Offsets in the International Marketplace: An Aerospace Industry View

Joel Johnson

Aerospace Industries Association

The issue of offsets, a practice in which a purchasing entity, usually a government, demands that a seller not only provides a service or product, but in addition helps the purchaser to obtain additional technology, business, or investment, has sporadically captured political attention in Washington for nearly two decades. Critics of the practice express concern that offsets send work off shore and can create future competitors. Exporting companies generally respond that offsets are a necessary part of competing in the world market and have relatively little adverse impact on the economy, especially compared to the benefits that accrue from the sales themselves. A series of government studies and reporting requirements seem not to have changed many minds nor resulted in any serious new government initiatives.

Offsets, both formal and implicit, are particularly prevalent in the aerospace industry. Aerospace tends to be seen by industrial and industrializing countries as a key industry for several reasons. It is intimately related to a nation's security, with aircraft generally accounting for the largest share of defense equipment expenditures for any modern military. The industry is seen as a technology driver, including in manufacturing techniques, that also pulls along other high-technology sectors such as electronics, advanced materials, and sensors. Aerospace is viewed as a prestige industry—a hallmark of a modern economy. Every country with an industrial base seems to want to be a player in aerospace.

Military aerospace products are invariably purchased by governments. Even commercial aerospace products, particularly in developing countries, are often acquired by government agencies or state-owned enterprises, such as air traffic control organizations, airports, and national airlines. These acquisitions are a highly visible use of taxpayers funds to purchase a product from off shore. Politi-



The National Academies | 500 Fifth St. N.W. | Washington, D.C. 20001
Copyright © National Academy of Sciences. All rights reserved.
Terms of Use and Privacy Statement



Below are the first 10 and last 10 pages of uncorrected machine-read text (when available) of this chapter, followed by the top 30 algorithmically extracted key phrases from the chapter as a whole.
Intended to provide our own search engines and external engines with highly rich, chapter-representative searchable text on the opening pages of each chapter. Because it is UNCORRECTED material, please consider the following text as a useful but insufficient proxy for the authoritative book pages.

Do not use for reproduction, copying, pasting, or reading; exclusively for search engines.

OCR for page 158
--> Offsets in the International Marketplace: An Aerospace Industry View Joel Johnson Aerospace Industries Association The issue of offsets, a practice in which a purchasing entity, usually a government, demands that a seller not only provides a service or product, but in addition helps the purchaser to obtain additional technology, business, or investment, has sporadically captured political attention in Washington for nearly two decades. Critics of the practice express concern that offsets send work off shore and can create future competitors. Exporting companies generally respond that offsets are a necessary part of competing in the world market and have relatively little adverse impact on the economy, especially compared to the benefits that accrue from the sales themselves. A series of government studies and reporting requirements seem not to have changed many minds nor resulted in any serious new government initiatives. Offsets, both formal and implicit, are particularly prevalent in the aerospace industry. Aerospace tends to be seen by industrial and industrializing countries as a key industry for several reasons. It is intimately related to a nation's security, with aircraft generally accounting for the largest share of defense equipment expenditures for any modern military. The industry is seen as a technology driver, including in manufacturing techniques, that also pulls along other high-technology sectors such as electronics, advanced materials, and sensors. Aerospace is viewed as a prestige industry—a hallmark of a modern economy. Every country with an industrial base seems to want to be a player in aerospace. Military aerospace products are invariably purchased by governments. Even commercial aerospace products, particularly in developing countries, are often acquired by government agencies or state-owned enterprises, such as air traffic control organizations, airports, and national airlines. These acquisitions are a highly visible use of taxpayers funds to purchase a product from off shore. Politi-

