Network Rail loses £982 million on derivatives

I have pointed out in past years that Network Rail, our nationalised railway industry, is very good at losing large sums of money on trading and owning derivatives. Yesterday I looked at charities close to the state and in receipt of large grants that have made a financial success out of it. Today I want to start a review of a nationalised business that receives far larger sums from the state and has made large losses out of it.

The Network Rail management claim they need to deal in derivatives, as they have substantial long term borrowings where the interest rate might go up when they need to refinance. Worse still the company has borrowed considerable amounts in foreign currencies, meaning they have a foreign exchange risk which would require them to pay back a larger sum if the pound falls whilst they owe the debt. They call what they do hedging.

Their latest annual account for 2014-15 states ” Some derivatives do not qualify for hedge accounting and are therefore classified as held for trading. Changes in the fair value of derivative financial instruments that do not qualify for cash flow hedge accounting are recognised in the Income statement as they arise.” This is a complex way of saying that although they claim all their derivatives are needed against borrowings they have made, accountants regard some of them as trading activities. When these go wrong they have to declare the loss each year as it occurs and put up more collateral – more cash – against the position they are running. Last year they needed to find an extra £690 million of cash to sustain their derivatives. The reported loss on derivatives was £982 million.
Is this what a nationalised.l railway should be doing with taxpayers money? Is this Jeremy Corbyn’s dream way to run a nationalised railway? I don’t think they should be borrowing in foreign currencies in the first place, and am glad they are now treated as a business owned for taxpayers by the Department of Transport, using the Treasury to borrow money for them in sterling. Their revenue is in pounds so it is better their debts are in pounds.

When we are trying to control public spending it does not help when a large taxpayer owned business does this in derivative trading.

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Housing Association riches

It is good to see a group of charities which are closely linked to the public sector doing well financially. The Housing Association movement has a successful business model. They invest in residential property, often with grant aid for the investment. They let most of the homes out to people who usually need Housing Benefit to pay the rents, so there is state underwriting of their main income. Housing Benefit stands behind many of the rent increases that are now common, owing to pressures from demand on the supply of rented properties. They make a surplus or profit on their trading accounts. They pay no tax on this surplus all the time they maintain their charitable status. They then see the value of their residential holdings go up as the market rises, yielding substantial tax free gains.

One of the largest reported a surplus of £209 million last year on trading account. It held £340 million in cash and liquid investments. Its properties which cost it £5.6 billion to buy and build were worth £16.3 billion (at market value assuming with vacant possession). It had received £2.695 billion of accumulated grants. This pattern seems common. Another I look at recorded an operating surplus of £106 million last year, held £170 million in cash and liquid assets and held £3.7bn of gross assets at book cost which was doubtless a substantial understatement of market value.

The issue I want to raise is what more can the Housing Association movement do to assist with the wish of many more people to own their own home? Could they use their cash, their skills as developers and their ability to borrow against the security of their large portfolios to make many more new homes available for affordable homes to buy? What should the government’s policy on grants be, given the financial strength of these bodies? Are these bodies doing enough to help in a market short of housing with high rents?

86% of UK householders would like to own their home, but only 64% do. This is down from 69% in 2001. Worse still the proportion of people under 40 who own their home has shrunk fastest, thanks to the pressure of demand and pre 2007 lending policies driving up prices.

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Buying British

The government has set an ambitious target to double UK exports by 2020. That would certainly boost growth and transform the balance of payments. Equally helpful would be reducing imports by making and providing more of the things we want for ourselves instead of importing them.

The Environment Secretary has recently said she would like to see the UK dairy industry expand its cheese, yoghurt and other added value manufacture of milk products. As someone who usually buys English cheese I know there is plenty of choice and good English product already available. Today I carefully selected UK yoghurt which was also available. It should be possible for the home grown industry to woo more domestic customers. I look forward to progress with clearer labelling without EU interference.

Homes are UK produced, but there is a wide array of components, utilities, fixtures and fittings which are imported. Maybe businesses could respond to the challenge of coming up with the perfect English or Scottish home, with a higher proportion of local materials and products included.

