Scottish Government

Background Analysis to the Framework for Economic Development in Scotland

2. Progress

This chapter briefly reviews some of the key trends in Scottish economic performance in recent years. More detailed discussions can be found in the bi-annual Scottish Economic Reports published by the Executive.

2.1 Economic Performance 1998-2003

Graph 2.1 compares the growth of Scottish GDP with that of the UK in recent years. Scottish growth since 2000 has been very similar to UK growth, but over the longer term, UK growth can be seen to be stronger, with an annual average growth rate of 2.7 per cent between 1995 and 2002 compared to 1.9 per cent for Scotland.

Graph 2.1 Scotland & UK: Annual Real Growth in GDP, 1998-2003

Sources: ONS, Scottish Executive

Although annual growth for Scotland has been positive in recent years, the performance of sectors within the economy has been divergent. Graph 2.2 tracks the output indices in the different sectors, highlighting the diverging performance of the services and manufacturing sectors. Services have remained in positive growth throughout the period, indeed outperforming the UK for most of this period. On the other hand, manufacturing output has declined steadily from 2000 until 2003 Q3, with a slight upward trend returning in 2003 Q4.

Graph 2.2 Index of GDP, Services and Manufacturing, 1998 - 2004 Q1 (2000 = 100)

Source: Scottish Executive

Over this period, the labour market in Scotland has tightened, with employment reaching a historically high level in the early part of 2004 as depicted in Graph 2.3.

Graph 2.3 Employment & Unemployment, 1998-2004 Q2

Source: ONS

2.2 Key Determinants of Performance

One of the key drivers of growth is the productivity of the economy. At the aggregate level, it is clear that the performance of the Scottish economy remains constrained by its overall productivity performance. Graph 2.4 below shows that Scotland's productivity, as measured by GDP per hour worked, continues to lag that of many significant OECD economies, as well as the UK as a whole.

Graph 2.4 Scottish productivity performance - GDP per hour³worked, 2001 (UK = 100)

Source: ONS

Addressing this productivity challenge forms the centrepiece of FEDS and it is discussed in considerable detail in the following chapters.

2.3 Strengths and Weaknesses

The original Framework document set out the strengths and weaknesses of the Scottish economy identified, in part, through the consultation process that was conducted in the preparation of that document. Many of these factors remain and are identified in Box 2.1.

2.4 Key Challenges

The key challenge to raise economic performance remains to improve productivity in the Scottish economy. Productivity growth, brought about by rising skill levels of the labour force, by improvements in management, by improved capital investment, and by technological advances, is the main driver for raising standards of material welfare. There is still a significant productivity gap between Scotland and the UK on the one side and many advanced economies on the other, including the US, France and Germany. This gap means that Scottish workers produce less for every hour they work than these competitors and this implies a less efficient use of resources.

Productivity is central to determining the unit costs of production and the resources that are utilised in the production process and, thereby, to the global competitiveness of enterprises. It therefore plays a critical role in the development and expansion of markets and in the determination of economic growth, employment, profits and wages. The policy priorities set out in chapter 1.2 are all geared towards raising productivity levels across the Scottish economy.

The second main challenge to long-run performance is the changing demographic environment in Scotland: the Scottish population is projected to decline, it is ageing and population densities across Scotland are changing:

• the decline in the population reduces the overall growth potential;
• With ageing, the dependency ratio - number of people dependent on support in relation to number of people contributing money to support programmes - rises, which puts substantial strain on the viability of present systems; and
• the changing population density, away from rural areas and urban centres to suburban areas, makes equitable regional development and regional public services increasingly difficult to deliver.

The challenge for the devolved Scottish government is to reverse the trends through migration and family-friendly policies and manage possible problems where they arise. Chapter 2.8. sets out the demographic context in more detail and chapter 9 presents the Executive's strategic response to the demographic challenge.

2.5 Global Structural and Cyclical Trends

Economic outcomes for Scotland's people and businesses are indisputably linked with global developments. Since FEDS was first published, there has been a series of major events that have affected the global economy. These, in turn, have had significant implications for Scottish economic development. They include:

• the emergence of international terrorism and its impact on business and consumer confidence and uncertainty;
• the continued rapid growth of the East Asia economies and notably China;
• the severe slow-down - and, in some cases, significant recession - in many developed and developing economies, including the US;
• the initiation of Economic and Monetary Union in 2002 and the other major political events, including the EU enlargement from 15 to 25 member states;
• the sharp contraction in international capital flows;
• the uncertainty over the US recovery in the light of the continuing questions surrounding the sustainability of US external and internal deficits; and
• the major exchange rate movements - especially against the euro - throughout 2003-04.

