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The result of the UK’s referendum on EU membership will have broad implications for Britain’s defence and security. This commentary looks at how foreign exchange movements, specifically the change in the value of the pound against the US dollar, could affect the cost of defence imports. Given the Ministry of Defence’s (MoD) reliance on defence imports, there might be substantial financial implications for defence.
Since posting an initial assessment on the general implications for British defence procurement and support if the post-Brexit devaluation of the pound is sustained, some further, simple calculations have been done on the implications of these currency movements. Some of the findings have attracted media attention (for instance see here, here and here). This commentary lays out the assumptions made, the calculations undertaken and the findings. The analysis does not use any classified information, relying on figures published by governments. As such, its conclusions should be recognised as providing important order of magnitude numbers, but not absolute, precise figures.
The starting point for the calculations is the scale of UK defence imports which rose from $7.2 billion in 2002 to $11.8 billion in 2012, according to the US State Department’s World Military Expenditure and Arms Transfers 2015 report. The assumption is made that these numbers for defence imports are unlikely to fall massively given the continuing support costs of in-service imported equipment for purchases made since 2012 – including the Rivet Joint fleet and the additional Chinooks – and the commitments to buy 138 F-35s, as well as replacements for the Reaper and Apache fleets, and nine P-8A aircraft. Thus, it is assumed here that UK defence imports will run on at least $10 billion a year.
The next assumption is that not all UK military list imports stay in the UK; some get re-exported in ‘British’ or collaborative goods like the Eurofighter Typhoon. According to the UK government’s Defence and Security Organisation, British defence export orders over the past decade have averaged £7.2 billion a year and the MoD itself spends over £16 billion a year on equipment and its support. Given this, it is a reasonable assumption that one third of UK defence imports may be re-exported, leaving the MoD with an import bill of between $6.5 billion and $7 billion. The great majority of this must be for the US as the inventory of American equipment in UK forces indicates, but the pound has also fallen significantly against other currencies, including the euro.
Moreover, this analysis reasonably assumes that the depreciation in the sterling will not be reversed for the foreseeable future. Clearly, that may prove to be wrong, but it is a reasonable possibility for which the MoD should make provision. In sum, the calculations comprise the following:
The pound has fallen approximately from £1:$1.50 a year ago to £1:$1.30 today. At a rate of £1:$1.50, $6.5 billion per year equals £4.33 billion per year. At a rate of £1:$1.30, even $6.5 billion per year equals £5.0 billion per year. This is a difference of approximately £700 million per year.
With a defence budget of slightly more than £35 billion, the £700-million shortfall amounts to a 2 per cent cut in the purchasing power of Britain’s defence budget, and a much larger cut in the purchasing power of the equipment and support budgets. This must be a substantial challenge for defence planners and programmers.
The implications for the British defence industry of the devaluation of the pound are complex and beyond this commentary’s scope. Clearly, a cheaper pound could make British exports more competitive, but the cost of the imported content of its systems will increase, including the costs of raw materials that are not covered by the military surveys from the US State Department. Given the political and military commitment to specific imported systems, there will be less money available for contracts with British firms, but in the medium to long term, a weak pound could make imports less appealing. However, capability rather than price has often been the dominant appeal of imported systems, so it would be rash to place too much emphasis on the cost of items alone in mapping out future procurement trends.
The previously published analysis noted the possibility that the British government may have hedged against losses in the value of the pound; it is now clear that the MoD has indeed covered itself for what the then procurement minister referred to as ‘the short term’, which is understood to be two years over which the hedging ‘positions’ of the British government could mitigate direct financial losses in currency transactions. Obviously that does not cover the delivery periods for most of the major buys to which the UK is at least politically committed, nor does it deal with the periods of in-service costs for imported equipment.
Several factors could negate the significance of the arguments here: the import figures could be shown to be significantly incorrect and/or the re-export calculation could be shown to be under-estimated. But if the numbers are broadly right, the calculations are straightforward and the conclusion apparent. A final possibility is that the defence budget could be increased significantly in real terms, as Julian Lewis, the chair of the House of Commons Defence Committee would prefer. Perhaps, but this is obviously not a possibility that the MoD can rely on.
Clearly, the MoD has scope for ‘re-profiling’: extending the period under which equipment will be bought, but the basic consideration remains that in the decade covered by the current Equipment Plan, the MoD is likely to have a lot less spending power for important elements of capability than it had before the referendum vote on 23 June.