Is there a chance that government will cancel the second phase of its controversial arms procurement plan?

Yes, there should be a pretty good chance. The rand has crashed, the economy is limping along and public opinion cannot be too enthusiastic about arms.

After a cursory reading of the report by the joint investigating team into the arms deal, it is clear that cancelling the second leg is a logical move. Cancellation, or postponement, would help contain the economic risks posed by massive defence spending.

SA has to exercise its option by 2004, for the purchase of aircraft to be paid for over the next 14 years.

If SA cancels the second leg, it will opt out of buying 19 Gripen light fighter and 12 Hawk jet trainer aircraft from Saab and BAE Systems. To date, it has committed to acquiring nine Gripens and 12 Hawks.

No doubt military experts will rush to point out that failure to purchase the full suite of fighter and trainer planes will not make sense from a military perspective. It is everything or nothing for the military strategists.

Factors such as operational capability, deterrent value and effective pilot training weigh in favour of the second tranche.

But military requirements are only one part of the equation.

When the two-phased purchase plan was announced in 1999, Defence Minister Mosiuoa Lekota said only adverse economic circumstances would result in SA exercising its refusal option on the second tranche.

With the rand crashing through new lows daily, and economic growth not meeting projections, it is a safe bet the assumptions on which the arms package were based have been blown to bits.

This is implied in the report, which quotes from the Bureau for Economic Research's affordability review: "The SA government is fully exposed to the depreciation of the rand against foreign currencies, which accounts for about 75% of the total purchase amount.

"There is no effective way of hedging the currency risk inherent in the procurements."

The bureau warned that exchange rate depreciation beyond the forward curve at the time would lead to a much higher price tag and financing bill.

Further on, the investigators' report notes that UBS Warburg, which had to assess affordability, had been "overly optimistic" on the exchange rate. "No high-risk scenarios relating to exchange rates were factored into the (affordability) report."

Over and above the amazing disappearing rand, there is another surprise cost factor attached to the Gripens and Hawks the full operational and maintenance costs were not included in the amount approved by the cabinet.

The result is unforeseen pressure on the defence budget.

The report says: "Certain information regarding the total cost of the advanced light fighter aircraft and lead-in fighter trainers was not submitted to the cabinet.

"The result is such costs will have to be accommodated in the department of defence budget."

Skip further ahead in the report to the assessment of the financial and fiscal implications, and it says: "A substantial (effect) on affordability that could materialise in future is the unsuccessful restructuring of the defence department's budget and the effect on the department's budget of underestimating the long-term full cost of ownership of the packages."

Overall, the model did not take full account of all possible risks, the report finds.

In deciding on whether to opt out or not, government will also take account of the success or failure of the defence offsets. BAE and Saab have offset commitments of a massive $8,7bn over 11 years, of which $7,2bn is not related to defence.

That is a tall order indeed. Projected exports are included in the numbers.

These offsets are pie in the sky. Take the much-hyped announcement last week that BAE and Saab have facilitated an investment in timber mills in Mpumalanga. Not only is the investment small $60m but it turns out that much of that was sourced locally, from the Industrial Development Corporation. And this is not an aberration.

According to BAE, a minimum of 30% of an offset investment has to be sourced offshore so little that there is not much protection for the balance of payments. Without much foreign investment, a spectacular export bonanza is envisaged. That's simply wishful thinking.

Government should opt out of the second arms deal tranche, given the exchange rate, the economic growth rate, hidden costs and offsets' likely failure to protect the balance of payments.

Steyn is Managing Editor at Business Day.