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

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

Financing Defense Exports

Unofficial estimates suggest that recent aid and credits for the export of military goods and services amount to about $10 billion annually and that access by exporters to competitive finance packages, more than the state-of-art features of the goods and services provided, are becoming a key competitive rationale in defense sales to emerging markets. Along with finance, job creation and economic diversification are also important sought-after objectives of offset programs in these markets.

How does then the United States fare in backing the financing of its defense exports? In contrast to European competitors, the United States does not have an export credit agency that can issue competitive government loans or guarantees for military sales. The U.S. Export-Import Bank does not provide financing for military sales, while the Bank’s counterpart program for financing defense equipment, the Pentagon’s Defense Export Loan Guarantee Program provides, because of restrictive legislative conditions, noncompetitive financing terms.

Lately, U.S. manufacturers have been claiming that the lack of competitive financing was one factor behind Hungary’s 2001 decision to lease 14 Gripen fighters from the Swedish Air Force, the Czech Republic’s 2001 decision, since cancelled, to buy 24 new JAS-39 Gripens, and Austria’s 2002 decision to buy 24 Typhoon fighters from the Eurofighter consortium.

To overcome this financing limitation and conscious of Poland’s political significance to U.S. interests, the U.S. Government made a special loan offer to Poland in October 2002 in support of the sale of 48 Lockheed Martin F-16 Fighter jets, Pratt & Whitney engines and Raytheon and Textron Systems missiles.

The up to $3.8 billion loan, on 15-years repayment terms, clinched in December 2002 the award of the Polish contract for the U.S. consortium, against competing offers from the manufacturers of JAS-39 Gripen and Mirage 2000.

What made this loan package unusual was that it was a direct government-to-government foreign military sale which can be authorized under the little-used Section 23 of the Arms Export Control Act which permitted the Security Cooperation Agency—the borrowing authority that manages the U.S. Department of Defense military sales program—to borrow money directly from the U.S. Treasury.

This enabled the loan to cover 100% of the procurement costs, the interest rate to be based on 10-year U.S. Treasury Notes rather than on higher commercial rates and, as a government-to-government loan, avoided the need for Lockheed to post a performance bond. Whether this special loan package will be duplicated in future military sales remains to be seen.

U.S. Policy Guidelines And Response

As the largest international arms supplier, the United States is highly vulnerable to offset demands and concerned about their impact on U.S. national security and commercial interests. The only official U.S. Government policy on offsets relates to military exports. It was first announced in a statement by the President on April 16, 1990, and was set forth as a policy of Congress in the Defense Production Act Amendments of 1992. The policy provides in pertinent part as follows:

"...Mindful of the need to minimize the adverse effects of offsets in military exports, while ensuring that the ability of U.S. firms to compete for military export sales is not undermined, the President has established the following policy:

  • No agency of the U.S. Government shall encourage, enter directly into, or commit U.S. firms to any offset arrangement in connection with the sale of defense goods or services to foreign governments;
  • U.S. Government funds shall not be used to finance offsets in security assistance transactions except in accordance with currently established policies and procedures...
  • The decision whether to engage in offsets, and the responsibility for negotiating and implementing offset arrangements, resides with the companies involved...
  • The President may approve an exception to the policy after receiving the recommendation of the National Security Council.

In 1991, the offset policy was supplemented by provisions contained in the Defense Offsets Disclosure Act of 1999. Specifically, Congress made the following findings:

· "A fair business environment is necessary to advance international trade, economic stability, and development worldwide, is beneficial for American workers and businesses, and is in the United States national interest.

  • In some cases, mandated offset requirements can cause economic distortions in international defense trade and undermine fairness and competitiveness, and may cause particular harm to small and medium-sized businesses.
  • The use of offsets may lead to increasing dependence on foreign suppliers for the production of United States weapons systems.
  • The offsets demands required by some purchasing countries including some close allies of the United States, equal or exceed the value of the contract they are intended to offset, mitigating much of the potential economic benefit of the exports.
  • Offset demands often unduly distort the prices of defense contracts.
  • In some cases, United States contractors are required to provide indirect offsets which can negatively impact nondefense industrial sectors.
  • Unilateral efforts by the United States to prohibit offsets may be impractical in the current era of globalization and would severely hinder the competitiveness of the United States defense industry in the global market.
  • The development of global standards to manage and restrict demands for offsets would enhance United States efforts to mitigate the negative impacts of offsets."

Finally, the Defense Offsets Disclosure Act of 1999 makes the following declaration of policy: "It is the policy of the United States to monitor the use of offsets in international defense trade, to promote fairness in such trade, and to ensure that foreign participation in the production of United States weapons systems does not harm the economy of the United States."

