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The Global Landscape Of Offsets In The New Millennium - Part I

By Dr. Pompiliu Verzariu U.S. Department of Commerce

Introduction

"Offsets" is the umbrella term for a broad range of industrial and commercial "compensatory" practices required of foreign suppliers as a condition of purchase in either government-to-government sales, or commercial sales under foreign public agency procurement programs.

Offset requirements may apply to the procurement of either defense (e.g., military aircraft, tanks) or high-cost civilian hardware (e.g., commercial aircraft, overland or satellite telecommunication systems). Offsets associated with military exports are frequently divided into direct and indirect classes.

Direct offsets are arrangements that involve goods and services directly related to the exported item and referenced in the sale agreement for military exports, while indirect offsets involve arrangements that involve goods and services unrelated to the exports referenced in the sales agreement.

Defense offsets are common practices in both industrialized and emerging or developing markets. The type of offsetting arrangements actually implemented depends on the sophistication of both the hardware procured and that of the importing country’s industrial basis—e.g., the country’s ability to enter into co-production arrangements for the procured items and absorb related state-of-art technologies.

Defense offsets with industrialized countries generally entail transfers of higher technologies and higher domestic content than those with emerging markets and their offset policies focus on establishing long-standing relationships with suppliers.

For example, the stated goal of Canadian, United Kingdom and Australian offset programs—known as Industrial and Regional Benefits in Canada and as Industrial Participation in the UK and Australia—is to achieve long-term collaboration with foreign suppliers.

The United States, on the other hand, emphasizes at least 50% local content requirements to maintain domestic defense capabilities. To date, European countries have demanded on the average twice the level of defense offset requirements demanded by emerging countries.

The distinctive feature of offset arrangements—whether their goal is to fulfill the industrialization, finance, marketing, public policy objectives’ of the trading parties, or any combination of these—is the compensatory performance element. This element is either required by the importing agency or is made necessary by competitive considerations. Offset practices are at the same time a non-tariff barrier to trade, a cost of doing business in an imperfect international marketplace, and a concession to importers that influences their choice of suppliers.

Major exporters of weapons, civil aircraft, telecommunications and other high-cost technology hardware—such as U.S. corporations which are among the world’s preeminent suppliers of defense items—are highly vulnerable to offset demands. In a global environment of budgetary constraints, fierce competition, and stagnant business opportunities, the ability of suppliers to meet offset requirements and/or to provide their clients with financial packages that can best those of competing bidders is a major competitive edge.

The suppliers’ consent to offset impositions is also a clear sign of the governments’ apparent inability or lack of determination to enforce a ban on offsets across industrial sectors and on a global scale, notwithstanding language in Article XVI of the GATT’s 1979 Government Procurement Code, now known as the WTO’s Agreement on Government Procurement, that proscribes impositions of offsets in nonmilitary procurements (military procurements are exempted from WTO rules).

Article 4.3 of the GATT’s 1990 Agreement on Trade in Civil Aircraft further states that "...signatories agree that the purchase of products covered by this Agreement should be made only on a competitive price, quality and delivery basis."

An effort to proscribe offsets in government procurement processes between the United States and the European Union was made in the text of the 1992 "Agreement Between the Government of the United States of America and the European Economic Community Concerning the Application of the GATT Agreement on Trade in Civil Aircraft on Trade in Large Civil Aircraft. The agreement interprets Article 4.3 to prohibit offset practices by stating that:

"...the signatories agree that Article 4.3 does not permit Government-mandated offsets. Further, they will not require that other factors, such as subcontracting, be made a condition or consideration of sale. Specifically, a signatory may not require that a vendor must provide offset, specific types or volumes of business opportunities, or other types of industrial compensation. Signatories shall not therefore impose conditions requiring subcontractors or suppliers to be of a particular national origin."


Although the agreement pertains to sales of large civil aircraft, a footnote in the agreement extends the interpretation of GATT’s Article 4.3 to all civil aircraft, which would include regional jets, business aviation and helicopters. However, the GATT Agreement on Trade in Civil Aircraft does not apply to government procurements of ground-support equipment or air traffic-control systems.

