SOUTH AFRICA'S DEFENCE-RELATED INDUSTRY: EXTRACT
THE ECONOMICS OF DEFENCE OFFSETS
When countries procure defence equipment they have a number of options, ranging from indigenous production to off-the-shelf purchase from a foreign supplier. In between there are various forms of involvement in production and the development of the product, each of which will have different implications for costs, programme risks, control over specifications and wider industrial and economic benefits (Hartley, 1991). In addition to direct involvement of the purchasing country, joint production, licensed production, subcontractor production, foreign direct investment and technology transfer there are various other methods of compensation such as counter- trade, which may be civilian rather than military. All of these are lumped together under the concept of 'offsets'. Countries often have different criteria for whether offset obligations are required for a particular transaction and what types of offsets are acceptable. The United States Government defines offsets as 'industrial compensation practices required as a condition of purchase in either government-to-government or commercial sales of defence articles and/or defence services'. The UK has followed a more restrictive approach (Martin, 1996).
It is useful to distinguish between direct offsets, which includes goods and services for the equipment the purchaser is buying (ie the supplier sources parts of the weapon system from the purchaser) and indirect offsets, which includes goods and services unrelated to the specific equipment, and can include foreign investment and counter-trade (barter counter purchase and buy back). It is also possible to agree to inward investment unrelated to the purchase of the goods. Such offset deals are an increasingly important part of the international trade in military equipment, especially in the aerospace industry (Martin, 1996; Udis & Maskus, 1991).
The nature of offset agreements will depend upon the type of buyer. In the case of a country with a defence industry, the emphasis of the offsets will often be on limiting the impact on the domestic industry by a relocation of economic activity from the supplier country to the purchasing country, including technology transfers. This relocation of economic activity may also be linked with offsets that focus on non-military products.
While official publications often herald offset agreements as beneficial to the purchasing country, the issue is much more complex and the costs and benefits of such programmes has been the subject of some debate. In general offset agreements are likely to be more of an attempt to justify foreign procurement, or to eschew domestic procurement, rather than an economic argument in support of the benefits of import replacement. In addition, while governments are usually only too happy to highlight the purported economic benefits (eg job creation) of offsets ex ante, they often seem reluctant to evaluate the economic impact of offsets ex post.
If a country with a local defence industry decides to procure new weapons systems, then it has to decide whether to produce the weapons locally or to purchase from a foreign supplier. Imports of off-the-shelf products (without offsets) tends to be the cheapest option, while local production is likely to be the most expensive option and the technology may not be available. If the decision is made to import then there is usually a search for a foreign supplier with the appropriate weapon system and a decent offset deal. If there is a local defence industry then it is bound to be affected by the procurement orders going abroad, but evidence suggests that maintaining a local defence industry is expensive and uneconomic for a small country (Dunne, 1996). This means importing arms may be more sensible, especially as there is usually a premium attached to offsets, with the result that the purchase price is normally higher. A study by Cooper (1999) argued that:
the costs incurred by arms companies as a result of offset deals are simply passed on to the recipient ... the level of job creation and technology transfer over and above that which would have occurred without offsets is generally minimal.
The welfare issues are unclear. Offsets relocate production to the purchasing nation, which represents a trade diversion that can be welfare-reducing. Imports can create wealth by allowing labour to be moved to more productive (competitive) areas of the economy.
On the other hand, international markets are not competitive and offsets may improve efficiency if they remove non-tariff barriers and lead to a search for more efficient subcontractors. Offsets may be considered as a subset of the myriad price-quality-quantity trade-offs, which characterise negotiations for large transactions (Martin & Hartley, 1995). They may lead to reduced transaction costs (reducing the number of contracts per trade) but they may also inhibit the flexibility of negotiating advantageous deals and result in inefficient procurement (Hall and Markowski, 1994)
Competitive bidding leads defence companies to compete on offsets and to come up with ingenious ways to deal with offset requirements. This sometimes leads to unrealistic and often complex offset agreements. The complexity of some agreements has led to the establishment of specialist agencies (eg Australia, Spain) within government to deal with offset programmes. This has helped both purchasers and suppliers to overcome the problems of the past, but there are still a number of potential problems. It is possible that the supplier may plan to renege, building into the purchase price the cost of reneging (moral hazard). It is often unclear how much of the offsets is genuinely new work; how much of the work would have been won without the offset, what is the technical content; and which companies and regions will benefit from the offsets? In addition, defence offsets have often been linked with development aid (eg Pergau Dam).