UK buyers seem to like buying cars imported from afar, whilst the UK industry is especially good at selling cars abroad. I have always bought an English manufactured car. I only once used a German car many years ago provided by the company I then worked for and was disappointed with the build quality and reliability. I have been satisfied with most of the English cars I have owned and impressed by many of the huge improvements they – and other overseas car industries – have achieved in recent decades in specification and performance. The UK industry could persuade more UK buyers.

Great advanced country manufacturing businesses are driven to success by great design and good technology. The UK has allowed some of its design edge to slip in textiles, ceramics, machine tools and other areas of engineering. As change is ceaseless and the digital age is anarchic in its impact on many old business models, there is still opportunity for the makers to march in bigger numbers.

One of the disappointing features of the public sector is how much it imports and how little it sells abroad. As a recent blogger has reminded us the NHS fails to bill lots of foreign visitors who receive treatment here. The nationalised railway along with the subsidised and directed private companies that form part of it import large quantities of equipment from overseas instead of basing the technology, design and production here.

Various parts of the UK public sector buy cars made overseas when there are perfectly good UK produced ones available. If I challenge this I am usually told it’s the result of EU procurement rules. Funny I don’t see German or French officials travelling around in UK made cars.

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The economic impact of cutting the deficit

Some people write to this site or in other publications to tell us that as sector balances in an economy have to sum to zero, attempts to cut the public sector deficit are damaging to output and activity as something else has to give to keep the sector balance. Let me explain why their view is likely to be wrong.

First, we need to grasp that there are conventionally four sectors with balances, not just the balance of payments and the public sector deficit they like to concentrate on. There is the private household sector, the private business sector, the public sector and the foreign sector or balance of payments. Turning their argument around, we have only been able to run a large public sector deficit because the business and household sectors wished or were required to stop net borrowing and generate a savings surplus, and because the overseas sector was prepared to let us buy more than we could afford, with substantial inward movements of money for loans and investments to balance the excess purchases. Whilst reining in the private sector a bit may have been necessary after the large borrowings of the pre crisis period, running a large balance of payments deficit and encouraging a lot of new foreign claims over our assets may not be such a good long term strategy.

Getting the public sector deficit or borrowing down can be balanced by any one of the following, or some combination of them. It could be facilitated by a movement out of balance of payments deficit, by making more of the things we want to buy here at home and or selling more abroad. It could be enabled by the private household sector borrowing more to facilitate more home ownership for example. It could be enabled by businesses borrowing more to invest, or generating less profit and cashflow if conditions become more competitive. More borrowing or less saving by either part of the private sector could be a good thing if it leads to more productive investment, better housing or other stores of value. If it is just a question of which brings more satisfaction, borrowing to spend on what you want or the government borrowing to spend on your behalf to buy what you want, it does not mean public sector borrowing is always the best choice.

The range of changes is considerable. There is no simple identity between the public deficit and the balance of payments. Curbing the public borrowing requirement as the balance of payments deficit on trade is coming down or as the private business sector has some profitable investments to undertake is a good thing, not a bad thing and can take place with growth occurring.

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Labour and democracy

One of the ironies of the Labour leadership contest is the dislike of democracy amongst the Labour establishment. We read of rumours that a senior figure wanted to terminate the contest prematurely because it might produce the wrong answer. We hear of conversations between Labour establishment advisers and others over whether they could have a single Stop Corbyn candidate. We hear that some Labour MPs would want to dump the new leader as soon as possible if it is to be Mr Corbyn. We watch and listen to Yvette Cooper and Andy Burnham respond to Mr Corbyn, allowing their agenda to be dragged into discussion of the suitability of the front runner rather than a positive case of why they would offer the best leadership. Yvette Cooper understands she needs to communicate a positive message of a better UK were she to lead, but is being hampered by the absence of a compelling vision and phrase. Andy Burnham just flip flops from one day to the next as he tries to gain the front runner position he seemed to think he had by right.

