UK: High hopes and low inflation.

UK: High hopes and low inflation. - Industrialists say how they would get to grips with a low inflation economy - a must if UK business is to prosper.

by Shirley Skeel.
Last Updated: 31 Aug 2010

Industrialists say how they would get to grips with a low inflation economy - a must if UK business is to prosper.

John Major's vision of zero inflation was, to no one's surprise, only a dream after all. And it may not be a bad thing: a little inflation helps to keep the nation's pocket money rolling in. The idea of a new era of low inflation is, however, still a very real possibility.

Our somewhat worse-for-wear Chancellor of the Exchequer insists that low inflation is still a priority and can be maintained by means of a tight rein on money supply and government spending. Even the ERM antagonist Sir Alan Walters, former adviser to Lady Thatcher, agrees. Margaret Thatcher did it from 1980 to 1986, he points out, stripping inflation from 20% to 3.5%, despite a sinking pound. There's no reason we can't do it again.

But sceptics predict the opposite, pointing to the impact of higher import prices now that sterling is down. But there is still a strong camp of economists who are predicting medium-term inflation of only 3% to 5% pa, although at the cost of high unemployment.

So what would this mean for the businessman? To answer this Management Today presented an imaginary scenario to a handful of top businessmen and economists to find out how they would think and act in a low-inflation economy. The scenario is that the pound has stabilised and recovery was under way. It also assumed low inflation elsewhere in the Western world, and increased competition as trade barriers come down.

Firstly, it is important to point out that two breeds of businessmen face enforced hibernation in the low inflation-world: the bluffer and the speculator. As Sears chairman Geoffrey Maitland Smith points out, while inflation rules, even a mediocre operator can appear to be making a good profit, as his sales and profits too are inflated. "But when you have low inflation your mistakes burn a hole in the boardroom table." One can also assume that financial backing for the incurable fumbler will go up in smoke too.

As for the speculator, his fodder is uncertainty and fluctuating prices. A more stable, low-inflation world would, says the CBI's chief economist, Professor Doug McWilliams, "create a sort of anti-Donald Trump society, where the man who plods along making things is more likely to prosper, whereas when prices zing and zap around the screen the one who makes money is the person who is cute enough to buy low and sell high."

For others the new scenario would be less dramatic in its impact, but still call for a serious rethink. For example, there is the relative attractiveness of equity or debt to finance a business. In the stable low inflation of our scenario taking on debt might be the more attractive option. But there are dangers for the unwary. Inflation will no longer eat away the size of the debt burden so quickly. Companies may remain apprehensive about debt after the experiences of the '80s. Alternatively, it is widely accepted that, as equity investors take on more risk than banks, they can expect a higher return.

As a result, debt tends to be cheaper than equity. Robin Biggam, chairman of the cable making and engineering company BICC, says, "Given a higher degree of certainty, a higher level of gearing becomes more acceptable because revenues are more secure." London School of Economics professor of financial management Michael Bromwich quite rightly points out that the choice will differ with the style of company: riskier firms will go for equity, for the simple reason that shareholders do not always have to be paid dividends, while interest, like death and taxes, is inevitable. Steady earners would do best to opt for debt. One of the big problems relating to this will be that of keeping the shareholders happy. The company's private and institutional owners may need a bit of boxing about the ears before it sinks in that a profit skinned of the fat of inflation may not look as healthy as it did in the '80s, but it would now more than ever be reflecting real growth. What appears to be sagging growth in sales and dividends - and for that matter wages - will need lucid explanation. Hopefully, the educational process will filter through the whole community, but managers may find they have to smarten up their communications and get shareholders, managers and staff all on the new track.

Another, and more serious, matter to be contended with will be the habits of the wage earner/consumer. The love affair with inflation will not be easy to end - a fact which may hit managers where it hurts most: at the profit margin. For while consumers are likely to remain price conscious in the '90s, it could still be difficult for employers to keep their labour costs down. Admittedly inflation is not going to stay down unless wages are held back, but individual employers could have problems. France found considerable resistance to wage restraint in the early years of its 10-year fight with inflation after entering the ERM. In the UK, high unemployment and weak unions will help but skilled employees, used to 8-10% wage increases, will take some convincing to be happy with 3% once the economy is healthier.

Pressure will also continue on the sales side throughout the '90s in our scenario, particularly in consumer industries. "Spending levels in the past in the UK have been fairly high and I don't assume that can go on forever," says McWilliams. For one thing, there would be the high unemployment and the new fear of debt to encourage consumers to save more and spend less. Savings are already near a 10-year high at 10.3% of disposable income. This could continue as it is only commonsense that lower inflation erodes savings less and drives up prices more slowly. People will prefer to put money in the bank. This restraint on consumers will flow through to other businesses.

