Publication: GCIS Issued: Date: Reporter: Reporte

How Much will Purchases cost?

The Auditor-General Shauket Fakie's special report to Parliament (15 September 2000) suggested that generally-accepted procurement practices in setting up the deal and selecting sub-contractors were not followed.

The report released by the public accounts committee seems to indicate that Cabinet was aware of the fact that the deal would cost more than R29 billion way back in September 1999 when the package was first sold to Parliament as "a bargain basement" deal.

As a result, loans of up to R48 billion were negotiated with several foreign banks, including Societe Generale of France, Italian bank Medico Centrale, & a consortium led by Commerzbank of Germany.The largest of the loans of about $3bn is from a consortium led by Barclays Bank of the UK, which was to finance the purchase of Hawk jet trainers and Grippen fighter aircraft.

The loans were negotiated for a period of 15 to 20 years, although the equipment was to be delivered in seven years.

The proposed audit would involve establishing whether, officials and ministers involved in the deal had conflicts of interest in the group of primary & sub-contractors attached to the deal, which they did not declare. It would also look into whether the deal would yield counter-trade & job creation (otherwise known as offsets) worth R100bn. - SABC News research by Lisa Costa Mendes

With acknowledgement to SABC News.

Costs and Pricing

The prices of the military equipment Cabinet has approved are given in the table below. The total cost of the package is R29,9bn (in real 1999 rands.) This compares with the estimate last November - before negotiations began - of R31bn for a slightly higher equipment configuration.

In order to reduce the risks of the total procurement to government, part of the package has been divided into a number of tranches. This allows government to limit its expenditure to R21.3bn if adverse economic circumstances demand it by cancelling 12 trainer fighters (LIFT) and 19 light fighters (ALFA.)

Savings and Risk Mitigation

The negotiation process achieved substantial savings and yielded significant measures for government to minimise the risks intrinsic to a large, import oriented procurement of this kind:

• The tranching approach outlined above allows government to curtail its total expenditures if future circumstances warrant it;
• A total of approximately R300m was saved through price reductions;
• Cashflows were significantly altered – mainly through delaying payments and extending payments over a number of years - to bring the annual payments in line with funds available on the government budget;
• The outcome of the loan negotiations allows government to pay for all the local content in rand, thus reducing government’s exposure to the risk of rand depreciation;
• In addition, all the payments in foreign currencies will now be financed from officially supported export credit loans on terms which are highly attractive.

Financing the Procurements

The imported content of the equipment (about 85%) will be financed through ECA loans (Export Credit Agency loans guaranteed by the governments of the supplier countries.). During the negotiations the Finance Negotiating Team, led by the Department of Finance, was able to secure terms which are highly attractive to the SA government and which are much better than it could achieve on the commercial markets. In fact, as a whole, these terms are much better than is typical of defence deals internationally.

The domestic component of the packages will be paid in rand raised, to the extent necessary, by the SAG on the domestic market as part of its normal treasury operations. This will allow government to limit some of the forex risks which are intrinsic to the purchases.

Because government is not exceeding its deficit targets to fund the packages, they will not add to the total public sector borrowing requirement or to government’s total projected interest burden.

The Fiscal/Budget Impact of the Deal

Payment for most of the equipment – hence the impact on the national budget - will be spread over an 8 year period, with some payments extending over as much as 14 years. The impact on the budget will, therefore, be relatively attenuated and is entirely manageable.

The fiscal impact analysis conducted as part of the affordability assessment indicated that Government will be able to cover these amounts without altering its existing deficit targets. Government will ensure that nominal revenues are sufficient to meet the package expenditures without cutting into the budget allocations of other departments excessively.

The Economic Impact of the Deal

General

An economic impact analysis was conducted as part of the overall affordability assessment.

This analysis indicated that the net effect of the total procurement on the SA economy is broadly neutral.

Over the medium and long term the benefits deriving from the Defence Industrial Participation (DIP) and Non-defence Industrial Participation (NIP) programmes will fully offset the economic and fiscal costs of the military equipment.

Government is naturally aware that the risk of the NIP and DIP benefits not materialising fully is intrinsic to the procurement.

During the negotiations, specific measures were taken to ensure these risks are minimised. Moreover, special steps will be taken by the Department of Trade & Industry (DTI) to ensure that the NIP and DIP commitments of the supplier companies are monitored and enforced.

In this context, Government is confident that the aggregate economic impact of the procurements will be acceptable.

Benefits

The industrial participation projects linked to the purchase deals will yield significant economic benefits for South Africa.

The total contracted commitments amount to R104bn. The actual economic benefit deriving from these commitments will amount to R70-billion over a period of 11 years.

The benefits will come in three forms:

• defence related offsets (about 20% of the total, or R14,5 billion). Local defence firms will earn over R4-billion via direct participation in the production of the aircraft and ships being procured. In addition, the suppliers will transfer technology worth about R3-billion in royalties and license agreements to South African firms, and will direct other export orders to South African firms for more than R7 billion worth of production of defence contracts with third parties.
• counter-purchase by the defence equipment suppliers of South African goods (about 45%, or R31-billion). The goods to be procured include automotive components, furniture, fabricated metal goods including railway wagons, and electronic goods.
• foreign investment in South Africa by companies associated with the equipment suppliers (the remaining 35% or Rb24m).

Offset benefits of this kind have become a standard feature of defence industry deals during the past 20 years, with more than 130 countries now making use of them. An investigation of international experience suggests that the ratio between benefits and costs which South Africa has achieved is probably unprecedented.

Job creation

The industrial participation projects will create significant numbers of jobs in sectors where the new investments are to take place.

This emerges from a comparison of the direct employment impact of the Non-defence Investment Participation (NIP) investments with expected trends in South Africa’s employed workforce.

Although the industrial participation projects represent foreign investment, the vast majority of the jobs created will be for South Africans rather than for nationals of the companies’ home countries.

In addition to the jobs created directly, the programme will also have an indirect impact in the labour market. The demand for raw materials, the spending of incomes earned by employees and the spending by Government of its tax revenues obtained from the companies will all contribute to economic growth and job creation. Just how big this "job multiplier" is, is a matter of debate amongst economists.

But estimates of the multiplier range upwards from a ratio of four to one for indirect jobs -- that is, a total of five jobs per direct job created by the programme. This would suggest that the industrial participation programme would exceed 65 000 jobs through its lifetime.

Managing the offset programme

The overall success of the entire offset programme will depend upon the mechanisms that Government puts in place to carry out this task and to carefully monitor the progress of the investment and counter-purchase projects already identified.

In similar offset programmes elsewhere, the benefits that eventually accrued to equipment-purchasing countries have been closely related to their governments’ capacity to successfully manage the implementation of these offsets projects.

At the same time, offset programmes have contributed in countries like Japan and South Korea to real improvements in industrial policy management across a much wider front than defence alone.

To ensure maximum benefit from the offset programme, special steps will be taken by the Department of Trade & Industry (DTI). These will be aimed at ensuring that the NIP and DIP commitments of the supplier companies are monitored and enforced.

With acknowledgement to GCIS.