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Over 130 countries have some form of offset policy. In a recent international survey Martin (1996) concludes that, although problems of getting data make comparisons difficult there are some general conclusions that can be drawn:
1. Typically the value of direct/indirect offset is measured in financial terms and success or failure tends to depend on whether the vendor meets the obligation within the specified time period. It is also often unclear whether the work actually occurred because of the offset (was it new) and whether the difference between the off-the-shelf price compared well with the offset value.
2. Offsets have involved a learning experience on both sides. Suppliers often underestimate the costs of meeting offset commitments. Originally there was no cost to failing to meet offset obligations but now financial penalties for non-fulfilment have been included in offset agreements. There has been a move away from promises of orders to determining a package of work for domestic industry in advance.
3. There has been a move away from rather general offset programmes towards more focussed offset programmes.
4. Time horizons have lengthened, especially for countries with domestic defence industries. Buyers provide incentives for foreign firms to continue placing work with local firms and often try to encourage foreign firms to establish more formal links with local firms.
5. There has been a move towards more focused longer-term investment strategies, joint ventures, technology transfers, etc.
6. It is unlikely that offsets will disappear in the foreseeable future.
Clearly the benefits of offsets to the procuring country are open to question and the only way of determining the true value of an offset arrangement to a country is to make a detailed analysis, including at the level of defence firms. When this has been done the impact on the economy has been much smaller than expected or promised (Matthews, 1996; Martin, 1996). For a small country the issue may be to maintain an intelligent customer capability (intelligent buyer) and to be able to maintain and upgrade systems rather than to retain a domestic production capability. This might be achieved through maintaining technological capabilities in research establishments and requiring technology transfers, rather than retaining a local defence industrial base. If there are to be defence offsets then they could be used for developing civil products and/or to assist with the conversion of defence companies rather than attempts to maintain local defence capabilities. Any other solution could be considered second best.
In the case of South Africa the decision has been made to procure the weapons, and the emphasis has been placed on offsets rather than price. While there are clear opportunity costs, particularly with respect to the local defence industry, considerable efforts have been made to implement offset policies that reflect the experience of other countries, such as the UK. There is also a reasonable amount of information available, which allows us to consider the probable economic impact of the defence offset deals. Before doing so we need to consider the nature of the arms acquisition programme and the government's policy on offsets.
THE DEFENCE REVIEW AND THE SANDF'S R30 BILLION ARM~ ACQUISITION PROGRAMME The cuts in South Africa's defence budget that have been taking place since the late 1980s have been funded largely through cuts in the SANDF's capital budget the Special Defence Account. In the 1999/2000 budget the Special Defence Account was allocated 17 per cent of the total defence budget, down from nearly 60 per cent in the late 1980s (Department of Finance, National Expenditure Survey, 1999). As a result of the cuts in procurement spending the SANDF has had to cancel or postponed most of its major procurement projects since the early 1990s (Batchelor & Dunne 1998).
The Defence Review, which was approved by parliament in April 1998, provided details of a new force design and force structure for the SANDF. It proposed reversing the trend of increasing personnel and operating expenditure to allow for increased capital expenditure by cutting personnel levels in the SANDF from 100 000 to around 70 000 by 2000/1. The proposed rationalisation process in the SANDF would reduce the share of personnel expenditure to 40 per cent and operating expenditure to 30 per cent of the total defence budget, thereby allowing capital expenditure to increase to 30 per cent of the budget, a level last achieved in 1993/9]4. The Defence Review also approved new equipment requirements for the SANDF in line with the proposed new force design and force structure (Defence Review, 1998).
As a result of the Defence Review Armscor, the DoD's acquisition organisation, issued requests for tenders to foreign suppliers to meet the SANDF's new equipment requirements, including main battle tanks, jet trainers, light fighter aircraft, light fighter aircraft, utility helicopters, corvettes, submarines and maritime helicopters. All potential foreign suppliers were notified of the government's policy on offsets, and requested to submit proposals with their tenders. The next section provides some detail on these policies and their proposed implementation.
