Finance and Constitution Committee

Meeting date: Wednesday, December 7, 2016

Official Report 475KB pdf

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Scottish Growth Forecasts

Item 3 is to take evidence from the EY ITEM Club on the Scottish growth estimates. I welcome to the meeting Mark Gregory, the chief economist; Dougie Adams, the senior economic adviser; and Duncan Whitehead, the head of economic advisory for Scotland.

Members have received copies of the growth forecasts along with a Scottish Parliament information centre paper on growth and forecasting. Before we move to questions from the committee, I invite Mr Gregory and Mr Adams to provide a brief overview of their work in the area. I can give you up to five minutes, if you want to take it.

Thank you for asking us to come in. EY sponsors economic research partly for our own interest and our business, and to facilitate the debate between business and Government on economic issues, so opportunities like this are very important to us.

I will give you the one-minute version. ITEM stands for independent Treasury economic model. When Margaret Thatcher was Prime Minister, she made public sector information available for the private sector to use. A set of businesses came together and formed ITEM to produce their own economic forecasts using the Treasury model. EY has been the sponsor for about the last 25 or so years—it used to be Midland Bank.

The process is that we have the Treasury model, now partly the OBR model, which we update. We then ask a set of businesses for input on what they see in the economy. EY provides the data and then Professor Peter Spencer, who is the senior adviser to the Item Club at the United Kingdom level, makes the final call on the assumptions that we use in that model. That produces a UK forecast.

For a decade now we have produced a Scottish forecast and the Irish economic eye forecast and, for the past 18 months, we have produced a UK regions and cities forecast, which includes six or seven Scottish cities and all the major cities in the UK. As we get into discussion with the committee, we can draw on some of that analysis to put Scotland in context. My role here is to provide information on the UK framework, but Dougie Adams and Duncan Whitehead are much closer to the Scottish data, so I will let Dougie talk to you about that.

It might be worth outlining how we do what we do. The current approach is to drive the UK results through an industrial sector model of the UK, then use that in the industry forecasts at a UK level to create employment forecasts at the Scottish level. We move them back up, using assumptions about productivity and trends in different industries, to the output figures and the gross domestic product figures that you can see. It is very much about industry-disaggregated forecasts, aggregate GDP and consumer expenditure. At the moment, we do not look at public revenues or public spending, but we feel that we will have to develop that in the longer term to meet the needs in Scotland.

Our latest forecast is downbeat compared to that for six months ago. There are a number of reasons for that, including the fact that global trade growth has continued to disappoint and that there are new domestic uncertainties about Brexit and how policy will evolve for trade across the Atlantic. The Scottish consumer has been very ebullient this year, but the savings ratio in Scotland is now almost alarmingly low. There is not much puff left in the consumer for next year, especially as employment is flat and employment activity rates have been falling. We therefore came up with a forecast of about 0.4 per cent for GDP growth next year. However, I stress that, in terms of economic forecasting, although the headlines are always about an individual number, in reality we are talking about directions of travel, and there are lots of uncertainties around how the details fall out. Perhaps economic models and forecasting are better as a basis for scenario work than for looking at individual point numbers.

Thank you for that useful overview, particularly on the top level and how you bore down into Scotland—I am grateful for that. On the uncertainty issue and the point estimates in your forecasts, are there economic factors or drivers that your forecasts are particularly sensitive to?

There are a number of them. One of the biggest uncertainties in the short term is business investment. Most economists feel that the uncertainty around Brexit is likely to stall investment spending until there is more clarity. The latest figures for the third quarter in the UK are not that bad, but they might be driven by decisions that were taken before the referendum. However, investment spending by businesses is a big uncertainty at the moment.

The latest OBR forecast for the UK, which came out in the autumn statement, has investment growing at more than 2 per cent, whereas ITEM thinks that investment at the UK level will probably fall by 1 per cent next year, so that is the range. If we look across the forecasts, we can see that variability at both the UK level and the Scotland level.

That is particularly relevant at the moment because for forecasts nine months ago, people were looking for business investment to be one of the most buoyant elements of demand in the economy. The big short-term uncertainty is therefore about business investment. In the slightly longer term, there is the uncertainty around trade. Are we in the single market? Are we in the customs union? What would trading under World Trade Organization rules and regulations look like?

Maybe that is not going to hit trade in the next 18 months to two years, but it might affect the amount of effort that companies put into developing particular markets and so on. With trade issues, we are looking out to 2018 and beyond for big uncertainties across the board.

In the longer term, labour supply issues are particularly important for Scotland. Scotland’s working-age population will fall by 0.2 or 0.3 per cent per annum as we get towards the end of the decade. We know that a number of sectors are very reliant on migrant labour. I believe that, in food processing, up to 30 per cent of the workforce is from the European Union. Labour supply is an issue for Scotland in the longer term.

I guess that another uncertainty, which looks back to business investment, is foreign direct investment and how attitudes to investing in Scotland or the rest of the UK will change because of Brexit.

Those are all big uncertainties and economic models are not really any good at sorting those out. Economic models are fine if we make some assumptions about how the uncertainties will play out because we can then develop scenarios, but if we do not know how they will play out, it will be pretty difficult to make confident forecasts.

The message that I take from that is that, at this stage, no matter who the forecaster is, there is a health warning on all forecasts because of the levels of uncertainty, as you describe them, and that we can look only at trends. Everyone is facing the same uncertainty in trying to define what will happen.

If we look at the Bank of England’s forecasts, it provides what it calls a fan chart, which shows the range of the probability of the outcomes, and the ranges are now wider than they have been for as long as they have been produced, for exactly that reason. It is always difficult, but it is probably more difficult now than it has been in living memory.

Businesses are facing exactly the same questions in their scenario planning. That helps to illustrate the difficulties of making investment decisions in the current environment but it does not mean that business investment stops. It just puts sand in the wheels.

