standard Industry Classification (SIC) codes 30 (office equipment & computers), 32 (components), 33(instrumentation).


The ability to standardise has given rise to the growth of specialist electronicmanufacturing services (EMS)21 firms who increasingly manufacture on behalfof so-called original equipment manufacturers (OEMs) such as IBM, HewlettPackard and Ericsson. Such contracting out allows OEMs to focus on highvalue added activities such as design and marketing, while the EMS firms,who often supply to numerous competing OEMs, can exploit huge globaleconomies of scale which have facilitated continuing productivityimprovements and falling global prices for semiconductors and circuit boards.

In response to these forces, the UK electronics industry has increasinglyfocused on the product development, design, systems integration andprocess control stages of the supply chain, supported by a world-classacademic research base. The UK accounts for over 40 per cent of Europe’sindependent electronic design by turnover, with many small, innovation-intense companies, some of which have global reputations in their niches.Alongside this, the UK has continued to prosper in low volume, high skill,bespoke areas, for example the scientific and precision engineering sector,where specialised technologies and highly bespoke products, oftencustomised to small local markets, mean that pressures towards verticalintegration and restructuring have not been so prevalent. Finally, supplychain disintegration has led to an increased role for global logisticsoperations, including localisation (which ensures the product is customisedand packaged to meet local requirements), inventory control and distribution,with the UK playing a particularly active role.

The auto industry is the historical leader in terms of the development of ahighly detailed division of labour, process efficiency, outsourcing, and supplychain restructuring.

As in the electronics sector, modularisation has played a key role in reducingcomplexity and facilitating supply chain restructuring in auto manufacturing.Global supply chains have evolved whereby vehicle manufacturers (OEMs)tend to focus on product development and design, assembly and marketingwhile buying in raw materials, a high proportion of components, sub-assemblies and systems, specialist electronic technologies, and design andengineering services. Vehicle manufacturers tend to be supplied by a threetier supply chain:

Tier 1 firms supply whole systems directly to OEMs. They design andmanufacture complex systems and modules such as powertrain, interiorsand bodywork and can integrate a wide range of products and servicesincluding R&D and product development.

Tier 2 firms, on the other hand, supply minor sub-assembly components orsupport services to tier 1 suppliers or OEMs.


25

21 Also known as Contract Manufacturing Services (CMS) companies.


The growth in the production and export of knowledge-intensive services isrelated to the ongoing transformation in manufacturing, discussed above. TheWork Foundation argue that manufacturing is itself responsible for our successin exporting knowledge services, with the manufacturing sector generatingadditional technical business services, royalties and licenses and trade-relatedjobs.22

Tier 3 firms supply raw materials, generic components and services usuallyto higher tier firms. Some tier 3 firms, such as materials suppliers, can belarge multi-nationals, while others, including component suppliers, tend to besmaller local operations.

Within this framework, first tier suppliers no longer just supply componentsand sub-systems, but have increasingly become partners in the innovationand production processes of vehicle manufacturers, carrying out about halfof all auto R&D activity in leading auto manufacturing countries. OEMsrecognise that they do not necessarily have all the knowledge and expertiseneeded to construct modern cars on their own.

But developments in the auto supply chain have not had as radicalimplications in terms of vertical integration as for the electronics industry.This is in part because labour costs are not a predominant component of costin this highly capital-intensive industry. Even where low cost economies doenjoy absolute cost advantages, relatively high transport costs as aproportion of production costs may mean these advantages do not translateinto increased trade between regions. Moreover, the functionality ofelectronic products is largely delivered via electronic technology, whereas acar has to integrate diverse components and fundamentally differenttechnologies. Innovation in vehicle design is increasingly dependent onelectronics and software control systems, which have to be integrated withmechanical components.

Within the UK, more than 40 companies manufacture vehicles, ranging fromvolume car and van makers, to specialist niche players manufacturing highvalue and luxury vehicles. In addition, there are over 2,600 companiesinvolved to some extent in the supply chain. While overall employment in theUK automotive industry has fallen in recent years, in line with many OECDeconomies, there are many positive stories regarding the UK auto sector’sresponse to globalisation. For example, Ford now sources 25 per cent of itsglobal engine requirement from the UK, with its Dagenham site now itsglobal diesel engine centre of excellence. Elsewhere, Nissan Sunderland’splant has become Europe’s most productive car plant, while Toyota(Burnaston) and Honda (Swindon) are also in Europe’s top 10 mostproductive car factories. The UK’s volume truck builder, Leyland Trucks,operates one of Europe’s largest and most advanced plants at Leyland.


26

22 Brinkley, I. (2007).


Thus the expansion of the UK’s service sector has risen not solely throughdomestic demand, but through a focus on tradable, knowledge-intensiveservices in which low-wage economies with less skilled labour are unable tocompete. Figure 2.4 shows that the UK has a greater proportion of value addedarising from knowledge-intensive services (or high-growth services as the OECDdescribes them) than any other major OECD economy except the US.

Figure 2.4: The sectoral composition of output (% of total valueadded, 2003)

Source: OECD Economic Survey of the UK.

Knowledge-intensive services go hand-in-hand with increased innovation inservices. The latest data from the Community Innovation Survey suggests thatbusiness service firms have a high proportion of innovation active firms – over60 per cent (Figure 2.5), only slightly lower than in engineering-basedmanufacturing. Business services are particularly strong service and processinnovators and also score highly as ‘wider innovators’, which includes firms whohave made major changes in management practices, business structure,organisation or marketing strategy.

0

5%

10%

15%

20%

25%

USUKFranceOECDDEUItalyCanadaJapanFinlandIreland

Post and Telecommunications Finance and Insurance

Knowledge intensive services

Business Activities


27


Figure 2.5: Types of innovation activity by business service firms,2005

Source: Community Innovation Survey (2005).

Both manufacturing and services have benefited from an increase in ‘intangibleinvestment’ in recent years. The phrase refers to a wide range of entities underthree broad headings: computerised information (software and databases),innovation-related assets (including research and development in natural andsocial science, mineral exploration and design) and ‘economic competences’such as brand-building, firm-provided training and management consulting.

