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Strategic implications of the COVID-19 pandemic for military planning

21 May 2020
Economics
Strategy
Floating virus particle

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

Part One of this two-part series focussed on cost implications of a large currency depreciation for the military. It showed how these can increase the cost of maintaining capability at an increasing rate, and force difficult choices relating to allocation of scarce resources.  

Part Two will now focus on the most important economic implication of the Covid-19 crisis for the ADF. In a nutshell, the crisis has amplified the economic vulnerability of Australia, and highlighted the need for the ADF to focus more on its own budgetary resilience. In order to do so, it is imperative for the ADF to understand these systemic vulnerabilities, which may impair its resilience over the long run.  

The ADF is almost entirely dependent on the Commonwealth budget for its resourcing needs, while Australia is in turn highly integrated into and dependent on the global economy. This dependence makes Australia vulnerable to the risk of economic contagion—the transmission of global crisis to the domestic economy—thereby threatening both it and the national budget. Australia’s economic vulnerability would, through logical extension, also extend to the ADF. A significant reduction in Australia’s national income could eventually curtail the ADF’s own budget allocation. This in turn could impair the financial viability of its plans, including for maintaining operational effectiveness and delivering capability enhancement.  

The COVID-19 crisis has brought matters to a head and amplified Australia’s economic vulnerability. This was powerfully demonstrated when it caused Australia’s exchange rate to fall to its lowest level against the US Dollar in the last 17 years (the currency has partially recovered its value since then). More importantly, this fall happened in just a month, even though Australia’s confirmed coronavirus cases were only a miniscule fraction of the total confirmed cases globally.  

Australia’s vulnerability to economic contagion is accentuated by two related factors: 

  1. Australia’s skewed trade profile 

  1. An already weakening economic outlook 

Australia has a highly skewed trade pattern with the global economy, as evidenced by the composition of its imports and exports. According to the Department of Foreign Affairs and Trade, Australia’s top 25 export products are dominated by services (mainly educational, tourism, and professional services) and low value-added primary products (such as resources, agricultural produce, and meat). Its top 25 imports, on the other hand, are dominated by value-adding energy and industrial products. Value-addition simply refers to a process where products have gone through some form of (industrial) transformation and/or enhancement process to increase their value to the user. Simplistic but typical examples are converting steel into automobiles and wood into furniture.  

It is noteworthy that the only industrially transformed products (refined petroleum and pharmaceutical products) in Australia’s top 25 exports account for less than 1.5 percent of their total export value. Quite simply, Australia’s global comparative advantage derives from its status as a ‘big mine, big farm, and big holiday camp’, but certainly not from being a ‘big factory, big research lab, or big venture capitalist’. It is fair to say that Australia is viewed by other advanced economies as a source of raw materials to power their own industrial sectors, rather than an innovation-powered industrial force to be reckoned with. That this would be so for a developed nation like Australia—in the 21st century—is an issue that should engender serious concern and apprehension at a whole-of-nation level.  

Australia’s trade pattern makes a significant depreciation, like the one recently experienced, a particularly threatening scenario for a highly trade-dependent economy (exports and imports collectively account for around 40 percent of the national GDP). Consider, for example, a currency fall of 10 percent. Unless the volume of exports rises by more than 10 percent, the total value of exports will fall. Given that tourism and international education represent relatively more discretionary spending for foreigners, and agriculture and mining typically face capacity constraints, it is to be expected that any global crisis will curtail the demand for the first two, and a significant fall in the value of the dollar will result in a less than proportionate increase in supply of the latter two. These factors make a fall in the total value of exports a perfectly plausible and likely outcome. And the larger the depreciation, the more pronounced these effects will be. This is in addition to the fact that any global crisis that reduces Chinese demand for resources could directly and quickly devastate the Australian export sector. 

On the other hand, a significant depreciation would immediately increase the cost of imports to the economy. The composition of imports shows products that are essential to the normal functioning of life and work in Australia, which in turn means that the demand of these products will not fall substantially in response to the price increase. Additionally, it is clear from Australia’s export pattern and other official data that its own domestic industrial capacity is not enough to provide a viable alternative to these imports, and thus act as a shock-absorber of sorts. Due to these factors, a significant depreciation—the most immediate and likely result for Australia in a global crisis situation—would throw its trade balance out of kilter and act as a drain on its national income. From the ADF’s perspective, the key point is that it will be constrained by the same lack of industrial capacity that afflicts the broader economy. Therefore, its worst-case scenario is that of a ‘double whammy’; one where Australia’s macroeconomic vulnerability—manifesting through large depreciations—creates unsustainable cost increases, and constrained industrial capacity forces it to accept those increases by failing to provide cost-effective alternatives. 

An even more fundamental problem from a budgetary perspective is that the Australian economy has already been underperforming for some time now. This is evident from the pattern of changes to the Official Cash Rate (OCR), which is the primary policy tool of the Reserve Bank of Australia to control monetary policy in the country. The Bank reduces the OCR to stimulate investment and growth when it judges the economy as having a weak outlook. In October 2011, the OCR was 4.75 percent, but by October 2019, it had been brought down to 0.75 percent, in response to generally weakening economic conditions. Then, by early February of this year, it was making favourable assessments of the global economic outlook, as shown by the following extract from its Monetary Policy Decision: 

At its meeting today, the Board decided to leave the cash rate unchanged at 0.75 per cent. 

The outlook for the global economy remains reasonable. There have been signs that the slowdown in global growth that started in 2018 is coming to an end. Global growth is expected to be a little stronger this year and next than it was last year… 

This assessment was made despite the fact that the coronavirus infection was already spreading around the world at the time. However, in the next month and a half, the escalating crisis forced it to issue two additional rate cuts, to bring the OCR to 0.25 percent! This was an unequivocal acknowledgement of the pandemic’s immense potential to wreak economic havoc. 

To understand the significant of these cuts, it is important to remember that the lower bound of conventional monetary policy is zero percent. The latter of these two cuts not only brought the Bank to the limit of its conventional capability, but was in fact accompanied by the Bank actually crossing it and entering the zone of ‘unconventional’ monetary policy. This is something that has been widely embraced around the world since the 2008 Global Financial Crisis, but which Australia had managed to avoid thus far, partly because of the RBA’s significant capacity to cut its benchmark rate. The form of unconventional policy being used by the Bank is called ‘Quantitative Easing’, which is the most extensively-used unconventional mechanism around the world, and which is basically just a fancy term for central banks buying government and private sector debt, and (often) paying for it by printing new money. In essence, this mechanism allows governments to take on new debt, which has direct long term budgetary implications.  

This is a big subject and a lot more can be said about this. The essential point for the military is that just within a few months, the COVID-19 pandemic has greatly amplified both pre-existing systemic weaknesses and an already weakening economic outlook. In doing so, it has made budgetary distress a distinct and perfectly foreseeable prospect over the medium to long term. The ADF needs to make this an integral part of its strategic considerations. Just as it plans for operational resilience in ‘degraded environments’, it also needs to strive for financial resilience in scenarios of macroeconomic uncertainty, which is most appropriately interpreted as a ‘degraded economic environment’. The stakes could not be higher, and the consequences of getting it wrong could not be direr.

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 - 4:54am

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