There will also be another impact on cash flow. Without the inflation element in either the sales or the margin, the actual cash coming in the door will be less than we saw in inflationary times. The pile of pound notes left in the till after costs will grow at say 3-5%, rather than 7-10%. Although this money will buy more than it did in the past, the incentive to grow cash flow, so as to expand the business, will be greater than ever.

There will, thankfully, be an offsetting factor to this, as pointed out by both BICC's Robin Biggam and medical group Smith and Nephew's chairman, Eric Kinder. Without inflation there would also be a sizeable reduction in the cash payouts of tax and dividends - whereas often much of reported profit is not cash at all (paper gains on inventories, for example). The amount of cash tied up in working capital would also be reduced (eg inventories would cost less without the inflation element in them). Both of these factors would tend to increase cash flow.

But regardless of how the cash scales tip, what the manager will be up against is continuing pressure on margins from prudent consumers and expectant workers - not to mention the surge in competition that will come as the survivors of the recession worldwide put their skates on.

The answer for the manager is that he will have to be even better at some of the things he is trying to do now. "Businesses will have to get more productivity," emphasises McWilliams. "That means more technology, more skills, more knowledge and less high-cost, low productive labour. The scale of the pressure may be something firms are not used to."

One way in which this reform can be achieved is by a redirection of profits - away from high dividends and short-term returns, towards longer-term investment in capital equipment, R and D and skills. A cliched and evasive goal maybe but hopefully made easier in a stable economy where future costs can be calculated, and financial backers could be comforted with the thought of surer, if lower, returns.

"With a more certain world there would be more encouragement to invest in new capital and technology, and more incentive to improve labour productivity," affirms BICC's Biggam. Already Britain's productivity is rising: in the last year factory output per person rose by 4% and the gap with the Germans has narrowed. But the growth of Asia Pacific (at twice the rate of the West) and the emergence of China (predicted by the OECD to overtake the US as the world's biggest economy by 2015) means the pressure for competitiveness is only beginning.

The labour that UK industries will seek in the future will be the skilled workers - a situation which, in the light of expected skills shortages, will put an additional pressure on managers. "Companies have no choice on training and development," says Kinder. "People argue about the price of it, but the need is so great for specialised skills that companies have to work more closely with the educational establishments to ensure they produce a more and more effective workforce."

Another factor that is highlighted in our scenario is the polarisation of companies in terms of their size. In the '90s, the Asians and large Western low-cost producers will extend their hold on some of the more basic world markets like steel, textiles, food, electronics and household goods. UK managers will have two choices. They could opt for a more sophisticated and unique product for their customer. Or they could invest in their infrastructure and marketing, and spread thinner margins over a larger base.

Sears' Maitland Smith sees room for both options in his business. He expects retailers will indeed see slower growth in sales and less cash in their margins in the '90s. One route to follow, he says, would be to open more outlets - increasing sales and buying power. "The retailer has got so efficient and maximised his profits in existing stores so much, what can he do but open more outlets?" He expects the move to new technology and the employment of part-time staff will continue, and that retailers will seek out new areas of demand such as mail order, holiday planning and catering for the growing numbers of elderly people. Customer credit schemes would also be expanded to build up a valuable data base on buying habits. This boosts efficiency by matching stocks to customer needs, and provides an avenue for fresh marketing efforts. Maitland Smith also expects we will see fewer product lines on shelves as retailers concentrate on the better-selling items. "Stock turnover will be what matters."

Biggam, in cablemaking, construction and engineering, would heartily welcome the low inflation scenario. Stability would make both the costing of long-term contracts far easier, and encourage investment in new infrastructure. Some raw material costs - like the copper metal in his business - are totally transparent and could easily be passed on to customers. But Biggam expects other costs, such as wages, might be difficult to contain, necessitating an increase in productivity. "Markets are already pretty international so increasingly one is looking to the cheapest possible way of making product - through sourcing where labour is cheaper or by setting up bigger units that can supply three or four markets. If your 'more certain' world applied across Europe, it would speed up that process of cross-sourcing. And of course if there were lower labour costs in one market it would make that market fairly attractive."