Research23 suggests that intangible investment has increased rapidly in the UKover the last few decades, both as a proportion of overall output and in relationto tangible investment. Figure 2.6 shows the growing importance of intangibleinvestment in the economy, rising from around 6 per cent of output in the 1970sto 13 per cent in 2004, in which time some £130.8bn was invested in intangibles.This was more than 1.2 times the spend on tangible investment, up from 0.4times the spend on tangible investment back in 1970.

0

10%

20%

30%

40%

50%

60%

70%

80%

Widerinnovator

ProcessInnovator

ServicesInnovator

GoodsInnovator

Innovationactive

Retail and Distribution Engineering-based Manufacturing Business Services


28

23 Marrano, M., Haskel, J. and Wallis, G. (2007).


Figure 2.6: Intangible investment as a percentage of output

Source: HMT estimates.

According to the OECD, thanks to the change in the orientation of the UKeconomy in the late 1970s and early 1980s towards more skilled and innovativeareas, by the mid-1990s the UK had already developed a specialisation in sectorsthat were less exposed to competition from emerging low-wage economies.They calculate that the UK’s specialisation24 is negatively correlated with that ofthe dynamic Asian economies, implying little head-to-head competition, withglobalisation ‘more an opportunity than a threat’. In short, the UK’s pattern ofeconomic specialisation seems to have already been poised to benefit fromglobalisation, according to the OECD.

THE ROLE OF FDI AND MIGRATION IN DRIVING UK PRODUCTIVITY GROWTH

AND COMPETITIVENESS

Alongside increased openness to goods and services trade, increased capitalflows (particularly FDI) and changes in the nature of migration into the UK haveboth played important roles in shaping the UK economy and helping to raiseproductivity and competitiveness.

The UK continues to be an attractive destination for inward investment. Figure 2.7shows that while flows into the UK fell following the end of the dot-com boom atthe start of the century, they have since recovered. The US remains by far thesingle most important source of inward investment, although its share of inwardinvestment has fallen over the past 10 years. The EU25’s share over this periodhas risen, to over 50 per cent in 2006, highlighting its importance as a source ofFDI. In 2006, the UK was the second only to the US in terms of FDI inflows.

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24 Calculated as revealed symmetric comparative advantage.


Figure 2.7: Flow of net inward FDI in UK25

Source: ONS.

In terms of MNE activity, in manufacturing, 35 per cent of turnover is attributableto foreign owned firms – the second-highest share amongst the G7 economies.26

The proportion of workers employed by foreign MNEs is approximately 20 percent in manufacturing. Within services, the figure is under 10 per cent, althoughthere is a substantial spread of results. MNE activity is particularly high in thewholesale and retail trade, with approximately 30 per cent of employees workingfor foreign MNEs.

There is a growing literature supporting the notion that FDI and engagementwith MNEs has played an important part in raising UK productivity in recentyears. FDI can positively impact on productivity in the host firm and economy bytransferring technology, skills, managerial know-how, and innovation, byproviding access to international markets, and by stimulating domesticinvestment and competition and enabling capital formation that would nototherwise have been possible. Bloom et al. (2007)27 find empirical evidence thatbeing taken over by a US multinational increases information technologyproductivity within firms, whilst Blomstrom et al. (1991)28 conclude from aliterature review that there is evidence of substantial spillovers from FDI bothwithin and between industries.

-10,000

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25 Defined as the change in inward investment in the UK from one year to the next. Negative values arise when flowsof previous FDI leaving a given country are greater than new FDI flows entering the same country.

26 OECD (2005b).

27 Bloom, N., Sadun, R. and van Reenen, J. (2007).

28 Bloomstrom, M. (1991).


The existence of MNEs can positively affect productivity as they have a greaterpropensity to invest in R&D activity, which drives innovation through thedevelopment of superior technologies and products. Furthermore, the presenceof foreign multinational firms can facilitate technological transfers and spilloversof best practice to domestic firms, whilst also promoting competition.

Recent OECD estimates29 show that the productivity growth of manufacturingMNEs in the UK was more than 6 per cent greater than that of their domesticcounterparts between 1995 and 2001, consistent with the notion of higher R&Dinvestment. Furthermore, the contribution of foreign firms to manufacturingproductivity growth was large compared to other economies.30 These findingsare consistent with results from Griffith et al. (2004),31 which suggest that foreignowned multinationals are on average more productive than UK based firms.

As well as having higher productivity growth, OECD estimates suggests thatforeign firms have higher levels of productivity than domestic counterparts –consistent with the use of superior technologies. For example, Criscuolo (2005)32

finds output per employee of foreign owned firms to be approximately threetimes greater than output per employee in the total UK economy. Comparedwith other countries, this analysis suggests that the productivity advantage isparticularly high in the UK, even after the industrial composition is taken intoaccount.

In recent years, the UK economy has also seen more international labour flows. UKinward and outward long term migration have increased over the last decade(Figure 2.8), with net migration also increasing. These trends have led to anincrease in the percentage of foreign born workers in the working age population,which reached 12.5 per cent in 2006, up from 7.4 per cent a decade ago.33


31

29 OECD (2007c).

30 Third-largest of countries in survey, behind Czech Republic and Sweden, and significantly higher than in the US.

31 Griffith, R., Redding, S. and Simpson, H. (2004).

32 Criscuolo, C. (2005).

33 As of August 2007. See Labour Market Statistics Report August 2007:http://www.statistics.gov.uk/pdfdir/lmsuk0807.pdf. See also: Home Office and Department for Work and Pensions(2007).


http://www.statistics.gov.uk/pdfdir/lmsuk0807.pdf

Figure 2.8: UK international migration mid 1996 – mid 2006

Source: ONS.

