Preparing The Offset Proposal

This article is reprinted from Countertrade Review. John Holmes is the editor of this outstanding monthly newsletter of the Australian Countertrade Association, 31 Mawson Drive, Mawson ACT 2607, Australia.

A company considering tendering or making a sales proposal to a foreign country known to have an offsets scheme will have certain preliminary work to undertake and complete before traveling to the country to make its offer.

1) The chief executive officer (CEO) of the company, and the executive staff, should understand the offset mechanism and the particular proposal.

The execution of an offset commitment will call for the collaboration of various divisions of the company, with its inevitable conflicts of interest, compromises and internal negotiations.

For example, the sales staff making the sale will not be involved in negotiating a training program for personnel coming to the company from the buyer's organization, this being the concern of the production staff.

The CEO may be called on to coordinate the divisions involved. To do this with any conviction he will need to fully support the sales offer and the offset proposal commitment that is part of it.

Possibly at the beginning the CEO may know nothing about countertrade or offsets, and so explanation and education will be necessary. Countertrade or offsets are virtually impossible if the CEO, personally, does not understand and support the process.

2) The country's offset requirements should be studied carefully.

The requirement stated in the tender document will be the minimum. It is possible that a more generous offset proposal may be made, which in a competitive situation could be a crucial factor in winning the tender.

Consultation with the company's agent within the country concerned, or with other Australian companies which have tendered successfully in that country, may determine whether additional offsets beyond the minimum requirement would be a competitive advantage.

Close attention should be paid to all the contract details, so that all are satisfied. If the company has not a legal officer, a legal firm or lawyer will have to be engaged who has experience with offsets.

Assessment of the country's economic and social environment, its political and legal system, and the objectives and history of its offsets scheme will be important.

In addition, before negotiations it would be very desirable to learn of the idiosyncratic cultural customs of the country that could influence the mode to negotiation and their approach to it.

3) Preparation within the company.

As most departments of the company will be involved in the offset commitment, to a greater or lesser degree, a coordinator will need to be appointed, and a procedure established to ensure the effective participation of each department- marketing, finance, legal, procurement, production.

In-house training may be desirable to acquaint staff of these departments with the offset process in general, and this project in particular.

As with all countertrade negotiations, a strategy should be developed, with the participation of all in the company involved. The negotiation team should be carefully selected and prepared, bearing in mind that it could be confronting a team of negotiators who most likely will have had considerable experience.

4) Make the best use of outside expertise.

Most aspects of offset demand and management will be strange, especially if the offset is the first one undertaken. Even the vocabulary is available from many outside sources: consultants, lawyers, banks, Austrade, other companies, and the Australian Countertrade Association.

If the company is to be involved in indirect offsets, this will mean that it will be undertaking conventional countertrade, in the form of counterpurchase. This in itself has its own problems and procedures.

5) Preparing the offset proposal itself for direct offsets.

Direct offsets, which include technology transfer, investment and joint ventures, technical training, research and development, maintenance services, local purchase of components and part-manufacture, assembly from imported kits, and export marketing assistance, call for much careful consideration.

Local assembly, and procurement of locally-made components. This is the most commonly found and most straightforward form of offset.

Often a certain number of the complete aircraft, or other piece of equipment being purchased, is imported, and then kits are supplied from which the remainder are assembled. Whatever can be supplied or manufactured locally is then included in the assembly.

In more extreme cases, a percentage of the value of the equipment is required to be purchased or manufactured locally, from the beginning. (The Australian offset requirement is for 70% local manufacture.)

This means that only the essential components which have technological content, that will not be licensed for local manufacture, will be imported from the supplier.

For the supplier, a high percentage of local content may be difficult to achieve, as there may not be sufficient manufacturing capacity available at the required level of technology.

Technology transfer, licensing, and the setting up of joint ventures with appropriate local companies may be involved, these sometimes being government establishments.

The advantage to the buying country of local assembly and the purchase of components is that it creates employment in the country.

On the other hand, it may reduce the level of activity and employment in the factories of the supplier, so there will inevitably be a keen negotiation in setting the percentage of local manufacture.

