Scottish Government

ANALYSIS OF HISTORICAL CONSTRUCTION COST MOVEMENTS IN SCOTTISH SOCIAL HOUSING FINAL REPORT

10.0 ECONOMIC CYCLES

10.1 Introduction

Economic cycles in the U.K. have traditionally been regarded as occurring every 6 to 10 years. However the last recession came to an end in 1992, since when the UK economy has experienced the longest unbroken economic expansion on record, enjoying a record 44 consecutive quarters of growth. Between 1979 and 1996 growth in Gross Domestic Product was more volatile in the UK than in any other G7 country. Since 1997 UK GDP growth has been more stable than any other G7 country.

Economic growth in Scotland has traditionally been slightly lower than in the U.K. as a whole: between 1963 and 2002 growth averaged 2.0% per annum in Scotland compared to 2.4% in the U.K. Historically, GDP has also tended to be less volatile in Scotland. During the late 1980's, the economy in Scotland did not overheat to the extent evident in the U.K. as a whole and in the early 1990's the recession was less severe. Chapter 4 observed that construction tender price movements during these periods were also less extreme.

10.2 Construction output and tender prices

Construction tender prices are influenced by supply and demand and the most obvious measure of demand is in the form of construction output statistics compiled by the Department of Trade and Industry. These represent the volume of construction work on site at any point in time and sharp increases in work on site coincide with real increases in construction prices as the industry reacts to higher demand by increasing labour rates and profit levels. Conversely, when output levels fall, representing a decline in demand for contractors' services, prices have been seen to fall in real terms as competition for a smaller overall workload increases, leading to tighter labour costs and lower profit margins.

Chart 10.1 illustrates the relationship since 1985 of the change in volumes of construction output in Great Britain with the change in real tender prices (represented by the BCIS All-in Tender Price Index). Figures for all work output have been used, representing volumes of new housing work, infrastructure, private industrial and commercial work, public non-housing and housing and non-housing repair and maintenance work i.e. all the sectors that call on the resources of the construction industry.

Chart 10.1 Construction Output and Tender Prices - Great Britain

Chart 10.2 plots the year on year annual percentage change figures for construction output and real tender prices (again represented by the BCIS All-in Tender Price Index). This chart more clearly illustrates the direct coincidence between increasing or decreasing rate of change in output with increasing or decreasing rate of change in real construction prices.

Of the whole time period examined, only in 1996 does the annual change in tender prices move contra to the direction of annual change in total construction output. However in 1996, there was a decline in output in the new build housing sector (down 4%) and in public non-housing work (down 8%), which may have had an effect on the mix of work from which the tender price index was calculated.

While the correlation between the real change in tender prices and construction output is clear in relation to statistics relating to Great Britain, the same cannot be said of examination of data specific to Scotland. Chart 10.3 plots the relative change in the movement of construction output at constant prices for Scotland with real changes in the Scottish Public Sector Tender Price Index since 1990.

Chart 10.2 Construction Output and Tender Prices - Great Britain - Annual Percentage Change

Chart 10.3 Construction Output and Tender Prices - Scotland

Real tender prices fell between 1995 and 1997 even though construction output dipped by less than 1% in 1996 only. Tender prices have increased steadily since 1997 but output figures have been erratic. Output jumped by 8% in 2000 but has since fallen back, contrary to the trend in Great Britain generally. The 2000 figure was heavily influenced by hectic on-site activity at the Scottish Parliament building, which commenced construction in the summer of 1999. This is indicative of a more volatile set of figures for a market the size of Scotland, compared to Great Britain as a whole, where trend lines tend to be smoother.

Chart 10.4 plots the annual percentage change figures of construction output in Scotland with the annual percentage change figures for the Scottish Public Sector Tender Price Index to determine whether a closer correlation can be observed.

Chart 10.4 Construction Output and Tender Prices - Scotland - Annual Percentage Change

A pattern of matching directional movements can be observed but, whereas the directional changes in Chart 10.2 in relation to Great Britain as a whole, coincide, Chart 10.4 shows that the directional changes in real tender prices anticipate the changes in output in Scotland by a year. This would suggest that for Scotland, changes in contractors' new orders may be a better anticipatory measure of changes in construction prices than construction output (see section 10.5).

10.3 Construction output and Gross Domestic Product

A relationship can also be demonstrated between Gross Domestic Product and construction output. Construction is of course an intrinsic part of GDP and in the mid 1990's accounted for about 7.3% of GDP in the U.K. and 6.4% in Scotland. However the amount of construction activity is also influenced by the health of other sectors of the economy. Chart 10.5 illustrates the pattern of GDP and construction output in Great Britain, both expressed as annual percentage change, since 1956. Four quarter moving average trend lines are also shown to more readily demonstrate the correlation between the two data sets.

Chart 10.5 Construction Output and Gross Domestic Product - Great Britain

Chart 10.6 also plots the annual percentage change for construction output and Gross Domestic Product in Great Britain but in a way that better illustrates that, when growth in the whole economy has been strong, the increase in the annual percentage change in construction output has tended to be significantly higher and conversely, when the rate of growth in the economy has fallen or has become negative, falls in construction output have been significantly greater.

However Charts 10.5 and 10.6 both illustrate that over the last two years, the general long term correlation of GDP and construction output has not applied. The annual rate of increase of GDP has been in decline but construction output has shown strong growth. Over this period, private sector construction growth has declined in line with GDP but total construction output (as portrayed in these charts) has been boosted by large public sector investment.

