Pay-off time, though long-term benefits are uncertain

Foreign defence contractors are moving swiftly to fulfil their counter-trade obligations, almost unnoticed beneath the controversy surrounding SA's multibillion-dollar arms package.

Just 18 months after the arms contracts were signed, government monitors have registered US3,55bn in countertrade programmes - nearly one-quarter of the $15bn obligations that the five consortia must fulfil by 2007 (2011 in the case of the BAE Systems/Saab consortium).

Hard questions remain, though, about how many of these programmes will achieve their purpose of stimulating the economy and creating jobs - especially against a looming world recession.

Many countries apply counter-trade, or industrial participation (IP), to foreign purchases, requiring sellers to plough back into the client country a percentage of the purchase price in the form of investments and/or sales and exports.

"Because we want to encourage manufacturing, we try to focus the companies on areas where we can get the maximum economic growth," says the chief director of IP at the Department of Trade & Industry (DTI), Lionel October.

But counter-trade benefits are usually bogus, says Geneva-based defence economist Peter Batchelor; the contractor factors the IP cost into the weapons' price . Also, IP programmes generally stem from what the companies can do rather than what the country needs.

Batchelor acknowledges, though, that SA has negotiated IP commitments worth an unprecedented 300% of the product price. Though the rand's continued slide against the dollar has raised the cost in SA currency of the weapons, so too has it lifted the value of the IP. Internationally, IP generally runs between 30% and 70%. But competition has been mounting in the global arms trade.

Batchelor believes SA got a favourable deal because the arms were procured as a package, and because this was its first major foreign purchase in 30 years. Suppliers wanted to get a foot in the door. BAE Systems would covet a favourable equity stake in State-owned defence conglomerate Denel, a deal expected early next year (see Economy & Business October 5).

SA regulations require IP - ordinarily 30% - on any State or parastatal purchase from abroad costing $10m or more. The arms package got special treatment because of its size and political sensitivity.

It divided the IP into two categories: requiring the foreign companies to buy directly from or procure business for SA defence companies - known as Defence IP, or Dip - and requiring a separate set of purchases, contracts and investments in the civilian market - known as National IP, or Nip. Dip is administered by arms procurement agency Armscor, while the DTI administers Nip.

Italian helicopter company Agusta, for instance, has a 312m contract to supply 30 light utility helicopters to the Defence Force. Its Dip and Nip obligations total nearly $1bn. So far it has entered into 14 Dip contracts worth $34,5m with defence companies such as Denel Aviation, Grintek Electronics and systems engineering and software firm African Defence Systems (ADS). Agusta's Nip claims so far amount to $530m (see table), and include such projects as a $5m gold chain factory and a $1,5m mohair jersey plant. The bulk of the Nip offset, though, is in the form of sales and exports by these plants .

The biggest deal in the arms package is BAE Systems/Saab's $2,5bn contract for 28 Gripen jet fighters and 24 Hawk trainer jets. That contract commits the consortium to IP worth nearly $8,7bn over 11 years (see table). It is operating 10 Nip projects and has Armscor approval for 23 Dip contracts. Several more are in the pipeline. Nip projects under way include:

- Procurement of electricity components in SA and export by SA-based multinational ABB of locally made power transformers;

- Production and export of mine drilling equipment by Atlas-Copco in Springs;

- Production of environmental management tools in Gugulethu near Cape Town; and

- Procurement of SA-made automotive components, such as catalytic converters and batteries, for export.

Dip projects include:

- Contracts with listed technology firm Grintek to design and make communications and audio components for the Swedish Air Force's Gripen fighters;

- Production by SA-based Advanced Technologies & Engineering of black box voice recorders and related equipment for Hawk trainer jets bought by Australia, Canada and SA; and

- A Denel Aviation contract to make flight control components for Avro commercial jetliners.

German steel manufacturer Ferrostaal, the representative in SA of the German Submarine Consortium, supplying three of the craft to the Navy for $857m, is expected to announce soon at least two projects for stainless-steel beneficiation in the Eastern Cape. It also intends to establish a condom factory.

The company originally planned to build a stainless steel plant as the key project of a new port at Coega near Port Elizabeth. But economic uncertainty forced it to scale back , though it still has the second-largest Nip commitment, more than $2,5bn.

Investigators examining the arms deal have questioned why Ferrostaal's Dip requirement is so low - about 27% - and why the 594m corvettes platforms, handled by German conglomerate Thyssen, carries just 17,5% Dip.

French defence contractor GFC Thales (formerly Thomson-CSF), which, in partnership with ADS, won the $513m contract for the corvettes' combat suites, has Dip obligations of about 70% and Nip of 123%. The ship contracts involve subcontracts with 20 SA defence-related companies, including Dorbyl Marine, Denel Airmotive, the CSIR and computer systems management company Communications Computer Intelligence Integration .

Contractors face a penalty of 10% of their IP obligation should they fail to meet their IP requirements or "milestones" . Some companies might be content to forfeit the penalty (having already factored it into the weapons' price) and walk away if economic conditions turned nasty, says Batchelor. But that is an unlikely scenario, says Ferrostaal spokesman Stephen Laufer. " The contractual obligation will continue to exist," he says.

Contractors have to protect their reputations, adds BAE Systems spokesman Linden Birns. "For BAE Systems and Saab, nonfulfillment of their obligations in SA is simply not an option," he says.

With acknowledgement to Peter Honey and the Financial Mail.