How difficult will that make the Scottish Government’s job of trying to set its budget next week?

I will just add something on business investment. As Dougie Adams said, it is highly volatile. It is encouraging that the Scottish Government is producing statistics on business investment. That is a new bit of evidence that has come to the fore. At the end of the day, many of the macro models are a function of the quality of the data that goes into them and the thoughtfulness of the assumptions that are made. If we bring that evidence to bear, it helps to enrich the discussions about what the uncertainties are and what the fan might be.

You are right, convener. I think that it was after the autumn statement last year that the commentators described the OBR as finding £27 billion behind the sofa for the UK public finances, which it then lost, and £35 billion more by the time of the budget in March. The ranges of spread are very significant when things are so volatile.

Also, in Scotland, as you get more and more control of the fiscal agenda, you do not have the base to look back on. That probably makes it even harder than it is when a system has been established for longer.

I want to ask some questions about employment. I am interested that your analysis shows differential rates for men and women. In particular, it pinpoints that, since 2015, there has been a 35,000 drop in the number of women in the workforce. I would be interested to hear an explanation of that and how it is likely to pan out.

It is a mystery. If we think about the adverse forces that have hit the Scottish economy in the past 18 months with the oil price shock, we think of a lot of oil-related jobs being more male oriented.

The rise in the women’s pension age should encourage women to hang on in the labour market for longer, but the data on employment activity rates show that women are exiting the labour market to some extent. That said, female employment at an aggregate level is still very high compared with what it has been in history.

Why there was a very sharp rise to 2015 in that number and then quite a sharp fall-off is a big mystery at the moment. It could be a quirk in the statistics. I do not know whether it is, and I cannot offer members a reason for it.

10:45  

Is there anything to show that the fall-off is sharper in certain sectors?

I do not have the data on that but it is an interesting question. Local authority employment might be an issue, but I do not have any data to show that.

Okay. The table in paper 2 shows forecast employment growth by sector. The bar chart shows that employment in education is due to drop by around 5 per cent between 2016 and 2019. Can you confirm what the figure is and say how that would manifest itself?

We have education employment dropping from 203,000 in 2015 to 197,000 in 2017. The public sector numbers for employment are driven by what we see happening at a UK level and are not modulated for specific Scottish policies. What we see happening to spending levels at a UK level drives the Scottish forecast.

If the forecast is a drop in employment in the education sector, do you accept that it is linked to the decline in growth and that it presents a challenge in respect of yesterday’s programme for international student assessment statistics if we want improvements in areas such as science and maths? If we reduce employment in those areas, it is clear that there will be a challenge.

To link back to our initial remarks on productivity, there is no doubt that education is key for Scotland and every western country if we are going to drive productivity growth to drive up living standards. I would not make too much of those numbers, except in that they portray the profile of spending on education at an aggregate UK level.

It is implicit in the UK Government’s spending programme that public services will improve productivity. In effect, more will be done with less. That is one manifestation of doing that. That is clearly the challenge that is set out. If that productivity is not realised, there will potentially be the challenges that are being talked about.

Okay. Thank you.

Good morning. I will ask about your GDP forecasts for 2016. Am I right in saying that you have downgraded them three times? At the start of the year, you forecast 2.3 per cent growth in GDP. You revised that down to 1.8 per cent, then to 1.2 per cent and your figure is now 0.7 per cent. Is that right?

Yes, that is broadly correct. There is a whole range of influences. The world economy has not grown as robustly as most forecasters expected 18 months or so ago, and trade growth has been lower, which obviously has an effect on the UK economy and the Scottish economy. The lingering effects of the oil price fall on Scotland have perhaps been more severe than we expected.

Scotland has not done well in its trade performance. Exports to the rest of the UK have been growing much more slowly than the rest of the UK’s GDP. That is probably down to composition effects as much as anything, but we have not got much bang from that buck. There have been all those influences, as well as the uncertainties thrown up by Brexit.

I wanted to comment on the fact that there has been quite a substantial revision since the start of the year. We would have hoped that you were able to forecast what was coming, but the fact that you have had to make such substantial revisions downwards rather suggests that you missed what was likely to be coming down the track. I note that you are now forecasting GDP growth for 2016 as a whole at 0.7 per cent, but have we not already exceeded that in the first three quarters?

We have data only for the first two quarters. One of the issues when looking at GDP is whether you look at the annual average against the annual average or at the profile as it runs through the year, so perhaps you would compare GDP in the fourth quarter of this year against GDP in the fourth quarter of last year.

In the data that we have to the second quarter, we have seen that the economy in Scotland was gaining some momentum in that second quarter. We have no particular evidence for the third quarter yet, apart from some employment data that looks pretty flat. The headline figures are annual average against annual average, rather than final quarter against final quarter, so we have not exceeded the percentage that you mentioned.

You comment on page 13 of your 2017 forecast that

“Overall GDP grew by 0.7% in the year to the end of June”.

You seem to be saying that there will be virtually zero growth in the third and fourth quarters of 2016.

No, we had a good quarter of growth in the fourth quarter of last year. The figure you have just cited is Q2 2016 over Q2 2015, which is not the same as the annual average level against the annual average level.

But you are expecting very little growth to have come through in the second part of 2016.

Yes.

Compared with other forecasters, you seem to have a very pessimistic outlook. Why are you more pessimistic than others?

I do not think that we are more pessimistic than others who are looking at the Scottish economy. I guess that, at the ITEM level, we are more pessimistic than the OBR, but we are not miles away from what most private sector forecasters are saying, so I do not think that we are particularly pessimistic. Unfortunately, over the past seven or eight years, pessimism has tended to be the side to err on.

