E
C
A
A
R
-- SA
ECONOMISTS
ALLIED FOR ARMS REDUCTION
Patrons
ECAAR --
Rhoda Kadalie
3B Alpine Mews, Box 60542
Human Rights Activist
Njongonkulu
Ndungane
Tel:
+27-21-465-7423
Archbishop of
website: ecaar.org/za
Chair
Terry
Crawford-Browne
OFFSETS and the affordability of the arms deal
Trustees
ECAAR--
*Oscar Arias
SUMMARY
*Kenneth J. Arrow
1. Earlier government announcements
William J. Baumol
2. The affordability
study
Barbara Bergmann
3. The Auditor General and SCOPA’s
14th report
John
Kenneth Galbraith
4. Offsets
Robert Heilbroner
5. Parliamentary public
hearings
Walter Isard
6. Media comments
*
Robert S. McNamara
8. Strategic, economic and financial
irrationality
*Franco Modigliani
9. The British-SA government loan
agreements
*Douglass C. North
10. Implications of cancellation of
the arms deal
Robert Reich
Robert J. Schwartz
*Amartya Sen
*Robert M. Solow
Terry Crawford-Browne
*Joseph Stiglitz
November 2002
*James Tobin
* Denotes Nobel Laureate
Affiliate Chair
J.
James K. Galbraith,
Akira Hattori,
Alex
Mintz,
David Throsby,
SUMMARY: It is indisputable that the South
African government’s 1999 decision to purchase warships and warplanes was
motivated by expectations that offsets would not only make the purchases
“affordable,” but would also provide unique stimulus to South Africa’s
industrial development and create 64 165 jobs.
It is also
indisputable that the Cabinet was given ample warnings that the offsets might
not materialise, that the expenditures would crowd out socio-economic
priorities, and that the foreign exchange risks were also substantial. Despite such warnings, the Minister of
Finance in January 2000 signed the loan agreements that give effect to the arms
deal.
International
literature agrees virtually unanimously that offsets:
increase rather than
decrease the costs of weapons acquisition,
distort market
forces,
are a cause of weapons
proliferation,
are almost impossible to
monitor,
are notorious for
corruption, and
impede rather than
contribute to economic development.
The arms deal is
strategically, economically and financially irrational, and consequently fails
the tests of objective rationality required of government administration.
ECAAR-SA seeks judgment that the loan agreements signed by the Minister of
Finance are constitutionally-unlawful, and therefore null and
void.
The Constitution
takes precedence over
It is however, also
evident that the arms deal contracts were government-to-government arrangements,
and that heavy pressures were exerted upon the South African government to
conclude these agreements. That the
arms deal was a political decision is not, in itself, a concern of the
The warships and
warplanes have not yet been delivered -- let alone been paid for -- and
accordingly can still be cancelled.
The estimated costs have already escalated from R30 billion to R67
billion. An opinion survey of ANC
voters recently found that 62% want the arms deal cancelled, 19% want it cut,
and only 12% support it.
The loan agreements
and guarantees signed by the Minister of Finance will cripple
A decision that the
arms deal is constitutionally-unlawful and therefore null and void will place
the financial consequences of cancellation on the European governments and
export credit agencies that colluded in these transactions in violation of the
EU Code of Conduct on Arms Exports and other commitments to good
governance.
OFFSETS and the affordability of the arms deal
The Minister of Trade and Industries, Alec Erwin insisted on August 13, 2002 during the parliamentary debate on the Joint Investigating Team arms deal report that the offset programme is well ahead of schedule in terms of benchmarks. It had attracted foreign investment, created exports worth US$6 billion – the target was US$3.9 billion – and created or retained 2 000 jobs.[1]
The decision to re-equip the South African National Defence Force was
taken, like any other decision by any public sector entity, where the
procurement will result in more than $10 million US imported content, it
immediately becomes liable to the national industrial participation
programme where they must meet a minimum of 30% of that imported
content through a range of specified obligations in a domestic economy.