OCR for page 158
--> cians naturally dislike such transactions. To make them more palatable, it is helpful if such purchases can be linked to job creation and increased capability in the aerospace and defense sector. In short, when the taxpayers' funds are spent, they, or at least their political leaders, want a "piece of the action." Offsets are the inevitable result. Thus it is not surprising that a discussion of offsets quickly turns to a discussion of the aerospace industry. A few notes about the U.S. aerospace industry might be helpful to put the offset issue in context. Aerospace has for many years been among the most dynamic and expansive of U.S. industries. In 1997 domestic and international sales by U.S. aerospace companies were estimated at $130 billion, or about 3 percent of all U.S. industrial manufacturing activity. New orders for the year totaled about $115 billion, and the backlog of orders at year end amounted to $218 billion. The industry currently employs approximately 870,000 Americans. The industry's export performance has been most remarkable, particularly when compared with that of other U.S. industries. In 1997 exports totaled $50 billion, whereas imports of aerospace products reached about $16 billion. This means that the U.S. trade surplus in aerospace products was roughly $34 billion, a continuation of a long-term trend of positive trade balances. As positive as these numbers are, it should be noted that, except for trade figures, all are lower than the last industry peak in the late 1980s and early 1990s. In 1989 the industry employed 1.35 million people, and its sales reached $139 billion in 1991. Two major trends hit sales and employment beginning in the late 1980s. First, the markets for aerospace products declined, as financially troubled airlines reduced new aircraft purchases and, with the end of the Cold War, the U.S. defense budget, particularly the procurement portion, plummeted. Second, the aerospace industry began a major restructuring, partly in response to lessened demand, but also to reduce costs by taking advantage of increased technological capabilities. Such technologies include use of computers to allow primes and subcontractors to design products without the use of draftsmen and extensive use of mockups. Improved machine tools and testing devices have reduced the work hours needed for production, testing, and rework. The bottom line is that productivity is improving, so that fewer workers, and in some cases less-skilled workers, can produce more of a better product. With the sharp increase in demand by airlines, employment is again picking up in the aerospace industry, but given the new efficiencies noted above and the continuing low demand for defense products, it is unlikely to return to former levels. Currently about 50 percent of U.S. aerospace products is sold to the U.S. government for defense, space, and air traffic control. Of the other 50 percent, about 75 percent relates to exports of both commercial and military products. Government purchases are expected to remain flat, so that most growth in the industry will depend on success in the international marketplace. There are several factors that bear watching on the international horizon that could have an

OCR for page 158
--> impact on the pre-eminent role of U.S. aerospace. Certainly competition in aerospace and defense products has increased, with other countries, particularly in Europe, improving the range and quality of their products in recent years. Aerospace and defense have become the glamour industries of the 1980s and 1990s, with every industrializing country attempting to stimulate some domestic aerospace and/or defense capacity. This is particularly troubling in the defense arena where there is serious surplus capacity for production of military products in Europe, Russia, and the United States at precisely a time when other nations are attempting to build their own indigenous capability. As with other industries, there is also an increasing tendency toward internationalization or globalization of the aerospace and defense sectors. That is, U.S. companies depend for a large portion of their sales on foreign markets and increasingly have found it useful to work with foreign companies on some projects or to obtain components and technologies from off shore when it is economically advantageous to do so. In the commercial aircraft and engine sector, the enormous cost of launching a new product has increasingly led to the formation of international partnerships so as to spread risk, obtain financing on more favorable terms, improve access to markets, and to obtain the best technology available or to avoid having to develop technology that already exists. Similar considerations have led the U.S. government to encourage cooperative military projects. Some industry observers and labor representatives have argued that this internationalization process, particularly the outsourcing of aerospace production overseas, threatens U.S. jobs and in the long run can create future competitors. These are the same arguments used against offsets. However, there is little evidence that the reduction in employment over the past few years has anything to do with increased reliance on offshore procurement of aerospace parts and components. In fact, during the period 1990-1995, imports of aerospace parts and components for aircraft and engines have accounted for a rather stable 5.5-6.0 percent of total U.S. aerospace production. What is clear is that, were it not for exports, U.S. aerospace employment would have dropped even more significantly during the 1990s. It is against this background that the question of offsets must be examined. For purposes of this review, it is assumed that offsets refer to the various conditions of sale that a foreign government imposes on the United States and other vendors that are in addition to supplying the desired military product. Such offsets may include direct offsets related to the product sold. Examples include allowing the purchasing country to manufacture some share of the product it is purchasing and even provide parts for similar products being sold to other countries (including the U.S. government). It may include training and transfer of technology to undertake such production or similar assistance to help the customer maintain the product being purchased. An agreement may also include indirect offsets, which can cover many different activities. The selling company may purchase goods from the customer country that are unrelated to the item

