Enduring strengths

• The UK is the second largest services exporter in the word, exporting $418 billion of services in 2019 – roughly 45 per cent of total UK exports.
• But looking more granular product level data reveals that the UK is specialised in a range of services including personal, cultural and recreational services as well as charges on the use of intellectual property. The UK also have advantages in art, aircraft, beverages and pharmaceuticals which together made up 8 per cent of total UK exports.
• The UK’s innovative advantages lie in key growth categories such as the life sciences and clean technologies, but in order to capture these opportunities more needs to be done to improve the aggregate patenting intensity of the economy.
• The UK’s advantages have been persistent with seven of the top 10 products in which the UK was most specialised in 1989 remaining in the top 10 in 2019. This persistence means that an economic strategy needs to take path-dependency seriously.
• Clustering countries into groups based on their specialisms reveals that the UK is similar to many prosperous countries with a diverse set of institutional structures. The main difference between the services grouping of countries and the manufacturing group is that the latter have on average 4 per cent more physical capital and 10 per cent more human capital in relation to the size of their economies. Evolving into a manufacturing economy would involve 2 per cent of GDP to be invested for a decade with correspondingly lower consumption.
• The UK’s services specialism comes with trade-offs to manage: more productive parts of the UK specialise more heavily in services trade suggesting that it may reinforce geographical gaps in the UK. While workers in tradeable services are 60 per cent more likely than the average worker to have jobs paying in the 95^th percentile of the wage distribution: suggesting that a services specialism may be associated with pay inequality. Policy needs to manage and mitigate these downsides.

A decade of stagnant living standards, weak productivity and low investment combined with a coming decade of major change – driven by Covid-19, Brexit and Net Zero – mean that it is crucial for the UK to renew its economic strategy.

The received wisdom is that the UK is a narrowly specialised economy; that it is only competitive in financial services and ancillary business services; and that this specialisation has come at the expense of our manufacturing industry and the high-quality jobs it provides. By ending our reliance on banking and reindustrialising, so the thinking goes, we can revitalise our economy. In this report, we argue that these are poor premises on which to base a new economic strategy. Policy makers should instead pay attention to the reality of the UK’s existing and potential economic strengths and how slowly they typically evolve. Building on these, and dealing with the trade-offs they present, will be key to a successful new economic strategy.

This report considers the UK’s present comparative advantages in exports and innovation, analysing how long they have existed and where they come from. We consider whether these strengths are indeed especially narrow or unusual compared to other countries, and also show which other countries share our patterns of specialism. We assess the prospects for some of our current key specialisms, and we analyse what challenges the UK’s comparative advantages pose for an economic strategy that seeks to provide good quality employment and to reduce inequality.

The UK was the fourth-largest exporter in the OECD in 2019 (behind Japan, Germany and US), and the fifth-largest in the world (also behind China), exporting nearly $900 billion worth of goods and services. But within this we have a very large specialisation in services: we exported $418 billion worth of services in 2019, the second-highest in the world. At just over 45 per cent of total exports, the UK’s services share is roughly twice that of the OECD average, and 1.8 times the global share. This is a far larger share than any country of a comparable size: among large rich economies, the US, France and Spain also specialise in services, but to a far lesser extent, with roughly a third of their exports being services. In contrast, Japan, Germany and Korea specialise successively more strongly in goods, with services amounting to less than a fifth of their exports.

Within this services specialism, the UK has a well-known, strong advantage in financial services, insurance and other business services, exporting more than double the global average share ($230 billion across these three services categories). However, financial services have been falling as a share of exports – from 12 per cent in 2009 to 9 per cent in 2019. And the UK is also a strong exporter in other services, such as personal, cultural and recreational services (including education), where our export share is one-fifth larger than the global average (totalling $5.7 billion in 2019). The UK also earns a lot from charges for intellectual property (such as royalties to broadcast UK-produced TV shows abroad). The UK also has strengths when it comes to exporting in a number of goods categories; a larger-than-average share of our exports are in aircraft, art, beverages and pharmaceuticals. There are clearly some goods where the UK has real relative strengths: it is not a services one-trick pony. The UK’s single biggest relative weaknesses is in electrical machinery and equipment, where the share in our exports is around half the global share.

Taken together, these specialisations are relatively varied. On a range of statistical measures, the breadth of the UK’s trade mix is average by the standards of medium-sized industrialised countries, meaning that the UK is not particularly concentrated, nor diversified, in its exports. We are slightly more specialised than France or Germany, but less specialised than Japan, and much less specialised than small but rich countries like Switzerland and Ireland. The UK’s pattern of specialism is therefore not unusually narrow or idiosyncratic. However, while the absolute size of UK exports in 2019 was only slightly smaller than other rich countries in relation to both the size of the economy (i.e. openness) and to imports (i.e. the trade balance), UK exports substantially underperformed our international peers’ in 2020-21.

Statistical analysis suggests that there are several broad types of exporting countries based on their revealed patterns of specialisation: one group comprises manufacturing-heavy countries, including Germany and several East Asian economies, and there is also a services-intensive group that includes the UK, France, the United States and Singapore. All of the latter three countries have higher GDP per capita than the UK, suggesting that a services focus can be consistent with higher levels of productivity and income than the UK’s has been able to achieve.