And we believe that the National Industrial Participation Project, both its
defence component and its civilian component, are meeting the objectives
that we originally said.
We needed to re-equip [the defence force], and in the process of re-
equipping it, we used the leverage that gave us to strengthen
industrial economy, which have to be to the benefit of our people.[2]
Other government spokesmen have however, been at pains in recent months to declare that offsets linked to the armaments procurement package were merely a bonus, and not the determinant for the purchases. The Minister of Defence Mosiuoa Lekota declared during the same debate:
We used the opportunity to benefit the economy. Otherwise we would have to spend the money. The offsets were a bonus. It is a distortion to twist the issue into offsets. We would still need to buy the equipment.[3]
1. Earlier government
announcements:
These statements contradict government motivations to the public in 1998 and 1999 that expenditure of R29.771 billion would generate offsets of R110.579 billion to create
64 165 jobs.[4] Offsets would not only make the acquisitions “affordable,” but would also stimulate economic development and create jobs. The public was informed then that offsets linked to the arms deal were not just a bonus, but represented a unique opportunity to attract international investment.
The government media briefing in November 1998 noted:
Analysis of international experience of offsets shows that offsets tend to succeed where
· Large established world class companies involved
· Recipient country has clear industrial strategy
· Recipient country has relatively developed industrial base
· Recipient country has good governance
· Institutional capacity exists to manage offsets.
It declared that jobs created and sustained through industrial participation:
· Figures are speculative
· Direct jobs created and sustained in
Defence sector
Manufacturing
Export orientated sector
Tourism
Construction
· Indirect multiplier effect estimated at not less than 4:1
· Net jobs created should easily exceed 65 000
The briefing also declares in terms of financing arrangements
mandate – negotiate an affordable
package
Two separate
dimensions
Negotiations with
Banks/Export Credit Agencies
Goals
·
Maximise ECA loan coverage
·
Achieve flexible payment options
·
Reduce margins, fees, ECA premia
Negotiation
Outcomes:
Loan
Packages
Best Case
Achieved
Affordability
Assessment:
Conclusions
Contractual
Architecture
Umbrella
Agreement
Loan Agreement
Ministry of Defence – Supplier-ARMSCOR-------------------Ministry of Finance – Bank
Supply Agreement DIP Agreement DIP Agreement
Next
Steps
October/November ‘99
October/December ‘99
In summary, the offsets and the financing arrangements were intrinsic parts of the acquisition programme. The Department of Finance’s August 1999 affordability study was equally self-congratulatory:
2.4
< Loan packages
2.4.1
Following extensive negotiations in
2.4.2 These concessions by the ECAs are largely unprecedented. The finance package finally achieved has greatly pushed out the boundaries of ECA defence financing and is probably unique. The terms now achieved with the ECAs and banks have substantially improved the financing in terms of cash flow, exchange risks as well as producing substantial savings for the borrower amounting to approximately US$101.9 million (over R600m).[6]
The mandate of the Finance Negotiating Workgroup followed a
cabinet Ministers’ Committee decision on
i. To assess the affordability of the procurements, including measures to increase affordability, and to formulate proposals for the Negotiation Team and Ministers
Committee on this subject.
ii. To assess the budgetary implications of the procurements and formulate
proposals for the Negotiating Team and Ministers’ Committee regarding these.
iii. To define the most appropriate way of financing the procurements of the
strategic packages.
iv. To assess the economic implications of various aspects of the proposed
procurements and formulate proposals for the Negotiating Team and Ministers’
Committee with regard to these.
v. To undertake the actual negotiations with suppliers and supplier-related parties
in respect of the financial aspects of the procurements.
