Economic orthodoxy v market pragmatism: a case study of Europe's 'abandonment' of defense offset.

Author:Matthews, Ron
Position::Case study
 
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  1. INTRODUCTION

    In 2009, the European Commission (EC) issued the Defense and Security Directive 2009/81/EC. This European Procurement Directive is intended to evolve a 'free' market in defense, equivalent to the single European market in the commercial sector. For this to happen, barriers to trade will need to be removed and open and free trade in military equipment promoted. This, of course, represents a major challenge. The arms market is unlike any other market. It is characterized by secrecy, high levels of government intervention, monopoly-monopsony industrial structures at the national level and oligopolyoligopsony structures at the global level. There is, moreover, another factor distinguishing the arms trade from most other markets, and this is that arms sales are inextricably linked to a phenomenon termed defense offset. This is where country-buyers of expensive military equipment demand some form of reciprocal benefit, such as technology transfer, local production and training --linked to the offshore vendor winning the sale. These additional benefits lead to second-level competition with respect to the attractiveness of the offset offerings. Whilst the demands for offset are legal, they are nevertheless controversial, not least because of the uncertainty as to whether its role should be driven by national security or economic objectives. The EC's position is that it adopts an orthodox ideological interpretation of offset, arguing that it is anti-competitive, trade-distorting and welfare-reducing, and, accordingly, offset between EC Member States is deemed illegal, in the absence of 'exceptional' national security reasons. Directive 81 aims to promote national security, ensuring that the primary defense contract is awarded purely on the effectiveness of the weapons system rather than on the attractiveness of the offset package, and separately that any offset sub-contract is determined solely on national security grounds. (1)

    Prior to the Directive becoming law, several European states adopted a pragmatic position on offset, refusing to abandon the broad spread of offset opportunities when procuring foreign weapon systems. After all, beyond Europe, offset is ubiquitous, and this has led to several of the poorer and smaller EU states questioning whether they are being unfairly penalized, given that almost every country in the world, outside the EU, practices offset (O'Dwyer, 2013). This has led to a heated debate, especially in the face of a growing interest worldwide on the use of offset, and a clamor by states to introduce official offset policies. There are no official statistics on the use and value of offset, yet a recent estimate suggests that the rest of the world will rack up close to US$500bn worth of cumulative defense-related offset investment by 2016 (Avascent, 2012). 2 The purpose of this paper, then, is to evaluate the role and impact of defense offset, particularly in the context of the European Union. It examines the premise and logic behind the European Procurement Directive, and also its regulations that carry the potential of dramatically curtailing the use of offset in the European Union (EU). Admittedly early days, but this paper seeks to analyze the Directive's impact on Europe's defense industry; that is, whether the Directive is reducing the use of offset, or whether Member States continue to demand reciprocal benefits, either within the regulations or more disconcertingly, without. A conclusions section brings the paper to a close.

  2. NATURE OF OFFSET

    Offset may arise in two ways. Firstly, it may occur through flexible, sometimes termed variable (Taylor, 2004, p. 37) or non-mandated (Markowski & Hall, 2014) negotiated processes. Here procurement agencies base their decisions according to a two-envelope system where bidder compliance with the technical specification is considered in isolation from associated value-adding/value for money enhancements to the arms package; the latter including voluntary vendor offers, both related and unrelated, to the equipment's capability requirements. The second route for offset demands is through mandated requirements. These are communicated via recipient countries' official offset policies, normally constraining the opportunity for negotiation.

