Increased security: Defence offsets programme helps to create local benefits

Looking to safeguard the county’s security in a tumultuous region, Saudi Arabia’s spending on defence continually ranks among the highest components of the country’s annual budget. While military expenditures as a proportion of the entire budget has fallen in recent years, defence and security spending accounted for 30.8% of the total 2012 budget and 31% of the 2011 budget, according to data from the Saudi Arabian Monetary Agency. Although these marked the lowest proportion of spending since 1984 in consecutive years, rising budgets fuelled by petroleum revenues have translated into defence expenditure that still rank amongst the highest in the world.

The country’s defence budget totalled $46.2bn in 2011, placing it among the world’s top spenders, according to the 2012 edition of “Military Balance” published by the International Institute for Strategic Studies. Saudi Arabia moved to the head of the pack in terms of its defence budget as a percentage of GDP with 8.26% of GDP. The next closest country was Oman at 6.42%; seven of the top eight nations by this measure were located within the Middle East and North African region.

Offsetting The Costs

While the multibillion-dollar arms deals, most of them for modern weaponry supplied by Western nations, dramatically enhance the Kingdom’s defensive capabilities, many of these transactions also include components which serve to further the country’s economic and educational interests. Due to the Economic Offset Programme (EOP), which was first established in the early 1980s, many of the large-scale weapons system transactions are subject to reciprocal agreements, or offsets, to mitigate the substantial costs of the deal. These costs include upfront financial expenses and continued maintenance and upgrade expenditures, over the course of a contract. From the vendors’ side, these offsets can take a variety of forms that spur economic diversification in the recipient nation, including maintenance and training programmes, developmental assistance, and local assembling and manufacturing operations.

The precise composition and value offset is quantified using a separate set of criteria for each deal, generally by employing a credit and multiplier system in which the developing country’s government can encourage specific types of offsets – direct investment versus knowledge transfer, for example. Under oversight from the Economic Offset Committee, the programme applies to all defence contracts in excess of SR400m ($106.6m), with contractors responsible for providing offsets equal to 35% of the contract value. In its three-plus decades of existence, the EOP has created dozens of new companies that employ thousands of workers across a wide range of industries, such as aerospace, energy, electronics, information and communications, medicine and medical supplies, chemicals and petrochemicals, and education and training.

According to Jim McDowell, CEO of BAE Systems Saudi Arabia, skills transfer is key. “Saudiisation of the workforce is a fundamental responsibility of any company. Foreign firms are obligated to transfer skills and prepare the way for locals to increase their participation in the future. However a shift in the local culture is also necessary, giving greater value to vocational employment,” he told OBG.

Local Firms

Over the years many of these local manufacturing agreements have become successful private businesses. Initiated in 1984 under the $5.6bn Peace Shield contract, the first offset programme signed with US companies Boeing and General Electric led directly to the creation of four aviation and avionics firms – the Alsalam Aircraft Company (AAC), Advanced Electronics, Aircraft Accessories and Components, and the Middle East Propulsion Company (MEPC) – and a software and systems integration company – International Systems Engineering.

Two of these original companies, AAC and the MEPC, are among the most successful examples of what these partnerships can achieve. Established in 1988 as a joint venture between Boeing, Saudi Arabian Airlines and the Saudi Advanced Industries Company, AAC has grown over the years to employ 3500 people (55% of which are Saudi nationals) in its aircraft maintenance, repair and overhaul business. While its primary business is derived from servicing military aircraft, the company has branched out into more civilian operations and has signed maintenance contracts with Saudi Aramco for its C-130 transport planes as well as with Syrian Air and Air Atlanta Icelandic for Boeing 747 airliners. AAC has also done well in recent years with military contracts, inking a SR545m ($145.2m), five-year deal in August 2011 with the Royal Saudi Air Force (RSAF) for work on its C-130 transport fleet as well as a SR1.42bn ($378.4m) contract for the maintenance of RSAF F-15 fighters.

Proven To Work

The MEPC has also managed to parlay its early partnership with General Electric into a successful business working primarily with the RSAF on maintenance of jet engines. Although looking to expand into the commercial sector, MEPC currently works for the most part on maintaining the F100-PW-220/220E jet engines made by Pratt & Whitney that power F-15 fighters as well as the RB199 engines used in the RSAF’s Tornado aircraft.

With the model now proven to be viable, the government has moved on to similar agreements with its other arms suppliers in Europe. Beginning in 1987 the Saudi government entered into the Al Yamamah EOP programme with the UK and France for the purchase of British Aerospace-built Tornado fighters and later Eurofighter Typhoons. Offsets derived from these deals differed from earlier models in that investments were made in more diversified industries, including the creation of the United Sugar refinery in Jeddah. Other more recent projects derived from British agreements include a SR2.4bn ($639.6m) seamless gas and oil pipes development with the Saudi firm Taqa as well as the BHAE Systems Project Finance Initiative, which provides $10m of equity in the form of a non-recourse loan.

New Programmes

After a period of reduced defence spending in the 1990s, the Saudi government embarked on a large spending programme to upgrade and enhance its defensive capabilities on the land, sea and air. By far the largest of these is the biggest foreign arms deal in US history – a $60bn order for new and upgraded aircraft weapon systems announced in 2010 and formalised in 2012. Under the terms of the deal, the RSAF will purchase 84 new F-15 fighters from Boeing and upgrade another 70 F-15s already in service. Other components of the deal include the purchase of more than 100 helicopters for the Saudi Arabian National Guard, Army and Royal Guard. These include 70 AH-64D Apache Longbow attack helicopters built by Boeing, 72 Sikorsky UH-60M Black Hawk utility helicopters (Sikorsky Aircraft), 36 AH-6 Little Bird armed reconnaissance helicopters also made by Boeing and 12 MD-530Fs.

Seeking to maintain the flow of trained pilots to fly these new combat aircraft, another contract was signed in November of 2012 under the Saudi-British Defence Cooperation Programme (SBDCP) for the delivery of 22 Hawk trainer aircraft and 55 Pilatus PC-21 aircraft, in addition to a variety of ground-based training devices also provided by BAE Systems. The $2.5bn deal is an upgrade from a previous SBDCP deal that supplied the RSAF with 50 Hawk Mk.65s and 50 Pilatus PC-9s. These contracts come on top of another $8.9bn aircraft order made with BAE for 72 Eurofighter Typhoons. Originally signed in 2007 under the Al Salam deal, only 24 of the aircraft had been delivered as of early 2013 due to ongoing negotiations over pricing after plans to assemble the remaining 48 aircraft in Saudi Arabia were scrapped.

In addition to upgrading its air force, the government is also looking into bolstering its ground forces through its first major purchase of main battle tanks since the 1990s. Saudi Arabia signed a €2.5bn deal in July 2011 for 200 Leopard II tanks made by KraussMaffei Wegmann. This deal could conceivably become much larger, as German newspapers reported in December 2012 that Saudi Arabia was seeking to triple or even quadruple its order to 600-800 tanks, worth some $12.6bn if confirmed.

With roughly $100bn in new arms procurement deals signed in the past few years, these new high-value contracts will not only provide Saudi Arabia with new EOP opportunities, but will also likely mean ongoing contracts for previously established EOP companies such as AAC and MEPC. This could very well usher in a new era for EOP cooperation for Saudi Arabia and its trading partners and provide further impetus for a self-sustaining defence and technology sector. US aerospace firm Lockheed Martin, for instance, announced in October 2012 its partnership with King Abdullah University of Science and Technology to collaboratively research and develop advanced technology, including nano-infused polymers, aquaculture and autonomous underwater vehicles.

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