Immigration has the potential to impact upon economic growth and productivityin the UK. Estimates from HM Treasury suggest that migration added 0.5 percent to the working age population and, therefore, supported growth to thevalue of around £6bn between Q3 2001 and mid-2006.34 In terms of output perhead, wage estimates collated by DWP suggest that, on average, foreign bornworkers contribute more to GDP than natives, earning £129 more per week.35 Theshort-run impact on productivity will depend upon the extent to which thecapital stock responds to the increasing labour supply.36 In the long-term,migrant labour, either through reducing the cost of low-skilled labour for firmsor through providing access to additional higher skills, may increase theattractiveness of the UK as an investment location. Relevant to this, ad-hocevidence collected by business organisations, including the Institute of Directorsand the British Chambers of Commerce, highlights the benefits arising fromskills, flexibility and work ethic that migrant workers bring.37

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34 HMT (2005b). In a similar vein, NIESR (2006) estimated that since 1998 immigration had raised GDP by 3.1 per cent.

35 DWP calculations, based on the Labour Force Survey. Economic migrants are not homogeneous, however. That is,(1) foreign-born wages are higher than those of natives, but (2) as the recent wave of A8 migration has shown muchdepends on the relative skills mix, hence the wage differential between foreign-born and natives has narrowedconsiderably in the past 6 years or so. This is largely due to A8’s going into low-skilled, low-paid jobs whichdepresses significantly the average foreign-born wage.

36 An increased labour supply for a fixed capital stock would, everything else being equal, point to a fall in short-termproductivity.

37 See: Institute of Directors (2007) and the British Chambers of Commerce (2007).


3. The policy responseto globalisation

3.1 Globalisation, trade openness and economic growth

The Government’s central economic objective is to achieve high and stable ratesof economic growth and employment. As Box 2 discusses, trade openness andglobalisation have an important role to play in raising the long-run rate of growthin the economy. Evidence suggests more open economies tend to grow faster.Openness to trade strengthens the drivers of productivity by providing greateropportunities to exploit economies of scale; by exposing the domestic economyto greater competitive pressures; by rewarding innovation and providing accessto new technologies; and by increasing incentives for investment.

Alongside the benefits to economic growth, consumers are already benefitingfrom globalisation through both the increased choice of goods and servicesavailable and through lower prices of imports, for example, of consumerelectronics.

In addition to these effects, globalisation offers potential benefits to certain sub-sets of the economy. For example, the creation of global supply chains couldincreasingly enable specialised SMEs to compete more effectively byperforming specific operations in the supply chain. Their flexibility, nimblenessand quality advantages may provide a competitive advantage over largercompetitors.

The positive impact of globalisation on the UK economy is noted in the OECD’sUK Economic Survey, 2007. The OECD also commends the UK on its positiveapproach to globalisation:

‘The United Kingdom’s good macroeconomic performance over the pastdecade has been underpinned by a willingness to embrace the opportunitiesoffered by globalisation.’38

33

38 OECD (2007c).


BOX 2: RULES OF THE GAME – BENEFITS OF OPENNESS

To maximise the benefits from globalisation it is vital to have a free and fairmultilateral trading system to foster economic cooperation, internationaltrade and investment. The rules based trade system, initially embodied in theGATT and now the WTO, provides a fair framework due to the principles ofmost favoured nation (MFN) and national treatment that can benefitdeveloping as well as developed countries, whilst providing clarity andcertainty to businesses. It is important that this system is maintained andextended through a successful Doha Development Agenda (DDA) tocapitalise on the benefits from further liberalisation.

While openness alone is not a sufficient condition for growth, sustainable growthwill not occur without it. This is supported by the trends in tariff levels and worldincome – since 1945, the average industrial tariffs of developed countries havefallen from nearly 40 per cent to less than 5 per cent. In this time, world exportshave risen by twenty-seven times and world income by eight times.

The Single Market demonstrates that openness and increased competitiveintensity generate significant economic gains. Recent European Commissionwork estimates that a 1 per cent increase in the ‘openness’ of an economyresults in an increase of 0.6 per cent in labour productivity the following year.One academic study (Meserlin, 2001) estimates that existing barriers toexternal trade and investment (e.g., tariffs, quotas, restrictive standards)could cost Europe’s consumers up to 7 per cent of EU GDP (Euro 600–700bn,equivalent to over Euro 1,000 per European citizen) a year.

Work by the OECD suggests that a 10 percentage-point increase in tradeopenness translates into an increase of around 4 per cent in per capita income.Though such data should be treated with some caution they are neverthelessindicative of the potential positive effect of openness on the economy.

According to the OECD, removing remaining trade barriers between theEU and the US could bring permanent increases in per capita GDP of up to3.5 per cent.

Dangers of protectionism

Protectionism is more likely to stifle rather than promote competitiveness.Policies that insulate firms from global competitive forces, for example thosethat misuse instruments intended for trade defence, represent a costly andineffective means of protecting jobs. Such action may be popular in the shortterm, but it is likely to inhibit growth and limit prosperity in the longer term.It tends to result in a narrower range of products and ultimately lower qualitygoods and services, at higher prices for consumers, leading to less customerchoice and a reduction in welfare. In the longer term, free trade and increasedcompetition makes countries stronger, not weaker. Open economies boostcompetitiveness and productivity, improve living standards, drive innovation,sustain economic growth and keep prices low.


34


However, whilst globalisation offers substantial opportunities, it also createchallenges for the UK economy. Globalisation puts UK firms and workers incompetition with those from across the globe and reinforces the need for UKfirms to continue to innovate and offer higher quality goods and service.

Against this backdrop of opportunities and challenges from globalisation, theGovernment’s policy response can be seen as three fold:

� Firstly, in recognition of the potential benefits to be derived fromglobalisation and greater openness, the UK is committed to reducinginternational barriers to trade. At the same time, we need to work withinternational partners to ensure that international institutions such as the IMFare fully equipped to provide the necessary direction and support to theongoing process of globalisation.

� Secondly, the Government’s strategy of raising productivity through ensuringmacroeconomic stability and putting in place policies to strengthen theproductivity drivers (competition, investment, innovation, enterprise andskills) will also work to ensure that UK business is best placed to takeadvantage of the benefits of globalisation and compete effectively ininternational markets. In an increasingly competitive global economy, there isa renewed emphasis on having a world class risk-based regulatory regimewhich finds the right balance in supporting both competitiveness and widerobjectives.