Trends And Prospects

Several global trends are now becoming increasingly apparent which, if they continue unabated, will likely shape the international offset landscape in the new millennium. This trends suggest that:

  • Aerospace weapons-related offsets will continue to account for the bulk of offset practices.
  • The drop in reported international military exports is counterbalanced by a rise in the value of offset demands.
  • The value of offset multipliers (incentive weighting factors) is shrinking while nonperformance penalties are becoming more severe.
  • Indirect offsets are increasing and outpacing direct offset commitments.
  • The accumulation of assumed offset obligation by U.S. and European defense suppliers are compelling these firms to bid against each other and each other’s supply chains.
  • In emerging markets, offsets are spilling over in the civilian sector driven by budgetary constraints and a buyer’s market (e.g., South Africa, Turkey, countries in the Middle East). These governments are beginning to require more stringent definitions of what constitutes “true” economic value in offset packages and in enforcing the fulfillment of offset obligations undertaken by suppliers.
  • Western suppliers are encountering heightened difficulties in identifying viable indirect offset projects in emerging markets because of a limited universe of lucrative or viable indirect offset opportunities for which the suppliers must compete with independent cross-border business. In these markets, offset obligations are increasingly difficult and costly to meet and are, in fact, seldom fully met.
  • Finally, because offset objectives in emerging countries are mainly driven by political objectives and these countries’ governments have the option to source similar equipment from both Europe and the United States, financing packages and the offset level offered tend nowadays to outweigh other procurement criteria in the sale of weapon platforms and other high-cost government acquisitions.

Indeed government-backed export financing, while always a key component of government procurements, has emerged as an important factor in winning large military equipment orders such as, for example, those related to the enlargement of NATO (see example in the "Financing Defense Exports" section of this paper).

As a result of the current tightening in offset performance conditions, especially those in force in emerging markets, the implementation of offset obligations is becoming costlier for foreign suppliers and increasingly difficult to fulfill successfully.

Conceived in the late 1980s and honed in the 1990s, most emerging countries’ offset regulations are of the boilerplate type—i.e., their performance criteria generally duplicate each other’s provisions by focusing on the modernization of the country’s industrial production base and on the enhancement of the country’s current account position through exports.

Some revisions in offset policies of a few countries, notably Turkey, are being implemented, yet offset frameworks in emerging markets mainly stress enhancement of present economic value in the countries’ existing manufacturing sectors, overlooking future economic value resulting from development of new skills in domains such as the domestic services sector.

While wedded to their offset policies, governments in many emerging markets are now increasingly questioning the offset process, the regulations in force as well as former objectives and expectations. Questions have arisen about issues such as justifying the need of state-of-art weapon platforms in view of changed geopolitical threats; the evaluation of the economic impact and long-term budgetary viability of co-producing the imported items; and the quantitative assessment of the "real" economic value of indirect offset packages. On their part, suppliers of defense goods and services are also increasingly concerned about the implications of offsets.

Questions they frequently ask are: can the buyer country absorb the incremental offset investments in a viable and efficient manner at the rates prescribed by the offset requirements; do the buyer’s country’s industrial sophistication and the required economies of scale justify the tooling-up costs of co-production; how should suppliers allocate their finite profits between investments in the buyer’s country and reserves that hedge penalties for shortfalls in offset performance; how does a global oversupply of identical components produced under previous offset obligations elsewhere and linked to repeated sales of the same defense platform affect the creation of a similar new production source; what real or effective drag will repeated global offset obligations cause on the supplying company’s financial standing.

Clearly, corrective measures by all parties to offset transactions will need to be taken to make such deals more, rather than less, vendor-friendly so that win-win scenarios may ensue. The situation suggests a need for new blueprints for offset programs and policies, particularly for indirect offsets in emerging markets, leading to a diversification and expansion of performance realms that can alleviate current bottlenecks in offset performance and still account for quantitative significant contributions to the importers’ economies.

Because they are rooted in the trade environment of the 1990s, offset objectives of most emerging markets will need to be rethought in view of what are commercially attainable, realistic goals and expanded horizons of offset activity areas. This rethinking should draw on what has been learned about shortcomings of existing processes.

Some of the hard questions which need better answers are: by what analytical process can the host country properly and quantitatively assess a priori the "real" medium- and long-term impact, value and costs of projects proposed as offsets by suppliers in order to reach the right decision in approvals; should the range of permissible indirect offset programs be broadened to include technical assistance in the large-scale development of the country’s vocational and professional human capital or in initiatives that expedite economic reforms; what are economic sector objectives that all government constituencies responsible for offsets in the buyer’s country agree on; what actions could be undertaken to facilitate and streamline offset processes and their implementation and what resources should the buyer governments and the foreign suppliers dedicate jointly to this purpose; and how can offset arrangements support programs that hasten regional integration or integration into global production chains.