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VOLUME I Analysis of the Effects of U.S. National Security Controls on U.S.-Headquartered Industrial Firms Submitted to: Panel on the Impact of National Security Controls on International Technology Transfer of the Committee on Science, Engineering and Public Policy of the National Academies of Sciences and Engineering Washington, DC August 25, 1986 Principal Investigators: Dr. William F. Finan Karen M. Sandberg Quick, Finan & Associates Suite 340 1020 - 19th Street, NW Washington, OC 20036 (202) 223-4044

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Table of Contents EXECUTIVE SUMMARY VOLUME I Page Number I. Introduction 1 II. Structure of U.S. Export Trade and International Sales as They Relate to the Export Licensing System Operating Characteristics of the Export Licensing System IV. Analysis of Firm Questionnaire on Export Controls 11 27 45 V. Summary of Interviews with U.S. Firms on Operation of the Export Control System 57 vI. Summary of Effects of U.S. National Security Controls on U.S.-Headquartered Firms 70 Tables and Figures VOLUME II Appendix A: Appendix B: Primary Sources of Data for the Report Industry Sector Analysis 1. Analytic Instruments 2. Medical Equipment 3. Machine Tools

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Appendix C: Tabulation of Export Control Questionnaire Responses Appendix D: Summary of Results of the August 1985 American Electronics Association Questionnaire on Export Controls Appendix E: Tabulation of Department of Commerce License Sample on Level of Military Criticality

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Executive Summary In principal, the U.S. export control system should have very little, if any, relative competitive effect on U.S. firms.1 This would be the case if the U.S. controls and procedures were identical to those utilized by other countries who subscribe to the multilateral control system (COCOM). But in fact, U.S. controls and procedures do differ. The greater scope of activity covered, the greater stringency with which foreign sales are regulated, and the greater complexity of the U.S. procedures are all factors when combined mean that U.S. firms bear a competitive as well as an administrative cost in complying with U.S. export controls. Estimating the international competitive effects of U.S. export controls is difficult. The difficulty arises from the fact that the effects on relative competitiveness manifest themselves in a variety of diffuse ways, with the degree of influence depending on numerous variables related to the operation of the system. This study does not attempt to estimate the total economic costs associated with the controls. It does provide an estimate for the 1''Relative'' in this context is defined with respect to firms headquartered in other countries that subscribe to the multilateral control system (COCOM).

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1 ~ scope of U.S. foreign sales covered by export controls, analyzes administrative measures of performance which indicate the way the system creates competitive costs, and indicates some of the economic costs associated with export controls. Coverage. The coverage of U.S. export controls2 includes certain sales (as appropriate) from foreign sources by U.S. firms as well as their direct exports from the U.S. It should be kept in mind that while this coverage includes products produced and sold offshore by a U.S. affiliate, it also could potentially include in certain cases of products manufactured by a foreign firm incorporating components or technology of U.S. origin. This latter category is large, but as a practical matter, there is no reliable source available to allow its size to be estimated. It remains outside the scope of this study. The scope of coverage is also narrowed to look at just manufactured items versus all merchandise because the central concern regarding effects of U.S. export controls on competitiveness center on the manufacturing sector. 2The focus of this study is the effect of the national security controls, but some of the data used in this study includes controls which exist for other purposes.

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Total 198S foreign sales to third parties for the industrial sectors most likely to have some portion of their sales requiring a validated export license, were estimated to be $130 billion.3,4 Of this total, only $78 billion required a validated license. The $78 billion can be further subdivided into the portion transacted under an Individual validated License (~VL) and the portion transacted under a bulk license (Distribution, Project, or Supply). An estimated $22 to $36 billion of U.S. foreign sales in 1985 used an IVL while an estimated $42 to $56 billion went under some form of a bulk license. These subdivisions are summarized in Figure A, which also divides the trade flow into geographic regions relevant to the export control process. Direct trade with the East Bloc comprises a very small portion of total transactions affected by export controls. This partly reflects the fact that many U.S. firms have either given up trying to sell to Eastern Bloc countries or have chosen to assign only minor resources to marketing in this region. 3These sectors are: communication and computer/office equipment, aircraft and parts, electronic components, instruments and machine tools. 4This is out of total U.S. foreign sales of roughly $440 billion for manufacturers in 1985.