From memory, I think that in January we were forecasting 2.7 per cent GDP growth for the UK. We produced what I believe was the first forecast after the referendum, when our figure was 1.9 per cent, which was higher than the consensus among others who were publishing forecasts at that time. We are still at 1.9 per cent for 2016 for the UK as a whole, and I would guess from the data that it will be 1.9 to 2 per cent, so we will be pretty close. Our forecast may be below that of the OBR, but we are pretty much in the range in terms of the UK level, and we have some specific Scottish factors to take into account. One thing that we have certainly seen over the past year is that we and others underestimated the knock-on effects of oil. You can pick the oil sector as an example, but its impact on professional services and other sectors has been starker than we realised, and we are still trying to figure out exactly what the right adjustment is in that area.

I am looking at the page of your forecast entitled “Brexit and Scottish exports”, which states that, according to

“The HMRC dataset of regional trade statistics ... a smaller proportion of Scottish manufactured exports by value went to the EU in 2015 than is the case for the UK as a whole. The respective figures are 41% for Scotland compared with nearly 48% for the UK.”

I am interested in such figures because I am also a member of the Economy, Jobs and Fair Work Committee, which has heard from a number of expert witnesses recently. The issue of the quality and availability of data specific to Scotland has been raised time and again, and I am interested in your view on that.

Also, there has been a suggestion of what is called the Rotterdam effect—I see that you are familiar with that term. As it applies to the UK, exports from Scotland might go to the UK and be counted as having been exported into the UK, but actually be en route elsewhere. I would be interested to hear your comments on that.

I will start with exports and hand over to Dougie Adams to talk about Scotland. The quality of export data is a concern for everyone. Yesterday, the ONS revised all its trade data and, from memory, it took half a per cent off the current account deficit in June compared to what it was previously. The trade statistics from the ONS have actually not been quality assured in recent times, because it has been so worried about them. There is an overall collection issue.

There is also a question of services versus goods. We can physically identify goods to some extent, but services trade data is very problematic. The Organisation for Economic Co-operation and Development has done some work on that, but it is really not very good. When we then try to disaggregate that to regions or the devolved Administrations, we are into problems. We have some knowledge of goods, but not of services. However, as Ash Denham rightly said, many of those goods go to Rotterdam but we do not quite know where they went before that. There is a set of overall challenges in the export data that will be particularly problematic in future as we negotiate on trade; we may not even really know what our starting base is as a country or for Scotland specifically.

The data from the Her Majesty’s Revenue and Customs database, which is very detailed, gives us just one indicator in trying to work our way through what is a pretty murky picture. We have simply tried to line up areas in which Scotland has a high proportion of exports that appear to go to the EU with the tariffs that could be faced if we ended up in a World Trade Organization-type of Brexit. A lot of straw men are being built in doing that, but it is one of the few bits of evidence—I hesitate to say concrete evidence, but circumstantial evidence—that we have on Scottish exports to the EU by sector. Even within sectors, when we drill down to an even more disaggregated level, the tariffs that could be faced by different goods that come into the same aggregate sector—for example, chemicals—could be quite different.

We are talking about exports, but, on the other side of trade, imports will be a very important feature of the Brexit debate. To take Jaguar Land Rover as an example, I imagine that it runs a trade deficit with Europe—it gets a lot of its supplies from Europe—but that it runs a surplus with China, which is one of its major export markets. When we are really trying to understand the sensitivities in trade we have to understand supply chains. The import side is at least as important and I think that there is a set of challenges in trying to unpick that as well. It will be really challenging.

If that is a murky area—I think that that was the description—what do we need to do as a country to sort that? That information will obviously be hugely important for the future in understanding what is going on in either the UK or the Scottish economy. What needs to be done? What do Governments and organisations need to do to get that sorted?

We have statistical systems that are really quite good for industrial economies and it is easy to measure the number of pounds of smoked salmon that we produce or whatever. When it comes to services we have bigger problems. It has become a lot more difficult to measure what is going on and where, because of the way that supply chains now work round the world.

Then there is the trade-off that is always there between the thirst for better data that would allow us to understand more things and the cost burdens that that would put on businesses that are already pressed with everything else that they have to do. There may be big data—electronic filing of tax returns every quarter and things like that—that will begin to help cut that Gordian knot, but it is a difficult problem.

11:00  

This is not an advertisement for EY, but we have just published a report for Groupe Eurotunnel that looked at the traffic through the Channel tunnel, for which we surveyed 200 of its customers. Although Eurotunnel understands its customers, it was not really sure of the exact details. It is a public report, and we presented it to a group of members of Parliament in the House of Commons. There are some interesting things in it. The West Midlands are the main origin of and destination for things that pass through the Channel tunnel, and it turns out that that is to do with parts for the car industry, which operates on two-hour supply chains—in effect, if there is not a delivery every two hours, people in factories are not working. The second-largest category is courier parcels, which is to do with online shopping and businesses that offer delivery within a day, for which the tunnel is very important.

One thing that you could think about in the short term—although it is only a partial solution—is sampling at Scottish ports and airports. That would help you, as you form your view on Brexit and the trade negotiations, to get at least some picture of where the sensitivities are in Scotland. Our experience is that the operators of ports, airports and so on have quite detailed knowledge of those operations and some of the challenges. You might think about that.

It is worth pointing out that, in the same piece of work, we picked up on the movement of fresh produce from Scotland to the continent—the Channel tunnel is a vital link for that.

On that very note, I represent the Highlands and Islands, where we have a strong tourism sector and a strong food and drink sector, as you have mentioned. I am interested in the concerns around the free movement of people. When I visited Shetland a couple of weeks ago, I heard anecdotal evidence that, in fish processing plants there, more than half of the staff are European Union nationals. Shetland has low unemployment rates, so there are no local people looking for jobs. What would be the impact of a very hard Brexit with no free movement of people on sectors such as food and drink and tourism, which have a huge number of EU nationals working in them?

