Exporters to stay under the cosh

Pre-Budget special: expectation and frustration. What businessmen want from the Chancellor; Tuesday is not likely to bring manufacturers any relief from the strong pound. Andrew Atkinson looks at the strategy

BRITAIN'S hard-pressed manufacturers stand to receive few if any favours from the Government when it presents its first full-scale Budget this week.

With manufacturing driven to the brink of recession by the strength of the pound, companies that depend on exports want Gordon Brown, the Chancellor of the Exchequer, to raise taxes on consumers. That would hold back domestic spending and might persuade the Bank of England not to raise interest rates, driving the pound lower.

"We'd like the Budget to take the pressure off interest rates and the pound," said Marina Wyatt, the finance director of Psion, which makes hand-held computers. "Sterling is too strong and it's having an enormous effect on us."

They probably will not get what they want. Mr Brown is likely to make few changes in spending and taxation. Instead, the Budget he will offer on Tuesday looks set to be dominated by measures designed to boost employment.

"They might raise some taxes to pay for things they want to do, but the broad thrust of the Budget will be neutral,"said Andrew Dilnot, the director of the Institute for Fiscal Studies.

That is bad news for the likes of GKN, the automotive and defence company, and Reed Elsevier, the Anglo-Dutch publisher.

Both said last week that 1997 profits were hurt by the strong pound. GKN estimated that sterling's rise cut pounds 32m from operating profits of pounds 401m. Reed Elsevier, with an almost flat second-half profit, did not quantify its loss but said the currency had had a "major impact".

Since August 1996, the pound has risen about 25 per cent against the currencies of Britain's main trading partners. Exporters have suffered as the currency gained.

Under the weight of the pound, manufacturing output has been declining since the fourth quarter, when it fell 0.5 per cent. If output falls for the first quarter as well, manufacturing will drop into a recession - two consecutive quarters of declining production.

"If the pound remains at current levels, the damage to the engineering industry will not be confined to the short term," the Engineering Employers' Federation said in a pre-Budget plea to the Government. "Once ceded, export markets take many years to regain."

On fiscal grounds, though, the case for higher taxes looks weak. From April 1997 through to January, the UK accumulated a surplus of pounds 4.23bn. The year before, the Conservative government then in office had to cover a pounds 10.59bn deficit.

Government departments usually increase spending at the end of each financial year, so that surplus will be whittled away. Even so, the Budget deficit for the 1997/98 financial year, which ends this month, is expected to be around pounds 5.5bn - a bit more than half the pounds 9.5bn Brown predicted in a pre-Budget report in November.

With tax increases worth around 0.5 per cent of gross domestic product due to take effect in April, the Chancellor seems set to meet his own "golden rule" for fiscal policy in 1998/99. Borrowing will be less than the amount spent on public-sector investment, and the ratio of debt to GDP will fall.

The economic case for tightening fiscal policy is more convincing. The problem is that the UK has a two-speed economy. Boosted by rising real incomes, consumers are spending freely and companies that serve the domestic market, such as service firms, are booming.

That, in turn, prompted the Bank of England to raise its benchmark interest rate five times last year, by a quarter-point each time. The increases pushed the central bank's base lending rate to 7.25 per cent.

Higher rates strengthened the pound and hurt manufacturers, while service companies increased output by 4.5 per cent in the fourth quarter from the year before.

The unbalanced British economy is a long-running story. It was evident back in July, when the Government announced an interim Budget soon after gaining power.

Instead of taxing consumers, however, Mr Brown heaped most of his increases on companies and pension funds.

"It was as clear in July as it is now that there's a dual economy, and he chose not to do anything about it," said Mike Dicks, an economist at Lehman Brothers International.

"The chances of him coming back with different conclusions about what should be done this time around are pretty slim," he added.

Although economic growth is expected to slow this year, opinions vary as to how much. Recent surveys suggest consumers are feeling the pinch of higher taxes and interest rates. Mr Brown could therefore argue that tightening fiscal policy now runs the risk of hitting the economy too hard.

The main reason for leaving the consumer alone, though, is political. When in opposition, the Labour party pledged not to raise personal income taxes, in an effort to shed its tax-and-spend reputation. Increasing taxes now that it is in power may be seen as breaching the spirit of that pledge.

"Brown will be very keen to say to voters they got no more than they voted for," said Adam Cole, economist at HSBC James Capel. "He's petrified of raising taxes on the consumer sector."

It is equally clear that Mr Brown will not use the improvement in the public finances for tax cuts or spending increases - something he believes could fuel consumer spending and push interest rates higher.

The Chancellor has promised that the Government will not repeat the mistakes of the late 1980s, when tax cuts fuelled a consumer boom that forced interest rates higher and led to a recession.

The Government has also committed itself to the tight spending plans laid down by the previous Conservative government until April 1999. And it now seems probable that it will attempt to keep a tight grip on outlays even after that.

"Even though the fiscal position looks quite good, you'd expect that at this stage of the economic cycle and it doesn't mean there's money to throw around," said Martin Weale, chief economist at the National Institute of Social and Economic Research.

With little room for manoeuvre on fiscal policy, the Chancellor will be left to expand on the main theme - an overhaul of the tax and benefits system to encourage employment, boost investment and improve skills.

Increasing the capacity of the economy to produce is Mr Brown's passion and defines him as Chancellor. The job of fine-tuning demand in the economy was handed to the Bank of England when the Government made it free to set interest rates.

The supply-side measures that will be introduced are expected to include plans for a 10 per cent starting rate of tax - it is currently 20 per cent - a US-style tax credit for workers, subsidies for childcare and reform of the national insurance system, an employment tax, and possibly changes in capital gains tax on profits from the sale of assets.