OCR for page 158
--> being sold. This is particularly attractive to companies that have large non-defense sectors that require intermediate goods from U.S. and international sources. It may involve providing marketing assistance to increase overall exports or exports from certain preferred sectors. Indirect offsets may involve investing in the purchasing country to stimulate nontraditional industry. It should be noted that industry does not regard a straightforward licensing or co-production agreement, which does not involve the sale of a product directly from the United States, to be considered an offset in terms of this policy discussion. Although there are certainly transactions that fall in a gray area, licensing or co-production agreements to produce U.S.-designed military products, which do not involve the sale of the end item from the United States, are no more offset related than a U.S.-owned automobile line in the United Kingdom or a U.S.-owned or U.S.-licensed electronics operation in Hong Kong. Thus the Japanese production of the F-15 under license from the United States is not considered an offset program, nor is the U.S. production of the Joint Primary Aircraft Trainer System (JPATS) under license from the Swiss. From an industry perspective, offsets are often considered a nuisance. Most companies would much prefer to compete on the basis of the quality and price of their primary product. Aerospace companies are generally not in the consulting, technology transfer, risk capital, or trading business. However, just as in the commercial aerospace arena, it has become necessary to find imaginative means to help customers finance their aircraft; in the international military market, offsets have become a recognized part of doing business with most government customers. Offsets are of course not a new invention, but at least in part simply another form of the age-old practice of barter and countertrade. Although inefficient, it should be remembered that, for every export a country makes, mathematically at some time and from some place there must be a corresponding import, unless a country is giving away the original export. That import will negatively affect some producer, but the society as a whole will generally benefit. Offsets in part close the trading loop in a bilateral and visible fashion, but they do not change the basic principles of trade. Furthermore, countries could generally obtain independently much of what they gain through offsets. The United States and other countries export billions of dollars of machinery every year that is used by purchasers to produce new or better products. Other companies specialize in providing customers with "turnkey" factories, tailor-made software, and consulting services for technology development, administration, and marketing. In general we applaud such exports of goods and services from the United States, even when in the long run they help create competitors overseas. In one sense, a sale with offsets is simply a way to bundle a number of goods and services in a single export package. Finally, it should be noted that offset requirements are not unique to dealing with overseas governments. American prime contractors for defense products are required to perform a number of activities for the U.S. government that are not

OCR for page 158
--> demanded of commercial transactions, such as setting aside business for small and minority-owned enterprises, adhering to unique cost-accounting standards, meeting military specifications that may have no relationship to commercial markets, and assuring the widest geographic spread of subcontracts and vendors consistent with meeting price and quality standards. When government is a customer, whether foreign or domestic, vendors are often expected to provide more than the best product for the best price. Critics of offsets also need to be reminded that when the U.S. Department of Defense (DoD) makes a major purchase of a foreign-designed weapons system, it almost always demands that it be wholly or in large part produced in the United States. Recent examples include the AV-8A and B Harrier, the T-45 Goshawk, the Multiple Subscriber Equipment system, the 9-mm Beretta pistol, and the Joint Primary Aircraft Trainer System. Although the United States regards this "domestic production line" requirement as related to security, to U.S. foreign trading partners it looks very much like a 100 percent direct offset policy. One other caveat needs mentioning. As the United States has the world's largest economy, it can be argued that offsets can provide a form of marketing advantage to U.S. firms. That is, the United States can absorb offset requirements, including some purchases from the customer country, with little or no impact on the overall U.S. economy more readily than can U.S. competitors. This marketing tool is particularly important to the U.S. defense industry given the lack of U.S. export finance for defense products and technology transfer controls that often preclude the United States competing with its best technology. The capacity of the U.S. economy to absorb offsets must be weighed against possible costs to the economy. In 1995 the U.S. gross national product amounted to $7 trillion. Total imports equaled $743 billion. Total aerospace production totaled $106 billion. By contrast, the most recent U.S. Department of Commerce study of offsets indicates that in 1995 total offset transactions for which prime contractors received offset credits totaled $2.7 billion.1 Recognizing that some of the offset values are negotiated credit figures that are often higher than actual market prices and that a number of these transactions involved switching from one foreign source to another rather than involving any potential U.S. sale, this number is clearly an outer boundary relative to a comparison with the general U.S. economic data. Of those transactions, about 60 percent were indirect offsets, thus involving sectors outside the defense sector. On an aggregate basis, it is hard to imagine that $2.7 billion in offset transactions would have much of an impact on an economy the size of the United States. After over ten years of studies of offsets by the executive branch and the U.S. General Accounting Office, no clear evidence has materialized that offsets have had any significant negative impact on specific sectors or subsectors of the U.S. 1   Department of Commerce, Bureau of Export Administration. 1997. Offsets in Defense Trade.