INDUSTRIAL PARTICIPATION IN SOUTH AFRICA Offsets or 'Industrial Participation' (IP), as it is officially referred to in South Africa, became mandatory for all government purchases in September 1996. In April 1997 Cabinet approved National Industrial Participation (NIP) policy and operating guidelines for all government departments and parastatals to be administered by the Department of Trade and Industry (DTI) (see Appendix 1). NIP effects all government and parastatal purchases or lease contracts (goods, equipment and services) with an imported content equal to or exceeding US$ 10 million (or the equivalent thereof) are subject to an Industrial Participation Obligation. The IP obligation must equal or exceed 30 per cent of the value of the imported content of the purchase or lease and must be fulfilled within seven years from the effective date of the IP agreement. The prospective foreign seller/supplier has to submit and implement business projects, which would generate IP credits equalling or exceeding the 30 per cent IP obligation. A 5 per cent performance guarantee is required prior to the IP contract being awarded.
The mission of the NIP policy is 'to leverage economic benefits and support the
Development of South African industry by effectively utilising the instrument of global supply chains. In May 1998 Grintek and GEC-Marconi (UK)8 entered into a joint venture, in which Grintek will produce subsystem components for telecommunications productions which GEC-Marconi sells globally (Business Day, 7 May 1998). In June 1999 Reunert and Dalmler-Chrysler Aerospace (Germany) together with a black empowerment group Kgorong Investment Holdings formed a new joint venture company, Reutech Radar Systems (Business Day, 9 June 1999). In August 1999 Grintek and Daimler-Chrysler Aerospace (Dasa) entered into a joint venture to develop high frequency radio systems (Business Day, 13 August 1999).
The arms deal has already had a significant impact on South Africa's defence exports. Some European governments have been 'prompted' to purchase South African defence products in favour of their own products, despite criticism from their domestic defence industries. For example, in early 1999 Denel's Somchem division was awarded a R1billion contract to supply fuses for the A590 155-mm howitzer guns used by the British peacekeeping forces in Bosnia (Business Day, 6 January 1999).
Some of the preferred European suppliers have also helped South African defence firms to bid for, and win, foreign defence contracts. In late 1998 Grintek was awarded a R56 million contract to supply audio-management systems for the British Aerospace-Saab Gripen fighter aircraft (Business Day, 16 November 1998). This was followed by an export contract in March 1999 from Ericsson Saab Avionics worth R6,2 billion to develop and produce electronic subsystems for the Swedish Air Force's next batch of 64 Gripens for delivery in 2003 (Business Report, 26 March 1999). Then in May 1999 Grintek was awarded an R8,4 million contract to design and develop the communications control and display unit (CCDU) for the aircraft (Business Report, 28 May 1999).
During early 1999 British Aerospace (Australia) and Denel Aviation entered into a joint sales effort to sell the Rooivalk Attack Helicopter to Australia. However, the bid was unsuccessful (Pretoria News, 22 April 1999). Analysis, Management and Systems (AMS) were awarded a R10 million contract to supply onboard computers for the sale of British Aerospace Hawk jet trainers to Canada. This contract was a follow-up to a contract to supply flight computers for Hawk jet trainers bought by the Australian Air Force in 1998 (Business Report, 27 August 1999).
JOB CREATION Total formal employment in the non-agricultural sectors of the South African economy has continued to decline since 1994, despite a 10 per cent expansion in real output, thereby creating a situation of ‘jobless growth' (Budget Review, 1999). Thus economic growth has been achieved through improvements in productivity (including labour productivity) rather than through employment creation. Unemployment in South Africa is currently estimated at 37,6 per cent of the work force and the need for 'labour-demanding growth' has thus become South Africa's most formidable economic challenge (Budget Review, 1999).
The foreign suppliers' defence purchases from the local defence-related industry, together with the prospect of increased defence exports, is likely to have a positive impact on job creation in local defence firms. Currently direct employment in the defence-related industry is estimated at 25 000 jobs (15 000 in the public sector and the rest in the private sector). Indirect employment (eg suppliers, subcontractors) accounts for a further 35 000 jobs.9 To put this into perspective more than 60 000 jobs in the defence industry have been lost since the late 1980s (Batchelor & Dunne, 1998).
The job creation estimates which were presented by government in September 1999 suggest that R104 billion worth of IP commitments will create approximately 65 000 jobs - this amounts to R1.6 million per job. This figure is extremely high and nearly 20 times higher than the average cost per job in the local defence industry. In 1997 the cost per job (remuneration costs per employee) in the public sector defence industry (Denel) was R93 722, while in the private sector (eg Reunert) it was slightly lower at R82 838. However, this is not an accurate reflection of the real costs associated with maintaining or creating jobs in the defence industry. In 1997 turnover per employee in the public sector defence industry (Denel) was R23 1 898 while in the private sector (eg Reunert) it was more than double - R464 633. Based on these figures, the estimate & R14.5 billion worth of potential DIP activities could create, or sustain, approximately 40 000 jobs (based on R350 000 per job) in the local defence-related industry.