� Thirdly, to ensure the benefits of globalisation are felt as widely as possible,the Government has a number of policies in place to help the UK economyadapt to its changing role in the global economy, as well as to reduce regionaleconomic performance differences and to protect the most vulnerableworkers through targeted labour market interventions.

STRENGTHENING THE INTERNATIONAL INSTITUTIONS TO SUPPORT

GLOBALISATION AND INCREASING TRADE OPENNESS

Facing the challenges of globalisation the UK and EU recognise the need toredouble our efforts to make the European Single Market work more efficientlyand to reach out to engage more effectively with the rest of the world as set outin the Government’s recent ‘Global Europe’ paper.39

The Single Market has the potential to bring further improvements in EUproductivity. But, achieving this will require further integration andstrengthening of competition across a range of activities. The Services Directive,which should start to open up the market for services across the EU following itsfull implementation in 2009, is estimated to be capable of boosting UK GDP by£4–6bn per annum (BERR, 2007). Full liberalisation of network industries(telecoms, postal services, energy and transport) has been estimated to be worth


35

39 BERR (2008). See also: www.berr.gov.uk/files/file44097.pdf


http://www.berr.gov.uk/files/file44097.pdf

potentially £52–66bn to consumers (Copenhagen Economics, 2007). Even inareas such as goods where cross border trade is already high there is scope forfurther improvement. Complete implementation of mutual recognition has beenestimated to have the potential to increase intra-EU trade in goods by 10 percent. Greater financial market integration could boost EU GDP by 1.1 per cent inthe long run (London Economics, 2002). A more efficient European patentsystem would help translate European intellectual capital into business capitaland spur innovation. Entry into force of the London Agreement which willreduce translation requirements is expected to save patent applicants Euro200m per year (European Patent Office, 2006). A single Community-wide patentcould lead to savings of Euro 30,000 per patent over 10 years. Finally, the UK hasbeen instrumental in securing an agreement to cut EU administrative burdens by25 per cent to ensure an appropriate level of regulation.

In addition to these there are a range of other areas where the UK has beenworking to increase trading opportunities and to reduce trade barriers.Specifically, the UK has pressed the EU to adopt a series of EconomicPartnership Agreements (EPAs) to promote development in Africa and otherregions, with some success. Further to this, the UK, through BERR and UK Trade& Investment (UKTI), continue to work to influence the outcome of the new EUMarket Access Strategy, which should serve to tackle a number of trade barriers.

One of UKTI’s key roles is to deliver for business internationally on behalf ofBERR. As a service delivery organisation, UKTI’s mission is to deliver maximumvalue for the UK economy by facilitating business success in the globaleconomy. It does this by helping UK companies internationalise, and throughassisting overseas companies to bring high quality investment to the UKeconomy.

UKTI works to open up overseas markets to UK business through a range oflevers,40 including promoting the UK brand abroad; assisting businesses inaccessing specific opportunities; and feeding business evidence into lobbying ofoverseas governments to remove barriers to market access, especially inemerging and high growth markets such as China and India. In particular, UKTIhas been working to coordinate bilateral ministerial engagement with keygovernments on trade issues. For example, the recent Prime Ministerial summitsin China and India provided an opportunity to promote the benefits ofliberalisation and the lead role of the UK as an open economy. To support itsincreased focus on emerging and high growth markets, UKTI has re-deployed£5.6m of resource to these markets and has set up a High Growth MarketsProgramme, recruiting 10 high-calibre business specialists to target and supportmid-corporate companies in high growth markets.


36

40 UKTI (2006) set out key responses to the increasing challenges of globalisation including: a step-change in theGovernment’s drive to market internationally the strengths of the UK as a knowledge economy and the UK brandabroad; and a reinforced focus on emerging and high-growth markets (identified as the China Markets (whichincludes Taiwan and Hong Kong), India, Indonesia, Malaysia, Singapore, South Korea, Thailand, Vietnam, Brazil,Mexico, Russia, Turkey, Qatar, Saudi Arabia, UAE, South Africa).


However, whilst progress has been made, more still needs to be done, and thereis no room for complacency in seeking further reductions in barriers to freetrade. Although barriers to trade have fallen significantly over the last half-century, particular sectors and products remain subject to high levels ofprotection. Average import tariffs between OECD countries are around 3 percent, but tariff peaks reach 506 per cent in the EU, and 350 per cent in the US.The highest tariffs are typically levied on goods from the developing world. TheUK Government continues to work to encourage the Commission to comeforward with meaningful and trade liberalising revisions to the operation of EUtrade defence instruments. And taking a lead role in the forthcoming trade talksto reject protectionism and to press for completely open markets to exports frompoorer countries has been identified by the UK as a key priority.

The scale, depth and speed of recent globalisation creates a challenge for theinternational community to ensure the appropriate institutions are in place toprovide the necessary support and direction to the globalisation process and toensure that the benefits of globalisation are shared internationally, not by some butby all. The global public goods on which we are dependent, such as peace, stability,and the natural environment can only be delivered by cross border agreements.

The recent financial volatility has illustrated the lack of a WTO equivalent forinternational finance. It has also highlighted that the nature and transmission ofshocks may be changing as economies become increasingly financially integrated.With prudential regulation and to a certain extent supervision being done at thenational level, there has been a diversity of policy reaction and opinion.

In terms of strengthening stability in the global financial markets and the globaleconomy, the Government is committed to supporting reforms which ensure theIMF’s primary role no longer focuses on resolving crises, but preventing them,through the surveillance of economies internationally.41 The Chancellor has alsooutlined42 how the IMF and the Financial Stability Forum (first set up after theAsian financial crisis ten years ago) need to work together as the internationalcommunity’s early warning system, with the IMF using its surveillance system toidentify global economic and financial risks, and the Forum taking a stronger rolein tackling them. This stronger role should include better communicationbetween nations and sharing best practice, from how best to support banks withliquidity problems to providing protection for depositors, and leadingcoordinated regulatory responses to risks to prevent problems before they occur.