It should be stressed that, given the unique size of the
packages and the tenor of the associated financial agreements, the impact of
package expenditures will extend far beyond the procurements themselves. Any decision about these procurements
and the magnitude of their claim on the budget will inevitably also constitute a
decision about the future level of defence spending in
The affordability study noted that:
Certain costs which are intrinsic to these purchases and the financial
packages were excluded from
the figures presented on
There are three viable sources of funds available to finance the packages:
Most pertinently, the affordability study concluded:
The proposed armaments
procurements are distinguished from other government procurements
by four key characteristics. The
sums involved
are extremely large; they involve fixed contractual commitments extending
over long periods with high breakage costs; they are heavily
import-biased;
and their costs are offset by a set of associated activities (the NIPs)
which cannot be
guaranteed.
These characteristics create a set of important and unique risks for
government. The analysis of
these risks suggests that as the expenditure level increases these risks escalate significantly. In
fact even expenditure of R16.5
billion may create a situation in which government could be confronted by
mounting economic, fiscal and financial difficulties at some future
point.
Ultimately the decision about expenditure levels really constitutes a
decision
about government’s appetite for risk.[8]
In his answering affidavit to our main application 9987/2001 filed in November 2001, the Minister of Finance declares in paragraph 35 and subsequent paragraphs that once the Cabinet decided to acquire the equipment, his role was merely to negotiate the most appropriate means of finance. He was, of course, also a member of the cabinet Ministers’ Committee that decided to purchase the equipment. In paragraph 53.2 he avers that “the agreements he signed are self-standing loan agreements with binding force and not dependent on any other agreements entered into by government.”
In other words, the arms deal stands independently of the financing arrangements. This is tantamount to claiming that the purchase of a house is independent of its mortgage. Not only is this claim absurd, but it is contradicted by the affordability study cited above and the loan agreement signed on January 25, 2000 by the Minister, the British Export Credit Guarantee Department and Barclays Bank PLC and related agreements.
It is also evident from the GCIS media release of
Warburg Dillon Read was paid consultancy fees of R8.821 million, and White and Case was paid R4.720 million for related legal consultancy fees. [9] The Joint Investigating Team report into the arms deal cost R9.505 million.[10] Additional consultancy fees relating to the offsets and paid by the Department of Defence during 2000/2001 and 2001/2002 amounted to R23.937 million.[11]
The affordability study also includes exchange rate assumptions 1998/99 to 2018/19. The assumptions were conducted by Warburg Dillon Read in consultation with the Department of Finance, including extraordinarily incompetent work in projecting forward rand/dollar exchange rates. The study notes that “built into the forward rate quoted by the market are international investors’ perceptions of risk (country risk, political risk etc), and there could be some rationale for applying a discount to this premium [in other words understating these risks] on the grounds of Government’s commitment to stable macroeconomic policy, inflation targeting and fiscal prudence.”
In fact, nowhere in the world do forward currency markets extend twenty years, let alone for an “exotic currency” such as the rand which is historically subjected both to volatility and substantial depreciation. The unreliability and recklessness of the Warburg Dillon Read study is illustrated by the fact that the rand/dollar exchange rate collapsed to R12.88 in December 2001, and is currently quoted at approximately R10.50 per US$1.
Consequently, the Minister of Finance was obliged to concede during his budget speech in February 2002 that in only two years the cost of the arms deal in rand terms had already escalated from R30 billion to R52.7 billion. The Warburg Dillon Read study had projected the following exchange rates until 2018, thus grossly understating the financing risks of the arms deal and that military spending would consequently crowd out state expenditures on social and economic upliftment:
Year
1998/99 6.30561
1999/00 6.85586
2000/01 7.52093
2001/02 8.20663
2002/03 8.89549
2003/04 9.60734
2004/05 10.30635
2005/06 10.99230
2006/07 11.67304
2007/08 12.33443
2008/09 12.99476
2009/10 13.96195
2010/11 14.99693
2011/12 16.09052
2012/13 17.25445
2013/14 18.49769
2014/15 19.84491
2015/16 21.28991
2016/17 22.83100
2017/18 24.47856
2018/19 26.25155
Given the rand’s history depreciation over the past 30 years, it is not inconceivable that rand/dollar exchange rates could fall further to R15 per dollar by 2005, R30 per dollar by 2010 and even R90 per dollar by 2018. The consequence of such currency destruction is likely to be social anarchy since it impacts hardest on the poor.
