Offsets In International Arms Trade Need For A National Policy
- Category: Strategic Research Review
- Published: Wednesday, 22 October 2008 00:00
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The end of the Cold War saw a considerable reduction in the demand for major weapon systems the world over. Additionally, free or subsidized military aid gave way to pure trade transactions. With limited buyers, the sellers were hard put to outbid their competitors. They had to make their offers virtually irresistible with promises of lucrative ‘add-ons’, collectively called offsets. Gradually, offsets became an essential part of all defense deals. From being an add-on, they became an important tool of decision-making as the purchasing countries used offsets to contend with the hostile public opinion against defense spending. Governments highlighted the benefits accruing to the national economy by way of technology transfers and buy-backs. Thus, the twin conditions of limited arms market and hostile public opinion in buying nations became the raison d'tra of the concept of offsets.
Many consider offsets as some sort of coercion or compulsion, unfairly imposed by the buyer. But that is not true. In any competitive environment, a seller has to make his offer more lucrative than those of others. This is the basic ‘mantra’ of marketing and is equally applicable to defense trade as well. A seller accepts offsets of his own free will, as it still makes good marketing and economic sense for his company.
The value of an offset is generally expressed in terms of percentage of the contract value. The Austrian air defense deal in 1993 had offsets of up to 200 per cent of the contract value, while their radar program recently had offsets of 280 per cent. The Czech fighter deal had an offset clause of 150 per cent. Interestingly, South Africa negotiated an arms package deal with nearly 350 per cent offsets in 1999.
Not all offsets are duly published. Sellers are generally reluctant to reveal the quantum of offsets they had to offer to clinch a deal. They term it as commercially sensitive information. They are wary of future clients getting wiser and upping their demands in turn. They are also wary of adverse local opinion, which may view it as leading to job losses, as many suppliers undertake to place orders for sub-assemblies on the local vendors in the importing country at the cost of the original vendors in their own country.
What is an offset?
Offsets have been described in a number of ways. In its simplest form, an offset is a trade-off or a type of barter system. As the concept has many connotations, it is difficult to find one single definition, which could encompass all the facets. Offsets can generally be termed as formal arrangements of trade, wherein a foreign supplier undertakes specified programs with a view to compensate the buyer as regards his procurement expenditure and outflow of resources. In other words, the supplier undertakes programs to generate benefits for the economy of the buyer country. It is a formal arrangement, as it has inbuilt contractual obligations. The negotiated package consists of the primary contract and the compensatory offsets.
Offsets can also be termed as trade arrangements with built-in reciprocity clauses to provide some sort of relief to the buyer to help him pay for the purchases. Some may term it as a narrow, simplistic and focused approach towards offsets, as they feel that the concept has much wider implications. As will be seen subsequently, different nations have used offsets differently to suit their specific requirements.
Perhaps, it would be best to define offsets as some sort of a leverage exploited by a buyer to obtain compensatory benefits by asking the seller to undertake well-designated activities to boost the economy of the buying country. Of course, the effectiveness of the leverage depends on the level of competition amongst the defense producers, their desperation to grab the order and the negotiating skills of the buyer nation.
Methodology of Offsets
Offsets can be direct or indirect. In direct offsets, the trade arrangement is related to the primary product sold. It implies that the compensatory dispensation remains confined to the main weapon system, its sub-assemblies and components. It does not transcend other economic or social activities. On the other hand, indirect offsets have a much wider scope and are not restricted to the product sold.
Direct offsets in their simplistic form may include buy-back or co-production or licensed production or sub-contracts of the system and its sub-systems. In this arrangement, the seller helps the buyer produce the product or a part thereof and purchases it back for incorporation in all similar systems sold by him elsewhere in the world. Therefore, the countries that want to develop their defence industrial base generally seek direct offsets. Most of the European countries follow this path. By far the most common and generally accepted to be the best form of direct offsets is technology transfer. It is considered the engine that drives offsets.
