The currency risk of defense materiel procurement

The Norwegian Armed Forces relies on international suppliers when procuring materiel. This means that the exchange rate is of great importance for the Armed Forces’ total materiel costs. The Norwegian krone can be very volatile, as shown by the financial crisis in 2008, the oil price fall in 2014 and the Covid-19 pandemic in 2020. The investment projects in the defence sector take several years to complete, and the exchange rate at the planning stage can differ substantially from the exchange rate during the procurement phase. This affects the Armed Forces’ purchasing power, which in turn can have consequences for the implementation of long-term defence plans. The purpose of this study is to shed light on this uncertainty by estimating the currency risk of materiel investments in the current long-term plan for the defence sector. Using accounting data and project documentation, we have estimated the foreign exchange exposure in the long-term defence plan for the period 2021–2028. The results from the analysis show that the currency exposure in the procurement portfolio will be fairly stable between 60 and 70 percent throughout the period. Based on these results, we have derived a method to estimate the impact of currency risk on future procurement costs. The results show that the procurement costs, in the worst case, could increase by about 28 billion kroner if the krone were to depreciate significantly during the period. A corresponding appreciation of the krone could reduce costs by about 22 billion kroner. The results represent extreme outcomes, but show the impact currency risk alone can have on the costs of procurement projects. We also study the challenges faced by decision makers in the defence sector when managing currency risk. Our insight in this area is based on conversations with informants in the sector who are responsible for the management, planning or implementation of materiel procurement. The conversations revealed that opaque currency assumptions in the procurement projects and the lack of uniform currency assumptions in the sector make it difficult to keep track of currency gains and losses. Motivated by this, we analyze the predictive performance of forward and spot exchange rates in predicting future exchange rates. Forward rates perform marginally better in the long run, but prediction error is substantial in both cases. This underlines the difficulty of predicting future exchange rates. Currency risk is an external risk factor that the Armed Forces cannot influence. Because of the Norwegian state’s self-imposed principle of self-insurance, it cannot hedge against this type of risk in the financial markets. However, we believe it still possible to reduce the negative consequences from currency exposure and risk. Røtvold (2016) has previously given recommendations for how this can be achieved and we believe these recommendations are still valid. Based on findings in this study we also provide a new set of recommendations. These are: 1) improve documentation of the currency assumptions in the procurement projects, 2) introduce uniform currency assumptions in the sector and 3) develop a system for better management of currency risk in the planning and management of the long-term plan.