Appendix 1
Issues Paper on Policy Issues in Aerospace Offsets

Kenneth Flamm1

June 9, 1997

Issue 1: What Exactly Is An Offset?

When a government intervenes in the terms of a commercial transaction to require an additional transfer of goods, services, or other commitments by a vendor which are not required to support the original sale, this is often referred to as an offset. The 1996 National Export Strategy described offsets as compensation packages resulting from contract negotiations for large purchases, such as aircraft. Offsets include a broad range of activities such as mandatory coproduction, licensed production, subcontractor production, technology transfer, countertrade, and foreign investment. In addition, offsets can be categorized as direct or indirect, though a given transaction may involve both types. Direct offsets refer to compensation directly related to the system being exported, whereas indirect offsets refer to compensation unrelated to the exported item.2

Offsets may typically include such things as transfers of technology, agreements by the seller to purchase from local suppliers with some connection to the buyer, agreements to invest in production or other facilities in geographical proximity to the buyers, or agreements by the seller to meet certain performance targets (e.g., export requirements) or undertake other related activities (e.g., countertrade) on behalf of the buyer. One can even point to certain transactions that might be regarded as ''reverse offsets," with the vendor reducing price or providing additional services in exchange for commitments by the buyer that would not normally be part of a "straight" sale (for example, agreement by aircraft vendors to reduce prices in exchange for buyer agreements to exclusively purchase their product over some future period).

Offsets, if defined merely as the activities listed above, are not uncommon in purely private arrangements between private companies operating in today's global markets. Many agreements associated with the rapid growth of so-called "strategic alliances" among multinational companies tie other commitments and activities in with the sale of goods and services to strategic partners. The overt or covert intervention by a government into the terms of what otherwise might be a purely private transaction can make an offset a legitimate subject for government policy.

Issue 2: Why is Government Involved in Offsets?

There are fundamentally five reasons governments get involved in offsets:

I. Industrial Policy.

In economies where government has an explicitly developmentalist view of its role in promoting industrial growth, governments often intervene to improve the terms of bargaining between national industry and foreign investors and vendors. Explicit restrictions and a government-run approval process for foreign investment, technology agreements, and access to local markets can be used to reduce or minimize competition among domestic customers in negotiations with foreign sellers, or otherwise increase the bargaining power of the domestic players vis-à-vis foreign interests. The restrictions are designed to improve the terms on which foreign goods and services are purchased. Obviously, in "commodity" markets with many vendors and a price that approximates long-run costs of production, there is little

1  

While the basic content of this Issues Paper was contributed by Dr. Kenneth Flamm, substantial changes and additions were made by the NRC staff to facilitate the workshop discussion.

2  

Trade Promotion Coordinating Committee, National Export Strategy: Toward the Next American Century: A U.S. Strategic Response to Foreign Competitive Practices. U.S. Government Printing Office, Washington, D.C., 1996, p. 155.



