The controversy over the country’s purchase of new submarines from the German firm ThyssenKrupp has almost been lost in the recent shuffle of raging fires and sexual misdemeanors in high places.
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Reminder: It involves a decision taken by Prime Minister Benjamin Netanyahu, as far as is known behind the backs of the defense minister and the Israel Defense Forces chief of staff, to buy three German subs for 1.5 billion euros ($1.6 billion). That was in the face of arguments by defense establishment officials that there were more important things to do with the money.
There’s also the matter of suspected conflict of interest on the part of the prime minister over the involvement of his personal lawyer David Shimron in the purchase, which diverted attention from the main issue: How decision-making is conducted in the Prime Minister’s Office and whether confidentiality has turned the entire field of military procurement in Israel into an area subject to whim.
These questions don’t have answers for the time being, but it is already clear that the answers go beyond the operations of the Prime Minister’s Office or the office of the defense minister. The office of Finance Minister Moshe Kahlon will apparently also need to jump into the fray, in the light of a dispute that erupted among top ministry officials in a somewhat different context, but which highlights the lack of clarity regarding how the country’s military procurement activity is funded.
The treasury’s involvement stems from a news report about anther major arms purchase, this one of ships to protect the natural gas rigs off Israel’s Mediterranean coast. The ships, which were supplied by the same German shipyard that was involved in the submarine deal and included the same Israeli intermediaries, cost more than $300 million euros – which was financed with a private loan.
It turns out that the Defense Ministry financed the ships in 2015 with a loan from Israel Discount Bank. The office of the Finance Ministry accountant general, Michal Abadi-Boiangiu, knew about the loan and approved it. But the staff at the ministry’s budget department, which is headed by Amir Levi, claimed they were unaware of it and did not give their approval for a loan that they viewed as a way of circumventing budget constraints.
In other words, since the Defense Ministry didn’t have the money to buy the ships, and since the budget department at the Finance Ministry opposed the purchase and was not prepared to add funding to the defense budget, the Defense Ministry found a way to finance the purchase outside the budget, by means of a private bank loan.
As far as is known, the purchase of the ships is now being looked into by the police as part of an inquiry into suspicions against Brig. Gen. (res.) Avriel Bar-Yosef, who at one time was a candidate to head the National Security Council.
The dispute over the ships has reignited ongoing tension between the accountant general’s office and the budget office, which have been accusing each other of playing accounting games of various kinds for some time now. This time it’s the budget department accusing the accountant general’s office of working with the defense establishment to help it to overcome budget department opposition to the purchase by bypassing the limitations of the defense budget.
The purchase agreement for the ships was signed in 2015 at a price tag of 315 million euros ($336 million), after the Germans generously provided a grant of 115 million euros to help defray the cost. But even the reduced price was beyond the defense budget, resulting in the refusal of the Finance Ministry’s budget division to provide additional funds for the purchase. Since the purchase price was to be spread out over several years and the ships were due to serve the Israel Navy for many years to come, the Defense Ministry came to an agreement with its German supplier to spread out the payments, with part to come from the defense budget in future years and part from natural gas royalties that the government would receive.
Spreading out the payments solved the problem of the limitations of the defense budget, but it raised a financing issue. The supplier needed to pay for the construction of the ships immediately and to fund the period between its own payment for the ships in Germany and the future payment it would receive from the Israeli Defense Ministry.
It’s not unusual for a government ministry to enter long-term contracts in which payments are spread out over years: for the construction of a hospital or highway, for example, or for the building of a privately owned desalination plant financed by water rates set by the government.
All such projects involve financing and all are financed in one of two ways. Either the government ministry funds the payments from its own budget (at the government’s own low financing costs) or the private company carrying out the work or operating the project finances it itself and passes along its own, more expensive financing cost, for example, by boosting the price of desalinated water.
What was out of the ordinary regarding the ships to protect the gas rigs was that the Defense Ministry bore the German supplier’s financing costs by inviting public bids from private banks. Israel Discount Bank was the successful bidder. There are several strange aspects to the loan. The Defense Ministry, for example, is insisting that the loan was the German supplier’s, but the ministry was the one that initiated the bids and it is also the party making the loan payments to the bank.
In addition, unlike previous purchase transactions, this time the state hasn’t been making payments in keeping with the pace of progress on the construction of the ships. Instead, it has taken out a long-term loan on which payments will continue long after the ships are part of the country’s naval fleet.
In addition, this is the first time in which an outside loan is being used to finance government procurement. As far as is known, there has never been a case in which a government ministry has chosen to finance its own operations through a bank loan. Clearly, such a practice also involves substantial risk by diverting the government budget to bank loans. If ministries are able to simply increase the budgets that they are allocated by taking out loans that have to be repaid in future years, it can be assumed that a lot of ministries would jump at the opportunity.
The cheapest solution?
The office of the accountant general is adamant that the approach in this case was correct, describing it as the cheapest possible solution. The fact that the Defense Ministry, rather than the German supplier, took out the loan greatly reduced the interest rate (which was almost the same as what the State of Israel pays on its other debt.) Otherwise, the price of the ships would have been higher, the argument goes, just as the price of desalinated water is higher in Israel due to financing costs paid by a private operator.
The accountant general’s office insists that major arms purchases have always been financed in such a way, including the purchase of F-35 stealth fighter planes, which is to include a financing component that the government will pay to Lockheed Martin to spread out the payments over a period of years.
So why haven’t we heard about this before? Most major IDF weapons purchases have been made in the United States and funded with military assistance that the United States provides to Israel. The financing costs have been paid out of the assistance funds and haven’t required creative accounting involving outside loans.
The bank’s financing of the ships was not hidden. The Defense Ministry made a formal announcement about it and the loan was duly recorded as a state obligation. Sources at the accountant general’s office said the security cabinet was also aware of the arrangement and approved it – as, they claim, did the Finance Ministry’s budget division. But sources at the budget division deny that it was aware of the arrangement until after the deal was signed. They say they are also unaware of any comparable case.
The suggestion that the arrangement was hidden from the budget division raises hackles at the office of the accountant general. They call it much ado about nothing, because the issue of financing is not something that the budget division needs to care about and the financing costs of the ships are low. In short, they say, nothing improper took place.
The office of the accountant general does acknowledge that there are relevant questions relating to whether there will be sufficient budgets in future years to meet the payments and whether it would result in a misstatement of the country’s debt-to-GDP ratio. The debt was recorded as state debt and the accountant general set a ceiling of $1.5 billion for outstanding loans on defense purchases. So is the approach really legitimate? It turns out that the answer depends upon whom you ask at the Finance Ministry.
The Finance Ministry issued the following response: “This involves very expensive weaponry that is due to be used for many years and the payment for which was made in installments. In the state budget, expenses are recorded on a cash basis and as relates to the debt-to-GDP ratio, the loan from the supplier was recorded. Approval of transaction by the security cabinet also included approval for the flow of payments to the supplier and the size of the loan taken from the supplier. The recording of the transactions and the loans was made in accordance with the required accounting rules. This relates to the ship transaction and does not at all relate to the submarine transaction.”