The Missing Middle: Defense Financing for Middle-Income Democracies

October 5, 2017

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Over the past 15 years, the United States has increasingly prioritized efforts to “build partner capacity.” The goal is to empower other countries to better handle their own security and contribute to international coalitions. During the Bush and Obama administrations, substantial new security assistance funds were created for the Department of Defense to increase the amount of training, equipping, advising and technical advice the United States provides to a wide array of countries. The new authorities enabled more sharing of resources between departments and were intended to make America’s security assistance programs more responsive to changing situations. Under President Barack Obama, the United States also substantially reformed export controls to expand defense trade with close partners. The Pentagon even created a deputy assistant secretary position specifically for security cooperation and building partnership capacity.

But while these efforts have led to more sales to rich nations and more grant aid to poor nations, they have largely left out increasingly critical allies and partners: middle-income democracies.

Unlike China, Russia, France, and every other major European defense exporter, the United States does not offer straightforward loans to countries seeking to procure U.S. defense systems. This policy has meant that U.S. capacity-building efforts leave out key middle-income countries — including Eastern European NATO members who are under the most substantial near-term threat from Russian aggression.

Wealthy partners like Western Europe, the Gulf countries, Korea, Japan, and Australia buy American systems through the State Department’s Foreign Military Sales or Direct Commercial Sales systems. Meanwhile, the State Department’s “Foreign Military Financing” program primarily provides grants to poorer countries or those facing severe security threats.

Middle-income partners — including a number of NATO allies who send their citizens to serve alongside U.S. forces and could incorporate advanced U.S. defense systems – are mostly left out. These nations — from the Baltic states like Poland, Romania, and Bulgaria to Indonesia, Colombia, and major players like India — do spend a fair amount on defense, and American companies compete for their defense dollars. But while the weapons systems offered by the U.S. are often superior, they are also expensive. These partners are too rich for grants, but often cannot justify buying expensive U.S. equipment outright. They often turn elsewhere to replace or upgrade their critical defense systems like fighter aircraft or helicopter fleets. The United States is essentially asking a first-time home buyer to pay all cash up front for their first home. It’s time to give these allies and partners a mortgage. To do this, we propose a dedicated defense lending program for middle-income countries.

Missing the Middle

Defense financing falls outside the rules on export subsidization of the World Trade Organization and the Organization for Economic Cooperation and Development, which means many nations can and do offer financing and subsidies to promote defense sales. Additionally, the sales for which financing is critical usually involve large, advanced procurements, such as military aircraft, ground vehicles, or missile systems. These are sales with large strategic ramifications and long-term foreign policy impact.

Strategic defense acquisitions lock countries into decades-long relationships and often lead to greater bilateral cooperation. For instance, in order to win Poland’s fighter competition in 2002, the Bush administration took the extraordinary step of offering a direct loan from the U.S. Treasury. Without that offer of financing, Poland today would likely not be flying F-16s in support of U.S. national security priorities from patrolling over the Balkans to countering ISIL. But as Poland looks to modernize further, it doesn’t have any regular U.S. financing program to turn to. Many Eastern European NATO partners are seeking to modernize their forces by moving away from the Russian and Soviet equipment that often still constitutes the bulk of their inventory. But they lack the cash to buy whole new fighter, helicopter, or tank fleets.

Middle-income countries can and do make use of U.S. security assistance programs that give away old equipment, such as the Excess Defense Articles or Third-Party Transfer programs. Romania, for example, took possession of its first F-16s in 2016 through a third-party sale from Portugal. But these programs are often ill-suited to a partner’s needs. Poorer countries may take what they can get, but middle-income countries often have specific requirements and are looking to make strategic long-term investments. Also, these programs are ad hoc — they depend on what the United States and other U.S. partners happen to be mothballing. Needed systems may not be available in the right quantity or condition when they are available at all.

For major acquisitions, the Defense Security Cooperation Agency does have the “dependable undertaking” program, which enables a buyers to break up their payments into installments. But this still requires a huge amount of cash on hand and is generally used only by wealthy countries making purchases outright.

The middle-income gap in U.S. security partnerships is also warping America’s broader foreign policy imperatives. Instead of focusing on building relations with rising middle-income democracies that could become steadfast long-term partners, the United States spends its diplomatic energy on higher-end buyers, such as in the Gulf, or on poorer countries often in crisis. The former is good for America’s defense industry and the latter for global stability, but financing the missing middle would probably deliver more strategic long-term value to the United States.

The Demise of Defense Lending

America has a long history of providing critical defense lending — most notably the “lend-lease” program President Franklin Roosevelt used to sustain the Allies before America joined the fight in World War II. Lending continued through the Vietnam War but fell out of favor during by the 1990s largely due to mismanagement.

During the Vietnam War, the Export-Import Bank provided $800 million in loans to South Vietnam (guaranteed by the Pentagon) to purchase military equipment. These loans were cannibalizing the Export-Import Bank’s lending capacity, prompting Congress to severely restrict the bank’s defense lending capability in 1968. Today the Export-Import bank can provide financing for a country to buy Boeing Dreamliners to modernize its commercial airline fleet, but it won’t provide loans to a country looking to buy Boeing F-18s to modernize its fighter fleet.

After Vietnam, the primary tool for providing military assistance became the State Department’s Foreign Military Financing program (FMF). Today, this roughly $6 billion program almost exclusively provides grant assistance, mostly to Israel ($3.1 billion in 2016) and Egypt ($1.3 billion). The top five recipients get roughly 90% of the total funds available. As its name suggests, this program used to provide financing. But many of these loans did not perform, leading to default by many poorer countries amid the debt crisis of the 1980s. The United States made lending requirements much more rigorous in the early 1990s and the FMF program shifted from providing loans to almost exclusively providing grant assistance.