No wonder people are fed up with aspects of contemporary politics. The Labour leadership discussion exudes a sense of entitlement rebuffed from the mainstream candidates. They look shocked that they are not leading the opinion polls, worried that their meetings don’t attract the following Mr Corbyn attracts, and bemused by the way Mr Corbyn has an army of followers enrolling as £3 voting members when they do not have lots of new people to draft in. They fall back on garnering the endorsement of Messrs Blair and Brown and repeating the establishment arguments that you have to carry on doing things much as they did them in Brown’s government and Miliband’s opposition period. “Credible” is their favourite word, mouthed without any sense of irony. How credible was Labour’s tax and spend strategy? How credible was Labour’s remodelled banking regulation? How credible is Labour’s passive acceptance of all things EU? What does Labour now think of its immigration policies of the last decade? Has Labour found England on a map yet or recognised our flag?

I certainly don’t think Mr Corbyn has the answer to the UK’s problems. I do think he asks difficult questions of the Labour establishment, and highlights the failings of their past economic, foreign and EU policies. It is his willingness to demand change and to point out that it was the Labour establishment that got them into their current mess that clearly appeals to many Labour supporters. Meanwhile the country could benefit from an opposition that was willing to oppose. If only one of them would pledge to oppose the accretions of power and the unwise laws coming from the EU that would liven UK politics up and shine a light onto just how much is now done for us by Brussels. The Opposition should be putting pressure onto the government to get powers back from the renegotiation. They need to confess just how much power they gave away and show some remorse at the limitations now placed on any UK government. The more parts of UK government policy the EU runs, the more the Labour establishment figures look like puppets of Brussels.

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China and markets

Last week whilst the EU has been focused on its chaotic Euro scheme and the Greek loan, and its troubled borders, the world economy has felt stronger ripples from China.
Last month the Chinese authorities indicated they thought their domestic share market had gone up too far too fast. Investors agreed and a sell off ensued. This threatened to get a bit out of hand, so the authorities took strong action to cushion the market, attacking short sellers, buying shares directly and asking main Chinese players not to sell. It was controlled capitalism designed to reassure and a reminder of how this is still a managed system with a government that has a lot of firepower and influence over markets. The need to intervene was a problem on the way to more liberal and liquid markets. Some market players disliked the degree of intervention and the temporary cessation of trading in shares.
This month the Chinese authorities decided they wanted to liberalise their foreign exchange market a bit more. They started the following day’s trading in their currency the yuan at the last price the night before, instead of returning to their managed rate. They were in practice moving from a crawling peg chosen by them, to a managed float, where the markets can lead in deciding whether the currency needs to go up or down a bit. This time some in the markets objected to more market influence on the exchange rate. or sought to claim the Chinese authorities were deliberately devaluing their currency. It took a strong statement from the government to reassure some that the plan is not to carry out a major devaluation but to allow market forces more play in setting the rate.
China is still embarked on a major liberalisation plan for her financial markets and currency. It will not always be smooth. It does mean that sometimes markets will set prices the Chinese authorities do not like. They will need to live with that more often. It does not look as if the Chinese now want to devalue their currency on the scale of say Japan, where the currency has devalued by a third against the yuan over the last five years. China is in transition from export and investment led growth to more consumer growth. It is likely China will now loosen monetary policy more, providing a further stimulus. For all the fears and alarums China is still growing at a reasonable pace, and the world economy should manage growth in excess of 3% this year overall.

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Economic crashes and changes of government

The Conservative party presided over membership of the Exchange Rate Mechanism which caused a damaging recession. This policy was recommended by Labour, the Lib Dems and the CBI, but it was a Conservative government that wrongly undertook it. Once the damage it had done was clear the Conservatives slumped in the polls to around 30% and were unable to win a General election for the ensuing 18 years. Many other issues were blamed for Conservatives lack of success in subsequent elections, but it was the economic mistake which did the damage and which the Conservatives fought to overcome without success until 2015.People were still raising the issue of the high interest rates the ERM caused on the doorsteps in 2005 and 2010. What most people want from a government is policies that allow or assist rising living standards for them and their families.

Labour presided over the banking crash and large slump which followed in 2007-10. Conservatives and Lib Dems had warned against the excessive build up in credit prior to the crash. Labour so far has been out of office for 5 years since the catastrophe, which caused a bigger and deeper recession than the ERM. Labour needs to re-examine how and why it got it wrong in 2005-10 and show it has learnt the right lessons from that experience. Voters will still be raising with them the Great Recession of 2008-9 in 2020, just as they did in 2015.

