The Weekly Wire: For Your Situational Awareness 5/29/20

 In Weekly Wire
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Fluctuating Exchange Rates Affecting Defense Costs

Aaron Lin, Research Associate

The financial and economic turmoil caused by the COVID-19 pandemic has caused significant fluctuations in exchange rates for many countries. Many currencies have weakened against the US dollar and other major global currencies over the past several months, raising defense costs. Exchange rates do not always enter the conversation when discussing national security and defense matters, but for countries that must import most of their major defense equipment, their money now may not get as much as it used to.

Rising costs in defense projects are typically associated with unanticipated complexity during the development phase, changing requirements, or even mismanagement of programs. Increased costs due to exchange rates present a very different type of challenge because the exchange rate fluctuations are mostly determined by broad market forces that defense ministries have no ability to control.
The recent announcement by the Norwegian Ministry of Defense that it had to increase its budget due to currency fluctuations demonstrates how big of an impact exchange rates can have on defense investment and operations. According to data from the International Monetary Fund, the Norwegian krone’s value had weakened about 12 percent against the US dollar. This meant that Norway would have to pay more for acquisitions, such as the F-35.

On the other side of the world, reports have emerged that Indonesia continues to be behind on payments for the KF-X fighter development project, which is led by South Korea. Furthermore, Indonesia has fallen behind on payments to South Korea for the recent submarine agreement between the two countries that would produce three submarines for Indonesia. Considering that the Indonesian rupiah has weakened 38 percent against the Korean won over the past decade, and that there have been cuts to the defense budget to reallocate money towards a COVID-19 response, it is not that surprising that Indonesia’s MoD is having difficulty paying its bills.

The KF-X isn’t the only large defense R&D project that has been running up against trouble that can at least be partially attributed to fluctuating exchange rates. An Australian parliamentary committee was told that the cost of building Australia’s future submarines could increase by nearly A$10 billion (US$6.6 billion) to A$90 billion (US$9.9 billion). On top of schedule delays caused by COVID-19, the Department of Defence’s deputy secretary in charge of national shipbuilding, Tony Dalton, to the committee that the Australian dollars exposure to the euro, US dollar, and pound was a factor in the increased cost. Highlighting the uncertainty exchange rates brought to such a large program, Dalton stated regarding the cost of Australia’s future Attack-class submarines, “It could go higher or it could go lower depending on foreign exchange rate variations…I don’t have a crystal ball.”

The following table compares select currencies and their exchange rates against the US dollar in mid-May 2019 and mid-May 2020. Although most currencies have been weakening against the US dollar, there have been some currencies that have strengthened. It is important to remember that these numbers can change significantly in relatively short period of time. This is just a snapshot of exchange rate activity in a specific period, which will mainly affect defense outlays for that timeframe. Such a snapshot is important considering the economic and financial shock from COVID-19. But examinations of rates over longer periods of time will be needed in order to ascertain any deeper trends.

Ukraine

On May 27, local Ukrainian news sources announced the country’s ambitious plans to replace its aging Soviet fighters with new fourth generation fighters. The Ukrainian Air Force currently fields several Soviet era fighters including MiG-29s, Su-24s, Su-25s, and Su-27s. Potential options for the acquisition of new fighters include Lockheed Martin’s F-16, Saab’s Gripen, Boeing’s F/A-18 Super Hornet, and the Eurofighter Typhoon. Ukraine is looking to acquire 108 aircraft, with the first 12 to be purchased in 2021-2022, with deliveries to be completed by 2025. The Ukrainian Armed Forces will continue with this batch order acquisition until the early 2030s. In addition to replacing the country’s fighter fleet, Ukraine is also looking to replace older rotorcraft, transport aircraft, and training aircraft. All of these acquisitions have an estimated price tag of $12 billion, a lofty amount for a country whose defense budget is not growing as quickly as it did following the annexation of Crimea. Political infighting and the impact of COVID-19 on the global economy will likely delay these acquisitions.

Taiwan

The US Defense Security Cooperation Agency (DSCA) has approved the sale of 18 MK-48 ADCAP Mod 6 torpedoes to Taiwan for an estimated cost of $180 million. The sale would likely be used to provision Taiwan’s fleet of submarines and reinforce Taiwan’s deterrence capabilities against China. The deal also includes the sale of all associated spare parts, logistics, and contractor support and engineering. Unsurprisingly, this elicited a statement from the Chinese government and associated Beijing-based experts. Chinese Foreign Ministry spokesperson Zhao Lijian announced the country’s objection to the deal, called for the cancelation of the sale, and said that the US should end its military links with Taiwan. Meanwhile, Chinese military experts were quick to point out the high cost of the deal ($10 million per torpedo) compared to “publicly available information” ($3.5 million).

This statement has several different issues that we attempt to address in Avascent Analytics data. First, it is important to remember that announced DSCA deals represent the maximum possible contract value if all options are excised, including those for logistics and support. This is done to prevent the sale from going through the reapproval process if revised and serves as a frequent stumbling block for armchair contracting officers when compared to the contract processes of other nations. Second, it should be noted that the pricing proxy for an MK-48 ADCAP is based upon a previous sale to Turkey ($170 million for 48) rather than Taiwan ($250 million for 46) indicating Taiwan either has a greater reliance upon the US for logistical support or has to sign more expansive support contracts due to the political issues surrounding sale to the island. Finally, according to the publicly available US budget, the hardware for a MK-48 ADCAP Mod 7 is worth $1.831 million in the current FY21 budget, and the older model Mod 6s are taken from US Navy stocks.

Latvia

On May 26, Estonia and Latvia both placed new orders for Carl-Gustav M4 anti-tank weapons. The new weapons were ordered under an existing agreement between Sweden, Latvia, and Estonia, and they are expected to be delivered between 2021 and 2024. The new M4 weapons are lighter than previous versions and are optimized for use in urban environments. Latvia and Estonia will likely use the new weapons to enhance their ground defense capabilities, as highly mobile anti-armor units are an important aspect of their respective defensive strategies

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