A £38bn debt weighing on the Ministry of Defence has been almost eliminated with tough financial management, Liam Fox will claim next week, as he seeks to highlight a turnround in the fortunes of Whitehall’s most “traumatised” department.

One year after David Cameron’s coalition initiated its Strategic Defence and Security Review that slashed MoD spending and personnel, Britain’s armed forces are still reeling. However, the defence secretary will tell the Tory conference in Manchester next week that MoD finances are now stable, thanks to removing the debt he inherited from Labour. At £38bn, this was bigger than the department’s annual budget.

Mr Fox will argue that the action the government has taken to balance the budget means the UK has a better base for strategic military planning than at any time in a quarter-century.

His allies may also be tempted to suggest that Mr Fox – whose recent 50th birthday celebration was attended by Lady Thatcher – is enjoying a boost thanks to the MoD turnround.

“Since we came to office, the Treasury has regarded management of major MoD equipment projects as the biggest financial risk in government,” an ally of Mr Fox said on Monday. “But the signs are the Treasury now thinks those risks are to be found in other parts of Whitehall.”

Last autumn, the MoD was forced by the Treasury to reduce its core budget by about 8 per cent in real terms over four years. But the MoD’s crisis was magnified because it had committed itself to buying £38bn of equipment for which no funds were set aside.

As a result, Mr Fox has been forced to introduce measures to balance the books. These include withdrawing aircraft carrier capabilities, scrapping surface ships and air squadrons, and cutting 42,000 in personnel.

Speaking at the Commons liaison committee in May, Mr Cameron said the MoD budget was “the most traumatised budget and frankly the most traumatised department I have come across as prime minister”.

Senior figures in the armed services nonetheless continue to feel deeply aggrieved by the extent of cuts. Some argue it would be impossible to deploy aircraft a year from now in the way they just have been in the Libya operation.

Yet Mr Fox’s overall strategy receives a boost today in a report into MoD finances by Malcolm Chalmers of the Royal United Services Institute, a think-tank. He argues that themeasures have eliminated the “black hole” – but will leave the UK with “a wide spectrum of capability” in 2020.

Prof Chalmers calculates the “black hole” came to £74bn with other factors taken into account, including chancellor George Osborne’s insistence that rebuilding the nuclear deterrent must be paid for out of the core MoD budget, not Treasury reserve.

He argues that, when all decisions taken in the past year are considered, the MoD “appears to have substantially narrowed – and perhaps even eliminated – the remaining funding gap”.

Senior officials acknowledge challenges. One of Mr Fox’s concerns is that, in the event of another recession, budget pressure would be renewed by Number 10 and the Treasury.

However, Prof Chalmers argues that, while cuts have been tough, claims that Britain’s long-term capability has been damaged are exaggerated. He says the UK will still emerge from reform with a revamped deterrent, at least one new carrier, the new Joint Strike Fighter squadrons and other new capabilities.

“Currently planned levels of defence spending should be enough for [the UK] to maintain its position as one of the world’s five second-rank military powers – with only the US in the first rank,” he said.

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Concern at submarine cost

The Ministry of Defence may have brought its budget into balance for now. But over the next decade, it will face huge challenges to keep its costs under control. The biggest concern is its plan to build a fleet of three or four submarines to carry Britain’s independent nuclear deterrent.

Construction work on the submarines is set to begin in 2016. This will see the UK spending £25bn over the subsequent decade in what will be by far the biggest equipment programme on the MoD’s books. According to some experts, rebuilding the deterrent will take up some 30 per cent of the MoD’s entire equipment programme by the end of this decade.

The big risk with the deterrent construction programme is that if costs cannot be kept under control, other projects will suffer. One of these is the UK’s plan to buy about 50 Joint Strike Fighter combat jets to fly from its new aircraft carrier, the Queen Elizabeth.

Professor Malcolm Chalmers of the Royal United Services Institute, a think-tank, said the JSF order could be at risk. He believes that the costs of building the deterrent after 2021, plus the costs of bringing the Queen Elizabeth carrier into operation at the same time, “could mean that there simply are not the funds to buy even the 50 or so JSF aircraft that at present seem realistic”.

A second project that could suffer is the plan to build a surface combatant, the Type-26 frigate. On current assumptions, 13 frigates will be built after 2020. “But growing spending on the Trident successor from 2021 onwards may oblige the government to accept a substantial reduction in the Type 26 order,” said Prof Chalmers.

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