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The effects of currency depreciation on the military’s cost structure

19 May 2020
Economics
Strategy
Empty bullet casings on a surface

This blog is part one of a two part series discussing the economic impacts on Defence in the wake of the ongoing COVID-19 pandemic

The ongoing COVID-19 pandemic has already upended everyday life and work around the world. Following the lead of major stock markets overseas, the Australian stock market fell precipitously in less than two months. Additionally, in less than a month, the Australian dollar fell to its lowest level against the US dollar in the last 17 years. This exceeds anything experienced, even at the height of the 2008 Global Financial Crisis. At the time of writing this article, both had partially recovered. However, the suddenness and magnitude of the drops highlights risks that the higher echelons of the defence planning community should seriously consider in its long-term planning. 

The public discourse relating to defence has focussed largely on the deployment of additional personnel to help deal with the crisis, while any discussion of the budgetary impacts of the currency depreciation is conspicuous in its absence. This two-part series seeks to fill this critical gap. This article (the first one) presents a simple mathematical example to illustrate the effects of currency depreciation on the military’s costs. The second part will focus on strategic implications of developments for its budgetary planning.  

The need for the ADF to understand the broad contours of the economy could not be more immediate or important, because it is almost entirely dependent on government budgetary outlays for its funding needs. However, the Government’s own budgetary capacity is in turn directly dependent on the state of economic conditions globally. Any economic crisis that affects the global economy will have a follow-on effect on the ADF’s budgets as well. The currency exchange rate is a key barometer for assessing these economic conditions for Australia, and the primary policy mechanism through which the domestic economy interacts with the global economy.  

The following example, though highly simplistic, aptly illustrates the budgetary impacts of large currency depreciations.  

Suppose that the Australian Army decides it needs to buy 100 bullets per year in order to maintain operational effectiveness. Suppose further that these bullets are not manufactured in Australia, and that they are available from the US at the cost of US$1 per bullet. In other words, the total cost of acquiring these bullets would be US$100 per year. Finally, assume that the initial exchange rate is 1:1 (i.e. the value of the Australian dollar is exactly equal to the USD) so that the bullets would cost the Australian Army exactly A$1001. So in the initial situation, the Army’s budget would need to reflect A$100 to meet its operations requirements. This projected need is incorporated into the Army’s annual budget, which accordingly allocates $100 for this acquisition at the start of the financial year.  

Now suppose that due to adverse economic conditions, the Australian dollar starts depreciating against the Greenback; it starts losing value against the US dollar. To understand this, assume that the Australian dollar depreciates 10% against the USD, to reach 90 US cents. So where A$1 initially bought US$1, it now buys only 90 US cents (alternatively, it will cost more in Australian currency to buy US$1). In such a scenario, the cost of the 100 bullets would rise to US$100/0.9 = A$111. The same number of bullets now costs $11 more. Additionally, given the initial values chosen, this shows that a 10% reduction in the value of the Australian dollar raises the costs for the needed acquisition by 11%.  

Given that the budgets are allocated at the start of the financial year, any depreciation of the exchange rate raises the total costs of maintaining capability. Additionally, this depreciation has arisen from factors completely beyond the Army’s control, and raises costs for it even though the listed price of the bullets (US$1 apiece) remains unchanged. The only way in which the Army can respond to this increased cost—given fixed budgetary allocations and assuming the cost is transferred to its budget (which is not normally the case)—is by choosing between its pre-determined standard for operational effectiveness and its pre-determined spending. In the former case, it would take funds away from other needs to maintain the ordinance capability at the pre-determined level, which would send the signal that the Army values these bullets more than the alternative uses from which resources were pulled. In the latter case, the Army can maintain its initial projected spending, but that would mean buying fewer bullets.  

But this is not all; the truly significant implication becomes evident as the currency continues depreciating further. Suppose the exchange rate was to depreciate in successive blocks of 10 percentage points each, relative to the initial value of 1:1. This would mean that the Australian dollar depreciates by 20% to reach 80 US cents, 30% to 70 US cents, 40% to 60 US cents, and finally, 50% to 50 US cents. The following table gives the impact of these successive depreciations on the cost of acquiring the 100 bullets.

Table showing effects of currency depreciation as explained in article

In a nutshell, this table shows that as the Australian dollar loses value from 10% to 50% against the US dollar, the total cost of acquiring the bullets will increase from an initial 11% to an eventual 100%; a 50% drop in the value of the currency will double the cost of buying the bullets, and likely blow out the budget. At the very least, it will force the Army to make the difficult choices outlined above. To further reiterate the earlier point, this budget blow out would have happened due to broader macroeconomic conditions that are completely beyond the Army’s control.  

More importantly, as the exchange rate depreciates by successive blocks of 10 percentage points (relative to the initial value of 1), the costs of maintaining the capability at the predetermined levels will not only increase, it will do so at an increasing rate (this is shown in the Column 5 of the above table, where the values are derived by subtracting the percentage change values in column 4 by its immediately preceding value). So where the initial 10 percentage point reduction raised the cost by only 11 percentage points, the last 10 percentage point depreciation raised it by 36 percentage points. Further depreciations would have increased the costs at an even faster rate.  

This simplistic example refers only to bullets. But the same logic would apply to much more complex platforms and capabilities as well, and there are many of these at any given time in various stages of development and/or acquisition. Currency depreciations, especially those that are large/sustained, would affect all these at the same time, thereby amplifying the total budgetary impact for the ADF.  

It is imperative for the ADF to increasingly recognise the strategic risks that would arise in such situations, or consider them an important enough priority to proactively pre-empt. How/where will it secure adequate, sustainable sources of funding in the event that a macroeconomic crisis restricts the Commonwealth’s ability to provide it?  

The second part of this series expands the discussion by addressing two further questions: 

  • How do the systemic contours of the Australian economy affect the government’s ability to mitigate the effects of large, persistent currency depreciations? 

  • What are the principles for the ADF’s appropriate response to these risks? 

Caveats: The above example assumes that it is the Army itself paying for the purchases from overseas. In reality, however, the bill may be footed by the ADF, Department of Defence or the Commonwealth Government generally on behalf of the Army. Regardless of who actually bears the costs, the basic result that depreciation increases purchases costs still applies. In other words, the possibility of depreciation itself creates a financial risk, and this must be borne by someone. This simple example also abstracts away the standard practice of currency hedging to emphasise this basic result. This is because an understanding of the risk pattern is essential before an effective hedging strategy to alleviate that risk can be devised.

The views expressed in this article and subsequent comments are those of the author(s) and do not necessarily reflect the official policy or position of the Australian Army, the Department of Defence or the Australian Government.

Discussion

Matthew Struthers on 19 May 2020 - 4:52am

Editor's note: This Land Power Forum post is now open for discussion.