The UK Economy - Business Investment

Business investment is a key part of economic activity. Firms invest in capital spending for a variety of reasons - for example to increase capacity, improve efficiency and take advantage of new technology. So what has happened to the value of business investment in the UK economy over recent years? The interactive chart below shows the quarterly value of business investment (in £ms) over recent decades. The chart updates once the latest ONS data is available, so bookmark this blog entry if you would like to be able to check latest trends in business investment.

Here is the chart:

Data from Timetric.

To view this graph, please install Adobe Flash Player.

Bank of England Target 2.0 from Timetric

Business investment is a key part of economic activity in the UK. It is responsible for about 10% of GDP. Business investment is also one of the most volatile parts of the economy - i.e. it is subject to fairly wild flucutations in value. A recent study showed that between 1971 and 2006, annual business investment growth was twice as volatile as that of household and government consumption, exports, imports and overall GDP.

The chart illustrates the dramatic fall in business investment during the recent recession in the UK. There was a drop of approximately £5bn in annual investment spending during the previous recession in the early 1990s. Looking to the right hand side of the chart, you can see that there was a substantial drop in capital spending between mid 2007 and early 2009 of around £15bn p.a. Since the middle of 2009, business investment has picked up a little, although it may have stalled in the early part of 2011 as business confidence in the UK’s economy prospects weakens.

To put this data into some perspective: business investment fell by around 20% during the recent recession. That is the worst fall since the late 1960s. The change in the UK’s manufacturing sector was even more significant. Between the middle of 2008 and the end of 2009, capital spending by the manufacturing sector fell by around 30%.

Some examples:

Some examples of firms which cut back their capital expenditure:

BT plc aimed to cut capital spending by £100m in 2009, reducing its investment spending to £2.6bn. However, its capital spending cuts were dwarfed by BT’s objective to cut operating costs by £1bn p.a.

In January 2009, Starbucks announced that it was scaling back its global expansion plans. It estimated that the decison would cut its capital expenditure for 2009 by around $100m to $600m.

Wolseley, the UK plumbing and building materials group, was another major business which had to cut capital spending - and combine it with cost cutting. Wolseley cut capex to around £160m for 2009, around half the £317m it spent in 2008.

British Airways was another that cut capital spending in response to the slump in demand and mounting losses. BA cut spending by 20% to £580m in 2008, down from £725m in 2007, and lengthened its schedule of orders for 12 new Airbus A380 aircraft.

Cuts in firms’ capital spending had substantial knock-on effects on demand in industries and markets which rely on business investment. Perhaps the best example is IT, since a large proportion of capital spending is IT-related.

In August 2009, Fujitsu Services, the UK arm of of the Japanese technology company, announced plans to cut around 1,200 jobs, about 10 per cent of its workforce, in one of the largest rounds of redundancies in the IT industry in the recession. The job cuts come in spite of a range of cost-cutting measures introduced by Fujitsu, including a company-wide pay freeze, a reduction in the number of contractors and temporary workers and tighter control of capital expenditure.

The CBI Industrial Trends survey in February 2009 had a useful summary comment that focused on the strategy of minimising capital expenditure during the worst of the downturn. It concluded:

“Businesses have cut investment levels amid uncertainty over the future. Some firms have introduced capital spending freezes although most plan some limited capital expenditure, to cover essentials such as satisfying health and safety requirements or when paybacks were quick.”

Why cut business investment?

What reasons are behind the significant fall in business investment? There are two main issues which students should focus on:

(1) The need to conserve cash and improve cash flow

Cutting back on capital investment is an effective way of conserving cash in a downturn. Postponing or cancelling significant investment projects has an immediate positive effect on cash flow - and it is a decision which is in the control of management.

For many businesses this was an obvious and sensible decision - in the short-term. For example, manufacturing businesses found themselves with plenty of spare capacity - they could respond to any upturn in demand by making use of spare land, labour and capital resources.

The credit crunch was also a significant factor - particularly in the early stages of the downturn (mid 2007 to end 2008) - when firms found it harder to obtain bank finance for their capital expenditure programmes.

(2) Increased risk and lower returns from investment

The key factors here are the two C’s - confidence and capacity. Both are strongly linked to “demand”. Every major investment decision involves a commitment of funding and an estimate of the likely future revenues and costs. The recession dented confidence amongst management about future revenues, at a time when the operating costs of firms were also under pressure. In other words, the perceived risk of investing was higher - so less investment was made (in general).

The recession had a dramatic effect on investment by lowering business confidence on investment appraisal: expectations of lower demand or uncertain future revenues are likely to lower the expected returns from investment projects

The perceived higher risk of investing during the downturn led many businesses to increase their required return from investment (a higher discount rate for NPV calculations)