Written evidence from the National Audit
Office
MANAGEMENT OF EXCHANGE RATE RISK BY THE FOREIGN
AND COMMONWEALTH OFFICE
BACKGROUND
1. This briefing has been prepared for the
Foreign Affairs Committee to provide an overview of the management
of exchange rate risk by the Foreign and Commonwealth Office (FCO),
in support of the Committee's inquiry into the FCO Departmental
Report and Resource Accounts 2008-09.[23]
2. This briefing has been shared with the FCO
and Treasury to ensure that the evidence presented is factually
accurate, but the commentary and views expressed are the sole
responsibility of the NAO.
3. In its Report on the FCO Annual Report 2007-08
the Committee concluded that:
"We are deeply concerned that as a result
of the Treasury's decision to withdraw its support for the Overseas
Price Mechanism, the FCO may not be able to meet the higher international
subscriptions over the next two financial years unless it cuts
its activities. We conclude that it is deplorable that the FCO
should have to shoulder the financial burden from within its already
tight budget to pay for subscriptions which also benefit other
Government departments, and we recommend that additional non-discretionary
costs should properly be met by the Treasury".[24]
4. The FCO responded that:
"We note the Committee's concern over HMT's
decision to withdraw its support for the Overseas Price Movements
mechanism and the recommendation that additional non-discretionary
costs of international subscriptions which benefit wider HMG should
be met by the Treasury. This will need to be considered in the
next Comprehensive Spending Review (CSR). In the meantime we have
put in place, with HMT agreement, a number of mitigating measures.
These include forward purchase of our foreign currency requirements
and agreement that the costs of international subscriptions in
excess of £102 million would be shared by the Treasury and
FCO in the ratio 60:40".[25]
5. Accordingly, this paper provides further
background on:
— the Overseas Price Mechanism;
— the reasons why Treasury removed its
support for this mechanism as part of the CSR 2007 settlement;
— actions taken by FCO to mitigate the
exchange rate risk;
— related governance matters and skills
within FCO;
— the impact of foreign exchange rates
on the financial results for 2008-09; and
— FCO forecasts of the impact on FCO budgets
and its business going forward.
This paper draws upon interviews with Treasury
and FCO staff, together with an examination of relevant FCO documentation.
THE OVERSEAS
PRICE MECHANISM
(OPM)
6. FCO has a global network of 268 overseas
Posts which help it to deliver its key objectives. Posts' budgets
are set in sterling at the beginning of each financial year. Significant
elements of the budgets are spent in the local currency and are
affected by both local inflation rates and currency fluctuations,
affecting in turn a Post's spending power during any financial
year. The Overseas Pricing Mechanism (OPM) was designed to identify
the effect of inflation and currency movements on local budgets.
7. Until 2007, FCO and Treasury used the OPM
to maintain the local purchasing power of the Department's settlement
through technical adjustments to the sterling settlement, to take
account of changes to local purchasing power resulting from exchange
and differential inflation rate movements. Every six months, the
Department would calculate the impact of exchange rate movements
and differential inflation rates on its purchasing power in over
160 countries in which FCO operates, and advise Treasury of the
net outcome across the Department's overseas operations. If the
settlement would have resulted in greater local purchasing power
than intended (because sterling's value had strengthened since
the spending settlement), sterling was returned to Treasury. If
additional sterling was needed to maintain local purchasing power
(because sterling's value had fallen since the spending settlement),
it was provided by Treasury. The annual adjustment was made from
the Treasury Reserve in the Spring Supplementary Estimates each
year. Figure 1 gives details of the annual OPM adjustments for
the four years up until 2007-08, as made in the Spring Supplementary
Estimates. This shows that in three out of the four years FCO
transferred resources back to the Reserve.
Figure 1
OPM ADJUSTMENTS AS REFLECTED IN THE SPRING
SUPPLEMENTARY ESTIMATES
Financial Year
| Amounts of adjustment
(£ million)
| Claim from the Reserve or
transfer to the Reserve
|
| 2004-05 | -14.1 |
Transfer |
| 2005-06 | -4.9 | Transfer
|
| 2006-07 | -9.6 | Transfer
|
| 2007-08 | +1.4 | Claim
|
| Source: FCO Spring Supplementary Estimates
| | |
| |
|
8. Treasury support to FCO under the OPM extended over
a number of years, going back at least as far as the 1980s. This
arrangement was unique to FCO as a tool to protect the Department
from exchange rate movements.