It is obviously a huge challenge. Paradoxically, we might find that there is more investment in kit that does stuff, rather than people, but there are clearly huge limits to that, particularly in the tourism industry. There would be an impact on costs, because businesses would be trying to bring in people from the rest of the UK or other parts of Scotland, and I guess that we would then get into housing issues in the Highlands. I suspect that one big effect would be that, as we have seen in the US, we would get a lot more illegal migration as people try to find ways to solve their particular business problems and take risks.

There is also concern about more complicated effects rather than just the effects relating to the free movement of people. There is the issue of currency. Last year, we had a strong year for tourism in the Highlands and Islands, probably because of the crash in sterling. Obviously, there are other impacts. What are your thoughts on how that will pan out in future?

Next year should be even better for tourism, because most models of tourism flows suggest that, although there is some immediate effect from a currency depreciation, the big effects take time to come through, particularly for far-travelled tourists. Tourism ought to be a bright spot through next year. At the same time, the other side of the depreciation, which we have not talked about, is likely to start rearing its head as we go into 2017—that is, increasing prices. Because the depreciation is so large, I do not think that that will have a particular impact on the tourism sector.

The exchange rate could be as significant as Brexit in terms of what happens in the UK economy. We have had a significant devaluation. There is an argument that the UK’s current account was such that that devaluation was probably going to come at some time and Brexit may have hastened that push.

In our survey of UK clients, 67 per cent thought that sterling would return to pre-referendum levels within two years, although I would say that that looks optimistic, certainly against the dollar.

However, to come back to the point made by you and Dougie Adams, I think that, although we are seeing the short-term benefit of lower prices, the question is not only whether businesses will move to allocate capital to that export opportunity, which could drive productivity and growth, but how they will look at the import side of things, where costs are going to rise. For example, will people try to substitute some of the imports that we currently get? The UK has been a great offshorer of activity—will some of that come back? There could be an opportunity wrapped up in that. Labour is obviously a different area, but it would be interesting to see whether businesses respond to that.

This is why business investment, although uncertain, is so critical. Now would be the opportunity to invest in exchange rate-related export and import opportunities, but if businesses do not see the exchange rate shift as permanent, that investment will clearly not happen for a while. The dynamic in that respect will be interesting.

Thinking even further ahead to how the whole Brexit negotiation might pan out, I wonder whether, in relation to free movement of people, there will be an issue with visitors coming to the UK. Obviously, the area that I represent is pretty concerned that Europeans might need visas to visit us in the Highlands and Islands.

Moreover, what sort of trade tariffs might be imposed on the export of food and drink? After all, whisky and salmon are among Scotland’s biggest export products. Can you give me some thoughts on that?

Unfortunately, it is all very speculative, because there are so many moving parts. With regard to food and drink, if we start to sign trade deals with other countries, there might well be an opportunity for more imports in some categories. The EU customs union, to some extent, protects food and drink produced within the EU, with some of the highest external tariffs being imposed on dairy and other such products. You are right to highlight risks with regard to people and tariffs, but there are also risks on the non-tariff side in relation to the ability to export, get customs clearance quickly and prove the origin of the goods involved.

One would imagine that, in the worst case, the impact would be negative. Equally, though, the recent signalling suggests that all options are in play, and one might try to mitigate things. The range is almost as we saw it at about the time of the referendum, when our profession took a bit of stick; however, the general view amongst, I think, 80 per cent of economists was that, with restricted trade and migration, the net result would be lower GDP in the long run. There is everything to play for, but there are definite risks out there.

I want to change focus a little bit from the least densely populated part of Scotland to the most densely populated part and ask a few questions about the very helpful if slightly depressing analysis of the city focus at the end of your report, in particular with regard to Glasgow. It is not only the city that I represent, but the first city in Scotland to have a city deal, and I want to ask you about a couple of remarks that you have made in that context.

In your report, you say:

“Glasgow has experienced a 0.1% increase in employment ... lagging behind both Scotland and the UK”

as a whole. Indeed, you also say:

“Over the period 2016-2019, employment in Glasgow is likely to remain ... flat.”

Signed a couple of years ago, the Glasgow city deal was the first in Scotland. At that time, it was the richest anywhere in the UK and worth more than £1.1 billion to the local economy. Its purpose was to boost jobs in Glasgow—by which I mean not just the city but the Glasgow and Clyde Valley region—and something like 28,000 jobs were supposed to be generated as a direct result. Given that your forecast for jobs growth is so flat and disappointing over the period in which the Glasgow city deal is in operation, are we to read the paragraphs in your report on Glasgow as a reflection of the deal’s failure?

To put it into context, the Glasgow city deal was created at a time when macroeconomic conditions were expected to be more favourable. On the employment outlook across the UK, we think that only London and the south-east will see employment creation in the next three years and that employment will fall reasonably significantly in most parts of the UK, even in the north-west and Yorkshire, which is talked about as the northern powerhouse. We have to look at employment from now going forward in terms of that macro-environment. It would probably be too big a step to challenge the benefits of the Glasgow city deal, given that the employment profile now is different from what we thought it would be. There is still growth in Glasgow in services such as professional services, but public sector spending is continuing to be squeezed. That will bring more job losses, and it is about mitigating some of that. The macro context therefore makes it hard now to evaluate the plan as was against the forecast.

I am not extremely familiar with the detail of the programme and project-level activities of the Glasgow city deal, but it is over a 10-year period.

Indeed.

Those programmes and projects should suit the macroeconomic and local economic environments that they are facing. We would still hope that an injection of additional investment would be supportive. Obviously, within the context of what is happening in the broader economy, there might be job losses elsewhere for other reasons, which is kind of netting it out.

Yes. One would indeed hope as you said, but against what kind of criteria should we now measure the realism of that hope? As you have just said, the macroeconomic circumstances now are different from those when the Glasgow city deal was signed. Furthermore, we are talking about not only the Glasgow city deal but the growth of city deals throughout Scotland. I think that every city in Scotland is to have a city deal, but we are now also talking about growth for areas outside the cities. How will we measure the success or otherwise of the city deals and growth deals if the measurement criteria are different from those that were assumed when the Glasgow city deal was signed two years ago?

