Will HS2 be kicked into the long grass?

The much criticised flagship HS2 rail project, which seeks eventually to build a new £50+ billion high-speed rail route between London and Scotland, has had a difficult few months.

Phase 1 from London Euston to Birmingham is due for completion by 2026, whilst the construction of Phase 2 – a Y-configured route from Birmingham to take in both Manchester and Leeds – is scheduled to operate from 2033. 

Recent confirmation of heavy investment in several much smaller rail projects in the North and the Midlands, a series of legal challenges to HS2 and even bureaucratic foul-ups at the Department for Transport (DfT) have all been negative for the project’s future.  And, at the macro-economic level, the UK economy is basically flat-lining thereby substantially deferring the year when the UK’s public sector net debt (PSND) will eventually start to fall – it recently passed through the previously unimaginable £1 trillion threshold.

As such, further deep public expenditure cuts seem certain as the UK seeks to protect its treasured AAA sovereign debt rating. Whilst the HS2 project has many flaws, such as its environmental impact, its weakest case remains financial. Quite simply, the numbers don’t stack up. And, even assuming that the optimistic passenger growth projections until 2033 are accurate, it is difficult to discern how a decent commercial return can be generated. A Tory minister was quoted in the Spectator recently as saying that the project was 'effectively dead'.

Compared with other EU countries, HS2’s projected Phase 1 capital costs per mile are way higher, whilst its claimed financial benefits are seriously inadequate. A Benefit-Cost Ratio (BCR) analysis by the DfT for Phase 1 barely shows a positive return, even before many risk factors. Not surprisingly, the DfT prefers to focus on the various contentious non-commercial benefits. In times of economic crisis, previous Governments have axed major projects. Within the next three years, the highly uneconomic HS2 project is a strong candidate to be shunted into the sidings.

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HS2 may be heading for the siding

The recently announced postponement of a decision on the controversial HS2 project, ostensibly on environmental grounds, raises various questions. The Government claims to have found a spare c£500 million, which would enable additional tunnelling to be built in the Chiltern Hills area, where opposition to HS2 is particularly strong. To be fair, £500 million of additional investment – when compared with the £45.5 billion invested in the Royal Bank of Scotland – may not seem a vast amount.

However, as the ASI’s recent publication High Speed Fail pointed out, the financial case for HS2 is already very weak, even before further tunnelling expenditure. Put simply, the numbers do not ‘stack up’. Indeed, assuming that HS2 eventually reaches Scotland, over £50 billion will have been spent. Given that the recent Autumn Statement revealed that the UK’s already horrendous public debt – now close to £1 trillion – continues to rise well ahead of expectations, the case for pushing HS2 into the siding gets stronger.

After all, like virtually all high-speed lines, HS2 will probably be loss-making, even with the pay-as-you-go funding model proposed by the Department of Transport. Between now and mid-January, expect the Treasury to crawl over the numbers, especially those relating to the capital cost and the projected size of the fare-box once Phase 1, between London Euston and the West Midlands, is operational. By Treasury standards, the projected Benefit Cost Ratio (BCR), which was sharply downgraded earlier this year to just 2x (including wider economic impacts), is very modest.

There is, though, considerable momentum behind the HS2 project, especially from those believing – rather optimistically – that it will sharply narrow the north/south divide. Of course, there is no certainty that the Government’s decision next month on HS2 will be final. The focus, though, will be on the financial analysis within the Treasury who will be very hard-pushed to claim the numbers really do ‘stack up’.

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The case for floating exchange rates

The sorry plight of the Euro-zone provides a robust case for the primacy of floating exchange rates. In years past, many initiatives were undertaken to fix exchange rates – many ended in tears. After all, as Lady Thatcher so elegantly put it ‘you can’t buck the market’. This sentiment is particularly valid in today’s currency markets where vast sums of money change hands – often on spurious rumours.

Where the Euro-zone ends up is anybody’s guess – its denouement, though, seems nigh. Whilst Greece’s chaos is a tragedy for the country, the fact that ten-year yields in Italy have breached the critical 7% yield threshold is immensely worrying. As an EU big hitter, Italy’s current financial plight greatly increases the risk of contagion.