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Figure A U.S. Business Activity Covered by the Licensing System, 198S ($ billion) Area of World East-West ($2,* .- COCOM ($35)* Other West ($32~* * ** 1 1 1 1 Under Validated Lic. ($78) Self-licensed ($362) Estimated Total U.S. Foreign Manufacturing Sales (**) ($440) Value of direct exports Sales.through ~ _ nonaffiliated parties . foreign affiliates and direct exports to

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The Individual Validated License (IVL). At the heart of the procedures associated with regulating strategically sensitive exports is the IVL. Even though most foreign sales of U.S. firms which require a validated license occur under a bulk license, the IVL application procedures and regulations seem to have a more significant influence on the marketing of U.S. products. Discussions also tend to focus on the IVL procedures because more data is publicly available to assess administrative process times and outcomes. The IVL control process falls on a fairly limited set of products and U.S. firms. Only ten of the several hundred commodity control list categories account for 92 percent of all IVL approvals for manufactured items. And approximately 2,000 to 3,000 firms (including some portion which are non-U.S. based) actively apply for Ives each year. Overlapping with these firms are the roughly 600 firms that hold Distribution Licenses. A different, broader perspective on the extent of influence of the IVL procedures is provided from the estimate of the number of foreign enterprises (distributors, affiliates, unaffiliated firms) interacting with the U.S. export control system. There are in excess

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of 100,000 foreign enterprises, i.e., recipients of controlled goods in the West that come under the very broad reach of the U.S. system. The result is that any competitive disadvantages created by the U.S. export licensing system will have a large ripple effect to the extent that there is alternative Western foreign availability. A number of measures of performance are used to gauge the efficiency of the IVL procedures from an administrative standpoint. These include average processing time within the Department of Commerce, rate of denials of applications, and the portion of applications returned without action (RWAd). We suspect that the statistics routinely reported for these measures are misleading for a variety of reasons. Starting with processing times, one of the factors which creates uncertainties for firms applying for an IVL is the large variation in processing times. DOC reports average processing times of approximately 25 days J but DOC narrowly defines processing time, that is, it only looks at the time from point of entry into the license system until final action is taken. A very different measurement results if the processing times are looked at from the point of view

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of the firm. Processing times from their point of view average 54 days, with one-third of all cases requiring more than 40 days. Even if only West-West applications are looked at there is still a large processing time variance; about one-quarter of all cases taking more than 40 days. For Western destinations, total processing time can average 40 days for COCOM countries (just within the legislative requirement), and 52 days for non-COCOM West destinations. Bloc destination processing times are even longer, averaging 79 days. The denial rate for applications reported by the Commerce Department averages between 1 and 2 percent of all license applications. This low denial rate might be interpreted by some as indicating that the system either is very loose--basically a paper drill--or that it only constrains business to a very minor extent. But the denial rate is quite low for several reasons. First, firms will generally try to avoid submitting a license application when they believe the effort required to obtain the license is inordinately high. Second, firms will modify their applications or withdraw them (request a Return Without Action) in order to avoid an outright denial being formally recorded. Thus, the official denial rate does not measure,

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to any meaningful degree, the real degree of restrictiveness of the license system. The third measure commonly reported is the number of cases which are RWAd. The reported RWA rate is nearly one in every six applications. The evidence suggests this is somewhat inflated by the fact that some licenses are RWAd more than once--some even three or four times before finally proceeding through the system. Recent changes in the Commerce Department procedures may significantly reduce the rate of RWAs recorded. There is also some evidence that administrative performance measures vary with the size of the firm making the application. Analysis of licenses submitted by larger firms versus those submitted by smaller firms suggests that larger firms have shorter average processing times with lower denial and returned without action (RWA) rates. For example, in West-West trade, small firms averaged 46 days processing time while large firms averaged 35 days. Reexport licenses. A large category of license applications in the U.S. system pertain to reexport authorization. Reexport applications represented about 10 percent of the Commerce Department case load in FYS5.

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Approximately 80 percent of all reexport applications from COCOM countries come from U.S. affiliates of U.S.-based parent companies. This suggests that compliance by foreign firms may be quite low, especially where the export is a finished product with U.S. origin parts components/ or technology. Level of Military Criticality. An important issue regarding operation of the license system is how processing times vary with the level of technology and the degree of diversion risk (i.e.,.the risk involved in the destination of the export). Does the system treat more critical technology to more sensitive destinations more carefully? If it did, one might expect processing times to lengthen as a function of criticality or risk of diversion. In order to look carefully at this issue, a large sample of license applications (over 1600) was drawn from the total number of applications completing the processing sequence in early June 1986 (about 3,000). The licenses were sorted by level of technology and destination. The results were especially revealing regarding how the license process treats sensitive versus less sensitive items. First, a very large component--17 percent of the total--of the license applications may not have had to be in the