In terms of spreading the benefits of globalisation across all nations, theGovernment has argued that institutions such as the IMF, World Bank and G8need to reflect the rise of Asia. And the UK has been working with the EU toachieve an ambitious, pro-development outcome from the Doha DevelopmentAgenda of the World Trade Organisation, although agreement is currently stillsome way off.


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41 IMF (2007).

42 HMT (2007).


Building global instititutions is not just about free trade and financial marketstability. Chapter 2 outlined the growing importance of knowledge-basedindustries to the UK economy. Analysis carried out by the OECD indicates thatinternational trade in counterfeit and pirated products could have been worth upto $200bn in 2005.43 It is therefore of vital importance that we have theinternational institutions in place to ensure there are sufficient incentives forcreativity and innovation, without unduly limiting access for consumers andpotential follow-on innovators.

The Gowers Review of UK’s intellectual property framework, published inDecember 2006, sets out a number of targeted, practical recommendations todeliver a robust intellectual property framework to promote innovation in aglobal economy. The principal recommendations of the Review are aimed at:tackling IP crime and ensuring that rights are well enforced; reducing the costsand complexity of the system; and reforming copyright law to allow individualsand institutions to use content in ways consistent with the digital age.

As the Stern Review noted, effective action to meet the challenge of climatechanges will require a global policy response, guided by a common internationalunderstanding of the long-term goals for climate policy and strong frameworksfor co-operation. International frameworks are required to focus on the followingkey areas:

� Emissions trading: Expanding and linking the growing number of emissionstrading schemes around the world is a powerful way to promote cost-effective reductions in emissions and to bring forward action in developingcountries. Strong targets in rich countries could drive flows amounting totens of billions of dollars each year to support the transition to low-carbondevelopment paths.

� Technology cooperation: Informal co-ordination as well as formalagreements can boost the effectiveness of investments in innovation aroundthe world. Globally, support for energy R&D should at least double, andsupport for the deployment of new low-carbon technologies should increaseup to five-fold. International cooperation on product standards is a powerfulway to boost energy efficiency.

� Action to reduce deforestation: The loss of natural forests around the worldcontributes more to global emissions each year than the transport sector.Curbing deforestation is a highly cost-effective way to reduce emissions;large-scale international pilot programmes to explore the best ways to do thiscould get underway very quickly.


38

43 OECD (2007d). This total does not include domestically produced and consumed counterfeit and pirated productsand the significant volume of pirated digital products being distributed via the Internet. If these items were added,the total magnitude of counterfeiting and piracy worldwide could well be several hundred billion dollars more.


� Adaptation: The poorest countries are most vulnerable to climate change. It isessential that climate change be fully integrated into development policy, andthat rich countries honour their pledges to increase support through overseasdevelopment assistance. International funding should also support improvedregional information on climate change impacts, and research into new cropvarieties that will be more resilient to drought and flood.

PRODUCTIVITY AND COMPETITIVENESS POLICY

The main way of improving global competitiveness, and thereby maximising thebenefits offered by globalisation, is by improving productivity. TheGovernment’s long-term commitment to achieving productivity improvementsis set out in detail in a Public Service Agreement (PSA) that BERR leads,alongside delivery partners including HM Treasury (HMT) and the Departmentfor Innovation, Universities and Skills (DIUS):44

‘Demonstrate further progress on the Governments’ long-term objectives:

� raise the rate of UK productivity growth over the economic cycle, and

� narrow the gap with our major industrial competitors.’

The framework for achieving productivity growth is two fold. Firstly, throughmaintaining macroeconomic stability to ensure businesses and individuals havethe certainty needed to make long-term investment decisions. To do this, fiscalpolicy is underpinned by clear objectives and two strict rules which ensuresound public finances over the medium term. The first is the Golden Rule,according to which, over the economic cycle, the Government will borrow onlyto invest and not to fund current expenditure. The second rule, the SustainableInvestment Rule, states that public sector net debt, as a proportion of GDP, willbe held over the economic cycle at a stable and prudent level. The Governmenthas also given the Bank of England operational independence to meet theGovernment’s symmetrical inflation target, to ensure lasting stability so thatbusiness and individuals plan effectively for the long term.

Secondly, using the Government’s levers45 to undertake microeconomic reformsto tackle market failures around the drivers of productivity (investment,innovation, competition, enterprise, and skills). Despite significantdevelopments under each of the key drivers identified in the Government’sproductivity framework, further progress is needed to continue to ensure thatthe greatest gains from globalisation are realised. Recent policy initiatives inarea are set out below:


39

44 HMT (2007).

45 HMT/BERR (2007) set out a number of key levers through which Government can influence the drivers ofproductivity. These include: investment in workforce and skills, infrastructure investment; taxes and regulation;competition and market frameworks; and public sector efficiency.


Investment

Investment expands the physical capacity of the economy and hence allowseconomic growth to take place. In an increasingly global economy, there are bothmore opportunities and competition in relation to attracting globally footlooseinvestment. The Government is committed to improving investment performancein the UK and a wide range of policies are in place to promote investment. Theseinclude fiscal and monetary policies to encourage macroeconomic stability, whichgive investors some certainty when making decisions, as well as tax breaks, suchas the R&D tax credit, to encourage investment.

Going forward, policy development in this area focuses on three majorindependent reviews. The Barker and Eddington Reviews examined theinvestment infrastructure framework and made recommendations with respectto the functioning of the planning system in the UK across transport, energy,waste and water, taking into account, for example, the UK’s future transportinfrastructure needs. Alongside this, the Stern Review made recommendationswith respect to future energy infrastructure requirements. These reviews willhave implications for planning for capital investment at all levels of government,and hence there will be an impact on domestic businesses that are looking toinvest as well as international flows of capital.