What has been then the U.S. Government response to the proliferation of offset practices? The response has been twofold: the government monitors the impact of defense offsets on U.S. defense trade and it supports U.S. defense exporters by promoting the competitiveness of U.S. exports. Thus, pursuant to Section 309 of the Defense Production Act of 1950, as Amended, the Bureau of Industry and Security of the U.S. Department of Commerce has been submitting annual reports to Congress on the impact of offsets in defense trade.

Previously in 1990, the U.S. Department of Commerce had established the Financial Services and Countertrade Division within its International Trade Administration. The Division provides, inter alia, advisory services to U.S. exporters on countertrade and on indirect and commercial offsets. Finally, the U.S. Government will, like other governments, support major U.S. defense sales by advocating with foreign governments on the exporters’ behalf.

Value Creation in Indirect Offsets

As already mentioned, fulfillment of indirect offset obligations, in particular, has become an increasingly arduous task for defense contractors who must now compete with civilian suppliers, as well as with independent investors for ever scarcer viable commercial opportunities.

In addition, capital investments—which have been favored in indirect offset directives of many emerging countries as economic development stimulants—are becoming increasingly difficult to implement. Among the reasons are cyclical economic slowdowns in the industrialized countries which may lead to decreasing or highly selective private capital flows; insufficient investment protection by legislative frameworks in some markets; or stringent government conditions on the granting of investment-related offset credits such as enforced by the United Arab Emirates.

Vendors, therefore, face a crucial issue: how to identify new offset options that can earn them substantial offset credit while satisfying the host countries' offset program conditions and, especially, complying with the countries’ indirect offset rationales—i.e., job and export creation, and economic development through industrial diversification. The question arises whether there are plausible options to soften and overcome offset impasses—e.g., by identifying new horizons for viable offset initiatives as a supplement to more traditional offset undertakings.

For example, the general dearth of viable industrial offset targets in emerging markets make initiatives with a "social flavor," such as investments in human rather than industrial capital, potential default yet essential options in indirect offset packages.

Such initiatives may entail upgrading corporate rather than academic skills through vocational training. These types of investments, while important social priorities of emerging market governments, have been plagued by chronic public funding shortages and largely ignored as offset initiatives by Western vendors because they entail low allocations of offset multipliers and credits.

The corporate training sector, which in the United States represents today a multibillion market, has in fact significant potential to promote long-term economic growth and foster job creation in domestic markets by contributing to productivity growth and substituting for ebbing capital per worker ratios in emerging economies.

Another overlooked horizon for indirect offset implementation are initiatives that effectively reduce national budgetary outlays in emerging markets. A practically universal characteristic of these markets is that their governments are the key, if not the main, financial providers and managers of their social infrastructure.

In performing this function, the governments must annually allocate substantial budgetary resources to the task. Therefore, offset initiatives that can alleviate by curtailing this burden might, if properly advocated and their impact credibly proven, be a welcome relief for these governments. In fact, South Africa and Saudi Arabia view their offset programs as serving a social purpose.

Indirect offset programs might, for example, emphasize initiatives in the health and other social services sectors; provide reform through technical assistance activities in the insurance and private pension sectors; fund vocational education programs for small and medium size enterprises; and address chronic unemployment by establishing venture capital funds for entrepreneurial initiatives.

Venture capital funds and special purpose finance facilities, which may target offset-related or independent projects, could provide foreign vendors with an opportunity to earn repeated or periodic offset credits against their offset obligations.

If agreeable to the host country government, investments in such finance infrastructures may earn foreign vendors offset credits not only for their participation in the funds’ initial endowments, but also for the funds’ diversified and repeated commercial investments—provided that the latter activities meet the enacted offset credit regime and are shown to have long-term beneficial impacts on the domestic economy.

For suppliers, the drive to gain, preserve or enhance market shares in a competitive and imperfect global trade environment will depend in coming years on creative marketing and financing strategies which rely on informed decisions, new interpretations of manageable risk and, for high-cost defense or civilian sales, on active advocacy by their governments.

These strategies include the acceptance of offsets as one of the available marketing and finance tools—along with such others as leasing, subcontracting, or investing in the client countries—that enable these countries to pare down over time their financial import exposure.

For importers—especially for government agencies in emerging markets whose offset policies still stand at the intersection of unrealistic expectations and rigid offset formulas—the new decade offers the opportunity to learn from the experiences of the past and adopt flexible policies that expand the horizon of offset-related activities, but still transfer measurable and real economic benefits to their country.

While broadening the traditional industrialization focus of offset policies is certainly in order, the new challenge for government entities responsible for approval of offset proposals will be establishing criteria and identifying methodologies for sound analytical evaluations of the true comprehensive economic consequences of the proposed projects.

The goal of such assessments should be to provide a realistic projection over time of the sectoral and cross-sectoral impacts, value, and costs of offset projects, including their overall job creation and job diversification potential.