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i system at all because they fell under General License provisions.5 Second, with respect to free-wor1d destinations, processing times correlate somewhat with diversion risk, but do not vary as a function of level of criticality. Third, an especially revealing result of the sample was the fact that one-third of the IVL applications for export to free-worId countries were in lowest level of technology--that is, these items were ones that COCOM has agreed may be exported to East Bloc destinations without prior COCOM approval. Further, two-thirds of the IVL applications were for items of sufficiently low-level technology that COCOM has already agreed that they may be exported to the Peoples Republic of China (PRC) without prior COCOM approval. These measurements suggest that the system is making only a very limited degree of discrimination between sensitive and less sensitive technology and furthermore is heavily loaded with applications covering very low-level technology items. Responses from firm interviews. Over 20 U.S. firms were extensively interviewed for the Academy study. The 5General License (GCOM) provisions allow exports to COCOM countries of products on the COCOM control list which do not require COCOM approval for export to the East Bloc countries. Some of these applications eligible for GCOM treatment may have been for reexport outside COCOM and therefore would have needed a license.

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conclusions developed from these interviews were that the export licensing system was directly inhibiting some firms from exporting (beyond legitimate restrictions imposed for national security purposes) and was contributing to an erosion of foreign sales distribution networks. What appears to be happening is that the export licensing process increases the cost of doing business abroad. First of all, it creates entry costs due to the need to train employees in compliance, learn the regulations, educate customers and so forth. Because of high administrative costs of compliance a number of firms reported they had either given up trying to sell to the East Bloc countries or had substantially reduced their level of effort. Second, companies must expend resources on an ongoing basis to sustain their ability to effectively deal with the requirements of the system. Firms that were larger and had a Washington presence were clearly better able to monitor and comply with the license systems requirements, and, in some cases, influence the scope of the requirements. Responses from firm questionnaire. Indicative of the complexity of the licensing process is the fact that almost half of the firms surveyed had at least one full-time employee specializing in export control compliance. Total direct compliance costs for U.S. firms in 1985 (i.e.,

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direct administrative costs only) based on the survey results were estimated to be about SS00 million. The questionnaire respondents also indicated only partial adoption of several new provisions in the 1985 legislation that renewed export controls. For example, over half the firms surveyed did not indicate foreign availability on a license application even when they believed it existed. With respect to use of the new General License (GCOM), only 30 percent of the respondents indicated they were using it. One important indication of the competitive impact demonstrated by the questionnaire responses was the growing problems that export controls represent with the foreign customer base. One-quarter of all firms indicated that existing free-world customers had refused to consummate business deals with them due to export controls. An even greater number, 38 percent, responded that their existing customers had indicated ~ preference to shift to a non-U.S. source of supply. Most firms, especially the larger firms, indicated they expect these problems to increase over the next two years. Study of Analytic Instruments Trade. The respondents to the firm questionnaire indicated that they believed foreign customers were becoming more sensitive to the

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differential that exists between U.S. export control procedures and those of other COCOM countries. This perception and the evidence of shifting customer preferences is supported by an empirical analysis of U.S. analytic instruments exports to other cOCOM countries.6 The evidence from analyzing the relationship between trade levels and the influence of export controls for this sector is that changes in U.S. export controls caused significant short-ter~ variations in the level of export trade--between 7 to 12 percent. Thus, the perception that U.S. firms registered in the survey regarding the sensitivity of their customers towards U. S . controls seem consistent with the sensitivity measured by this empirical result. * * * Because the U. S . export controls are a net negative competitive factor internationally, a U.S. firm competing against a foreign firm abroad must be sufficiently superior in other dimensions to overcome the disadvantage created by export controls. That is, the U.S. firm must be capable of offering a better price, or superior technology, or superior marketing and service support to overcome the export control factor. 6Excluding Canada.

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Providing these compensating actions is becoming increasingly difficult for at least two reasons. First, the evidence indicates that foreign customers seem to be giving greater weight to export controls as a negative factor as they become more visible. Second, U.S. firms are losing their relative competitive edge in high technology areas. As established by the large sample of license applications, a substantial portion of the applications in the system are for low-end items--that is, comparatively low technology items. Any technology edge one might expect a U.S. firm to have is less likely to exist for this low- end category. As more and more non-U. S . sources exist for these items, the more likely it is that U.S. export controls will drive a foreign customer to use a non-U.S. source. The relatively tighter U.S. controls will probably have an increasing negative competitive effect over time as relative improvements in foreign technology availability continue. The result is that the competitive costs of lost sales being borne by U.S. firms related to compliance are probably greatest for the least sensitive of the goods they are selling abroad and those costs are likely to increase.

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Simply stated, the system is creating the greatest costs where it provides the least benefit. Thus, U.S. - headquartered firms are likely to be bearing a cost of compliance which is significantly higher than is needed to ensure that the goals of the export controls are being fulfilled. !~< .

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