Moreover, while UK exports grew moderately slowly in the decade to 2019, at an average rate of 3.3 per cent per year (in dollar terms) — similar to the 3.1 per cent growth enjoyed by Germany but much slower than the 4.8 per cent for the US — none of this underperformance was due to the UK’s product mix. It is the case that in 2009 the UK was specialised in products that, on average, saw relatively strong worldwide growth in exports in the ten years that followed, meaning product mix explains none of the 1.5-percentage-point shortfall in growth in UK exports when compared to the US over this period. The gap is therefore instead explained by the UK losing share in the markets in which it exports.

Both these factors suggest that the UK’s specialisation in services does not of itself explain the shortfall in productivity and incomes relative to the international frontier, nor the recent stagnation in its productivity growth.

Most developed countries, including the UK, have not changed their specialisms much over the course of recent decades. For example, the UK’s strength in services was present in 1980, before the rapid deindustrialisation of its economy was complete, although it did increase significantly in the late-1990s, peaking around the time of the financial crisis. Of the top 10 products in which the UK was most specialised in 1989, seven were also in our top 10 in 2019, and the top two then – financial services and beverages – are still the top two now.

More broadly, comparative advantage in most product categories has not tended to change much over time: internationally, we find that a country’s revealed comparative advantage (RCA) in a product ten or even thirty years ago has generally been a good predictor of that country’s RCA today. The extent of this ‘persistence’ in the UK is similar to other advanced economies. Large swings from goods to services or vice versa are rare: among countries comparable to the UK – i.e. high-income OECD countries who did not undergo a post-communist transition – since 1980, only Finland and Norway have experienced a change of a magnitude sufficient to move the UK from being a services specialist to a country that exports goods and services in the same proportions as the rest of the world.

A renewed economic strategy cannot ignore the UK’s history and current endowments: it needs to build on these areas of strength and protect them from new risks. Key areas of long-standing UK specialisation rely on a highly educated and innovative workforce, and international openness to talent and ideas. In the case of finance and business services, the UK’s specialisation reflects London’s role as an international financial centre. The UK’s creative strengths can be traced to cultural openness, high quality creative education and – in media – the important role that public service broadcasting has in shaping the market. Pharmaceuticals, as part of the wider life sciences sector, draws on and contributes to the UK’s strong science base.

But although an economy’s strengths are persistent, they are not immutable. For example, we show that it would only be a ‘short hop’ from the UK’s current mix of goods specialisation to several other product areas in which the UK could grow its exports, including products across several machinery and pharmaceuticals categories. Patenting activity of UK-resident inventors also highlights areas in which the UK’s advantages could grow. The UK is innovative in chemistry and the associated fields of pharmaceuticals and biotechnology. Although these fields saw relatively weak growth in global patenting activity in the decade to 2015, they are widely recognised to be growth areas of the future. The UK also has a promising strength in patents relating to clean technology, where further growth is anticipated due to international commitments to Net Zero. A successful economic strategy needs to capitalise on these new areas of high growth opportunity, while building on existing strengths.

We have seen with the examples of Singapore, the United States and France that a specialisation in services can be consistent with high incomes. Moreover, services specialists exhibit a wide range of institutional characteristics: it’s not the case, for example, that only low-tax economies can thrive as service exporters.

One thing the goods exporters have in common is that, on average, they have somewhat higher levels of physical and human capital: countries in the manufacturing group include post-Communist and East Asian countries with traditions of high investment. The manufacturing group on average has 4 per cent more physical capital and 10 per cent more human capital in relation to the size of their economies than the services group. For the UK to close this gap, it would require additional investment of approximately 2 per cent of GDP for a decade, and correspondingly lower consumption or higher imports. And, although higher investment may be helpful to succeed more broadly in manufacturing, it is not sufficient: the know-how that enables companies to employ capital and labour productively is largely tied up within firms. Furthermore, manufacturing employment is only 8 per cent of the total, suggesting that the number of extra jobs available from even a proportionally large expansion in manufacturing would be limited.

Specialising in services is associated with high average incomes, but there is evidence that incomes generated by tradable services may be spread unevenly across individuals and regions. More productive parts of the UK specialise more in services trade, whereas there is no relationship between the level of regional output per hour and goods exports: this suggests that services could be reinforcing geographical gaps within the UK in value added, a key measure of spatial inequalities. Moreover, a similar fact is true across the wage distribution: workers in tradable goods industries are (roughly) 20 per cent more likely than average to have jobs in the upper-middle part – i.e. 50th to 90th centiles – of the wage distribution. In contrast, workers in tradable services – e.g. bankers and management consultants – are most overrepresented at the very top, being 60 per cent more likely than the average worker to have jobs paying about the 95th percentile of the wage distribution. Jobs in non-tradable services are most common at the bottom of the wage distribution.

On the other hand, France is an example of an economy with lower inequality than the UK (with a Gini coefficient of 0.292 compared to 0.366 in the UK in 2019) that specialises in services, albeit less so than the UK (France’s share of exports in services is 1.4 times the world average). So, services specialisation does not inexorably lead to high inequality.

Finally, the UK’s export strengths will be challenged by the form of our new trading relationship with the EU. The UK’s specialisation in services increased over a long period of deepening trade liberalisation with the EU, especially in services. The Trade and Co-operation Agreement has resulted in much higher trade barriers for UK exports, especially in a range of regulated services, for which it contains limited provision. Policy makers will have to wrestle with the trade-offs involved in a partial re-integration into EU trade, if this option is available to the UK, or deal with and mitigate the consequences of higher trade costs for some of our key export industries.

Future Economy 2030 reports will examine how the benefits of our tradeable sectors can be more deeply exploited and more widely spread throughout the country, and how trade and industrial policy, inter alia, can bring this about.