History suggests the main opposition party only gets another chance to govern when the party in government damages the economy sufficiently, as Labour did in 1968-70 (devaluation crisis), Conservatives in 1974 (coal strike crisis), Labour in 1979 (winter of discontent following trip to IMF and recession), Conservatives in 1997 (Exchange Rate Mechanism recession of early 90s) and Labour in 2010 (Great recession and banking crash).

An opposition party can reduce its problem and get closer to power by making the right apology for past mistakes and showing it has learned from the bitter experience. The narrower the gap, the smaller the error of the government before the Opposition has a real chance of winning. Claiming the crash of 2007-10 was all the fault of the bankers, or that it was an international crash which the UK government could not avoid is not going to wash. The Conservatives rightly could not get away with saying the ERM was a multi party and establishment policy so they should not be uniquely blamed for it. If something happens when you are in government the public rightly expects you to take action to stop it or alleviate it. In the case of the economy voters know that there are external events that you cannot avoid, but they also know that a government has plenty of powers that can make a difference. In the case of rigging the exchange rate or failing to regulate banks properly, they know those were bad decisions by incumbent governments.

Labour needs to accept that

1. It spent and borrowed too much in the public sector prior to the crash, with PFI and other off balance sheet financings adding to the excess borrowing (e.g. Network Rail).
2. It set up a new system of financial regulation in 1997 which failed to rein in excessive credit prior to 2007, so both public and private sectors were borrowing too much.
3. It then with its regulators made the worse error of revealing the weakness of the banks without helping them fix their illiquidity, bringing the whole banking system close to collapse. It should have held secret talks to get the banks to recapitalise themselves, whilst supplying short term loans against security.
4. Only after it had damaged the banks did it make the liquidity available that the banks needed.
5. It wrongly invested in RBS at too high a share price without demanding the changes and reforms needed.

Once it has understood that far from “saving the world” Labour compounded its errors it can get on with thinking through a future economic policy that could enhance the prosperity of UK people.
The fact that the USA and parts of the EU made similar errors in regulating banks does mean this was a “global crisis”.The crisis in the UK that was the fault of the UK government and regulators.

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Gordon Brown seeks candidate with credible economic policy

There is a delicious irony in Gordon Brown saying Labour needs a credible economic policy from its new Leader to be able to win an election. It was his boom and bust policy towards bank regulation which lost them two elections in a row, so I am not sure his judgement of what a credible economic policy would look like can be relied on.

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Why the BBC is embarrassed by England and seeks to break up our country

I am meeting representatives of the BBC at their request following my submission that the review of the BBC considers their services to England.
I will not of course be meeting BBC England. After much prodding there is now a webpage on England, but there is still no BBC England with England’s news and other programmes in the way there is a BBC Scotland or BBC Wales. The BBC still seeks to implement a regionalisation agenda for England, breaking us up into regions that encourage little loyalty or even recognition.
My first question to the BBC is Why do you insist on trying to balkanise England when you do not do the same for Scotland? The Highlands and islands are very different from the lowlands, the borders are different from the central belt, yet you allow Scotland to be a single entity. Why is my part of England called the South of England? Why is Wokingham lumped with Dorset and the Isle of Wight, but not with neighbouring Surrey or west London?
My second question is why are you so embarrassed by England? The answer appears on your short profile of England which you have now published on the BBC website. In a revealing passage the BBC states

“Scottish and Welsh nationalist movements have long been part of the political mainstream, and are seen as champions of legitimate historical identities. English nationalism…has often been portrayed as a reaction to non white immigration and is seen as largely the province of the far right. But there is a constitutional nationalist movement that focuses on the English Parliament issue”

So England cannot have a BBC England because a few nasty people have pursued extreme nationalism, whereas in the case of other nationalist movements we look at the majority law abiding membership of those movements and not the criminal fringes. It is interesting that they seem to equate proper national coverage for the nations of the UK with nationalisms. Why can’t they just give sensible national coverage for England within the UK? Many English people want their country recognised and loved without wanting to break up the UK.