Yet, as noted by the Joint Investigating Report into the arms
deal, the Cabinet was given sufficient warning of the financial risks involved,
but chose instead to make a “political decision.” In video testimony to the Public
Protector’s office on
RW: Ja, Affordability is an entirely subjective term. Affordability is ultimately a question of political choice. You can afford a huge amount for health services for example if you don’t spend money on very much else, etc. etc. So ultimately there is no mutually objective concept of affordability out there. So it’s a question of political choice. And, you know, I should just add there, I am sure this is a theme to which you will refer later, this is a choice which the Cabinet is paid to make. That is their job... What is their job? To decide what the country can afford, and what choices should be in terms of commitment in fiscal utility. Having said that, I would say the part of the affordability team a little more broadly which is to look at the fiscal and economic impact of the procurement, and the risk involved in this procurement in order that the Ministers Committee and I guess ultimately Cabinet, would be in a position to make a well informed choice about the affordability of the purchase and if you want, if the country could afford it.
I am not going to express a view of whether it was smart or not. OK. But I will make one or two I guess less judgmental points. The first point is that prior to the contract actually being signed, no commitment was actually been made yet. Now, expectations may have been raised, a whole lot of thing may have happened, but you were not actually obliged to buy anything until such time that you sign on the dotted line.[12]
Question CvdM: In the report you allude to the fact that an increase military budget could have an impact in terms of the expenditure switching away from social, educational and other health expenditure if the economy did not grow too fast. Were any studies done, or any investigation done to see what the impact of that would be on the economy? I am alluding to the fact that, increased, at the moment the military budget makes up about 6% of the budget, but if it goes up to say 14 or more percent, and the economy do not grow that fast, what would the impact be; the effect of the impact on education, health and social services. Was that ever considered in the affordability study?
RW: Well, at a general level, yes. I mean, that >>>>>>>>>> I was saying earlier, I mean, what you’re doing..the only way you can model this, is basically to look at broadly, what kind of expenditure exists within the economy. Different kinds of expenditure, as you know, have different sorts of impact within the wider economy. So, if government has decided not to spend R5 billion a year on military stuff and not on other productive sectors, that has a number of impacts on the economy. What the effect on a specific sector would be, on education and so on down the line, we dealt with in some degree, in the report, and we gave certain examples to show how much of the whole project was the equivalent to of the housing budget, or whatever >>> , we showed that over a three year period….
CvdM: Yes, but the point what I want to make is, no attempts were made to show what extent the defence budget increase at the time could crowd out the expenditure on other functions of government.
RW: That could be not right, I’ll give you the reference.
RW: I am holding the final affordability report that went to Cabinet, or the Ministers Committee rather, it begins with 00580, I am on page 00643 at point 4.5, headed fiscal acceptance of procurement expenditure levels, 4.5.3, there are several paragraphs there, including a table, which look on the impact on overall government expenditure >>>>;4.5.4 is headed impact on other departmental expenditure; and there is a number of paragraphs, there is a table there, which looked at the impact of these expenditures with different scenarios on the housing budget, on the Siemet program, on the education budget, as examples. So, this was covered well.[13]
In September 2000 the Auditor General expressed concern that
the offsets and their related performance guarantees were unenforceable. This gave rise to further investigation
and public hearings in October 2000 by the parliamentary Standing Committee on
Public Accounts (SCOPA), and a recommendation of an independent and expert
forensic investigation into allegations including corruption. The transcript of SCOPA’s public
hearings held on
Dr Gavin Woods, MP Chair of SCOPA
Mr Laloo Chiba, MP member of SCOPA
Mr Chippy Shaik, Director of Procurements, Department of Defence
Mr Jayendra Naidoo, Chief Negotiator Defence Countertrade Package
Mr Andrew Feinstein, MP member of SCOPA
Mr Ron Haywood, Chairman of ARMSCOR
Woods: The Auditor General stresses importance of adherence to procedures. His report provides stark examples of how policies and procedures were not adhered to during the acquisition process. He recommends a forensic audit.
