This is in part a follow up on the timely visit to Washington DC last week by Permanent Secretary to the Ministry of Defence, Stephen Lovegrove. Highly respected by those who know and work with him and with every justification in my view, Lovegrove is an apparent breath of fresh air when it comes to communication and more open approach seemingly being taken to what is clearly a difficult and extremely important job.
Another important element of the Permanent Secretaries undoubted qualities is that he not only understands the complexities and difficult issues that the MOD has to face, as he always should of course, but that he also understands the vital importance of the UK defence industry and the role that it plays in the economy. Likewise, Lovegrove places similar importance on recognising the value of significant investment put into the UK by various large US defence primes – those that chose Britain as the gateway to other foreign markets.
In Washington DC last week to meet with peers and possibly members of the Trump administration, Lovegrove also found time to meet with a small group of specialist journalists at the British Embassy in Massachusetts Avenue. Here I understand that he talked across a wide range of issues including views on the impact of change in the White House in so far as they might impact on the UK and on the vexing issue of currencies and hedging.
From what I hear Lovegrove was sanguine about the Trump administration and, similar to my own view, appears to believe that apart from the prospect of the US raising defense spending in the years ahead, not that much is likely to change in respect of business opportunity for the UK and of how defense business between our two nations countries is done.
Reported in Defense One, Lovegrove said that “We are not really spending a huge amount of time trying to moderate our stance in respect to what may or may not be happening over in the USA” and “To be honest” he said, “I think that there is good evidence that, as long as we in the UK can continue to provide best-in-class capability, then people will want to come and invest in the UK and buy UK kit.”
Asked his views about the issue of the falling value of the pound sterling since Brexit and on hedging, Stephen Lovegrove was reported to have said thatBottom of Form
the “collapse in the value of the pound [sterling] against the dollar has [so far] had only a minor impact on the UK defence budget over the ‘short term’ and [that] for the moment [this] is not a big problem”.
Mr. Lovegrove who has been in the Permanent Secretary role since 2016 and not surprisingly, as the top civil servant in defence he is well respected in the corridors of Whitehall. In the reported interviews he apparently went on to suggest that “the hit on the near-term budget [in respect of currency exchange] is in the small tens of millions of pounds and is not a big issue”.
Wise hands will note the not so small emphasis on the words ‘short term’ here and on that basis, particularly given that there is some choice over timing of orders, payments and delivery dates for the MOD to contemplate, I have no issue with the reasoning expressed on the specific currency related issues.
Equally true to suggest of course that even if there are much larger potential issues in regard of currency fluctuations to be faced between sterling and the dollar valuations and how much has been hedged forward to cover foreseen requirements two or maybe three years down the line, it is also possible that if we get our Brexit strategy right markets may take the view that sterling is actually too low and could begin a process of reversing the recent sell-off trends.
The issue of Foreign exchange is now being far more frequently raised in respect of the MOD than I can personally ever remember before. Not the least of those to put the issue in the public domain was the Royal United Services Organisation (RUSI) and what they said has to all extents and purposes been backed up in by the NAO (National Audit Office) report on the Defence Equipment Plan 2016 – 2025.
Last October Trevor Taylor, Professorial Research Fellow in Defence Management at the Royal United Services Institute (RUSI) pointed to concern that if sterling’s recent decline in value was sustained, the cost of Britain’s defence equipment import requirements could (on then current targets for defence equipment purchase) increase by around £700 million per annum from 2018/19 – an amount that represents about 2% of the defence budget.
Meanwhile and more recently, the NAO pointed out that the international nature of defence procurement means that many of the MOD’s largest procurements are paid for in foreign currency – examples being the F-35 Joint Strike Fighter and the Boeing P-8 Poseidon Maritime Patrol Aircraft.
In its report the NAO reminded Ministers that the MOD [Equipment Plan] forecasts suggest that it ‘will’ spend £18.6 billion in US dollars and £2.6 billion in Euros over the 10-year period of the plan. Using the Department’s foreign exchange rate planning assumptions, the NAO said that this equates to $28.8 billion and €3.2 billion respectively. Within this foreign currency spend, approximately $8.5 billion and €1 billion has been added as a result of new commitments following the SDSR 2015 review process.
As the NAO also pointed out, the MOD manages the risk of exchange rate exposure for US dollar and Euro requirements using forward purchase contracts with the Bank of England. This is normal practice and basically similar to the system used by industry to hedge its requirements. The NAO says that the MOD is covered forward 89% and 99% respectively of 2015-16 in-year expenditure in US dollars and euros. The NAO also informs us that when forward purchases do not [sufficiently] cover the whole difference between the corporate rates used in the cost estimate for a project and the actual rate paid, the MOD may choose to fund the variance from the wider defence budget.
Finally the NAO remarked that “following the decision to leave the European Union, the pound has significantly lost value against other currencies. If planning is undertaken using unrealistic rates there could be serious affordability issues for those projects and possibly for the Plan as a whole.