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Appendix 1 Issues Paper on Policy Issues in Aerospace Offsets Kenneth Flamm1 June 9, 1997 Issue 1: What Exactly Is An Offset? When a government intervenes in the terms of a commercial transaction to require an additional transfer of goods, services, or other commitments by a vendor which are not required to support the original sale, this is often referred to as an offset. The 1996 National Export Strategy described offsets as compensation packages resulting from contract negotiations for large purchases, such as aircraft. Offsets include a broad range of activities such as mandatory coproduction, licensed production, subcontractor production, technology transfer, countertrade, and foreign investment. In addition, offsets can be categorized as direct or indirect, though a given transaction may involve both types. Direct offsets refer to compensation directly related to the system being exported, whereas indirect offsets refer to compensation unrelated to the exported item.2 Offsets may typically include such things as transfers of technology, agreements by the seller to purchase from local suppliers with some connection to the buyer, agreements to invest in production or other facilities in geographical proximity to the buyers, or agreements by the seller to meet certain performance targets (e.g., export requirements) or undertake other related activities (e.g., countertrade) on behalf of the buyer. One can even point to certain transactions that might be regarded as ''reverse offsets," with the vendor reducing price or providing additional services in exchange for commitments by the buyer that would not normally be part of a "straight" sale (for example, agreement by aircraft vendors to reduce prices in exchange for buyer agreements to exclusively purchase their product over some future period). Offsets, if defined merely as the activities listed above, are not uncommon in purely private arrangements between private companies operating in today's global markets. Many agreements associated with the rapid growth of so-called "strategic alliances" among multinational companies tie other commitments and activities in with the sale of goods and services to strategic partners. The overt or covert intervention by a government into the terms of what otherwise might be a purely private transaction can make an offset a legitimate subject for government policy. Issue 2: Why is Government Involved in Offsets? There are fundamentally five reasons governments get involved in offsets: I. Industrial Policy. In economies where government has an explicitly developmentalist view of its role in promoting industrial growth, governments often intervene to improve the terms of bargaining between national industry and foreign investors and vendors. Explicit restrictions and a government-run approval process for foreign investment, technology agreements, and access to local markets can be used to reduce or minimize competition among domestic customers in negotiations with foreign sellers, or otherwise increase the bargaining power of the domestic players vis-à-vis foreign interests. The restrictions are designed to improve the terms on which foreign goods and services are purchased. Obviously, in "commodity" markets with many vendors and a price that approximates long-run costs of production, there is little 1   While the basic content of this Issues Paper was contributed by Dr. Kenneth Flamm, substantial changes and additions were made by the NRC staff to facilitate the workshop discussion. 2   Trade Promotion Coordinating Committee, National Export Strategy: Toward the Next American Century: A U.S. Strategic Response to Foreign Competitive Practices. U.S. Government Printing Office, Washington, D.C., 1996, p. 155.

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scope for such policies to accomplish much. In imperfectly competitive markets, however, with small numbers of sellers or buyers, such policies can significantly affect the terms and consequences of final agreements. II. Jobs and Exports. In economies where government has a major influence on the behavior of certain sectors (because of public ownership or regulation), governments are frequently tempted to impose formal or informal offset requirements on procurement from abroad that are linked to politically popular goals like jobs or export creation. III. Defense Base. In all countries, defense purchases (closely linked to the aerospace sector) are undertaken by a single customer (the government) with a noneconomic goal (national security). Transactions involving domestic and foreign defense firms (and non-defense goods and services with defense applications) are scrutinized and shaped by all governments to reflect their perceived national security interests. In today's international system, national security often has an explicit economic component, such as protecting or stimulating the defense-industrial base. However, in many parts of the world, national security is seen as synonymous over time with industrial strength and national technological capability. Consequently, these broader economic goals are pursued with the sustained national commitment and breadth of policy mechanisms usually reserved in the United States for national defense.3 IV. Public Funding of R&D. Government funds a major portion of the R&D going into defense, including the aerospace sector. While private firms are probably best equipped to secure the deals that capture the maximum return on private investments in new technology, the same may not hold true when it comes to securing the maximum national return on public investments in new technology. For example, if $15 billion is invested in developing a new engine technology, a firm may logically consider its direct return from licensing the technology and $3 billion in lost profits on possible future sales won by its now more competitive foreign licensee, and decide that $4 billion in licensing fees is a good deal. If the company alone invested in the technology, that would be the end of the discussion. If the government funded the $15 billion, however, and made the resulting know-how available to multiple U.S. companies, it might reasonably want a U.S. company to consider the possible costs of future competition to other U.S. firms as well. If this future loss from the new competition to all U.S. firms were, say, $6 billion, the $4 billion licensing deal would be a whole lot less attractive from a national perspective. This is not a calculation that the U.S. company would normally make in evaluating the deal from its own purely private perspective, but might be the appropriate one in considering the transfer of know-how based on publicly funded R&D. V. Trade Issues: Export Subsidies, Dumping? Offsets might be regarded as a form of subsidy to exports (since other goods, services, and commitments with some economic value are being bundled into a sales transaction). There are restrictions on subsidies and pricing behavior in international trade that discipline the use of such subsidies, and governments therefore are interested in offsets as a trade issue in sectors where they may be used to promote exports by national companies. The defense sector (including much of aerospace) is unique in this regard, in that the national defense exception written into the GATT exempts defense goods and services from some of the effects of these disciplines. The limits on "green-lighting" of R&D subsidies to product development in commercial sectors, for example, arguably do not apply to defense articles. Indeed, one might even argue that what might be labelled as "dumping" (sales of products at prices that do not cover the fully loaded—including R&D—cost of production) is routine practice in international sales of defense articles. Issue 3: What Policy Issues Related To Offsets Should be Addressed By. the U.S.? 1. Unilateral Action. To what extent should U.S. policy attempt to unilaterally counteract foreign offset policies when these are designed to improve the terms of trade for foreign parties at the expense of U.S. economic interests? What tools could be used to this end? Is the U.S. government equipped to make the economic judgments needed to support an activist policy? 2. Multilateral Rules. The special role of aerospace in discussions of offset policies is clearly related to its close linkages to defense, on the supplier side, and to procurement by government departments, and state-owned or -operated enterprises, on the demand side. Offsets are not a policy issue in other sectors where trade and investment are clearly covered by the GATT or by OECD investment codes. To what extent should the U.S. take the lead in discussions of some international agreement establishing rules of the game on offsets in defense-related trade and government procurement? 3   National Research Council, Conflict and Cooperation in National Competition for High-Technology Industry. National Academy Press, Washington, D.C., 1996, pp. 12-41 and pp. 117-119.