Innovation

The ability of UK businesses to compete with firms based in lower-cost economiesin an increasingly global economy will be dependent upon developing stronginnovation processes. Policies already in place to promote innovation include:record investment in science to maintain the world-class performance of thescience and engineering base; R&D tax credits for all firms to incentiviseinnovation; and BERR’s new Technology Strategy to support collaborative R&Dand knowledge transfer networks through strong business input.

In addition, UKTI’s role includes attracting high quality investment to the UKeconomy. UKTI’s Strategy ‘Prosperity in a Changing World’ (July 2006) signalleda step-change in the Government’s drive to market internationally the strengthsof the UK as a knowledge economy and focus increased resources to attract highvalue foreign direct investment particularly from R&D intensive internationalcompanies and innovative inward investors, to grow their business in and froma UK base.

UKTI has taken the lead with both public and private sector stakeholders indefining and coordinating work so that across the globe our messages insupport of the UK sector are clear and consistent. In 2007, marketing strategieswere launched covering financial services, creative industries, life sciences, ICTand energy technologies. These are already bearing fruit in enhancedcoordination, ensuring we can work with a breadth of overseas markets tocommunicate the range of expertise in goods, services, know-how andtechnology which modern Britain has to offer.


40


A new R&D programme was launched by UKTI in April 2007, to help attractglobal R&D to the UK. The programme sits within the Government objective ofincreasing R&D as a proportion of GDP to 2.4 per cent by 2014, as set out in theScience and Innovation White Paper.

Skills

Workers with higher skills levels contribute to higher productivity levels throughbetter ability to utilise capital, greater capacity to innovate and greater ability toadapt to changes in the economic environment. As outlined in the Leitch Review,increasing global pressures will strengthen the need for a highly skilled, flexiblelabour force. And ensuring that labour markets adapt efficiently and quickly torapidly changing skills requirements as a result of global forces is a major policychallenge. Its recommendations are central to the Government’s response to theUK’s skills challenge, set out in World Class Skills, and to the ambition to becomea world leader on skills by 2020. In particular, the Government is committed toimproving the skills of the population throughout their working lives to create aworkforce capable of sustaining economic competitiveness and enableindividuals to thrive in the global economy.

The Government is committed to improving the quality and responsiveness toindividual and employer demand and to focus the skills system on training thathas clear economic value. For example, the Government has recentlyannounced a doubling of funding in the Train to Gain Service as part of amassive investment programme, which will see more than £11bn a yearinvested in education, employment and training. By working closely withJobcentre Plus through their Local Employment Partnerships, Train to Gain willalso support people who have been unemployed to secure employment withtraining and progression on to higher level skills.

Government has also announced a major expansion of apprenticeships, withover £1bn in Government funding to increase overall places from 250,000 todayto more than 400,000 by 2010/11. The Government also plans to lift theeducation and training leaving age to 18 by 2015 as well as strengthening theprovision and support available to young people and adults to meet theambition set out in the Leitch Review of achieving world class skills by 2020.

Enterprise

Future UK prosperity depends critically on the ability of UK businesses torespond flexibly and quickly to exploit opportunities in rapidly changing globalmarkets. This requires both established and new sectors and businesses to havethe capabilities to bring new ideas, knowledge, and skills into the economy, andalso to identify, prioritise, and exploit potential overseas opportunities in atimely manner.

Successful international entrepreneurship is important to the flexibility of theeconomy as a driver of innovation and as a stimulus to competition, with more


41


productive firms replacing less productive ones, and through the capacity ofnew firms and entrepreneurs to innovate and introduce new technologies.Access to international markets also promotes incentives for investment ininnovation by enabling entrepreneurs to maximise the returns to theirinvestment in intellectual property, through selling into a larger market.

Young and innovative SME exporters contribute crucially to the flexibility whichallows the economy to respond to economic shocks and changes to the UK’scomparative advantage. In time, some of these dynamic SMEs and ‘bornglobals’ of today will become the large firms in profitable mature sectors of thefuture. However, they will not fulfill their potential without developing thecapabilities necessary to exploit overseas market opportunities successfully.

The Government is playing an important through role in helping young andinnovative companies with high-growth potential acquire the capabilities andaccess to networks that are necessary for successful internationalisation –principally by acting as a trusted intermediary.46 UKTI provides access toinformation and advice that the private sector alone will not or cannot provide toUK businesses seeking to exploit opportunities overseas.

Government also facilitates beneficial cooperation among businesses, enablingthem to work together to overcome barriers and develop potential trade andinvestment opportunities, for example through international cooperation onR&D, or showcasing UK capabilities in emerging markets overseas.

The Government promotes an enterprise culture by incentivising business startups, through policies such as the tax cuts introduced for small firms, as well asensuring small firms have sufficient access to finance (Small Firms LoanGuarantee scheme), and minimising the regulatory burden. There has beenconsiderable work over recent years to reduce the burden on firms, for examplethe principles set down by the Hampton Review (2005, 2006) for reducing theadministrative cost of regulation. Any changes that are taken on in the wake ofHampton are likely to have a considerable impact on the way that businessesdeal with regulations and the subsequent burden upon them.

Looking more widely than SMEs, a number of recent reviews cover differentaspects of enterprise. The Stern Review, for example, refers to the opportunitiesfor businesses from new markets resulting from the need to tackle climatechange – from creating new products that meet a specific aspect of theenvironmental challenge, to developing better means of meeting the energyrequirements for current and future generations.

Globalisation is an important factor both in the growth in carbon emissions andconsequent threat to the climate but also in increasing the flow of ideas andtechnologies needed to tackle climate change.


42

46 DTI (2006) notes that young innovative and high-growth potential companies will not be able to fulfil their potentialwithout the capabilities and access to networks which are necessary for successful internationalisation.


Delivering 60 per cent reductions in carbon emissions by 2050 will mean aparadigm shift in the structure of the UK and international economy. Reducingthe carbon footprint and more sustainable resource usage are already becomingimportant competitive differentiators for companies and even countries. Theinteraction between these forces and globalisation are difficult to predict but arelikely to have important implications for both OECD and high growth marketswhich will have to adapt their development or growth models.