Chart 10.6 Construction Output and Gross Domestic Product - Great Britain - Annual Percentage Change

Chart 10.7 illustrates with a line graph the trend of GDP and construction output from 1963 and Chart 10.8 shows the pattern over the shorter time frame, generally used elsewhere in this report, of 1985 to 2002.

Chart 10.7 GDP and Construction Output 1963 - 2002

Chart 10.8 GDP and Construction Output 1985 - 2002

10.4 Gross Domestic Product - Great Britain and Scotland

The long term trend GDP growth rate for Scotland has been slightly lower than in the U.K. as a whole. Between 1963 and 2002 GDP growth in Scotland has averaged 2.0% per annum, while in the U.K. growth has averaged 2.4% per annum (see Chart 10.9)

Between 1963 and 1974 GDP growth in Scotland slightly exceeded that in the U.K. as a whole (averaging 3.2% per annum compared to 2.9% per annum). Since 1974 the reverse has generally been the case (except for the recession of 1989-92), GDP growth in Scotland averaging 1.6% per annum compared to 2.2% per annum in the U.K. as a whole.

The chart illustrates the reduced volatility of GDP in Scotland, particularly during the late 1980's / early 1990's period, when U.K. growth, fuelled largely by events in London and the South East, increased by 18.4% between 1984 and 1988 (average 4.3% per annum) but by only 1.8% (average 0.4% per annum) over the following four years. By contrast, GDP in Scotland increased by an annual average 2.3% and an annual average 1.6% over the two periods respectively.

Chart 10.9 Gross Domestic Product 1963 - 2002

Every year since 1993, growth in Scotland has underperformed that of the U.K. as a whole, growing in total by 19.4% (2.0% per annum average) compared to 29.2% (2.9% per annum) in the U.K. Over the last three years particularly, as emphasised in Chart 10.10, the margin has widened considerably, growth in the U.K rising by 7.2% (average 2.4% per annum) but only 3.1% (average 1.0% per annum) in Scotland.

However in 2001 and 2002 GDP growth in both Scotland and the U.K. has been below long term trends.

Chart 10.10 Gross Domestic Product 1995 - 2002

In 2002 the rate of GDP growth in the U.K. declined to 1.9%, while in Scotland there was no increase at all. While there was a 4.2% rise in output from the Scottish Services sector, higher than the increase of 2.6% reported in the U.K. figures, there was also a 10.0% fall in output from the Scottish production sector, in comparison with a 3.6% fall reported in the UK figures. This significant decline in Scottish production output, and the zero growth recorded overall across the Scottish economy, is largely explained by the global restructuring which has taken in place in the Electrical & Instrument Engineering sector, which has had a greater impact on the Scottish economy than on the wider balanced U.K. economy. In 2002, the sector accounted for 6% of Scottish GDP by weight but output of the sector, dominated by radio, television and communications, has fallen by 35% since the third quarter of 2000.

As a result largely of the poor performance of the economy in Scotland over the last three years, GDP growth in Scotland since 1995 has been lower than every other major European country.

10.5 Contractors' New Orders and Construction Output

Changes in the volume of construction output are presaged by changes in the value of new orders secured by contractors. This data is also collected and published by the Department of Trade and Industry for Great Britain and for separate regions, including Scotland.

Chart 10.11 shows the long term (from 1957) pattern of contractors' new orders and construction output at constant (1995 prices) for new work in Great Britain. It clearly demonstrates how a change in direction in new orders is followed by a similar change in the trend of output statistics.

Chart 10.11 Relationship between Contractors' New Orders and Construction Output

10.6 Gross Domestic Product and Earnings Growth

Earlier sections of this report have seen that earnings and Gross Domestic Product have both grown consistently over time. However there is no clear correlation between growth in GDP and growth in real earnings as evidenced in Charts 10.12 and 10.13 below.

Chart 10.12 plots the movement of GDP in Great Britain with the real change in whole economy average earnings, both from base dates of 1985.

Chart 10.12 GDP and Whole Economy Average Earnings - Great Britain

The dip in GDP that occurred in 1991 was not reciprocated in average earnings figures, though the annual rate of increase declined, as illustrated in Chart 10.13. Since 1992, growth in the economy has consistently outstripped growth in real earnings.

Chart 10.13 plots the annual percentage change in Gross Domestic Product and that of whole economy average earnings from 1985.

Chart 10.13 GDP and Whole Economy Average Earnings - Great Britain - Annual Percentage Change

Although not totally consistent, Chart 10.13 demonstrates a considerable degree of correlation between the annual change in the two trends e.g. a general fall in rate between 1998 and 1991, a consistent pattern of change between 1993 and 1997 and both trends falling post 2000.

10.7 Conclusion

Some correlation can be observed between the performance of the economy as a whole (as evidenced by GDP) and changes in average earnings in the economy (which should be a reasonable proxy for changes in average earnings in the RSL sector), although a consistent shadowing of the economy data by earnings data is absent.

However a strong correlation has been demonstrated between the pattern of construction tender prices and construction activity, evidenced by construction output and contractors' new orders statistics, themselves closely related to the economic cycle. While clear for Great Britain as a whole, the pattern is less distinct when examining data for Scotland only. However, even in areas of relatively low fluctuation of economic growth such as Scotland (and the North of England) tender price reductions as well as increases have been observed.

Examination of historic trends shows that when the economic cycle is in a period of growth, construction prices can be expected to increase ahead of general inflation. When the economic cycle is in decline, construction prices may well increase at a lower rate than general inflation or even fall in nominal as well as real terms.