We have been talking with the Scottish cities alliance about how performance in that regard might be benchmarked. However, to put the Glasgow city deal into the context of UK cities and regions, London grew on average at 3.4 per cent a year over the past three years, but we now forecast that it will grow at 1.9 per cent. You can see from that that the macro effect hits everyone. The stronger that a city or region is, the more resilient it will remain in the short term. The sector mix and the prospects for those sectors in the short term are big drivers for the short-term outlook for cities.

We have to use some kind of benchmarking to measure performance. For example, Manchester has been outperforming other cities in its region, and it is way further down the line in terms of its city deal. However, if we looked at Manchester’s growth against what it was and against its peers, we could derive some ratios as to what the growth effect looks to be relative to the investment; and we could then look at the Scottish city deals in that context.

Our discussions with the Scottish cities alliance have involved looking not just at the Scottish cities relative to each other but at where policy has made a difference. The positive that I would take is that Manchester is outperforming, which suggests to me that there is an opportunity to do something across all the cities and regions through a devolution agenda. However, that would take time and we need to understand the dynamics in terms of drivers—for example, how important infrastructure and skills would be for that and over what time period would we see a difference. My suggestion is therefore to think about benchmarking Scottish city deals against city deals elsewhere in the UK that are now public and starting to develop.

The other consideration is the sector make-up of a city. Some cities are forecast to do quite well over the coming years—for example, Reading—because they are very weighted towards professional services, IT and the scientific sectors. Those sectors are forecast to do quite well across the UK. It is important to look at each individual opportunity and see what the sector make-up is and how the macroeconomic environment is affecting performance at the sector level.

That is a good point. Scotland performed strongly in our UK attractiveness survey last year, but what was most noticeable was that both Glasgow and Edinburgh performed very strongly in terms of attracting foreign direct investment into what I would call the digital and knowledge industries. Another dimension of benchmarking is therefore assessing whether a city has the sectors where growth and opportunity seem highest, and trying to challenge that situation as well.

We ought to think about not just growth but the quality of growth and whether it is creating a long-term platform. With its universities, Scotland seems to be in a good position in that respect, but the city deals need to unlock that potential.

Thank you very much—that was very helpful.

11:15  

Good morning. I would like to follow up on James Kelly’s questions on employment by sector. I also have a question on forecasting more generally.

I was a wee bit surprised by the reaction that the impact on gender inequality in employment was “a mystery”, even in the context of what has happened in the oil and gas industry. It is true that there are certain high-value parts of that industry that employ more men than women, but we have heard consistently that it is the induced employment in the wider economy that is particularly vulnerable. It seems to me that that effect should have been expected.

The forecasts by sector suggest that the accommodation and food services sector will be the third-biggest growth area and that areas such as education and health and social care—in which women are more likely to be employed in the public sector at a higher pay rate than they would get for equivalent work in the private sector—will be among the hardest hit. Growth is predicted in low-paid jobs such as those in the accommodation and food services sector. If we look at that picture as a whole, are we not likely to find increasingly stark inequalities, not just of gender but of income, in the Scottish economy? Should that not be the principal driver of Scottish Government policy, now that, in addition to wanting to achieve a social objective in reducing those inequalities, it is particularly reliant on income tax revenues?

The public sector effects that you talk about are well documented and have been going on for a long time, yet female employment rates and the aggregate number of women with jobs in Scotland grew strongly until 2015, so maybe the oil situation is having a bigger effect on women than we are assuming. However, that does not quite feel right.

We are living in a world in which we face a major challenge on the equality agenda. Technology is disrupting numerous sectors that had good jobs in the past, with the result that they will have fewer jobs in the future, albeit that they might be higher-paid jobs. How we distribute the gains from technology and, to a lesser extent, globalisation among the population is a well-recognised problem across the west, which Scotland shares with everyone else. I do not think that there are any easy answers to it.

Do the witnesses have any other comments? I think that Mark Gregory mentioned reductions in employment in education and health and social care in the context of productivity. It seems slightly bizarre to use the same definition of productivity in those areas because, there, the same throughput with a lower labour input is not an increase in productivity but a reduction in the quality of service and in what is being sought.

Yes. I was describing the implied mathematical relationship, which is that we are going to do more with less.

Does it not result in doing less with less?

There is a debate about productivity more generally. Increasingly, we define productivity in terms of the cost side of the relationship, whereas the value side of the relationship might prove to be more important.

I can illustrate that. One of my clients is a financial service company, and it found out that its sales force was spending 11 per cent of its time selling. Yes, it had to do a lot of compliance work, but the company had outsourced its IT, finance and human resources, so the people who theoretically were there to create value were spending a lot of their time on activities that reduced overall costs but were not necessarily maximising their resources. I think that we should be switching the productivity debate to a debate about where we can create value, which might sometimes mean spending more money in the short term because we are trying to get a different output.

I agree with you that, when we look at productivity, we must be careful to ensure that we understand what benefit we are trying to get and what the multiplier benefit of that might be. If we found that we would get better outcomes if we spent more on education or health, that might boost productivity at the macro level over time because we would have healthier people who were able to work more or better educated people who, one assumes, would produce more value. That debate is not in the paper, but that is where the productivity debate should be.

Stepping back a bit, we talk about equality and the inclusiveness agenda but, when growth is weakening, it becomes more challenging to achieve that. You can see that on a regional basis in the EY ITEM Club regional report, where we see the impact of slower growth across the UK propagating itself across the regions. Some regions are more affected than others, and the regions that are showing the least growth are those that were doing least well before any of the recent revisions. That kind of challenge has now become even more of a challenge, given the change in the macroeconomic context.