Technology transfer. Clearly the seller will throw away its competitive advantage if it transfers all of the technology related to the product being sold.

The seller then will select the technology it would be prepared to transfer, in the form of know-how and/or licenses. The situation may arise where the buyer (or the government to whom the tender is made) might press for certain technology which the seller is reluctant to release.

There have been many instances, in the field of avionics and hi-tech armaments, where offsets agreements have broken down because the sellers have refused to transfer crucial technology, for either commercial or strategic reasons.

On the other hand, the buyer might accept technology unrelated to the product being purchased. Sellers then are at liberty to offer technology which for them is superseded, but nonetheless is significant for the buyer.

In addition, the seller may be able to offer technology available from other companies, not only local companies but of foreign identity. (The latter is possible in the Australian offsets scheme, for example.)

Investment. Decisions will be necessary, related to the funds that can be committed to investment in existing enterprises or to the establishment of joint ventures in the buyer's country.

Usually investment is preferred in enterprises that will continue after the offset commitment is complete, as the buying government has the objective of permanently enhancing its industrial sector with the investment.

Technology transfer may be linked with the investment, and may indeed form at least part of the equity of the seller in the enterprise. Finding appropriate companies in which to invest, or to form joint ventures, could be a considerable task, but the buying government may have proposals to make.

Training. Professional and technical training of personnel from the buyer's country would usually be related to the product being purchased, but it could also be of a more general nature, specified by the buyer.

More often than not it would involve the bringing to Australia personnel for training, either in-house or at technical institutions. An alternative is to fund training in the buyer's country, by setting up an organization and providing the teachers.

Some monitoring is necessary: in-house and other training programs in Australia have sometimes been criticized for being holidays for the would-be trainees, with little achieved.

Research & Development. Contributions in personnel and resources can be offered to the buying government, given a knowledge of what would be preferred.

Maintenance and servicing. This would be a normal part of any sales of equipment with a high technological component.

As an offset proposal it could be for the establishment of a special center for servicing and maintaining the equipment sold, with the provision of plant and equipment, and stocks of spare parts, as well as the training of the locally-recruited personnel to man the center.

In some instances, these centers service not only the equipment supplied to the country concerned, but to others in the region.

6) Preparing the offset proposal itself for indirect offsets.

Indirect offsets can cover a vast range of products and activities, and are not the real concern of the defense or other authority purchasing the equipment. Indirect offsets serve other objectives, such as increasing employment generally, or in improving the country's exports.

The major forms of indirect offsets are as follows:

Investment. The buying country may nominate certain industries in which investment would be preferred, or the seller may make proposals, related to the arrangements that can be made with associated or collaborating companies either in its own country or possibly others.

As with direct investment, technology transfers, licensing, and the setting up of new companies or joint ventures could be involved. These new industries may be required to have export potential.

The buying country may require the investment to be made, and the establishment of the new industry, in a region of the country that is relatively undeveloped and where there might be a high degree of unemployment.

While this sounds fine in theory, in practice it can lead to difficulties in that the industry may not be viable in that region. It could be remote from the supply of raw material inputs, and the local infrastructure may be deficient-railway and transport access, power supplies, telecommunications, shipping, and so on.

In many cases when these industries have been set up, subsidies have been necessary for them to continue, and the political acceptability of the projects have been called into question.

It is possible that the buying country may accept, in fact may even seek, investment in the form of joint ventures with local or foreign companies with particular technologies of special interest. Especially in that they may enhance the country's defense preparedness.

Investment and technology transfers from companies in third countries may, in some countries' offset schemes, be considered as offsets.

Assistance in export marketing. When the selling company is a large multi-national with a world-wide marketing organization, it could be negotiated for it to take over or assist in the international marketing of the equipment manufactured locally, be it either the product contracted, or the goods made in an unrelated industry. Particularly one in which it has invested.

Technical and professional training. An interest of the buying country may be in the establishment of an educational or training institute at any particular level, such as a secondary technical college, a faculty, or a research or teaching institution in a university.

Civil construction projects. An indirect offset could include infrastructure projects, such as the construction of a road, port facility or airport.