WHY WAS
OPM REMOVED BY
THE TREASURY
AS PART
OF THE
CSR 2007?
9. As part of the 2007 CSR settlement, Treasury withdrew
the OPM mechanism, as one of a package of elements within the
settlement. In Treasury's view, whilst some of these elements
were highly challenging (such as the required efficiency savings
and withdrawal of OPM), other elements were to FCO's benefit,
including substantial growth in the Department's capital expenditure
limit and a cost sharing agreement with the Treasury for subscriptions
to international organisations. In the Department's view, the
increase in capital was provided to fund the increased costs of
security across the network including those resulting from a personnel
shift from Europe to the conflict zones, notably South Asia as
well as the Middle and Near East and North Africa, to help fund
a new Embassy in Kabul and to assist with the UK's share of UN
and NATO Headquarters costs.
10. Treasury's purpose in withdrawing OPM was to introduce
what it saw as more modern methods of risk management. The Treasury
faces many competing demands on the expenditure reserve it retains,
so it has long been the Government's policy to ask departments
to bear the risk of predictable variations in expenditure in their
Departmental Expenditure Limits (DEL). At the time of the 2007
CSR settlement, the Treasury considered it appropriate to extend
this to include currency movements, particularly as there were
risk management instruments commonly available in the financial
markets, and historically the FCO' s annual adjustment for currency
variations had averaged out at around £10 million.
11. In general terms, Treasury has long recognised that
some expenditure is subject to variation that is unpredictable
and results in cost variations of a scale that cannot be managed
within departments' DELs, and these are scored against Annually
Managed Expenditure (AME). FCO considers that the fluctuations
in sterling since 2007 and the high proportion of its annual expenditure
spent in foreign currencies should lead to foreign currency spend
being classified as AME, rather than DEL. However, Treasury does
not consider this spending is appropriate for AME, not least because
it looks to FCO to factor in exchange rate changes as a part of
resource allocation decisions.
12. FCO contends that in several areas of foreign policy
priorities, such as the need to negotiate a climate change agreement
or to respond to the terrorism threat, the risks and opportunities
to the United Kingdom of doing business abroad, or choosing not
to, do not change alongside rises or falls in foreign exchange
rates.
ACTIONS TAKEN
BY FCO TO
MITIGATE THE
EXCHANGE RATE
RISK
13. At the time of the CSR settlement, sterling was at
a historically high point against the US Dollar and Euro. The
Department's budgets for the CSR 2007 period were agreed at assumed
rates of £1 to 2.0143 US Dollars and £1 to 1.4578 Euros.
An appreciation of sterling against the CSR rates would increase
the spending power at Posts and also reduce the sterling costs
of the Department's contributions to international organisations.
Depreciation against the CSR rates would reduce spending power
at Posts and increase the sterling cost of the Department's contributions
to international organisations.
14. The Department began considering how to manage its exposure
to foreign exchange risk immediately after receiving notification
of the November 2007 CSR settlement, in which Treasury confirmed
its intention to withdraw funding for OPM. At the FCO's request,
the Treasury agreed in principle that the Department could adopt
a forward purchase regime for the main currencies it needs. Between
November and January 2008, staff attended workshops with banks
to understand the various options available. The Department then
began to assess its total annual exposure to foreign exchange
risk.
15. The Department's objective in developing its proposals
was to achieve as much budget certainty as possible, through buying
foreign currency forward. Spending power would, though, still
be reduced if foreign currency were to be purchased at any rate
below the CSR assumed rates, and since then all forward and spot
purchases have been significantly lower. For example, the average
forward purchase rates secured for US Dollars were $1.95 for 2008-09,
$1.62 for 2009-10 and (to date) $1.52 for 2010-11. With the CSR
rate at $2.0143, this has put considerable pressure on US Dollar-based
budgets. What neither the FCO nor the Treasury foresaw was the
extreme volatility in foreign currency markets in the early part
of the CSR period following the global financial crisis.
16. The FCO considered three main options for managing
its net foreign exchange exposure:
(a) continue to purchase at spot rates for all currencies
as and when the currency is needed;
(b) forward purchase 100% of its currency needs for the whole
of the CSR period; or
(c) forward purchase a significant portion of its major currency
exposure (initially US Dollars and Euros), and purchase the remainder
at spot rates as and when needed.
17. In February 2008, proposals were submitted to the
FCO's Finance Committee, which finally approved option (c) and
recommended the forward purchase of 80% of the FCO's net US Dollar
and Euro exposure for 2008-09. This percentage would allow for
any incorrect profiling by budget holders and avoid any build
up of unnecessary pools of foreign currency.