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3. Augmented National Security and Competitive Advantage. Offsets are a competitive tool in an increasingly cutthroat global market for defense equipment. The U.S. is alone in being able to sustain a viable, broad-based defense industry solely on the strength of its large domestic market; other countries with advanced arms industries must export substantial volumes of defense goods into a shrinking global market just to keep their industrial base economically sustainable. Similarly, the ability of U.S. civil aircraft manufacturers to extend offsets provides an advantage in the global competition with Airbus, though this advantage may be reduced by the willingness of the government participants in the Airbus consortium to offer other inducements. 4. Current Trends. With the end of the Cold War, the subsequent downsizing of national defense efforts, and the increasing reliance on dual-use technology programs, the importance of the civil aerospace industry has significantly increased.4 The objectives of offsets, both for the nations (or firms) that accede to them and the nations that impose them, have shifted significantly. Increasingly, the emphasis is on the acquisition of new technologies and manufacturing skills, often with an export objective. In this environment, the goals of equipment commonality and force modernization, while still important, must be weighed against the increasing competition for technological capabilities with both defense and civilian applications. A similar assessment may be useful with respect to offsets in civil aircraft markets. In a global economy characterized by the emergence of technologically competent competitors, does the U.S. still have sufficient competitive advantage to accept offset requirements that involve shifts in employment and transfers of advanced technologies in order to make today's sale? This question is especially relevant insofar as these transfers are known to constitute integral parts of national programs targeted on strategic industrial sectors such as aerospace. In short, what is the likely long-term impact of offsets on the U.S. defense base; U.S. industrial competitiveness; high-wage employment; and the composition of U.S. exports? 5. Assessment Mechanisms and Multilateral Options. Economics and national security are inextricably intertwined in defense industries and civil dual-use technologies. Consequently, any policy on the rules of the game for sales of defense or other high-technology goods may require a framework that addresses a whole complex of linked economic and security issues. The U.S. has historically charted these dangerous waters by making all arms sales policy decisions on a case-by-case basis, that is, by steering clear of anything resembling a coherent, articulated, and explicit resolution of some of these tradeoffs. Should we be thinking about a more coherent policy, including a strategy for negotiating the international arrangements it will require? Are the U.S. government and industry anywhere near the internal consensus required before we attempt to pressure our allies to resolve the same issues we have consistently refused to address? Lastly, there is the question of institutional mechanisms. Does the United States government have a means of integrating the issues associated with aerospace offsets on a sustained basis? The 1994 National Research Council report, High-Stakes Aviation, argued that there is no institutional mechanism that is committed to the development of a U.S. aviation strategy and that can understand and include the views of the relevant stakeholders and identify concrete measures to sustain and improve the competitiveness of the U.S. aerospace industry.5 4   Ibid., p. 76 and pp. 152-158. 5   National Research Council, High-Stakes Aviation: U.S.-Japan Technology Linkages in Transportation Aircraft. National Academy Press, Washington, D.C., 1994, p. 7.