Tertiary activities. There have been many examples of indirect offsets involving tertiary services, such as tourism, shipping services, printing, and arranging conferences and legal services.

In the case of tourism, buying countries have made available a number of hotel rooms which have been allocated for vacations taken by the suppliers' employees, or have been sold to tourist agencies for the general public.

Commodities and semi-manufactured goods. The inclusion in the offset package of goods unrelated to the equipment being supplied involves the countertrade procedure known as counterpurchase.

Counterpurchase requires the supplier to accept goods, either nominated by the buyer, or selected by the supplier, and to dispose of them on the international market.

As the supplier is more likely than not to be a manufacturer, it would not have any marketing experience related to the goods supplied for counterpurchase, but would still have to arrange for their sale on the international market.

The most convenient course of action is for the company undertaking the counterpurchase to engage a trading company. A number of these trading companies exist with considerable experience in counterpurchase, located in overseas commercial centers such as Singapore, London and Vienna.

Each has its own particular expertise in terms of geographical regions and commodities. Rarely would any one company be able to handle all commodities and goods in all countries.

Some specialize in the Far East, or Africa, others may be in grains or metals; still others in manufactures.

Locating the right trading company for the products concerned calls for a knowledge of the international countertrade network, which is the competence of a consultant.

The important role of the trading company is that it will contract to take over the entire counterpurchase transaction, without recourse.

No matter whether the counterpurchase goods are nominated by the buying country or have to be located by the trading company, the latter will sell the goods on the international market, and deposit the proceeds in an escrow account. When the sale is complete, the trading company advises its client.

In the case of a normal countertrade transaction, as distinct from an offset arrangement, the seller is then able to carry out the delivery of its product, completely certain that it will be paid. In the offset situation, the completion of the sale of the goods finalizes the trading company's contracted commitment.

Trading companies (like consultants) charge fees for their services. The fee for finding and disposing of counterpurchase goods could range up to 5%, depending on the difficulty of selling the goods and the time required for the execution of the contract.

Political Risk Insurance In Countertrade Transactions

Political risk insurance is part of the equation in countertrade transactions. The cover available from government export insurance agencies is usually limited, often being confined to the main supply contract.

The gap is then filled by the private market, which in turn is limited by its capacity for particular countries at any one time.

The risks covered are:

Debt risks: Non-payment by the buyer; an embargo on exchange transfer; non-honoring by the guarantor.

Trade risks: Non-delivery by the supplier; failure to process, toll or refine.

Government risks: Import or export embargoes; cancellation of licenses; termination through Force Majeure. Unfair calling of guarantees.

Confiscation: Although this has a different insurance market, with more capacity available. Risks in confiscation include transit, storage (warehouse or quayside), and tolling.

Riots, strikes and civil commotion.

War on land.

Until recently, only public entities were covered for political risk, but now private entity default can be covered. Therefore there is now full political and credit risk cover.

Private Market Capacity

The private international insurers having capacity in the political risk market are headed by Lloyd's, with $50 million for contract frustration and $750 million for confiscation.

The others are AIG ($24 million and $120 million), Unistrat ($10 million and $10 million), CITI ($6 million and $30 million), Exporters ($50 million and $50 million), FCIA ($10 million and $10 million), TUA ($7 million and nil), Global Trade ($2 million and $2 million), and others ($23 million and $128 million).

Claim Case Study

This case concerned confiscation in Ukraine, where a Western trader had a stock of 26,000 tons of gas-oil stored in that country. The Ukrainian company was Krimnefteproduct, a state-owned company responsible for all gas-oil installations in Ukraine.

The trader discovered that there was no gas-oil in their designated tanks, and Krimnefteproduct wrote a letter to them stating that they had "borrowed" the gas-oil but were committed to paying it back.

Krimnefteproduct offered to supply railcars in compensation, but this was not taken up. So compensation was then offered in parcels of 1,500 to 2,000 tons over two years, which left 9,500 tons short.

The trader now had two options: to take legal proceedings, or to obtain the balance through negotiations.

The second option was chosen, but while the full tonnage was eventually delivered, prices had fallen and there was a monetary shortfall of $300,000. The insurers paid this to the trader in an ex gratia payment.