18. The FCO operates in over 120 local currencies around
the world, with significant expenditure incurred in US Dollars
and Euros. 27 currencies are purchased by the FCO's Treasury Team
in the UK, with the exposure in only six worth more than £4
million each per year (US Dollar/Euro/Japanese Yen/Swiss Franc/Canadian
Dollar/Hong Kong Dollar) and 14 costing less than £2 million
each per year. The FCO now includes Japanese Yen in the currencies
it forward purchases, but does not consider it cost effective
to place forward contracts for the others, which it purchases
at spot rates in the UK and sends to Posts. It should be noted
that the majority of currencies the FCO uses cannot be purchased
in the UK and continue to be purchased locally.
19. For the longer term, the Department considered a
more sophisticated risk management strategy. In April 2008, the
Department placed a contract with HiFX Intelligent financial services,
a specialist Forex trade company, to provide, in exchange for
a monthly fee, professional advice on the range of options available
to the Department in managing its risk. HiFX recommended two hedging
strategies; one for euro and one for US Dollar. Both of these
derivative based options were approved by the FCO Finance Committee
on 14 April 2008.
20. However, HM Treasury has set out the main principles
for dealing with resources used by public sector organisations
in the UK in a document known as Managing Public Money.
Paragraph 5.9.3 of Managing Public Money states that the
Treasury "will always refuse proposals to speculate".
The rationale is that providers of complex financial instruments
intend to profit from their business and provide a cost of finance
that is inferior to the UK government's cost of borrowing. Adhering
to these guidelines, the Treasury would not sanction the more
complex hedging proposals that had been put forward by the Department.
21. The Department then submitted proposals to the Treasury
to purchase forward for up to 80% of FCO's requirements for US
Dollars and Euros for 2008-09. This was to include all foreign
currency spend within FCO's DEL, including all international subscriptions
and the Peacekeeping budget. Following a further period of negotiation
and discussion, in May 2008, Treasury agreed this proposal and
the Department placed its first contract on 28 May 2008.
22. In August 2008, Treasury agreed that FCO could proceed
to enter into forward purchases to cover requirements for 2009-10.
Mindful of the principles of Managing Public Money, the
Department continued the practice that contracts for forward purchases
of US Dollars and Euros would be placed on the 15th day of each
month, with contracts entered into for a maximum of 12 months
ahead. Monthly data on exposure to foreign currency risk would
be derived from detailed forward profiling spreadsheets that were
maintained by FCO's Strategic Treasury Team. Figure 2 illustrates
how FCO calculated the number of US Dollars that they would forward
purchase during 2008-09 for delivery in 2009-10.
Figure 2
ILLUSTRATION OF HOW THE DEPARTMENT CALCULATES THE AMOUNT
IT PURCHASES IN A FORWARD CONTRACT
The Department assessed the amount of total US Dollars required
to meets its obligations under its three main expenditure sub-heads
of (i) Peacekeeping and Conflict prevention, (ii) Contributions
and Subscriptions to International organisations and (iii) Post
funding as $932.1 million for 2009-10. This figure was used as
the basis for determining the amount of US Dollars that would
be secured in forward purchase contracts during 2008-09, maturing
in 2009-10. A percentage of either 80% or 90% was then applied
to each of the subhead requirements based on the degree of certainty
over the amounts and timing. The total amount of US Dollars required
for 2009-10 is $819.1 million. In the event, the Department secured
$811.6 million in forward contracts to be purchased during 2009-10.
Expenditure Subheading |
Estimated US Dollar
requirement |
Percentage
applied | US Dollars required
for 2009-10
|
| Conflict Prevention & Peacekeeping |
537.2 | 90% | 483.5
|
| International Subscription | 197.0
| 90% | 177.3 |
| Post funding | 197.9 | 80%
| 158.3 |
Total requirement | 932.1
| | 819.1 |
Source: FCO management information
| | | |
| |
| |
23. In December 2008, as expertise within the FCO and
the Treasury's confidence in them grew, the Department developed
proposals to modify its initial strategy to one based on a "horizontal
layered" approach, in order to counter the increased volatility
of the foreign exchange markets. The strategy involved purchasing,
each month, one year ahead 1/12th of each of the following 12
months' exposure. The two benefits of this proposal were presented
as (i) greater budget certainty, sooner and therefore improved
forward planning and (ii) improved risk management, by spreading
the risk of sudden changes in exchange rates.