We are going to have to work harder. The tougher the economy gets, the more we need to do to rebalance the economy or to address inequality—more than we need to do in a growing economy, when we have a bit more resource to move around.

There is another inequality paradox. It has long been the case that highly paid people are paid more to make them work harder while low-paid people are paid less to make them work harder.

I have a more general question about forecasting and how you do what you do. It is sometimes said that nobody predicted the financial crash. However, it is probably fairer to say that nobody using mainstream, dominant economic theory predicted the financial crash. A decade or so ago, people who were using less fashionable economic models got the timing, the causes and the extent of the financial crash right. What have you done since then to bring in a broader range of viewpoints and economic approaches to ensure that we have a fuller range of understandings of the way in which the economic discipline can be used to tell us something about where we are?

Dougie Adams told me this morning that he predicted the crash. I am going to check his report on that, because he did not sell any of his share portfolios.

There is certainly a weakness in macroeconomic models in their treatment of the financial sector and the vulnerabilities there. Models have tried to take more account of the financial sector. However, given the way in which these events come along, I suspect that we should be looking not to the last crisis but to the next one.

There is a new block in the model for the financial sector and its influence through the economy, credit spread and stuff like that, which was not there before. There has been some attempt to fix that particular issue with macroeconomic models. Nevertheless, as you say, there is a lively debate about macroeconomics having never seemed to be a settled discipline.

I often hear it argued that there is not a lively enough debate about macroeconomics.

You are not reading the right blogs.

I would appreciate any links.

A case that is made is that the discipline involves—perhaps as some other academic disciplines do—people having to talk the same language to one another, reinforcing the dominance of a centrist approach, rather than exploring other economic models that have become unfashionable but that can prove useful. Is that a fair criticism?

It is a fair criticism to some extent. The profession got somewhat isolated and a little bit hung up on the mathematical solution to almost every problem, whereas we are trying to forecast how 65 million UK consumers will behave in their individual decisions and you would imagine that sociology and other disciplines might be able to inform that forecast to some extent. The problem is to try to represent that in a model that works at an aggregate level. As Dougie Adams said, those models give you indications of directions of travel, but I am not sure that they pick break points in the trend. If there is a weakness it is that if there is a shock that is outside the bounds, it is almost certain that we will not have captured it correctly.

I want to clarify something in relation to Patrick Harvie’s early line of questioning on education and employment in education. In relation to the table on sectoral outlook before us, you said that the public sector spend was not modulated for the Scottish situation. Can you clarify that?

I meant what might be in next week’s budget, for example.

So are you saying that that table reflects the spending situation at Westminster level and we cannot draw many conclusions on the Scottish situation from it?

Yes.

Thank you. I just wanted to be clear on that.

Your report highlights a number of concerns surrounding the recent performance of the Scottish economy. Pages 17 to 19 highlight concerns such as falling international exports, flat GDP, rising economic inactivity and low job creation rates. Can you explain to us, as far as possible, whether those are caused by long-term structural issues with the Scottish economy or by shorter-term changes in commodity prices, such as oil and chemicals? From a policy perspective, we can try to address some of the structural issues, but we do not have a lot of control over the price of oil or chemicals.

I probably said in a rather cack-handed way that the export performance was partly driven by compositional effects—we know the problems faced by the metals sector over the last year and the price pressures on the chemical sector. Many of the particular issues are short term and cyclical, and some of them will be helped greatly by the depreciation of sterling. No doubt there are other structural issues at work in the make-up of the Scottish economy. However, structurally, the Scottish economy is now much less vulnerable than it was 30 or 40 years ago, when it was heavily dominated by capital goods production.

You mentioned the increasing divergence between the performance of the Scottish economy and that of the rest of the UK. Can you talk us through the main drivers of that divergence, which seems to be increasing to some extent?

One big driver is population; our population is growing and is much bigger than we expected it to be 10 years ago, but it is not growing as fast as that of the rest of the UK, particularly the southern part of England. That has an immediate knock-on to GDP growth. Our aggregate rate of productivity growth seems to be a bit lower than the average for the UK as a whole, but that probably comes down to sector composition and the very fast productivity growth in some sectors in London, which is a unique situation. Those are the two main reasons.

The public sector is a slightly bigger weight on the Scottish economy and we know the pressures that it has been under, so that would be another contributor to that gap. In the short term there have also been the commodity and oil price effects.

11:30  

Fifty per cent of all the exports from Scotland come from 50 companies. On page 17 of your report, you highlight a decline in international exports. Have you seen compelling reports or research on why that is the case? Is there a structural issue in the Scottish economy that prevents more companies from exporting? Is there a cultural issue?

Exporting is difficult; it is not an easy thing to do. For a medium-sized company, it is a big commitment of resource, with uncertain pay-off. Some of the models of trade and exporting that have proved fruitful in recent years have focused on the quotient of the leading sectoral companies in the economy. There might be quite a large number of companies in a given sector, but only the leaders are likely to be exporting. There is a compositional effect at the industry level.

There are lifestyle businesses—I am not saying that people want to work only one day a week, but if a business does not want to take many risks and can make a good return for its owners and employees, taking the step to exporting can be a big risk.

We have made the point to UK Trade and Investment, as it used to be—it is now the Department for International Trade—that we often focus on exports when we should look at trade, by which I mean the links to foreign direct investment and the bilateral relationships that evolve over time.

Germany is an exemplar in that regard. Its trade with China is very much two way, and over time there is leverage from such relationships. I am not familiar with the Scottish level, but at UK level we have not often linked pieces of trade. If a Scottish company makes an investment in a European country, over time it is likely to build relationships and create soft power, so that the company’s exports and investments become linked in a different way. The issue will be increasingly important for all of us if the Brexit process continues as it is doing and Scotland thinks about its role as a trading nation.