While the openness of the Scottish economy makes economic growth vulnerable to specific developments and shocks of this type, the potential benefits and opportunities from being increasingly integrated within the global economy are enormous. The Executive is clear that economic prosperity will result from successfully competing in both domestic and international markets. Scotland cannot and should not be isolated from the global economies.

At present, gross exports account for around 33 per cent of total demand in the Scottish economy, while the ratio of gross imports to total domestic output is around 37 per cent. Graph 2.5 shows the trade position for Scotland, demonstrating that international developments are crucial to the overall strength and success of the Scottish economy.

Graph 2.5 Scottish trade position, 2000

Source: Scottish Executive 2000 Input-Output Tables.

In small economies, exports to other markets provide unique opportunities for expansion. They typically involve little displacement of output in Scottish or UK markets, and they allow greater scope for scale economies to be achieved. Scotland has extensive links to the global economic environment.

Graph 2.6 Scotland's Export Markets, 2002

Source: Scottish Executive, Global Connections Survey.

The Executive published the Global Connections Survey in February 2004. This showed the key economic markets to which Scotland exports, and hence the economies that have the most significant impact on our economic development. The main trading regions of Europe, North America and Asia together represent almost 80 per cent of all the international exports from Scotland.

2.6 Scottish Structural and Cyclical Trends

Two key structural changes in the Scottish economy have arisen in the past two or three decades, the most recent of which has arguably been occurring over the past three or four years. In the late 1960s and 1970s, there was a sharp decline of the traditional, heavy manufacturing industries in Scotland. This trend continued for some years, along with the parallel growth in the service sector. This major adjustment was followed by the rise of significant inward investment flows that financed the development and consolidation of new high-tech industries, particularly those related to the electronics sector. During the 1990s, many inward investment projects brought new manufacturing facilities to Scotland, centred around the production and assembly of electronic components and office and communications equipment.

The sharp slowdown across the global economy over 2001 and 2002, however, precipitated the worldwide restructuring of the electronics sector that had already been underway and which arguably was inevitable in the light of the significant global trends in communications and comparative labour costs. In consequence, many of the overseas-owned operations that had prospered during the 1990s came under great pressure, with a significant number being forced to cutback their operations and, indeed, close in some cases.

Graph 2.7 Scottish Manufacturing and E&IE output, 1998 - 2004 Q1 (2000 = 100)

Source: Scottish Executive

The major cyclical downturn of the early 1990s was instrumental in sparking a major structural change in the Scottish economy. Over this period, the overall employment rate in Scotland actually increased and the unemployment rate declined. Although this period of change has caused much difficulty and distress to those individuals, families, enterprises and communities concerned, this is a testament to the flexibility and adaptability of the Scottish workforce.

The strong performance of the service sector has compensated to a large extent for the decline of the manufacturing sector in recent years. One of the most essential and dynamic elements of the service sector are financial services. In the year 2000 this sector contributed 4.7 per cent of total GDP in Scotland and currently accounts for 4.5 per cent of the total number of employee jobs (up from 3.7 per cent in early 1993).

However, the production sector continues to play an important part in the Scottish economy. The whisky industry as well as the extraction of mineral oil and natural gas are particular strengths. Beside these, the Executive continues to support knowledge-intensive industries like electrical engineering and biotechnology. The future of manufacturing in Scotland lies in the application and production of advanced technologies where low-cost countries do not have a competitive advantage.

2.7 Developments in the EU

International developments continue to impact on economic development in Scotland. In particular, the expansion of the European Union (EU), will increase both competition and market opportunities. Further to this, the introduction of a common currency, designed to promote price stability and transparency, has a significant bearing on how Scotland interacts with the EU. Around 57 per cent of Scottish international exports go to the European Union, which suggests that Scotland relies considerably on the economic strength of the region. It also means that the variability of the Euro is important in determining the competitiveness of Scottish products and services. At the same time, North America and Asia cover a large proportion of international exports, around 12 per cent and 9 per cent respectively. In total, the economic performance of Europe, North America and Asia is not only crucial to the performance of the export sector, but also to the overall performance and strength of the Scottish economy.