    This paper focuses on mandated offset demands from buyer countries, seeking to exploit the post-1980's emergence of a buyers' arms market. This condition reflects a long-term imbalance in market forces; simply put, there are fewer buyers of major military equipment compared to sellers. In 2014, this imbalance meant that just eight arms importing nations (India, Saudi Arabia, Turkey, China, Indonesia, Vietnam, Taiwan and the UAE) accounted for 50% of global arms trade, spending US$14.1bn, and wielding enormous market power to leverage not only the product, i.e. the combat aircraft or Main Battle tank, but also the underlying production processes. (3) Naturally, defense contractors export arms for profit, but offset invariably adds to complexity and hence contractual risk. This will be translated into extra cost, and where the burden falls will lead to friction between the exporting company and importing nation, with outcomes dependent on the relative strengths of the bargaining parties. In extremis, if the buyer does not secure the offset, then the primary defense contract will not be signed, and the deal will move to a competitor company prepared to offer what the buyer demands. Although there are constraints on vendor maneuverability, the scale and value of the deal will dictate its negotiating strategy. For instance, the vendor may soften its stance on recovering all of the additional cost of offset through increases in price, or it may offer enhanced value offset packages that appeal to the buyer, and in some measure compensate for the offset-related cost premium.

    Offset can either be direct or indirect to the primary defense contract; the former being where the offsetting investment creates 'defense' production capacity, often involving technology transfer, whilst the latter has regard to investment into the civil sectors of the buyer government's host economy. Civil offset normally occurs when the buyer state has no interest in developing a defense-industrial base. For instance, Saudi Arabia procured 72 Tornado fighters from the UK in the mid-1980s, and sought 1 billion [pounds sterling] of civil offset, leading to British investment into sugar refineries, medical products and aerospace maintenance, repair and overhaul (Matthews, 1996, pp. 235-6). Singapore procured US military equipment in the 1980s that led to an indirect offset to establish a materials R&D institute on a local university campus (United States General Accounting Office, 1996, p. 27). Also, South Africa's early 2000's procurement of German submarines and Swedish fighters led partially to indirect offset that had profound socio-economic benefits through investment aimed at creating black African jobs. Indeed, one of the offset projects supported the construction of a factory to produce condoms in a country riven by HIV/AIDS (Botha, 2003, p. 9). Such examples highlight the role that offset can play in promoting defense industrialization and economic development. There is also an offset category that straddles both the defense and civil domains, somewhat appropriately termed 'dual-use'. This category covers such fields as micro-electronics, avionics, telecommunications, sensors, optical fibers as well as offset investment into university engineering and computer departments. Dual-use offset is increasingly recognized in global policy circles as reaping benefits for the recipient nation in both defense and civil sectors, especially important given that today a high proportion of the value-added in modern weapons platforms derives from commercial technologies.

    Offset has grown in popularity since the 1970s, such that there are now over 130 countries worldwide with some form of offset policy (Behera, 2015, p. 9). Defense has always been the principal driver of offset deals, but over the last decade there has been a surge in civil offset. This is where states demand civil offset on the back of major civil procurements in such 'big ticket' fields as commercial airliners and power-generating stations. Brazil, for instance, buys foreign satellite systems and expects much of them to be built locally (Selding, 2013). World Trade Organization regulations do not apply to defense trade, enabling offset to flourish unrestricted. By contrast, civil offset linked to major civil procurements is disallowed for industrialized states, though developing countries are treated as an exception, based on infant industry arguments. (4)

    Industrializing countries view offset policies in a positive light, but their importance can be over-stated. Two countries arguably enjoying offset 'success' are Japan and Singapore. (5) Yet, neither country publishes offset policies, preferring offset to be negotiated according to relative bargaining strengths. The elements of the offset deal are agreed on a case-by-case basis. The goal for both parties is a technological partnership that will endure into the long-term, rather than a short-term accommodating contract. Securing long-term trust-based commercial relationships is an important dimension in the Japanese and Singaporean offset models, but it is not the only consideration. A further critical variable in the offset performance of these two Asian states is possession of technological absorptive capacity. Offset acts as a vehicle for the transfer of production capacity and technology; however, to spur high value technological development in the recipient nation there must also be local R&D investment, indigenous supply chains and industrial clusters to stimulate innovation and partnerships between engineering universities and domestic industry. The challenge facing most industrializing states is that they do...

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