Foreign Policy Research Institute A Nation Must Think Before it Acts What the Unit Costs: U.S. Federal Reserve Policy, International Currencies, and Military Procurement

What the Unit Costs: U.S. Federal Reserve Policy, International Currencies, and Military Procurement

At first glance, the movement of currencies seems to have little to do with the trajectory of military capabilities.  But look closer and what emerges is a clear connection between international finance and international security, particularly for countries whose militaries rely on foreign arms.  Since a country must buy armaments, like other goods, with local currency that must be converted into a foreign one, the exchange rate at which that conversion occurs is very important.  A stronger local currency means a country can buy more from abroad; a weaker one means it can buy less.

Soon after the global credit crisis hit in 2008, the U.S. Federal Reserve quickly loosened monetary policy to support the American economy.  But its trio of quantitative easings—purchases of bonds with newly created money—has had far-reaching consequences.  They not only lifted the U.S. economy, but also weakened the U.S. dollar relative to other currencies.  Fearful that a suddenly weak U.S. dollar would trigger disruptive money flows and undermine their export industries, many countries tried to stabilize their currencies’ exchange rates against the U.S. dollar.  To do so, their central banks slashed interest rates and expanded their monetary bases.  Happily (for the moment), that had the attendant benefit of spurring economic growth.  And so, countries as diverse as Brazil, Indonesia, and South Africa boomed.

But that virtuous cycle is ending.  Before long the U.S. Federal Reserve will start to taper its bond purchases—a first step toward tightening American monetary supply.  As a result, the U.S. dollar has generally strengthened against other national currencies.  For those countries whose currencies have become relatively weaker, that has meant that everything they import is now more expensive, from grain to oil to military equipment.  Countries whose governments subsidize imported food and energy have seen their subsidy expenditures balloon.  In response to such inflation, some central banks have sought to temper the weakening of the currencies by raising interest rates to drain the excess liquidity from their economies.  Unfortunately, that also slows economic growth and strains their capital markets (sometimes in countries whose unemployment is already relatively high).  In any case, both these factors further weaken local currencies, which in turn reduce the foreign purchasing power of their governments’ arms procurement budgets.

The Indian military knows that all too well.  India’s high inflation and a balance-of-payments crisis in the early 1990s caused the value of the Indian rupee to precipitously fall.  Given the concurrent demise of the Soviet Union and its generous arms export terms to India, its hoped-for military modernization plans never transpired.  Costs, in Indian rupees, for new military kit from abroad soared.  Even the prices for spare parts to maintain its legacy Soviet hardware climbed.  Indian warships designed with Russian combat systems in mind went unfinished and those in service became expensive to maintain.  A Godavari-class frigate built in the early 1990s was estimated to cost four times as much as comparable one in the 1980s.

To Indian military leaders old enough to remember that era today must seem uncomfortably familiar.  Reacting to the U.S. Federal Reserve’s increasing monetary restraint and high inflation, the Reserve Bank of India raised interest rates to defend the rupee.  That has slowed the country’s economic growth and, in turn, pressured its currency.  In fact, the rupee slid 14 percent against the dollar between May and August 2013.  With such a currency backdrop, India’s military is finding its new modernization program difficult to achieve, even apart from its internal bureaucratic challenges (perhaps a topic for a future blog).  In one recent example, the Indian navy must decide how to replace the Sindhurakshak, which was lost in an August 2013 explosion.  Early speculation is that the navy will lease another Russian Kilo-class submarine.  But that would entail annual payments which could rise if the rupee falls further.  And if the navy decides to buy a replacement, that submarine would be 14 percent more expensive than it was only four months ago.  Such considerations hinder not only India’ military, but also multinationals selling everything from artillery pieces to attack helicopters, all of which India needs.  Indeed, if New Delhi proceeds with the formation of a new two-division mountain strike corps, it may find its new divisions under-equipped for battle.

A weak currency can also affect developed countries, like Japan.  There, the Bank of Japan has exacerbated its currency’s relative weakness by starting its own aggressive monetary expansion program, just as the U.S. Federal Reserve is ending its.  Consequently, the Japanese yen has plunged 22 percent against the U.S. dollar since last year.  That will impact potential Japanese purchases of OV-22 and long-range unmanned aerial vehicles from the United States.  And that is particularly bad news for Japan’s Air Self-Defense Force, whose technological future rests on the already-expensive American F-35 Joint Strike Fighter.  A weaker yen means that each new fighter will cost more yen.  Under a June 2013 foreign military sales agreement with the United States, Japan agreed to acquire its first four F-35 fighters for $124 million apiece or about ¥10.2 billion each, at the then-prevailing exchange rate of 82 yen to the dollar.  Had they been acquired at today’s exchange rate of 98 yen to the dollar, each new fighter would have cost ¥12.7 billion, almost 25 percent more.

Though Japan’s Ministry of Defense still considers the F-35 fighter as vital to keep a rising China and resurgent Russia at bay, it has already begun to rethink the timing of its purchases.  Originally, Japan planned to complete the acquisition of 42 fighters by 2021.  But given the rising costs, Tokyo might decide to stretch out aircraft deliveries until 2023.   For many of today’s defense planners, it seems wise to include not only include smart weaponry, but also smart currency hedges in one’s arsenal.  The costs of war remain variable.