South Korea negotiated a unique direct offset arrangement with its F-16 procurement. It acquired technology from Lockheed Martin to produce most of the parts of the F-16 and final assembly of 108 of the total 120 purchased aircraft. It also extracted an undertaking from Lockheed Martin to co-develop its KTX-2 advanced trainer.
However, long-term economic viability of direct programs needs to be examined in depth before embarking upon them. Rapid obsolescence of technology and over capacity can render a program wasteful. Turkey invested heavily in setting up assembly lines for an F-16 program. But today, it is faced with dwindling orders and overcapacity, as many other countries that bought the F-16 had also established similar facilities under their own offset programs.
On the other hand, indirect offsets generally take the form of compensation trading. Actually, they are pure trade arrangements. Reciprocal trade, counter purchase, switch trading, counter deliveries and parallel trade fall under this category. Some may like to term them as different shades of the age-old barter system, which specifies the exchange value of products / services for other products or services of equal value. However, counter purchase has a little different connotation. Herein, the seller of the defense equipment agrees to buy or help in finding a buyer for a specific percentage from the original importer within a specified period. The product to be counter purchased may vary from oil to agricultural produce. One of the earliest defense deals, which followed this arrangement, was oil for weapons by the oil-rich Gulf countries. The importance of indirect offsets can be gauged from the fact that over the years a definite shift is discernible towards them. Today, indirect offsets outnumber direct offsets by two to one, as the buyer countries have realized the immense economic and social potential of offsets.
Offsets can become rather complex in case the buyer demands investment in infrastructure and social sectors like health care and education. Buyer nations, at times, demand assistance in penetrating new markets for their products. In some cases, the seller is forced to spend a part of the cost in the defense industry of the importing country.
The Czech Government drove a hard bargain while negotiating to lease Gripen jet fighters from Sweden. It managed to extract a highly competitive price with lucrative indirect offsets. The Swedish-led consortium offered to help in 30 projects spanning energy generation, automobiles, aerospace and transport.
While negotiating a deal for 18 SU-30 fighters from Russia for 900 million dollars, Malaysia obtained offsets with wide-ranging dispensations after three years of intense bargaining. Russia agreed to acquire palm oil worth 300 million dollars in part payment of the aircraft. It agreed to provide technology worth 270 million dollars. Further, Russia undertook to establish a joint venture facility to service the aircraft and co-produce some components. It also accepted a Malaysian astronaut for training. This is an ideal example of seeking offsets according to the defense and economic needs of the country.
Most of the countries have laid down an ‘offset threshold’ for defense imports. It implies that all arms deals above that value would necessarily have associated offsets.
Offsets are commonly assigned a ‘multiplier value’. It is a factor applied to the actual value of an offset transaction to calculate the credit value earned. It is a methodology of assigning weightage to different offset programs. Buyers use multipliers to provide sellers with incentives to offer offsets in targeted areas of their choice.
This is the commonest type of direct offset in defense transactions. Up to 30 per cent of all offsets provided relate to technology transfer of varying degree. Most of the buyers want the technology to manufacture the complete system, if possible, or at least its sub-assemblies. Although commonly touted as the most beneficial offset, its effectiveness remains suspect for many nations.
Despite the US providing professedly latest technology to a host of its allies, its technology lead is increasing. No country is keen to offer the latest technology. The technology on offer would invariably have limited residual effective life. Such a technology is useful only if it is utilized as a take-off platform for indigenous development of more advanced technologies. This was the route taken by Japan and South Korea. Unfortunately, not very many countries have understood this aspect. This applies to India as well. Transferred technology must make the local defense industry self-sustaining. Further development must be indigenous. If every subsequent technology has to be imported, it does not contribute to the technical prowess of the country and hence, dependence upon imports continues.
No producer is going to transfer his technology to a client unless there are commensurate commercial gains. Even if the technology is deemed free as an offset, the seller invariably tries to charge an inflated price for jigs, fixtures, test beds, training and technical documentation. Therefore, before seeking technology, the buyer should carry out a detailed analysis of the technology on offer and ascertain its requirement.