They are also hung up on devolution. Apparently you cannot have national feelings withouth a government. Their dismissive attitude to England is unpleasant. ” The kingdom of England had a distinct identity until it was subsumed into the UK in 1707″ – not you note 1603 and the union of crowns. “The establishment of devolved parliaments in Northern Ireland, Scotland and Wales after 1997 gave those constituent parts of the UK their own political identity, leaving England the only part directly run by the British government”.

England is a country with no England government. It has officially recognised symbols including its flag which is flown from Churches, sports stadia, and official buildings as appropriate. You are allowed to have the English flag on your number plates. Yet the BBC claims that “Markers of specific identity such as the flag of St George tend to be unofficial, while similar signs of Scottish and Welsh nationhood are sanctioned by the separate institutions of those countries.”

So when they ask me what my issue is, I will say simply stop denying England’s flag and national feelings, stop trying to break England up, and stop judging England by the minority tendency of its criminal extremists.

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How bankrupting then bailing out some banks changed UK politics

There have been two fundamental decisions taken by UK governments in my lifetime that have haunted politics ever since they happened. The first was the decision by Mr Heath and then the British people to join and stay in the EEC. The second was Labour’s decision to drive various commercial banks into financial difficulty, only to then put large sums of taxpayers money into them as new share capital.

This second decision overshadows current public debate. It has made possible the Corbyn challenge, seemingly offering free money to spend on public sector projects by printing cash to pay the bills. Regimes that have tried this elsewhere have usually found it ends in very high inflation, high debts and a crash.

The crash and bail outs of 2007-8 has led to a general dislike of the banks, when flourishing trusted banks are an essential component of any successful free enterprise economy.The bank manager may rarely be liked or loved, but does need to be respected and listened to. Every individual, family and business needs a bank account to settle bills, a savings account if they have a surplus, or an overdraft or mortgage if they need to spend more than they earn for sensible reasons like buying assets.

It has spawned a rash of policies to show different parties are tough on banks – with higher taxes, larger fines, bigger penalties, more regulations. Of course any bank executive or bank breaking the law should be prosecuted and punished appropriately, but turning banks into a cash cow for the government just delays the rebuilding of their balance sheets and limits their capacity to lend more to finance recovery. If taken to extremes it could also lead to their exit from the Uk altogether, with the loss of employment and tax revenue that would bring.

I fully share the popular distaste for taxpayers money being pumped into large businesses that have been and will be rich again.I can’t defend large share subsidies to RBS when the bank carried on paying very large salaries and bonuses to staff at a time when there was an obvious need to control public spending. This single act has encouraged a cynicism about politics.People hear the political attacks on banks and bankers but see the political action of the Labour government pumping in collosal sums without demanding fundamental reform of pay, bonuses and activities as the price of equity support.

At the time I urged the Bank of England to use its normal facilities to lend against security to keep the banks out of grave financial trouble. The Bank instead gave us all a lecture on moral hazard and set its mind against lending. With the FSA the Bank failed to demand that the commercial banks reined in excessive lending early enough. Once it had occurred they then demanded it be sorted out more quickly than was possible, and made their worries public to make runs on the weakest banks likely. The crisis was not just bad commercial banking but also dreadful Central banking.

Once the publicity created the crash, the government then caved in and gave large sums in new capital. Instead they should have gone for controlled liquidation, propping and supporting the deposit base and the general commercial activities that were crucial with loans, and demanding the sale of the more exotic and overseas assets to help slim the groups and pay some of the bills. Shareholders and bondholders should have taken the hit, not taxpayers.

Allowing competing private sector companies subsidised capital without demanding reform was a moral and political disaster. It has led directly to a feeling that different laws apply to the banks and to an attitude which thinks that one bad policy mistake justifies more such mistakes. It has led directly to some assuming that money printing is now acceptable and could work on a larger scale for wider purposes. It has also led to a new hostility between the many voters and one of the nation’s leading economic activities which still pays a lot of the bills. I will look at its consequences for the two main parties in a future post.

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  • About John Redwood


    John Redwood won a free place at Kent College, Canterbury, He graduated from Magdalen College Oxford, has a DPhil and is a fellow of All Souls College. A businessman by background, he has been a director of NM Rothschild merchant bank and chairman of a quoted industrial PLC.

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