OCR for page 158
--> economy. A variety of hearings over recent years by Congress and the International Trade Commission have had witnesses allege damage related to offsets, but provided no specific examples of such damage. The 1997 Commerce Department study on offsets focuses on three industrial base subsectors that have seen their U.S. market share deteriorate over the years—gears, machine tools, and shipbuilding.2 In each case offset performance for the period 1993-1995 was less than 1 percent of domestic production of the sector during the same period. It was also not clear to what extent offset credits were generated for purchases that were diverted from one foreign supplier to another, rather than from a potential U.S. supplier. There are perhaps occasions when both the U.S. government and the prime contractors have not exerted enough caution to ensure that they do not establish a climate in which subcontractors can be unduly pressured by foreign customers into agreeing to licensed production as part of an offset or co-production agreement. Improved communication among DoD officials, primes, and subcontractors could help avoid such situations. There are certainly problems related to the defense industrial base. But it is likely that offsets tend to reflect those problems, not cause them. Overall, the U.S. defense industry suffers far more from other problems—for example, the recent sharp decline in the DoD procurement budget, DoD acquisition regulations, high costs of venture capital, and a financial system geared to short-term returns rather than to long-term improvements in productivity and product—than it does from foreign-imposed offset requirements. In 1990 the Aerospace Industries Association submitted a paper to the executive branch suggesting that it incorporate a set of principles into any federal policy with respect to offsets. These principles, outlined below, still represent the thinking of the major aerospace and defense companies: 1. The U.S. government should not take unilateral measures through statute or regulation to control offsets that would simply cause business to go to foreign competitors (except for current technology transfer restrictions related to security). Comment: Most U.S. products that are eligible for export must compete with similar equipment produced in other countries. It does no good for U.S. producers or the industrial base if the United States restricts offset offers by U.S. firms that simply result in a customer turning to another supplier who is willing to provide the equipment and a satisfactory offset package. Industry has seen this happen with great frequency in the unilateral application of foreign policy and national security export controls. Almost invariably the end result is to shift demand to other suppliers without obtaining the desired foreign policy or security objective. The government should avoid yet another unilateral form of controls that is even more market-distorting than the practice it was set out to discourage. 2   Op.cit., pp. 54-59.

OCR for page 158
--> 2. Direct offsets should not be allowed when a purchase is wholly financed by U.S. assistance on grant terms, except when there is agreement by DoD and U.S. defense firms competing for the business. Comment: When U.S. grant funds are provided to a country, it is generally required to use them to purchase U.S. products. Hence a unilateral limitation on offsets by the U.S. government is unlikely to result in a country refusing to buy from the United States. It is true, however, that a country contemplating the purchase of more than one system might well be influenced to purchase one or another from the United States depending on the offset offers made by other countries. Hence, unilateral controls might favor one product and one U.S. firm over another, but the total purchases from the United States are unlikely to be affected. As noted above, there may be some cases in which the U.S. government might determine that it is to the U.S. advantage to allow a U.S. ally to use grant funding to establish some domestic production capacity for a U.S. product, as in the Egyptian M1A1 tank sale. In such cases, if agreement is reached with the U.S. defense firms involved, limited funds might be used for such purposes. However, such use of funds should be avoided if at all possible, as it risks undercutting support for the overall military assistance program. 3. Efforts should be made by the United States to obtain a multilateral agreement on disciplining offset practices, or at least to obtain understandings with the major U.S. defense trading partners to restrain their offset demands. Comment: Ideally, some international code of conduct on offsets might be negotiated, which would reduce or eliminate offset demands without prejudicing U.S. suppliers. Examples of similar agreements include the Arrangement on Guidelines for Officially Supported Export Credits that was negotiated in the Organization for Economic Cooperation and Development, and the World Trade Organization Agreement on Government Procurement. Industry is not overly optimistic on this score. In the first place, the effort to limit official export credits has been only moderately successful, with foreign governments quickly finding ways around the agreement to help their own firms (e.g., mixed credits). In a world in which most foreign governments purchase far more civilian goods than the U.S. government (e.g., surface and air transport, communications, power generation, etc.), the room for back door offsets is quite large. It would be difficult to prove that there was a formal relationship between one country's purchase of a European military product and a purchase by that country's national telecommunications company from the customer country. Indeed, it might be difficult to determine when a U.S. aerospace company's purchases from a given country were or were not related to a purchase by that country of the U.S. company's military products. Furthermore, in any negotiations on offsets U.S. allies are almost certain to demand that, if they are to limit offset demands, the United States must be willing