Eric Kinder, maker of goods from orthopaedic implants to Nivea skin cream, says that a level of sophistication will have to be developed right down the production chain. Suppliers and producers will have to complement and support each other more than ever before, co-ordinating quality and delivery. He says more specialisation of non-commodity businesses will be called for, in order to reap higher margins. "The thrust behind ensuring a good strong company for the future, certainly in our business, is continuing sophistication of your total international infrastructure and a strong R and D. And that means effective R and D, not just how much you spend." He sees an ideal set-up for survival to be one of running a slower-growth but high cashflow business in tandem with a high-growth, capital-hungry business, thus ensuring both security and growth.

Both McWilliams and the LSE's Bromwich stress much the same points - the urgent need in an open-bordered, more stable-priced world for enhanced productivity, longer-term investment and the export of more imaginatively developed goods. Performance-related pay, they say, will be vital. "Short termism in the stock market," says Bromwich, "should be moderated because of the stable environment, so you may find shareholders are willing to think longer term as well, taking the pressure off businessmen." Investments will have to be angled more towards export markets, to broaden the customer base for more specialised goods. As McWilliams puts it, "Britain has only 1% of the world population and 5% of its GNP. It's not surprising that as the world shrinks many businessmen find they can't survive by doing business with just 1% of the population."

Should the low-inflation vision that has wooed business but defied politicians for so many years actually be realised in the '90s, it will be no dream run. Yes, planning will be easier and stability will encourage investment but consumers could be fussy spenders, skilled workers be demanding prima donnas, and our global competitors be happily reaping as many of the benefits of stability as Britain - some of them from a stronger base.

McWilliams predicts that some of Britain's high-labour, low-productivity industries will not survive a more highly competitive '90s. The UK could find itself increasingly feeding its population from the skills of its financiers, scientists, engineers and consultants. To achieve this successfully, without putting the country even more badly in debt, might take the kind of national re-think of investment and wages policy that has only come in the past in nations such as Germany and Japan.

France, since it locked itself into the ERM in 1979, has shown something of what can be done through purposeful restraint. Inflation there is under 3%, wage rises are averaging under 2%, its trade balance is in a healthy surplus and 2% GDP growth is predicted for the year. Admittedly the recession, as it takes grip there, may yet darken this picture.

The successful recipe we have seen at work elsewhere, involving greater co-operation of government, business and labour, undoubtedly calls for more action than the individual businessman alone can muster. But the change in thinking has to start somewhere. Bromwich, for one, says he is seriously concerned about whether today's British businessman has the will needed to pull the country winningly through the next two decades. "They carry on doing what they have done in the past. You have an enormous amount of short-termism in management as well as in the City - people solving today's problems and not getting around to tomorrow." This is the kind of attitude that will be exposed in the cold light of low inflation.

Kinder is probably more optimistic than his peers but even his picture is slightly overcast. He says, "A company will have no choice. Either it satisfies the characteristics underlying a good company or eventually it will go the way of all flesh."

Geoffrey Maitland Smith - Sears.

Although the stability of a low-inflation economy would be excellent for business, Sears Plc chairman Geoffrey Maitland Smith is in one industry that will need to muster all its talents to beat one after-effect of the recession - the consumer's reluctance to spend freely again. Maitland Smith expects this will endure, and is at the forefront of strategies to gain market share. New store openings - a practice that in low-inflation times is best done by leasing rather than purchase, as land will give poor returns - tops the agenda. But he is also fascinated by other options, particularly that of catering for the growing ageing population. "There is a tremendous window out there that retailers are starting to wake up to." Home shopping, holiday planning and the selling of garden tools are a few examples.

Doug McWilliams - CBI.

Professor Doug McWilliams, chief economist for the CBI, says it can be argued that low inflation discourages new investment because bricks and mortar lose their glossy returns. He counters, however, that the incentive to invest in machinery and technology is much enhanced. "Low inflation generally means lower personal spending, but that could be compensated for by higher business spending." The new atmosphere would allow longer-term thinking, an attitude Britain needs to adopt if it is to meet the fresh competition that will come in a revived world economy from the East. Europe, he says, will quickly have to become more efficient. Low inflation would expedite this.

Robin Biggam - BICC

Scottish sceptic Robin Biggam finds it hard to imagine low inflation lasting in Britain: "Like living through the '70s in Switzerland you mean?" he laughs. Were it achieved there would be no happier person than the chairman of cable-makers and engineers BICC. A steady economy would encourage governments and industry to invest in his services. He is wary though of shareholders' ready acceptance of the new order. "City expectations would have to change," he says. Looking to the experience of Japan and Germany, he believes the stock market would benefit from low inflation.

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