Don’t Fear the Offset

5 January 2011 (Last Updated January 5th, 2011 18:30)

Does offsetting distort the military market? Robin Ashby and Adam Dempsey of the UK Defence Forum investigate.

Don’t Fear the Offset

US Congress has been waging war for some years on what it sees as the unfair trade practice of countries purchasing defence materiel and demanding offset opportunities as part of the price of doing business. Offsetting provides an opportunity for purchasing governments to impose compulsory inward investment obligations on foreign suppliers.

This has made offsetting a particularly attractive proposition for developing economies. Offsets can result in foreign companies facilitating joint production, foreign direct investment and additional benefits for the wider economy. According to Jane's, since 1999, 22 countries have introduced formal offset policies.

Yet the establishment of offsetting as a tolerated feature of the market has not been without criticism. The European Commission has joined the US in the belief that offsets are "market distorting", but what is the evidence?

For the developing world, offsets may give political cover by deflecting domestic criticisms of using a foreign supplier to ensure that the purchase benefits indigenous arms and unrelated industries. For many small and developing countries, maintaining a domestic defence industrial base in its current form is simply uneconomic.

"Offsetting provides an opportunity for purchasing governments to impose compulsory inward investment obligations."

Not only are offset obligations expected to reduce arms acquisition costs they are also expected to stimulate economic development and employment within purchasing countries. This could be accompanied with general and more specialised transfers of technology.

According to Brauer and Dunne, academics in the study of military offsets, South Africa's R29.9bn acquisition programme in 1999 was underpinned by an offsetting strategy that sought to get the arms and keep the money at home. Whilst countries like Vietnam, Malaysia and India see offsets as key to enhancing self-reliance in defence production, others such as South Korea and Taiwan are keen to improve their reputation as global exporters. For countries such as Brazil offsetting underpins regional power aspirations and the desire to produce materiel domestically for export.

Brazilian boom

Industry analysts and executives are increasingly concerned at the relatively low threshold levels at which offset obligations can be triggered. Brazil, for example, stipulates that offsets are required on all contracts over $1m.

This places Brazil on a par with EU countries like Austria, which has an offset threshold of $1.48m. As a result, offset obligations are increasingly applicable to smaller companies within global supply chains. This is prompting some prime contractors to allocate resources to dedicated offset units to deal with a state's offsetting strategies.

Yet concern over the impact of added costs to the supplier is unlikely to significantly alter the outlook of emerging countries with a proven track record of offsetting. Since the 1970s, Brazil has used offsets to overcome incrementally technological barriers. This has been accompanied by the development of a civilian industrial base to effectively absorb foreign capital, technological transfers and know-how. Brazil can point to the aircraft manufacturer Embraer as the best example of what can be achieved through offsets.

"Offsets can result in foreign companies facilitating joint production and additional benefits for the wider economy."

In 1981 the then state-owned Embraer entered into an agreement with Aeritalia and Aermacchi of Italy to co-design and produce the AMX fighter. Each company was involved in the production of sections of the aircraft, with other Brazilian companies making additional subsystems under licence.

According to Brazil's agency for industrial development (ABDI), the AMX agreement was fundamental to the Brazilian aeronautics industry's acquisition of project management, system integration and manufacturing know-how.

ABDI may also point to Embraer's penetration of the civil regional jet market in the 1990s as further vindication of collaboration with overseas companies.

As of 2010, Embraer controls around 15% of global business aircraft sales. International cooperation has allowed the company to develop its technological prowess and become one of Brazil's truly global enterprises. Moreover, Brazil now enters into defence purchase agreements with a degree of confidence in its offset strategies. Brazil's FX-2 requirement looks increasingly likely to be fulfilled by Dassault's Rafale fighters. In a deal worth an estimated $7bn for 36 Rafales, Brazil made technology transfer the cornerstone of the purchase. Not only will this allow Brazil to domestically produce fighter aircraft, it also contributes to a broader strategy of encouraging governments to "buy Brazilian".

Yet Brazil's approach to offsetting has come at a cost. Despite being a world leader in the civil jet market, Embraer has been extensively subsidised by government money. This has been particularly crucial as Embraer's foothold within the domestic market remains tenuous. In 2009, for example, the state-owned development bank BNDES granted a domestic airline a $102.4m loan facility to cover the purchase of four Embraer regional jets. These subsidies reflect the fact that many Brazilian airlines remain customers of other manufacturers. They also suggest that, despite the best efforts of its offsetting policies, Brazil remains some way off self-reliance in the manufacturing of aircraft of any type.