Any technology, which is product specific and does not have applications in other fields, will invariably not be cost-effective. Hence, the technology sought should be such that the recipient can exploit it fully by developing its other applications as well. That will provide the necessary economies of scale. The buyer nation should also match the technology sought with its own capability for its smooth absorption.
The greatest drawback of technology transfer as an offset is that it is very difficult to measure its real impact and effectiveness. The recipient nation has to have a dedicated set-up to collate and assess the overall benefits. Technology transfer for the sake of getting an offset is of no avail.
Management of the Offset Process
Generally, it is for the buyer nation to decide as to what offsets to seek. It is a very crucial decision and demands careful consideration. It is not the type of offset but its relevance that should guide the selection. Normally, offsets should be in consonance with the national economic objectives. They should be broad-based and fulfill an economic need.
The success of any offset program depends primarily on proper selection, detailed planning, close supervision and regular monitoring. Therefore, the whole process of offsets has to be managed in a well thought out and coordinated manner.
The complete offset process can be broadly considered in five stages:
The US Experience
The US has no declared policy on offsets. It feels that offsets go against its stated promotion of ‘free and fair’ trade. As the largest exporter of arms, it considers offsets as a burden on its economy and a necessary evil, which cannot be wished away. The Congress in 1999, had opined that unilateral efforts by the US to prohibit offsets may be impractical in the current era of globalization and would severely hinder the competitiveness of the US defense industry in the global market. It accepts that offsets are a part of the current defense trade environment.
Being the oldest and the largest provider of offsets in the world, the US has gained invaluable experience in this field. It is generally estimated that the US defense industry has offset obligations of over 10 billion dollars. It has a very exhaustive system in place to compile data on offsets and to monitor them closely to minimize their adverse effects. All firms with more than 5 million dollars offset liability are required to report to the Secretary of Commerce.
For the first time in 1984, the Congress addressed the subject of offsets in defense trade under Section 309. It requires the President to submit an annual report on the impact of offsets on the US defense-industrial base. The US Department of Commerce (Bureau of Industry and Security) submitted its latest report to the Congress in July 2004. The report covered a ten-year period from 1993 to 2002. It makes very educative reading. Some of its findings are:
Need for a National Policy
More than 130 countries are demanding offsets in one form or the other. Most have a central body to oversee offsets in their entirety, as per their national policy. The UAE had set up an empowered Offset Group way back in 1990. It demands and negotiates offsets in varied fields like health care, shipbuilding and other industrial activities. It also seeks joint ventures with local partners. Its policy mandates that all sellers of arms to it must generate, within a period of seven years, commercially viable products worth 60 per cent of the contract value. South Africa has a policy of seeking three faceted offsets – about 20 per cent of the contract value as direct defense oriented offsets, 45 per cent as counter purchase by the seller and 35 per cent as foreign investment in South Africa.
The Swedish policy on offsets gives primary importance to the creation of long-term employment opportunities in the country. It seeks newer markets for its goods to improve balance of trade. It also demands technology and know-how to ensure maintenance of the purchased defense equipment.
The British defense industry was quick to grasp the increasing importance of offsets. The British Defense Manufacturers Offset Group was established in 1990. The members exchange knowledge on offsets and share expertise to deal with different countries. It is also creating a data bank wherein the offset policies of the major arms buying countries have been compiled to enable the members to negotiate effectively.
In addition, the Defense Export Services Organization under the British Ministry of Defense provides support and offset advice to British arms exporters. It also administers the policies for seeking offsets from the producers who export to Britain. The British call it Industrial Participation (IP). Under the British IP policy, a minimum of 100 per cent offset is essential for all contracts over 50 million pounds for French and German companies, and 10 million pounds for all others. It further stipulates that offsets have to be defense related, new and of equivalent technical quality; and have to be fulfilled within the period of the main contract and at no extra cost. It permits both direct and indirect offsets. Incidentally, the UK’s offset benefits exceed 5 billion pounds, with the USA being the main provider.