OCR for page 158
--> to negotiate on some of its procurement practices. These would include its "buy America" laws, its domestic set-aside programs that do not allow foreign participation, and the general U.S. insistence on a warm production line for any major system it purchases from off shore. As it is unlikely that the United States will be politically or militarily willing to do so, negotiations are unlikely to be very successful. It is perhaps more probable that the inefficiencies and political irritation caused by offsets might eventually lead the major U.S. allies, such as Canada, Australia, Korea, Britain, and France, to at least reduce their offset demands, either explicitly or informally. This is unlikely to happen, however, until Europe succeeds in further downsizing and rationalizing its defense industry to more closely match current demand. We assume that U.S. negotiators will explore such options. 4. In cases in which the only competitors for a foreign contract are U.S. firms, the U.S. government might play a useful role in limiting offsets, but should do so only after full consultations with the U.S. firms involved in the competition. Comment: As a general rule, industry believes that the government should support all U.S. companies in their efforts to compete against foreign companies, but should not attempt to intervene in individual company offers with respect to price, terms, or content of offers, including offsets (except for security-related technology controls). However, there are rare cases in which U.S. companies appear not to face foreign competition. In these few cases in which either the foreign government must buy a U.S. product for political reasons, or because there is simply no other comparable product available, the U.S. government might consult with U.S. companies involved to determine the feasibility of placing some restrictions on offset offers. This could prevent two U.S. companies from escalating offset offers, or even a single U.S. company from being pressured by the foreign government into making excessive offers. There are three major dangers to such government involvement. First, any formal U.S. government policy of intervention when there are no foreign competitors might simply encourage the foreign customer to stimulate such competition, to pursue a different approach to addressing their defense problem, or to decide against any purchase. Second, the U.S. government might bring undue pressure on U.S. companies to agree to government involvement, even when such interference might favor one company over another. Finally, if confronted with a percentage cap on offsets, a country might well demand higher quality offsets from companies, which might be more onerous than a higher percentage. 5. The collection and publication of information on offsets by the government should be handled with extreme caution. Such information, particularly when attempts are made to standardize the data, can be very misleading and thereby exaggerate the U.S. perception of the problem, encourage even stronger

OCR for page 158
--> demands by other governments, disclose proprietary information, and possibly damage the competitive position of U.S. firms in international defense business. Comment: U.S. industry has generally opposed massive data collections on offsets. It has done so because each offset is so unique—and the meaning of individual numbers (particularly percentages) so particular to a specific offset program—that aggregating the data may obfuscate the issue more than it clarifies. It should be noted that there is a clear incentive for the selling firm and even some agencies in the purchasing government to inflate the offset figures so as to put the best image possible on the purchase of a foreign product. However, this in turn tends to distort the importance of offsets in U.S. studies. It also may well escalate the demands of other countries that read the reports. In general, if the concern is over the impact of offsets on the defense industrial base, the government would be better served by identifying which specific industries seem to be in trouble. Studies of those industries should then identify all the sources of their difficulty, including offsets. It is likely that if such studies are conducted, it will be found that offsets are not a very important aspect of problems relating to the industrial base. It may well be the case that even where offsets appear to affect a weak subsector of the economy, it will turn out that offsets are more a symptom than a cause of the problem. That is, subsectors that have not kept up technologically, or employ technologies that are widely available around the world, or that are employing high-paid labor in low-skilled jobs are precisely the types of sectors for which foreign alternatives prove attractive, with or without offset obligations. However, if government can find specific subsectors that are particularly impacted by offsets, it would then be possible to work with the limited number of companies that account for most offset performance to see if greater restraint could be used in meeting offset obligations in such subsectors. In summary, the aerospace industry has concluded that, whereas the U.S. government might continue to make clear its dislike for offsets to U.S. trading partners, it should use extreme caution in taking any action that would simply shift purchasers away from U.S. producers. The government essentially agreed with those views, and in 1990 the White House issued a policy statement3 on offsets that tracked closely with the industry recommendations enumerated above. That statement remains the policy of the U.S. government, which industry supports. Although all policies must change with external circumstances, so far there do not appear to be any developments in the offset world that would justify a departure from current policy. The aerospace industry certainly is prepared to continue to work with the government to monitor the offset landscape to ensure that current policy continues to be appropriate. 3   Statement by the White House Press Secretary, April 16, 1990.