Embraer's successful entry into the commercial airline market was matched by a decline in military sales. Whilst the company controlled approximately 40% of the civil regional jet market by 1999, military sales had declined to 7% of its total output. Embraer states that defence sales now account for 13% of its overall revenue. Yet its global prowess in civilian markets also reflects arguments that few of Brazil's indigenous arms programmes have proved commercially viable despite its approach to offsets. Despite Embraer's partnership in the AMX project, commercial sales have been poor. The first export order of any note for the AMX-T came in 2000 when eight were sold to Venezuela. The failure of the AMX project suggests that the Rafale agreement may also prove to be less than commercially viable.

"Not only are offset obligations expected to reduce arms acquisition costs they are also expected to stimulate economic development."

Offsetting in India

Like Brazil, India's approach to offsets has developed at a steady if unspectacular pace. Whilst an official offset policy was only introduced in 2005, India has actually been receiving technology transfers since the 1960s when the Soviet Union began providing financial and material support to develop a domestic arms industry. With the introduction of the defence procurement procedure 2005 (DPP) India implemented a policy stipulating that contracts over $64m must have offsets amounting to at least 30% of the contract value.

This places all subsequent DPPs at the heart of India's objective to achieve 70% self-sufficiency in defence production and a reduction in the reliance on foreign arms suppliers. More recently the DPPs have been joined by a "buy and make Indian" initiative.

This seeks to prioritise requests for proposals for Indian defence companies that can demonstrate the type of financial and technological capabilities that are, in theory, gained from offset obligations.

The latest order for Hawk aircraft, designed by BAE Systems and originally manufactured in the UK, might be an interesting trailblazer. As part of the deal, the aircraft are to be built in India. Potentially, therefore, the lower costs of production might enable BAE Systems to market the aircraft globally – a sort of hybrid offset success.

But as of 2009, the Indian defence industry remained capable of fulfilling only 30% of the armed forces' equipment needs. Moreover, India's recent invitation for bids on a $10bn order for 126 fighter aircraft underline predictions that the country will become the second-highest defence spender within Asia over the next five years.

India's continued reliance upon imports of military hardware reflects Minister of Defence AK Antony's remarks that the country's offset policies are still evolving. More recently India has overcome problems associated with previous DPPs by allowing the banking of defence offsets. Whilst this potentially increases opportunities for the private sector, India's commitment to self-reliance remains thwarted by the dominance of the nine state-owned defence companies. Until India develops a mature private defence sector it seems likely that smaller firms will continue to lack the confidence to position themselves to benefit from offsets.

Focusing on two prominent developing economies demonstrates that offsets do not necessarily result in the emergence of major new players in the defence industry. This in turn reflects academic debate that the end of the Cold War did not lead to the diversification of the global defence sector. Instead the business of defence witnessed a substantial concentration of ownership through mergers and acquisitions (M&As). In the US, a wave of M&As began in 1993 spurred on by Pentagon Deputy Secretary William Perry's "last supper" speech. Since then, the US defence sector has been dominated by four major companies.

"Offsetting can underpin regional power aspirations and the desire to produce materiel domestically for export."

The Stockholm International Peace Research Institute's (SIPRI) 2008 report on the top 100 arms-producing companies demonstrated the continued dominance of Western defence industries. SIPRI's list contains 45 North American companies, accounting for 60% of arms sales. Western European companies provide 34 entrants and account for 34% of defence sales.

By comparison, only two Indian companies make the list and there are no entrants from Brazil. Tellingly, the combined arms sales of developing countries account for no more than 3% of transactions. In addition, scrutiny of GDP growth in the countries mentioned above gives no startling evidence of any major economic boost from offsets.

The continued dominance of Western companies reinforces arguments that barriers to entry into the global defence marketplace remain considerable. Fundamental to the marketing of defence products is the development of personal contacts and networking.

The overwhelmingly Western "SIPRI 100" clearly holds the advantage over companies from the developing world. The dominance of Western companies also means that brand loyalty and combat proving place a formidable barrier in the way of new products. As a result, the ambitious offset policies of developing nations may result in the ability to develop military hardware but generally still offer no guarantee that an indigenous defence sector will advance from the global periphery.

The one exception might be Singapore. Since the mid 1980s, Singapore has used offsets to facilitate technology transfers that allow the local production of components, and involvement in research and development. Accordingly, its defence industries are niche specialists and have adapted their offset strategies to reflect this – the Singapore-designed and produced MRAP vehicle is en route to Afghanistan now. Singapore has plans to invest 2.5% of its GDP in intellectual property as a national development objective. On this evidence, it might prove that offset strategies can work if they are pursued tenaciously and backed by sensible indigenous investment.

This article was first published in our sister publication Defence and Security Systems International.