24. Both Treasury and the FCO Finance Committee approved
this "horizontal layered" strategy and the first purchase,
including a "catch-up" forward purchase, was made in
December 2008. HiFX continues to provide the Department with weekly
advice on available trading options.
25. In terms of management information, the Director
of Finance receives monthly updates on the currency forward purchases.
Within the Monthly Key Performance reports presented to the Board,
there is a one page high level summary on forward purchases. For
each currency purchased, this includes the period covered by the
last contract placed and the foreign currency value and the sterling
equivalent of that contract, together with the total value of
contracts entered in the CSR period to date and the total realised
and unrealised gains and losses in the financial year.
26. In June 2009, the Department sought and Treasury
gave it permission to forward purchase into the next CSR ie from
1 April 2011 onwards. Until this point all of the Department contracts
had been up to 31 March 2011. The rationale behind this continues
to be a non-speculative strategy with the objective of achieving
budget certainty.
GOVERNANCE AND
SKILLS
27. Both FCO's Director General Finance and Director
of Finance are finance professionals who understand the mechanics
of making forward purchases of currency. FCO already had plans
to enhance its treasury management function before the withdrawal
of the OPM and, in February 2008, appointed a new Head of the
Treasury Management Team. The Department did not plan to recruit
any additional staff specifically to arrange the forward purchases,
but did plan to provide focussed training when required to those
personnel involved in administering the contracts. The majority
of the training has therefore been on the job. This has not been
problematic given the relatively straightforward forward purchase
arrangements which the Department is dealing with.
28. Although there were some significant senior staff costs
incurred in the early stages of setting up the arrangements for
placing forward purchase contracts, FCO considers that the on-going
in-house staff cost to maintain the spreadsheets and place a call
to the Bank of England once a month to be relatively small. FCO
continues to pay HiFX a monthly fee for professional advice in
this area. However, the Department considers the indirect costs
of managing the broader consequences of the withdrawal of the
OPM have been far greater with a considerable amount of senior
management time, including that of the FCO Board, Heads of Mission
and Management Officers, taken up in managing the impact of currency
fluctuations.
29. In September 2009, a firm of external consultants,
commissioned by the Director of Finance, completed a review of
FCO's foreign currency management arrangements. The review team
were also asked to propose a potential foreign exchange management
framework. The report concluded that progress had been made in
a number of areas but that there was a need to produce a formal
document of policies and procedures. The review team noted that
a formal Treasury policy was being drafted, to include objectives,
policies, instruments, limits, timelines, roles and responsibilities,
as well as specifying controls and segregation of duties. In addition
to the Policy document, the review team recommended that a Treasury
Procedures Manual should be prepared which contained detailed
step by step descriptions of the forward purchase process.
IMPACT OF
FOREIGN EXCHANGE
RATES ON
FINANCIAL RESULTS
30. In September 2008, the Chief Secretary to the Treasury
agreed to FCO drawing down End of Year Flexibility (EYF) of some
£15 million to compensate for adverse currency movements.
However, the full year pressure of the decline in sterling was
around £100 million (some 5% of the total budget of some
£2 billion). FCO therefore had to look for efficiency savings
beyond those planned in the CSR to live within its DEL. In the
event, FCO did not need to draw the full EYF because of foreign
exchange gains made against early currency purchases and being
able to utilise identified under-spends, as part of improved financial
management under the Five Star Finance Programme. It ultimately
drew down some £6.5 million and stayed within its DEL budget
for 2008-09.[26]
31. The 2008-09 Resource Accounts[27]
detail the forward purchases entered into by FCO during 2008-09.
The Department purchased 559 million US Dollars and 102 million
Euros, which were delivered at a cost of £367 million. Due
to the weakening of sterling over the course of the year, these
purchases resulted in a realised net exchange rate gain of some
£43.6 million. The Operating Cost Statement[28]
was credited with an overall net gain of some £40.8 million,
after taking account of gains and losses on other currencies.
32. The 2008-09 Resource Accounts[29]
also show forecast unrealised gains of some £89.4 million
on forward purchases maturing after the balance sheet date, based
on the actual exchange rates at 31 March 2009. Since that date,
forward purchases have been extended as far as November 2011,
while others have matured. As at 18 November 2009, FCO forecasts
a net gain of some £30.2 million on forward purchases maturing
during 2009-10, as illustrated in Figure 3 below.