Shaik: VAT, duties and export credit premiums. The DoD had not originally incorporated the ECA premiums.
Shaik: The foreign exchange rate was calculated at R6.25:US$1, but by December 1999 when the contracts were signed, the commitments were in Euros. Total costs are difficult to say because of foreign exchange fluctuations. The Minister of Finance contracted the financial aspects in March 2000.
Shaik: That is the responsibility of the Department of Finance. We now calculate the costs at R46,5 billion at the year 2011. Financing arrangements are a matter between the Department of Finance and overseas banks. The financing costs are not included.
Naidoo: The National Industrial Packages are intangible. Nowhere in the world would you get a 4:1 multiplier. We got over 2:1. The procedures were complex.
Naidoo: The negotiating teams were: Department of Defence; the technical committee; Department of Trade and Industry, National Industrial Participation Programme; National Treasury, banks and Export Credit Guarantee Department.
Naidoo: The NIP policy originally required only 5 percent. The negotiating team concluded that 5 percent was inadequate to ensure the industrial participations. We doubled the performance guarantees to 10 percent, but the tender documents had only required 5 percent. It is not common practice for such performance guarantees to be linked to the offsets, which would then have become a disincentive to the suppliers.
Shaik: After the Cabinet decided on the package, the negotiating team dealt with the suppliers as preferred bidders.
Feinstein:
We as a committee don’t deal with policy, but value for money for public
funds. Why don’t we spend most of
our budgets on arms in order to leverage economic development? It doesn’t make sense to me as an
economist. International literature
suggests these offsets are subsequently diluted or disappear, or the suppliers
factor the penalties into the costs.
Why should
Shaik: Too much emphasis is being placed on suggestions that the DoD is acquiring equipment because of the countertrade.
Feinstein: The deal presented to Parliament is that R43.8 billion is being paid for armaments, a second fundamental factor being that we will receive massive economic benefits. We want surety that the economic benefits will be forthcoming.
Naidoo: It is a highly questionable proposition that offsets will generate economic development. Our exercise was to recoup some of the expenditure on the armaments approved by government. The acquisitions were not meant to generate a massive economic boom, but would be economically neutral. The defence industry works world-wide on the basis of offsets. If it failed to perform on its commitments, it would be unlikely to gain business elsewhere.
Feinstein:
Of the R104 billion, only 10 percent of R30 billion (R3 billion) is
guaranteed. What monitoring
programmes and enforcibility have been instituted? How can we legally bind a
commitment? If the offsets are not
going to be growth generating but economically neutral, what was the point of
the offsets? We need the legally
binding contracts, and we need to ask why the deal was not underplayed but
instead emphasized that
Woods: We find the figures malleable and conditional, and that the agreements are fudged. How do you monitor the offsets?
Feinstein: The Auditor General has noted that the packages were negotiated before the Budget was provided. Did the tail wag the dog? What exit clauses apply between the prime and sub-contractors? The Auditor General indicates grey areas. The Department of Defence had very limited control over the selection process. Is that so?
Shaik: The package was government to government with tenders provided by the respective embassies. There were government commitments to the pricing structures, and also government undertakings of responsibility to perform the offsets.
Haywood: Denel’s joint ventures with the suppliers mean that Denel will break even financially next year and will become a major supplier in international markets. The British government has a representative at the Department of Trade and Industry to make sure that the offsets work, and another representative from DEXA. The offsets must be considered over a seven year period.