During public sessions before the House of Commons Defence Select Committee earlier this year Mr. Lovegrove together with other senior members of his team have been at pains to stress that the MOD is hedged forward by at least two years and maybe longer. This detail was also repeated by Minister of Defence Procurement, Harriet Baldwin MP at a separate more recent session of HCDC during February.
We live in a world of ‘if’s’ and ‘buts’ of course and another option that the MOD can take to ensure that currencies cause less impact on the budget cost is to simply push programmes back. The problem with that is that it generally raises the overall cost of the capability programme in question. For the sake of defence, I very much hope that this is not an option that the MOD chooses to take.
For all reassuring words, expressed caution and realistic concerns it seems to me that there is a serious problem to be addressed here and I reason this by reminding of the words Lovegrove used in Washington DC – namely “short term”.
The NAO referred to a figure of $28.8 billion being the amount of dollar related spend within the Equipment Plan period that, on current planning assumptions, is exposed to foreign currency fluctuations. Included in that figure is support for various existing US built equipment programmes and the important ongoing in-service support for various UK military capability programmes such as Sentry E-3D, Air Seeker (Rivet Joint), Boeing Chinook and the current British Army fleet of Apache attack helicopter capability. Also included I assume are the already announced purchases of F-35 Joint Strike Fighter planes and that have already been ordered.
During 2016 the MOD also ordered a further six F-35B Joint Strike Fighter aircraft topping an order for four that it had made in 2014 deliveries of which will soon be complete. These orders come on top of four F-35 aircraft already delivered and that have been in use for training purposes by the Royal Air Force and Royal Navy from the time of the first aircraft being delivered in 2012.
Supporting the commitment made in SDSR 2015, the UK Government has also confirmed orders for nine urgently needed Boeing P-8 Poseidon Military Patrol Aircraft capability that are slated for delivery from 2019 onwards and the MOD has also announced an intention to acquire 50 AH-64E Apache attack helicopters from Boeing to replace the existing Apache fleet – although at what stage the ordering process the latter rotary capability is currently at I am unclear.
As confirmed by the previous Chancellor of Exchequer, George Osborne and separately within SDSR 2015, the UK is committed to acquiring a total 138 F-35 aircraft through the programme lifetime. The current intention is that at least 24 F-35B variants will be available for use on board the Royal Navy’s first Queen Elizabeth class aircraft carrier by 2023.
No one is blaming the MOD for the Brexit factor impact on the ten year defence equipment plan of course as this really couldn’t have been foreseen that easily. Even so, the NAO sees this as just one of many problems that the Defence Equipment Plan is burdened with and while it no longer has to sign off the defence plan as it did in the past, it has not surprisingly placed great weight on a belief that the Equipment Plan in its present form carries too many cost risks. Thus, despite choosing to use the words to describe there only being minimal concern ‘short term’ there is in my view no value in trying to hide behind the potential negative impact of currencies being small – unless you happen to believe that sterling will quickly regain its lost value against the dollar. Positive thinker and optimist though I am personally recognised to be, somehow I doubt that is going to occur.
Sterling today is hovering around the rate of $1.22 – note that it was closer to $1.60 just a year earlier.
The responsibility for hedging currency is as it has always been at the behest of HM Treasury as opposed to being with the MOD and it is reasonable to assume that the Treasury will not take any unnecessary risks in relation to hedging policy if it can be avoided. Gordon Brown may have given our gold reserves away for virtually nothing but the Treasury isn’t about to make a similar mistake on unnecessary hedging if there is another way.
There is one additional way that I have not mentioned of course – it is to raise the defence budget proportionately to cover the fall in sterling value but somehow I doubt that is something that is being contemplated.
Stephen Lovegrove was I am sure quite right in saying that “we have a very prudent hedging program with the Bank of England and the Treasury and feel comfortable we’ve managed to mitigate most of the currency risk there” He is also reported in Defense News to have said “We certainly have thought about what might happen if the pound stays at its current low levels in three or four years’ time and clearly there would be impact” and I am sure that is correct as well.
There are no easy answers to this and when Lovegrove asks the question “How that gets defrayed. Whether or not that [hedging] activity will have to be undertaken through the Treasury, whether we seek to renegotiate [contracts]” and then poses a view that “these things are a couple of years hence” he is again absolutely right and cannot be accused of fudging the issue.
Summing up, the Permanent Secretary was reported to have said “we have no concrete plans to do anything, it’s three years off, we are hedged for three years….there will no doubt be moments when we have to take decisions but when that is will be the subject of crystal balls”.
By the way, the anticipation has been that the UK will be spending in the region of $10 billion a year on purchases of defence equipment from the US over the next few years although that figure may well be somewhat lower in 2017 and 2018.
While it should also not be forgotten that the UK exports something close to £8 billion of defence equipment exports a year and more if security equipment and services is included it is does not serve well in this case to try and match the amount that we buy from abroad with the amount that we sell abroad.
More on this subject anon no doubt – Commentary will return on Thursday.
CHW (London 13th March 2017)
Howard Wheeldon FRAeS
Wheeldon Strategic Advisory Ltd,
M: +44 7710 779785