These developments are driving innovation across UK industry and newopportunities internationally. The UK excels in some areas already – innovativeenvironmental regulation, carbon trading, waste to energy, carbon abatement,planning and design. UKTI has integrated these into its marketing of UKinfrastructure overseas. It will now develop a strategy to market UK expertise andtechnologies that mitigate climate change across the main sections of theeconomy responsible for carbon emissions (identified by the CBI Climate ChangeTask Force as efficient buildings and appliances, low carbon power generation,low carbon transport and low carbon industrial processes.) This is also reflectedin UKTI’s work to secure high quality inward investment in renewables and otherenvironmental goods and services, which the UK needs to develop itscompetitive advantage for the future.

Competition

Economies need competitive goods markets in order to benefit from increasedtrade. The UK’s competition regime is highly regarded, with the CompetitionCommission (CC) ranked joint first in the latest Global Competition Review andthe Office of Fair Trading (OFT) ranked amongst the top ten competitionenforcement agencies internationally. The Government will continue to supportstrong, independent competition authorities and better regulation to ensure UKproduct markets maintain high levels of competition. This will ensure that thepotential benefits of increased competition are maximised whilst mitigatingagainst the risk of abusive practices from new international suppliers.

Although not a driver of productivity in its own right, effective and well-focusedregulation can play a vital role in making markets work by correcting marketfailures and approximating for competition where markets are inadequate. It canalso be used to promote fairness and social objectives. More and more, as theeconomy grows and citizens feel more wealthy, society expects the Governmentto provide protection for the general public, consumers and employeesconsistent with the best international standards.

To improve our understanding of how regulation affects productivity, thedepartment has recently commissioned five short research projects exploringthe links between regulation, productivity and growth. Previous researchindicates that regulation can affect productivity through changing the incentivesto invest. Two of the research projects are, thus, considering possible sources ofregulatory uncertainty and ways in which this can affect investment decisions.


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Regulation can also contribute to productivity growth by, for example,stimulating technological change and innovation. Previous research suggeststhat environmental regulations can achieve productivity improvements andanother of the research projects is considering whether such outcomes are alsoachievable in other policy domains.

However, inefficient regulation can impose significant burdens on the private,public and third sectors, and this affects our competitiveness and the quality ofpublic services and affects productivity by distorting business decisions andbehaviour. The Government’s regulatory reform agenda is therefore focused ondelivering better regulatory outcomes while driving down unnecessary burdensand distortions to behaviour.47 This is being achieved by:

� Reducing administrative burdens on the private and third sectors by a net 25per cent by 2010. Simplification plans published in December 2007 show thatGovernment departments have identified annual savings of £3.5bn by 2010,with £800m of savings already delivered;

� Achieving effective new regulations by introducing a new form of ImpactAssessment from May 2007 which makes estimates of the costs and benefitsof new regulations a much more transparent and evidence-based part of thepolicy making process;

� Ensuring inspection and enforcement is proportionate and risk-based. Forexample, the Regulatory Enforcement and Sanctions (RES) Bill will, subject toParliamentary approval, establish the Local Better Regulation Office as astatutory body, give it powers to promote consistency of regulation at locallevel;

� Improving transparency and communication of regulatory changes; and

� Working with the European Commission, European Parliament and otherMember States to address the quality of the stock and the flow of Europeanlegislation.

Significant progress has been made across all these areas. The Government’sambitious and wide-ranging regulatory reform agenda is one of the mostrespected programmes in the world, confirmed by international surveys.However, the Government is clear that despite the considerable progress onregulatory reform, much more still needs to be done, including meeting ourcommitments to deliver a 25 per cent reduction in administrative burdens bothat UK and EU level and reducing public sector data burdens by 30 per cent. TheGovernment will continue, year-by-year, to review regulation and to reporttransparently on its progress. And it is committed to continuing to listen tobusiness, charities, consumers and frontline staff in the public sector, tounderstand their priorities for regulatory reform.


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47 See: www.bre.berr.gov.uk


http://www.bre.berr.gov.uk

Additionally, the department is hosting the new Risk and Regulation AdvisoryCouncil (RRAC) which was launched on the 16th of January this year. TheCouncil was appointed by the Prime Minister as a key part of his drive toimprove the way risk to the public is understood and managed by Government.The RRAC will take forward the UK’s first ever work programme dedicated tounderstanding and promoting proportionate responses to public risk,particularly when faced with event-led pressure. The RRAC, led by No 10 andmanaged by BERR and its Secretary of State, John Hutton, will be pan-Governmental and cover public, voluntary and business sectors. The RRAC willbe supported by a team reporting to Vicky Pryce, Chief Economic Adviser andDirector General of Economics at BERR as well as Joint Head of the GovernmentEconomic Service. The choice of topics to be addressed over the next year willbe finalised after consultation with stakeholders.

ENSURING THE BENEFITS OF GLOBALISATION ARE SHARED WIDELY

Whilst globalisation brings substantial opportunities for the UK economy, it isalso likely that some firms or workers will benefit more than others. Ensuringthat the benefits to globalisation are shared widely will be crucial to enabling theGovernment to meet its targets regarding maximising employmentopportunities for all, reducing child poverty and reducing the gap in economicgrowth rates between English regions.

Government is helping to ensure that all people, places and business areequipped to meet the challenges of the global economy, through targeted labourmarket policies, programmes aimed at regional regeneration and a dedicatedmanufacturing advisory service to aid business transformation.

LABOUR MARKET

As the structure of the economy changes in response to globalisation andtechnological change, workers are more likely to have to retrain so that they canmove into new jobs and sectors. Therefore, labour market adaptability isincreasingly important in a globalising world so that workers are able to move intoother areas of work and are not out of work for long. An Index of Labour MarketAdaptability prepared by BERR shows that labour market flexibility improvedbetween 1992 and 2001 and has since stabilised at historically high levels.48

Whilst the Government believes in maintaining and improving labour marketadaptability, it recognises this cannot be at the expense of the rights of employees– particularly those who are most vulnerable. This involves striking the balancebetween laws and regulations in the workplace that provide decent minimumemployment standards but are sensitive to business conditions. In striking thisbalance, the Government has put in place a fair framework of basic workplacerights, including the right to a minimum wage, a right to 24 days’ paid leave, and


45

48 BERR (2007b).


the right not to be forced to work more than 48 hours a week on average.Government is taking a tough but targeted approach to enforcement of theserights, including the establishment of a Vulnerable Worker Enforcement Forum.

