With the end of the year approaching, Stephen Boyle, head of Economics for RBS looks ahead to 2015.
“There’s always a “but”. If it had not been for one thing, I would have been confident that Scotland’s economy would continue growing at a decent lick in 2015. Incomes would rise and many more people would find work. In the rest of the UK, inflation would stay low and Bank Rate would likely remain at 0.5% throughout the year.
But. Since the middle of 2014 the price of oil has halved. While the waters around Scotland are rich in oil and gas ours’ is a costly province from which to extract black gold. Around three-quarters of the field developments that would have been likely to proceed in the next few years need an oil price of $60 or more to breakeven.
Offshore investment looks set to fall and that affects the onshore economy. There are 1,600 firms in the UK supply chain that supports the oil and gas sector. Of them, 800 are in Scotland and nearly 600 are in the Aberdeen area. The sector accounts for more than 3% of Scotland’s economy, making it bigger than all of our food and drink industries combined. Its linkages to other sectors means the impacts of weaker oil and gas activity will ripple through to others, with the transport, legal services and equipment leasing industries likely to be most affected.
A low oil price could also be bad news from the renewables sector. If gas prices fall, too, gas-powered electricity generation would make renewables less competitive and less attractive to investors.
If the price remains around $60 for several months more, it will have materially adverse impact on Scotland’s economy in 2015. Instead of growth just north of 2% next year, we might be looking at something closer to 1%. The industry has already responded to the low price: utilisation rates and prices for supply vessels and drilling units have fallen, while service companies have cut wages.
Meanwhile, the first tentative signs of the wider impacts have been seen in the housing market. Prices in Aberdeen fell by 0.5% in November and are down 1.1% over the last three months. In contrast, prices across other UK cities rose by 0.4% and 1.6%, respectively.
Where the oil price goes next is unpredictable. The fall has been the product of what are essentially small changes: a modest increase in supply and an even more modest slowing in demand growth. A reversal of either would see the price rise. What’s more, most oil producers need a markedly higher price to balance their public finances, providing an incentive next year to restrict supply.
There are winners as well as losers. A fall in the oil price is like a tax cut to oil consumers. For households, that means a boost in spending power because of lower inflation. For businesses in industries like transport, it means higher margins,
Had we not been confronted with the challenge of a low oil price Scotland would have faced the same external risks as the UK.
By far the greatest of these lies in the euro area. That it has largely been quiet on that front for two years reflects the European Central Bank’s success in convincing bond holders that it would do what it takes to preserve the euro. So successful has the policy been that the government of Spain can borrow money for ten years at 1.9%, less than the US.
While the ECB has kept the euro area’s problems at bay, it has not solved them. They are a combination of highly indebted governments, still-weak banks and low productivity economies. They need a solution that has three parts. First, a fiscal and political union in which all countries guarantee the debts of others. Second, a banking union that brings stability to the financial system. Finally, economic reforms are needed to boost productivity.
Europe’s leaders have taken only baby steps on this journey. With a fair wind, completing the job will take a decade. During that time, much of the euro area will be hobbled by austerity, constraining demand for UK exports. For us, that is the benign outcome. The adverse result is that while it heals, shocks push the euro area into financial crises and recessions, from which the UK cannot be immune.
Will we get through 2015 without another euro episode? Recent developments in Greece are hardly grounds for optimism. And the Russia-Ukraine conflict matters to the Scotland mainly because of its effects on core Europe.
China is the second risk. Much of its growth since the 1980s has been built on investment. Its capital stock is now so large that it needs a rise in domestic consumption not seen anywhere at any time fully to utilise it. If the capital will not all be used, it cannot generate the income its owners expected. This matters not least because much of the investment was funded by China’s banks. They need more capital to shoulder the losses that are coming. What’s more, I cannot find a country in which private credit has grown as fast as in China and not had a financial crisis.
China could be different. The state has the capacity to recapitalise the banks. That would probably mean a slowdown in credit and economic growth. Again, this would be the benign outcome for Scotland. While growth would slow, the impact on us would be modest. More worrying would be a stumble into bank failures and a financial crisis, with the resulting sharp slowdown in China materially affecting the Scotland, most likely through the impact on the EU. With UK banks’ exposure to China is up 300 per cent since 2008, weakness in China could be transmitted through the financial sector.
The final risk is domestic. An indecisive general election outcome could prompt concerns about the ability and willingness of the UK to tackle a debt and deficit that remain very high by peacetime standards.
Beyond the ups and downs of 2015, Scotland can take on Mission Possible. The only question is do we wish to accept it. Income per person in the best-performing advanced economies – Australia, Austria, Norway, Switzerland and the US – is £8,500 per year higher than here. Almost all the gap is down to their higher productivity.
Winning the prize needs commitment and action. These actions should be evidence-based. That evidence is clear. How to win the prize is easy to write if harder to achieve: invest in assets that will generate more income than the assets we have today.
If people are our greatest asset we know that skewing education investment towards our very youngest gives the highest return. Inadequate capital investment is a long-standing UK weakness. We should build on incentives encouraging firms to invest and break the planning logjam that obstructs many projects. With that done, we can prioritise the highest value for money public investments: generally smaller road projects, rather than large projects, trams or railways. Finally, we should continue to focus resources on the centres of research and development excellence in our universities. But the most important innovations are made day-by-day by people who spot what their suppliers and competitors are doing, using that to make their own operations more efficient. And that brings us full circle to investing in people.
Not everything takes taxpayers money. Government has an important role as a regulator, simplifying the planning regime and making sure markets are competitive. The power of competition is often under-estimated. It is one of the best ways of delivering investment in assets, although the scope for Scotland’s government to act is very limited.
Oil casts a long shadow over what would have been a good year for growth in Scotland. But whether the economy grows quickly or slowly in 2015 there is a greater opportunity. Will we grasp it?