If two thirds of world growth is coming from emerging markets, does that mean that, over the short, medium and longer term, more of our exports will go to such markets?

Yes and no. Opportunities are there, but it will partly depend on what we produce and where the opportunity is. What we have seen, particularly in our foreign direct investment, is that North America remains an attractive market for Scottish producers—and the FDI is coming in, too. Yes, there will be faster-growing markets, but there will still be a balance and what we produce might well play more in other markets.

This relates to Dean Lockhart’s questions. You said that only in London and the south-east is employment forecast to grow. It strikes me that the relative tax take issue in the fiscal framework that was agreed between the UK and Scottish Governments therefore becomes significant for us. If that was a factor in the forecasts, there are risks for the Scottish economy.

Both Governments are responsible for the area. What could they do to help the Scottish budget in those circumstances? You might not be able to answer that today. It will be important in future for Scotland to understand what both Governments can do to begin to impact on the tax-take issue.

It is interesting to observe that in the autumn statement and the accompanying OBR report, the anticipated take from income tax at UK level has fallen. That is happening at UK level. If you are looking at income tax as a way of collecting funds in Scotland, that is obviously something to keep an eye on.

Any suggestions that you can give us on how we might address that would be helpful. I saw an interesting article in the Financial Times last week, which said that there has been a 25 per cent increase in the number of corporations, as people try to avoid paying income tax. There are significant dangers in that for the Scottish economy, because we have no control over that area. I simply make that comment.

We have talked about export data, but employment data is also problematic and we do not really understand the self-employed economy and what people earn and how they contribute to the tax system. All our labour data is largely sample based, and at the UK level the samples become very small relative to the increasing number of people who are self-employed. Therefore, when thinking about employment or income taxes, for example, that becomes quite a significant issue.

The interesting point is that if tax were to be changed here, that might reduce the tax take and improve the Treasury’s position, which would be a bit perverse. Understanding all the issues is going to be important.

First, I would like to ask for some comparisons between the Scottish and Irish economies. Mark Gregory, who is EY’s chief economist covering the UK and Ireland, mentioned forecasts in his opening remarks. According to the forecasts in his paper, GDP growth is about 0.4 per cent for Scotland and about 0.8 per cent for the UK, but the Republic of Ireland’s growth is about 3.6 per cent, which is nine times higher than the rate in Scotland. Ireland has come from a particularly difficult place, given the banking crisis and depopulation. It does not have the strength that Scotland’s economy has in food and drink, life sciences and financial services, so why would its growth forecast be so much higher than Scotland’s growth forecast?

You are right. Whenever we produce our forecasts for the Republic of Ireland—yesterday, I was reading our latest one in draft—we have to start from strange numbers. Ireland was getting up to a reported 26 per cent growth in GDP earlier this year. That was driven by various classifications of leasing companies and some tax inversions, but Ireland is growing at a healthy rate—last year, it might have grown in real terms by about five or six per cent, which is some of the bounce-back from those things.

Ireland has been successful at developing its tech sector and its attractiveness to tech and life sciences. That is not always about its domestic capability, but it has been able to get inward investment from the US tech sector. You can look at the west coast for examples of that. That success slightly distorts the numbers, because a lot of products come in that contribute to GDP even though they leave without necessarily having a massive Irish input.

Ireland has also restructured its economy since the financial crisis. Companies cut nominal wages—they did not just stop giving people wage rises; they took cost out of the labour supply, and the competitiveness is now coming back. We might also see people hedging their options on whether they have operations in Ireland versus the UK mainland, given that one will be in the European Union in the long run and one will not.

Ireland has a competitive exchange rate and its aggressive use of tax policy in that regard is well documented. It has also been successful at targeting certain sectors with FDI, which has provided a boost to the economy. There are still challenges with the banking sector that have to be worked out over time; that is probably also the case for property. However, in the past few years, Ireland has worked hard at trying to change the nature of its economy.

Let us look forward to a potential Brexit impact on Ireland. We are its biggest import destination. We might be looking at a situation in which, in 2019, the UK is outwith the European Union, but Ireland is still forecasting healthy significant growth rates. Why is there that huge differential between Ireland and Scotland?

That is partly because people might not yet be baking into those forecasts the Brexit impact in the same way that we are assuming that the base case position will be, if not the cake-and-eat-it model, to have a reasonably smooth transition, which is only one of a range of possible scenarios. That is probably the most significant factor in that at this point.

Forecasts for Ireland beyond 2019, as they are for the UK, are even more speculative than normal in that context.

Thank you for coming to talk to us today. I want to discuss exports and Brexit. However, will you first clarify a point for me? In answer to Ash Denham’s question, you talked about export statistics. If I heard you right, you said that there is uncertainty about the statistics. In particular, if we are trying to understand whether Scotland’s exports go to rUK, Europe or the rest of the world, is it the case that there is considerable uncertainty about what those numbers actually are?

Yes.

Looking through the report, we are talking about a WTO rate on beverages, for example, of 20.7 per cent, which could hit Scottish whisky exports. The WTO is talked about as our option. Is it true to say that the UK’s situation vis-à-vis the WTO at the moment is that the deals that the UK has with non-EU countries through the WTO are, in effect, by virtue of its membership of the EU?

Yes.

So anything that is in place at the moment between the UK and a non-EU country would, in effect, have to be started from scratch again—we would be back at square 1.

I saw Government ministers—or maybe it was experts—saying yesterday in a select committee that, should the UK take the WTO option, we would try to grandfather the relationship. We would take what we have now as our WTO tariff schedule through the EU and move that over. The challenge is less on tariffs than it is on quotas. Often, there is a set of quotas that sit with those tariffs, and we will have to agree with the EU how to divide those quotas. That is probably the more challenging piece of that process.

Yes, but that is a big assumption. That is not the way that business is normally done.