Any such estimates are questionable, however, as the impact of the arms acquisition programmes, including the DIP activities, on job creation in the local defence-related industry is difficult to quantify. Certainly local purchases by the foreign suppliers, equity investments, joint ventures and export contracts will help to maintain jobs in the local defence-related industry, and prevent further retrenchments. In addition, even if the estimates presented above are accepted, they represent considerably fewer jobs than could be created if the money were used for other purposes than buying arms.
NON-DEFENCE INDUSTRIAL PARTICIPATION
Government, through it’sNIP policy, has attempted to use the defence purchases to leverage substantial investment in the non-defence sectors of the South African economy. It has attempted to ‘direct’ this investment to particular sectors (minerals and energy) of the industrial economy and to specific parts of South Africa such as Kwazulu-Natal, the Western Cape and the Eastern Cape (The Star, 29 July 1999). It has also attempted to link it with other national economic and industrial policy initiatives (eg the DTI’s Spatial Development Initiatives and Industrial Development Zones) (GCIS, 15 September 1999)
In September 1999 the government released some details of the foreign suppliers’ NIP offers.
CONCLUSIONS South Africa faces a number of economic challenges, including attracting foreign direct investment and creating jobs. In this context the government has decided to spend nearly R30 billion on imported arms for the SANDF. At no point has the government considered trying to limit the purchase costs of the SANDF's acquisition programme, by simply buying the cheapest off-the-shelf weapons (or even second-hand weapons). Instead, it has invested considerable effort into negotiating offset offers from the foreign equipment suppliers to benefit the local defence related industry and the national economy.
Leaving aside the issue of whether the expenditure on arms was necessary at all on security grounds, this paper has shown that the choice of imports with offsets seems a risky one. The purported economic benefits of offsets are questionable and what little empirical evidence is available suggests that they tend to have a much smaller impact on the local economy than expected. It is very difficult to judge whether the prices are reasonable, given the fact that there are no market prices and no standardised goods in the defence market. It is also unclear whether the work attached to the offsets is genuinely new work at the same level of technology etc.
The South African government has made a serious attempt to develop IP policies that
reflect the lessons learned by other countries. However, there are still potential problems, which leave the promised benefits of the arms acquisition programme open to doubt. There is still the possibility of firms reneging on agreements and simply paying the agreed penalties and whether the promised inward investment will take place and generate the numbers of jobs that have been promised. In addition there is the question of capacity within government (eg DTI and Armscor) to monitor the implementation of the NIP and DIP offers.
The local defence industry will certainly benefit from the direct offsets and while it might struggle to retain the capabilities to produce a range of advanced weapons systems it could become a part of the global industry as subcontractor to some of the foreign equipment suppliers. There are capacity and capability problems in the areas relevant to the navy orders, which suggest that the sector will benefit little, but the local aerospace industry has the capacity and capability to benefit significantly from the Air Force orders.
Whether South Africa should be maintaining a defence industrial base at all is an important question, given the evidence that it can be a drain on the economy. Off the shelf purchases would have been cheaper and would have allowed the government to allocate the savings to encourage conversion in defence related industries. This would have allowed it to develop those areas of the economy with the highest potential for economic growth and job creation, thereby dealing more effectively with the current high levels of unemployment.
A related issue is whether government should be using its IP policies (and its human resources) to support the maintenance of a local defence production capability. It could support a strategic capability to assess and make informed choices between competing weapon systems (ie an intelligent customer capability). This would seem to be preferable given the costs of maintaining a local defence production capability, the current state of certain sectors of the defence industry, and the fact that the international market has relatively stagnant demand and excess capacity.
Many of the foreign suppliers' NIP offers are certainly highly questionable. It is not clear whether SA will be getting state of the art technology in areas of growth, or old technology in areas of over capacity (eg stainless steel). The dangers are clear. After the economic damage the misallocation of resources to strategic industries and capital-intensive mega-projects caused under apartheid, it is important not to make the same mistakes again. It is not clear from our survey of the issues that the implications for industrial policy implicit in some of the offset offers have been fully thought out. It is certainly the case that the alternatives have not been given adequate consideration.