Countries of the erstwhile communist bloc like Hungary, the Czech Republic and Poland are modernizing their armed forces to make them compatible with the NATO forces. They have also become aware of their bargaining power and have evolved detailed offset policies.
India has no declared offset policy for defense purchases. Many large-scale procurements have an in-built clause, wherein after the initial supply of fully built items, the balance quantity is produced indigenously with transferred technology. This route was followed in the cases of MIG series of aircraft, Jaguars, BMPs, T-72 tanks and T-90 tanks. Even the recently finalized deal of Advanced Jet Trainer HAWK includes production in India with receipt of technology. However, they cannot be called offsets, as the transfer of technology is negotiated as a part of the overall deal, albeit at a cost.
A suggested set up for India could be as follows:
- Location: Union Ministry of Commerce.
- Composition: To be chaired by the Union Commerce Minister: It should consist of members from the various Ministries dealing with foreign trade, Director General Foreign Trade and Director General Technical Development. It should also have representatives of Indian industry both public and private sectors. The Group should co-opt other experts from different fields as and when required.
- Perform the role of an overarching body at the national level. It should formulate national policy on offsets with clearly spelt out aims and objectives. The policy should be pragmatic and have long-term benefits. It should have continuity and should encompass the complete spectrum of all economic activities. It should be flexible to cater for a changing environment.
- Prioritize areas and fields in which offsets should be sought.
- Fix offset thresholds for different types of procurements.
- Issue guidelines to all concerned Ministries for fixing offset percentages.
- Issue directions for apportioning weightage to direct and indirect offsets.
- Lay down broad framework for monitoring arrangement.
- Issue guidelines for feedback and evaluation.
- Give ‘in principle approval’ to offset packages for all import deals over Rs 1,000 crore.
- Create a national data bank.
- Location: Ministry of Defense.
- Composition: It should work as an adjunct to the Defense Acquisition Council (DAC). The DAC is headed by the Defense Minister and includes all Ministers of State for Defense, Chiefs of the three Services and all Secretaries in the Ministry of Defense. It should have a permanent cell for offsets to provide continuity. Advice of various experts must be taken when discussing specific programs.
- Formulate defense-offset policy, which should flow from the national policy. Identify and prioritize areas for offsets.
- Evolve and issue guidelines for fixing offset thresholds, keeping in mind the value of the deal, level of technology and the exporting country involved.
- Fix offset percentages for different procurements at the time of taking ‘Buy’ and ‘Buy and Make’ decisions. Identify the recipient for the transfer of imported technology. It could be a public or private sector enterprise.
- Prioritize various offset programs by assigning them differential weightage through multiplier values.
- Amend Defense Procurement Procedure-2002 to incorporate offset stipulations. All Requests for Proposals should contain terms for offering offsets in the form of a matrix to facilitate their inter se comparison.
- Develop necessary skills to negotiate deals and sign contracts.
- Evolve an effective implementation, monitoring and feedback mechanism.
- Set up an exhaustive data bank.
The World Trade Organization prohibits its signatories from imposing, seeking or considering offsets for government procurement transactions. While many countries impose no formal offset requirements, there is, at the same time, an understanding that any seller who wants to do business must voluntarily submit an offset proposal. There is no doubt that offsets are here to stay and their importance is bound to rise in future.
The value of an offset depends primarily on its appropriate selection. Ill-conceived and ill planned offset programs invariably prove to be highly wasteful in national resources and uneconomical in value. Therefore, programs have to be selected on the basis of their viability, estimated offset credit value, ease of monitoring and demonstrability of accruing benefits. Offsets should not be viewed in isolation as one-time agreements, but as an important and integral element of long-term national policy. To derive full benefit from offsets, it is absolutely necessary to understand the dynamics of offsets. Being one of the biggest buyers of defense equipment, India can draw immense benefits with a well thought out offset policy. It is time India puts its act together for optimum exploitation of offsets in all defense deals.
This article first appeared in the India Defence Review and has been reproduced here with the permission of the Editor