Aside from Ireland, Portugal and Greece, there are other potential casualties. The French Government is petrified that its credit rating may be cut, whilst its banks are exposed to large ‘haircuts’ on bad debts. Germany is desperately worried it may become the Euro-zone’s ‘lender of last resort’. Spain, whose position seems less grim compared with Italy, is also in the firing line. Expect, too, more reports of large transfers of deposits from the weaker Euro-zone member banks into Germany, Switzerland and the UK.

When the Euro was being debated, many siren voices predicted it would end in tears – and they were right. A combination of political myopia, hubris and sheer EU pigheadedness drove the project forward. Had the EU retained individual currencies, notably the Deutschmark, varying economic performances would be reflected by exchange rate movements. Hence, Italy’s old lire would be weak, to the benefit of its exporters’ competitiveness.

Instead, struggling Euro-zone members are locked into too high an exchange rate despite their profound wish to grow their economies. Of course, some companies dislike floating exchange rates, but currency risks can be insured against via banks. Let the case for floating exchange rates prevail.

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Europe’s crisis is the UK’s opportunity

cowThe profound financial crisis at the heart of the EU provides an ideal opportunity to address the issue of the Common Agricultural Policy (CAP) which was set up in the 1950s mainly at the instigation of Germany and France. Currently, it accounts for annual expenditure of over €50 billion and represents a colossal percentage – some 40% – of total EU costs. Central to its operation are many concepts – subsidies, quotas, levies and intervention prices – that are anathema to most free market economists. 

Not surprisingly, the CAP has also given rise to such Pythonesque features as butter mountains and wine lakes. Whilst some progress has been made in reforming the CAP in recent years, the reality is that it remains a highly expensive anachronism of post-war recovery – and very unsuited to today’s competitive economy.

Inevitably, in the short term, the EU’s focus will be on saving the euro as the markets continue to home in on the dreadful public finances of both Italy and Spain – whilst accepting that Greece’s case is virtually beyond recall. Amongst the more sensible proposals for resolving the euro crisis is a currency split between two EU blocs – the northern and southern countries, with France’s membership underpinning the latter.

In any event, the euro crisis is giving rise to fundamental thinking about the future of the EU. Indeed, within the UK, eurosceptics are becoming far more vocal, with continuing calls for a referendum on the UK’s future EU participation. Furthermore, at some juncture, the UK may need to make further financial contributions to saving the euro – whether directly, through the IMF or bilaterally as with the Ireland.

In return, the UK should demand concessions of its own, including major cuts in CAP payments and, in the long term, its abolition. Its replacement should be based on individual national agricultural policies. Remember, the PR executive mantra – every crisis provides an opportunity.

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The decline of British retail

With the on-going eurozone crisis, the UK economy is now enveloped in unremitting gloom. Of course, if you over-spend as conspicuously as has been the case over the last decade, the return to normalcy will be immensely challenging – and time-consuming. After years of excess debt, the UK is now experiencing the first elements of a ‘hard landing’.

Last week, the UK retail sector had a shocker, possibly its worst week for generations. The mighty Tesco announced that its core UK like-for-like sales growth over the last quarter, excluding petrol and VAT, fell by almost 1% – its worst performance for 20 years. Whilst Sainsbury’s underlying figures were less gloomy, recent data from other less defensive retailers is far worse. The retail electronics sector remains in a desperate state. Both Dixons and especially Comet (owned by Kesa) are struggling whilst HMV’s share price continues to plummet. Last Wednesday, Mothercare stunned the market, with a trading statement that sent its shares spiralling down by 42% – an astonishing fall for a reputable high street retailer.

In assessing these figures, remember that annual inflation is c5%, so that these like-for-like sales figures are, in real terms, even more depressing.
Currently, optimism is a rare commodity in the retail sector, which partly explains the widely reported last-minute re-drafting of the Prime Minister’s conference speech. The prospects for Christmas already look very grim. Few retailers expect their post-Christmas trading statements to be favourably received.

However, the benefits of a market-led economy mean that it can adjust readily to changed circumstances. Tesco, for example, has already launched parts of its ‘Big Price Drop’ campaign, which – despite an adverse impact on margins – should boost sales. In time, as debt levels revert closer to equilibrium, shoppers will return in greater numbers and lift the high street gloom. But the stark lesson for governments remains – never lose control of public borrowing.

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