As I understand it—as I was saying to Duncan Whitehead earlier, with trade, the more you understand it, the more you do not understand it if you are someone who has not spent their career doing that—that process will be subject to a challenge by any WTO member, and there are 160 or so members. There is clearly scope for someone who will see an arbitrage opportunity, so there is a definitely a risk there.

On a separate issue with regard to exports, the report quotes some balance of payments current account numbers. The UK is at about -5 per cent of GDP on its current account, give or take a bit. My understanding is that Scotland has a positive balance of payments on its current account. Is that correct?

It is hard to know.

Is that because of what we talked about earlier?

Yes, it is very hard to know. The trade stats in the national accounts are as good as anybody can produce, but other things that affect the current account position, such as flows of profit payments and interest payments, are difficult to get a handle on, so it is difficult to know. I have seen some attempts at putting some numbers together, but—

We might assume—given our offshore exports, our food and drink and whisky exports, and the activities of our financial services sector and a whole bunch of other sectors—that our balance of payments would be positive. Are you saying that there is nothing hard and fast there?

There is nothing hard and fast. We have seen much faster import growth than export growth over the past year, and the fact that rUK companies and foreign companies that operate in Scotland repatriate profits and pay interest and dividends affects the current account. It is not just about trade; it is about other flows.

The ONS put out a paper last week that shows that, since 2011, the UK current account has gone from, let us say, -3 to -6 per cent of GDP, and most of that decline is due to a fall in the return on investment overseas. I think that our return on capital has gone from around 8 per cent to 5 per cent on that. Potentially, Scotland is disproportionately exposed to that because it has had a strong financial sector; there is a good chance that Scotland has a disproportionate share of Britain’s overseas investment.

Okay. My last question is a hard one.

Not like the others, then.

They were just a warm-up. The report is clearly written in the context of Brexit and where we are today, six months after the vote. Let us ignore how the process might happen, but if we woke up tomorrow, Brexit was off and you revised the numbers, how much better would they be?

Good question.

It is a good question. We have talked about the uncertainties around business investment, trade and foreign direct investment. If those uncertainties were X-ed out, I think we would see numbers that were quite a bit better.

11:45  

At the UK level, I think that we started the year at 2.7 per cent and are now at 1.9 per cent. Some of that decline was probably because the economy was slowing in the run-up to Brexit, and we will not get that back. That probably accounted for 20 per cent of the 1.9 per cent, so we might have been at 2.3 per cent for the UK. I do not know whether we can read that across to Scotland, but it feels as if that is the kind of slowdown that we have seen.

It is hard to call, because—to return to Patrick Harvie’s point—we are trying to forecast people’s intentions and how they will react to an uncertain environment. That is why it is so difficult. People are not necessarily behaving as we think they should be.

Sure, but if that uncertainty were lifted—

There is actually a harder question than even that one. Usually when an economy is hit by a shock, there are bad effects, but over time it adjusts and catches up a lot of the damage. The issue now is what the long-term effects of Brexit will be. How will it affect our labour supply, our investment spend and so on? You can make arguments on both sides.

The bigger question is what the impact is on the UK’s and Scotland’s economic potential. Our economic potential has a big impact on what we will raise in taxes and have available to devote to the good things that we all want.

The other interesting thing in the Scottish context, as we were discussing earlier, is that the savings ratio is as low as it has ever been in Scotland. Normally, in times of uncertainty, the savings ratio goes up. People have been forecasting a slowing of the economy across the UK partly because it was thought that consumers would start saving more but, in fact, they have continued to spend. Scotland is at the extreme end of that. Maybe there is less of an upside in the sense that Scottish consumers seem to be ignoring Brexit at this point, or they think that the rainy day is going to be so wet that they are going to spend now, before it happens. That is why trying to flip that can be quite hard.

I wonder whether there are other issues. The current account deficit has been exposed through the Brexit process so far. If Brexit were off, would that issue go away? I think that it would still be there. I do not think that everything would reverse.

Thank you.

I want to ask about exports and productivity and the forecasting in relation to Scottish Government targets. In 2014, the Scottish Government said that it wanted to increase the value of Scottish exports by 50 per cent by 2017. A target was a ranking in the top quartile for productivity against key OECD trading partners by 2017. Obviously, 2017 is not that far away now. How close will we be to hitting those targets? Also, notwithstanding everything that you have said about Brexit, would it be fair to say that those targets were challenging even before Brexit?

They are challenging targets. One of the issues with a target that is put in value terms is that an industry can be doing quite well in terms of production volume, but if prices are crashing through the floor, as they have been in some industries, it is not possible to get the value up. People are selling plenty but not getting much for it.

On the productivity issue, we have had in Scotland, as in the rest of the UK, a long period in which aggregate productivity has not grown by much at all. That might be because we have made different choices. France and Germany, which are major economies in the OECD, are often held up as examples of economies with high productivity. France has high productivity, but it also has very high unemployment. We have a different mix. Growing productivity fast has lots of good effects, but it can also have negative effects for some people.

At the UK level, George Osborne set the target of £1 trillion of exports by 2020. If we look at the ITEM forecasts, we think that the UK might get to £700 billion of exports with the exchange rate boost by that time, so that target is some way off. We have done several special ITEM Club reports on exports, and the conclusion—which is not particularly startling—is that you need to sell things that the fastest-growing markets want to buy in order to really improve your export performance.

We have talked about helping exporters to access markets, but there needs to be much more investment on the supply side of the economy. Investment is needed in the infrastructure, to enable exporting, and in skills, to enable us to push into the right sectors. I am not sure that the UK as a whole has ever had an integrated plan to make that happen. Those targets will always be challenging unless there is much more push behind them.

Thank you very much for coming along today. It has been a fascinating session and I have learned a lot from the process. We have HMRC coming next week, so your responses today have probably teed up quite a few questions for us.

Oh! Good luck with that!

Thank you. I close the meeting.

Meeting closed at 11:50.