On 1 January 2002, the euro notes and coins came into circulation, and at that time all euro-zone countries ceased using their sovereign currencies. It was the final stage of the conversion into full monetary union, as monetary policy had already been transferred to the European Central Bank. Ultimately, this should create a more stable environment for Scotland and the UK to trade with, as exchange rate fluctuations for individual countries, affecting prices and competitiveness, should not be as diverse as they were previously. However, the European Union is Scotland's primary export market and therefore exchange rate fluctuations between Sterling and the Euro will still have a considerable impact on the price competitiveness of Scottish goods and services.

Enlargement is one of the most important opportunities for the European Union. It is a unique, historic task to further the integration of the continent, extending a zone of stability and prosperity to new members; and making it easier for Scottish companies to do business in the new member countries. Enlargement increases the size of the EU market in population terms to around 450 million consumers, bigger than the USA and Japan combined. In GDP terms, accession represents an increase in scale approximately equivalent to adding another Netherlands to the single market. While ultimately, this will boost economic growth and create jobs in both old and new member states, it needs to be borne in mind that in the short and medium term, accession presents challenges as well as opportunities; for example, to inward investment flows into Scotland and to Scotland's share of EU structural funds.

Structural funds

One of the principal aims of the European Union is to reduce the level of disparity between regions by promoting economic activity across the Member States. This is delivered via European Structural Funds, which are worth over 1 billion in Scotland for the period 2000-2006. The four funds which benefit Scotland are:

• ERDF - European Regional Development Fund (regional and economic conversion).
• ESF - European Social Fund (training and employment).
• EAGGF - European Agriculture Guidance and Guarantee Fund (rural development).
• FIFG - Financial Instrument for Fisheries Guidance (adapting fisheries structures).

These Funds are provided through three strands, called Objectives: Objective 1 (for regions lagging behind in their development), Objective 2 (for regions affected by industrial, urban or rural decline) and Objective 3 (to improve skills). Scotland negotiated a transitional Programme for the Highlands and Islands, worth 214m (exchange rate at July 2003) over 7 years to compensate for loss of Objective 1 status from the last funding period (1994-1999). Three Objective 2 Programmes cover the East, South and West of Scotland respectively, and are worth around 556m over 7 years (at July 2003). The Objective 3 Programme covers the whole of lowland Scotland and is worth approximately 310m (again, at July 2003). Scotland also benefits from 4 Community Initiatives which comprise around 5 per cent of the 2000-2006 Structural Fund budget and are pilot projects/test beds for activity which, if effective, will then be mainstreamed into the larger Funds.

The objectives of these Funds and Programmes are clearly consistent with the overall FEDS objectives as the following chapters describe. In particular, chapter 7 considers the Executive's Global Connections Strategy and EU Strategy.

2.8 Demographic Trends

In the four years since FEDS was published, the issues surrounding Scotland's demographic challenge have become far more prominent.

Three main demographic trends will bear on future economic development in Scotland:

• the projected gradual decline in the population;
• the ageing of Scottish society; and
• changing population density in the regions.

In 2002, 5.05 million people were living in Scotland. Whilst the population size has been relatively stable over the last 50 years, the population peaked in 1974 at 5.24 million and has been slowly declining since. The latest projections for Scotland are that by 2026 the total population will have decreased by 220 thousand to 4.83 million. Population decline and ageing puts double pressure on the numbers of people of working age. The Scottish working-age population (given current retirement ages) is expected to fall by 8 per cent between 2002 and 2027.

The projected decline in the Scottish population is unusual within a UK and European context. In the last twenty years the population of the UK has increased by almost 4.5 per cent, whilst in the same period the Scottish population has shown a fall of just over 2 per cent. Slowing population growth, however, is a phenomenon found in all developed economies and is primarily linked to falling birth rates. The natural decrease is projected to be the main cause for future population decline in Scotland, while net migration is expected to play only a minor role.

Population decline, the ageing of Scottish society, and the changes in population density across Scotland put

• adjustment pressures on the economy as the working-age population is declining;
• pressure on the budgets of public authorities across the UK as more older people need to be supported and outlying regions are being depopulated.

These pressures bear directly on the outcome objectives of FEDS. The decline in the working population reduces growth and regional development becomes a greater challenge as the economic viability of some regions is threatened by depopulation.

Graph 2.8 Net migration and natural population change in Scotland

Source : General Register Office for Scotland

The Executive's approach to many of these demographic pressures is set out in chapter 9. In particular, the Executive's Fresh Talent initiative is aimed at boosting the working-age population and alleviating demographic pressures on the economy. The Executive's approach to regional development is responding by promoting linkages between all regions that serve to provide economic opportunities across Scotland and counteract reductions in population density.