Today the U.S. government retains the legal ability to provide loans to foreign countries, but the process is cumbersome and American officials have lost both the incentives for and the habits of offering and managing loans. Providing loans now often needs approval from Congress. And rather than counting as interest-generating assets, the loans count against the overall FMF budget just like grants. So FMF lending has become limited to extreme cases. For example, after ISIL’s capture of Mosul last year, the State Department used Iraq’s $250 million FMF allocation to facilitate a $2.7 billion loan to bolster the country’s forces.

Still, policymakers rarely know that such loans are possible or see them as a viable option. This creates a circular logic: Since loans are not something the United States is doing in normal circumstances, defense lending is not something the United States does.

Restarting a Strategic Lending Program

In restarting a defense lending program, Washington needs to be mindful of its past problems. A new program should be highly targeted. Rather than lending to just anyone, the initiative should be designed to fill the gap in security assistance efforts and to advance U.S. diplomatic goals.

Congress should appropriate funds to the State Department to start up a defense lending program to these partners. The program should be designed to eventually pay for itself or generate profits for the Treasury Department as the loans mature and countries pay them back — just as we see with the Export-Import Bank. In fact, a new defense lending program would look a lot like what the Export-Import Bank does for commercial lending. It should be based on the following principles.

Do No Harm

The Trump administration’s budget proposal for the State Department guts American diplomatic capabilities, including by cutting roughly a billion dollars from FMF overall. Its proposal to turn grants to loans is not aimed, as we propose, at middle-income countries that could afford to pay back loans with reasonable interest. Instead, the administration wants to convert grants to loans for poorer countries in Southeast Asia and Africa, which would likely drive these nations closer to Russia or China. Furthermore, a considerable portion of the security assistance to these lower-income countries supports critical yet more mundane efforts, such as defense institution building programs, the maintenance and sustainment of equipment, and human rights training. Developing countries may reject these programs if they are only offered in the form of a loan. Even if these nations accepted the loans, they could be put in a situation like the 1980s where they struggle to meet the obligation. The Trump administration should give grants to these partners, while targeting loans to middle-income partners — the ones for whom it makes the most sense.

Put the State Department in Charge

Lending to a country is ultimately a strategic bet. It is an overall foreign policy decision, not a narrow military one. The State Department is the appropriate arbiter and manager of such a program in coordination with the Pentagon, Treasury, and White House. The State Department’s FMF program used to be a lending program. Recreating a lending capacity within the department’s Political-Military Affairs Bureau, which manages FMF, is likely more straightforward than inventing a new capacity from scratch at another agency such as the Export-Import Bank. This will also require Congress to allocate resources to the State Department specifically for this purpose.

Lend Just to Middle-Income Countries

The purpose of defense financing is advancing U.S. foreign policy interests and expanding security cooperation with up-and-coming partners. Therefore, defense lending should be conditioned to ensure that loans target both middle-income countries and those that partner with the United States on common security priorities. This program should be about providing loans to that “first-time home buyer” who can become a long-term partner. Loans would not be without risk, but if managed effectively, they will bring immediate diplomatic benefit and the promise of greater strategic partnership.

For the purposes of this program, we recommend defining middle-income broadly based on World Bank criteria ranging from “lower-middle income” (e.g. India and Indonesia) to the bottom half or more of “high income” (a group that would include Poland at $12,680 per capita Gross National Income but exclude Spain at $27,520). The range agreed on by the State Department, the Treasury Department, Defense Department, and Congress should also factor in an analysis of the countries’ relative strategic value to determine eligibility for the defense lending program. The U.S. government’s confidential Interagency Country Risk Assessment System, which determines the credit risk associated with lending to countries, would in theory also be applied if it is not too restrictive. All of this makes standing up a new loan program bureaucratically complicated. But the challenges of implementation should not get in the way of the strategic objective of partnering more effectively with rising middle-income countries.

Lend to Democrats, Not Autocrats

Since lending to middle-income countries entails some financial risk on the part of U.S. taxpayers, the program should bet on democracies, not autocracies. While supporting democracies may not be a priority for President Donald Trump or Secretary of State Rex Tillerson, Congress has the ability to narrow the focus of the program. The lending requirements could make it clear that maintaining democratic ideals and respecting human rights are prerequisites for the loan, and failure to comply could have consequences.

Requiring recipients of U.S. defense financing to be democratic and to have a solid human rights record would also create a positive and explicit linkage between democratic status and being a close security partner of the United States. The program should create an incentive for developing democracies to stay on the democratic path, respect human rights, and develop relations with the United States.

With these criteria in place, a new defense lending program would target a relatively small but strategically important set of countries. This would include Eastern European NATO members as well as countries like India, Colombia, Indonesia, Brazil, Argentina, Tunisia, South Africa, and Kenya. A program of this nature would enable the United States to help eastern NATO members finally transition away from Russian/Soviet equipment and modernize their fighter, helicopter, and tracked vehicle fleets. It could help India or Colombia modernize their fighter fleets or naval forces while simultaneously building closer relations to the United Sates.

Run properly, a new defense lending program would help key U.S. allies and partners boost their capabilities, incorporate American systems over Russian and Chinese ones, boost U.S. business, and profit the U.S. Treasury and taxpayers.  Any administration, including the current one, should be able to get behind this.

In both the Bush and Obama administrations, national security leaders argued that the United States should strive to be the “partner of choice” for countries around the world. More nations will be able to make that choice if Washington helps them afford it.

 

Max Bergmann is a Senior Fellow at the Center for American Progress. He served in the State Department from 2011-2017. Vikram Singh is Senior Advisor on National Security, Democracy and Technology at CAP and was a senior official at the Pentagon and the State Department.

Image: U.S. Air Force/Tech. Sgt. Ryan Crane

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