Figure 3
FORECAST POSITION ON FORWARD PURCHASES MATURING DURING
2009-10
| FCO forecast position on forward purchases
| Gain/(loss) £ million |
Realised gains/(losses) on forward purchases maturing between 1 April 2009 and 18 November 2009
| 43.4 |
| Unrealised gains/(losses) on forward purchases maturing between 19 November 2009 and 31 March 2010
| (13.2) |
| Total forecast gains/(losses) on forward purchases maturing between 1 April 2009 and 31 March 2010
| 30.2 |
Source: FCO management information (unaudited)
| |
| |
33. As at 20 November 2009 and since the start of forward
purchases, the Department has purchased a total of 1,177 million
US Dollars and 236 million Euros, delivered at a price of some
£844 million, resulting in an overall estimated net gain
to date of some £88 million (unaudited). Forward purchase
contracts for 1,238 US Dollars and 320 million Euros, costing
some £1,107 million, will mature between December 2009 and
November 2011, with a forecast loss of £48 million.
34. Figure 4 shows the decline in Sterling against the
US Dollar and Euro since 2007, set against the assumed rates which
underpin FCO's CSR settlement and average rate of forward purchases.
As sterling has always been below the CSR assumed rates (Paragraph
12) since the beginning of the CSR period, even the forward purchase
contracts which appear to deliver gains actually represent a reduction
in the Department's purchasing power compared to that agreed in
the settlement.
Figure 4
THE DECLINE IN STERLING AGAINST THE US DOLLAR AND EURO
NOVEMBER 2007 TO OCTOBER 2009
Source: www.x-rates.com and FCO management information
IMPACT OF
EXCHANGE RATES
ON FCO FOR
2009-10 AND BEYOND
35. Several government departments and agencies, including
the Ministry of Defence (MoD), Department for International Development,
the British Council and the Department of Health do transact some
of their business in foreign currency. MoD has been using forward
contracts for approximately 20 years, placing quarterly contracts,
up to about five years in advance, to cover a schedule of fixed-date
payments in US Dollars and Euros for major capital projects. However,
the proportion of its contracts as compared to its overall DEL
is considerably less than that of the FCO. FCO has a much smaller
DEL, compared to MoD, and about half of FCO's expenditure is in
foreign currency, making it much more challenging to absorb gains
and losses. Much of the foreign currency spend is non-discretionary,
for example, subscriptions to international organisations, contributions
to UN Peacekeeping which are legal obligations set in foreign
currency, local staff salaries, rents and other contractual obligations.
36. A number of factors will increase the amount to be spent
in foreign currency in 2009-10 and beyond, such as increasing
contributions to UN Capital projects and international subscriptions
to NATO. The UK government's contribution to Peacekeeping missions
has also risen due to increased activity through the UN and the
European Union. The forward purchase contracts entered into during
2009-10 are on less favourable rates than those entered into during
2008-09. As a result, during 2009-10 there will be a larger difference
between contract rates and the Department's budget rates which
were set in December 2007, with a resultant larger gap in budget
and reduced purchasing power.
37. The withdrawal of the OPM and the subsequent fall
in the value of sterling has had a major impact on the FCO's business
worldwide. FCO estimate that from funding of some £830 million
for what it considers its core activities,[30]
the Department has to cope with exchange rate pressures of some
£100 million in 2009-10 on budgets where some 80% of Posts'
costs are considered to be inflexible in the short term, for example
staff salaries, rents and other contractual obligations. Measures
taken by Posts to stay within budget include reducing the working
week to four days or requiring involuntary unpaid leave for some
locally employed staff and embarking on a redundancy programme
for others.
38. In addition, FCO told us that it has had to reduce
provision for: security abroad; health and safety, including over
50% of essential works in the difficult environments of Africa;
and current and future capability. This, in its view, is severely
impacting on its ability to deliver frontline diplomacy and has
led to wide-ranging cuts to programmes supporting international
priorities, including counter-terrorism.
23 November 2009
23
HC 460, Session 2008-09. Back
24
Para 214, Second Report of the Foreign Affairs Committee Session
2008-09, HC 195. Back
25
Response of the Secretary of State for Foreign and Commonwealth
Affairs, April 2009, Cm 7585. Back
26
Note 2 of Resource Accounts, Volume Two, Page 122. Back
27
Note 29 of Resource Accounts, Volume Two, Pages 149 to 151. Back
28
Note 8 of Resource Accounts, Volume Two, Page 127. Back
29
Note 29 of Resource Accounts, Volume Two, Page 150. Back
30
FCO budget information. Back
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