Competing for Foreign Military Contracts: The Financial Connection

Peter C. Evans
Ph.D. Candidate, Department of Political Science
Massachusetts Institute of Technology

19 February 2003

My research in this subject grew out of interest in export financing for non-military projects. However, the culmination of the US F-16 sale to Poland captures the large role that government financing can play in the sale of military equipment. In this sense, the global arms market is not only about technology or capability, but also about the terms of the sale—the total price, length of repayment, and interest rates that sellers offer buyers.

This presentation will have four primary components, which include:

To start, let's look at the perspective from France. Between 1996-2000, France exported over $45.4 billion in arms. Of that, 50% was to countries rated "high risk" or "unacceptable risk" by Intelligence Resources, Inc.—reflecting an overall judgment of the countries ability to actually complete payment on items ordered. So, military exports are a risky business. As a result, supplier states have become actively involved in providing financing incentives, guarantees, and credits to offset this risk.

Overall, there are three basic kinds of financing available to countries wishing to purchase large capital goods. First, there are commercial banking entities. However, as a result of the debt crises of the 1980s, many banks averse to such lending. Next, there are government export-import institutions, like the US Export-Import Bank. Finally, there are national and non-governmental development agencies. On a chart with two axes representing borrower risk and risk horizon, commercial banks focus on short term, low risk loans, ex-im institutions take the middle ground, while development agencies concentrate on the high risk, long term project (telecoms, power generation, dams, etc).

Notably absent from this picture is a role for the financing of military projects. In the US, for instance, the Ex-Im bank is prohibited from military sales, while the other financing institutions generally do not loan money for military purposes. Looking to Poland, the nation had nowhere near the $3.5-4 billion required to purchase sufficient quantities of fighters deemed necessary for its security and new NATO membership. Thus, financing played a key role in Poland's choice.

More broadly, economic instruments play a large role in foreign policy. On the incentive side, economic assistance (e.g., the Marshall Plan), externalities management (e.g., environmental remediation), and bribes (e.g., US provision of fuel oil to forestall North Korean nuclear development) can play a role in influencing countries. As for negative instruments, sanctions and withholding of financing can also be foreign policy tools.

There are many motivations for such policies. Export promotion is the most common rationale — states want to assist their domestic firms. States may also employ these tools as part of a broader mercantilist economic policy, or, for more specific sectors or products, states may use these instruments as part of a strategic trade policy — gaining first mover or market advantages that diminish the long-term competitiveness of other countries. Finally, individual companies may influence or "capture" their host governments for simple rent seeking.

For non-military financing, a web of international norms and standards now manage the rules of competition. Restrictions on subsidies, limits on mercantilist policies, environmental standards on World Bank projects, and prohibitions on bribery all reflect such norms that have emerged over the past 20 years. Encompassing the WTO (trade measures, subsidies, countervailing measures), OECD (development assistance, Arrangement on Guidelines for Official Export Credits), the Berne Union (private, commercial lending), and the G-7/8 (episodic treatment of problems), these norms provide a nascent model for addressing the basically unregulated financing of military purchases.

This brings us to the fighters being offered to Poland. First, a Saab/BAe partnership offered the J-39 Gripen. Having sold small numbers to Hungary, South Africa, and Sweden, the Gripen is in urgent need of foreign sales to maintain the viability of the program. Together, the Swedish and UK governments offered 15 year financing at 4.5% interest. Next up was the Mirage 2000-5, built by Dassault of France and offered with 15 year financing and a 3.4% interest rate. Finally, the Lockheed Martin F-16 was offered through the Defense Security Cooperation Agency at approximately 5.8% interest over 13 years, with the first eight years being a grace period. This represented a departure from recent US military financing, which had phased out loans in favor of grants.

So, why is this a problem? First, there is a lack of transparency in all of these arrangements. My research demonstrated that hard data is difficult to find, and that nations often provide misleading or confusing information on the topic. In addition, there are negative consequences for supplier countries. In the form of subsidy costs, crowding out of civilian exports, and the potential use of those weapons against the supplier country, these financing mechanisms are not without consequences. Further, for the purchasing country, these sales can distort priorities, aggravate debt levels, promote regional arms races, and even enable internal repression.

Given this context, let's look at the US program. Overall, data pulled from SIPRI suggests that US arms sales between 1992-2001 totaled $143 billion. A more comprehensive breakdown includes:

Overall, the lion share of this went to Israel, Egypt, Turkey, Greece, Jordan, and Portugal. In this sense, military contractors see a very small part of the world when looking at US-assisted sales of equipment.

Moreover, the US Government acting as a marketing/management intermediary offers many advantages to the buyer and seller. The buyer receives DoD prices, and benefits from DoD management of the contract. Likewise, the seller benefits from having the US Government as the contract enforcer, which reduces payment risks, and does not have to post a performance bond to guarantee delivery under the agreed to terms.

While the US does not finance military sales through the Ex-Im Bank, foreign countries see the FMS program as basically an export credit agency for military sales. Accordingly, countries compete with the US to offer the best terms for military equipment.

A real question is whether this can be controlled. Using existing norms and guidelines as a model, there exists the possibility of developing a new web of agreements to make sure that the most pernicious effects of government financed military sales are minimized.

However, there are real obstacles to achieving such norms. For instance, the US is alone in using a separate agency altogether (FMS) to finance military sales, while most other European countries use national export credit agencies (like the US Ex-Im Bank). Such different institutional setting would complicate any effort dedicated solely to the financing of military equipment purchases. Moreover, the existing web of institutions (WTO, OECD, Berne Union, G-7/8) that monitor commercial trade suggests that a single venue may not be sufficient to effectively control the terms of such financing. Finally, states may oppose any limits or guidelines. The US, for example, may not be interested in limiting its own ability to steer foreign contract to US firms for economic and/or security reasons.

Altogether, the financing of military equipment purchases is a complex question — complex in defining the quantity and quality of the financing itself, and complex in understanding potential methods of controlling such financing.

Peter C. Evans specializes in international political economy, energy market liberalization and international trade finance. He has served as a consultant to broad range of private firms and trade associations including Cambridge Energy Research Associates, Rio Tinto, American Superconductor Corp., and the US-ASEAN Council. He has also served as a consultant to US government agencies and multilateral organizations including assignments for US Export-Import Bank, US Department of Energy, and World Bank. He was a visiting scholar at the Central Research Institute for Electric Power Industry (CREIPI), Tokyo, Japan from 1991-1993. He was energy and environment editor for the Harvard China Review, 1999-2001 and contributing editor for the China Energy Report from 1994-1998. Mr. Evans holds a BA from Hampshire College and Master's degree from the Massachusetts Institute of Technology where he is currently completing his Ph.D. on the problems associated with achieving global common standards among export credit agencies.

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