The Government also recognises that globalisation can bring challenges for themost vulnerable workers. The acceleration of the UK’s transition to a knowledgeeconomy that comes from increasing trade with emerging economies is likely toincrease the premiums attached to skills and capital and lower-skilled workersare likely to find it more difficult to tap into the economic benefits ofglobalisation. However, the impact can be complex. For example, a recent paperfound that offshoring had actually offset the growing wage inequality betweenhigher and lower skilled workers, but increased high skilled relative to mediumskilled wages.49 Some recent IMF analysis shows that while labour’s share ofnational income has been declining, technological change has had a much moresignificant impact than globalisation.50

There are also concerns about the loss of UK jobs through trade and offshoring.However, while limited, existing research suggests that job losses fromoffshoring are small compared to total job creation. For example, one studysuggests that only 3.4 per cent of total job losses in 2005 were due to offshoring(less than 7,000).51

Lower-skilled workers may also be affected by the increased mobility of people.While the majority of new European immigrants are relatively well-educated incomparison with the indigenous population,52 they predominantly work in theleast skilled occupations and in the low-paying industries. This highlights theimportance of migrants being complements, rather than substitutes, for UKworkers by filling skill gaps.53 This rationale lies behind the Government’sproposed points based scheme. The scheme will provide a simpler, moreobjective method of determining entry for work, which is informed by a properassessment of the UK’s labour market needs by the proposed MigrationAdvisory Committee (MAC), to ensure that labour migration is managed in thebest interests of the country.

Alongside the Government’s commitment to improving overall skill levels setout above, the Government is also working to support displaced workers at thelocal level. This is not about protecting people from change – which is notpossible – it is about investing in workers to help them respond to change.Where closures are likely to result from trade or offshoring, RegionalDevelopment Agencies (RDAs) take the lead in working with the company toexamine potential alternatives. Where these are not found, they work with


46

49 Canals, C. (2007).

50 IMF (2007).

51 Rüdiger, K. (2007).

52 Saleheen, J. and Shadforth, C. (2006).

53 The economic and fiscal impacts of immigration were summarized in a recent cross-departmental submission to theHouse of Lord Select Committee on Economic Affairs. See: Home Office and Department for Work and Pensions (2007).


agencies such as Jobcentre Plus to identify short- and longer-term solutions tothe problems which may be caused. There is also a comprehensive package ofsupport for those facing redundancy, including the Rapid Response Serviceoperated by Jobcentre Plus and the Rapid Response Action Fund for one-offsupport to address individual barriers to re-employment. There are manyexamples where RDA-backed projects have made real differences on theground, generating economic value and helping regions respond to economicshocks. RDAs have helped business start up, grow and prosper. They haveintroduced demand-led skills and training schemes; created new opportunitiesand global networks for local business and attracted overseas investment.Advantage West Midlands has been instrumental in leading the renaissance ofthe Birmingham area following the demise of MG Rover. Similarly, the vibrancyof our leading cities has been fostered by the RDAs – helping Liverpool,Newcastle, Manchester, Leeds, and Warrington modernise their industrial bases,reinvent themselves following the deindustrialisation of the 1980/90s and takeadvantage of the new opportunities of globalisation.

RDAs play a vital role in helping regions prosper. It is estimated that they havecreated or safeguarded nearly 800,000 jobs, aided the creation of around 60,000new businesses and brought some £8bn or private sector funding into regionaldevelopment. However, the review of sub-national economic development andregeneration identified that more reforms are needed to ensure that regions andlocalities have the flexibilities, powers and incentives to respond to economicchange. This will include strengthening the role of local authorities in economicdevelopment and encouraging collaborative working at the sub-regional level.

The Government’s Selective Finance for Investment in England scheme supportscapital investment and job creation by companies operating in disadvantagedareas. For example our support for Vauxhall at Ellesmere Port enabled thecompany to win the allocation of the new Astra. The recent reform of UKAssisted Areas has enabled important financial flexibilities to be better targetedon those who have the need for support and the opportunity to make best useof it.

Manufacturing strategy

Increasing global competition means that the UK manufacturing sector faces arange of pressures and opportunities. As noted in the previous chapters,developments in information technology, just in time production methods andin transport have made it possible for manufacturing companies to operate on aglobal basis, with the processes of the manufacturing value chain spread outacross locations across the world to reduce costs or gain access to new markets.

In 2002, the Government published its Manufacturing Strategy which set out aframework of Government support across seven main ‘pillars’ (macroeconomicstability, investment, science and innovation, best practice, raising skills andeducation levels, modern infrastructure, and the right market framework) to


47


provide the conditions for a successful, knowledge intensive, highly skilledmanufacturing sector in the UK.

The Government’s Manufacturing Strategy co-ordinates a range of supportincluding the Manufacturing Advisory Service which provides manufacturers inevery region with access to practical advice and has generated over £460m ofadded value for the companies it has helped, and the Technology Programmewhich, since 2004, has supported over 600 projects across 40 technology areaswith a combined business and Government investment of more than £900m.

In 2008, BERR is conducting a review of the Government’s ManufacturingStrategy to ensure that UK manufacturing can take maximum advantage of theopportunities to compete in the development and manufacture of greenproducts that will either generate electricity from renewable means, or boostresource efficiency. The review will also examine key areas such as innovation,skills and training, and investment, and is expected to report in Summer 2008.


48


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Department for Business, Enterprise and Regulatory Reform. www.berr.gov.ukFirst published February 2008. © Crown copyright. BERR/Pub 8693/02/08/NP. URN 08/607

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