The use of offsets in foreign military sales - Tutorial

Acquisition Review Quarterly, Summer, 2003 by Robert L. Walter

United States defense firms have increasingly encountered demands from their foreign buyers to provide compensation for selecting U.S. suppliers. These quid pro quo transactions, also known as offsets, compensate the buyers for the economic damage caused by purchasing costly U.S. defense equipment. While these offsets may appear to be solely a form of price cutting, the motives of the foreign buyers can be varied. The behavior of these buyers can be explained by economic incentives ranging from labor market distortions and desires for foreign investment to the need for international financing. In most cases, it appears that offset transactions are a form of commercial policy that the buying governments use to address domestic problems. Defense industry personnel will likely encounter offset transactions and will benefit from a better understanding of the buyers' motivations.

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In the 1980s, I studied and wrote about the use of offsets in defense sales to foreign governments. (1) (The term offsets is used in defense sales to mean the compensation given to foreign buyers, by U.S. sellers, to offset the economic impact on the foreign buyers from having purchased U.S. made items, rather than domestically-produced items.) Since the time of that writing, the defense environment has undergone significant changes with the end of the Cold War and the breakup of the Warsaw Pact, mergers within the defense industry, and the changing level and nature of the threat. With a changed defense environment, there is a need to reexamine the issue of offsets and to validate the economic explanations of why buying nations request, and even demand, offsets when purchasing foreign-made defense items.

To gain an understanding of the current environment surrounding offsets in the defense industry, officials in the industry were contacted and, when willing, questioned about their experiences. (2) Because of the proprietary nature of the information, and the fact that competitions involving offsets are currently on-going, few specifics can be identified in this article; however, the general motivations behind the use of offsets are presented.

Offset agreements appear to be common in large defense sales of aircraft, radars, and other electronic systems, to foreign governments. In fact, it appears that offset agreements are the norm in such transactions. In a typical offset arrangement, the buying country (who most likely has a formal offsets policy or even a law governing offsets) (3) requires the selling firm to provide economic offsets or compensation for having purchased the particular foreign-made system or items. The offsets may include purchases by the selling firm from the buying nations, as well as marketing assistance for, investments in, or technology transfers to the buying nation. The seller may also agree to produce a portion of the product in the buyer's country. The value of the offsets expected by the buying nations frequently equals the value of the original defense purchases, and the time required to fulfill the offset commitments may easily exceed the delivery time for the purchased defense equipment. (4)

It appears that the current competitive environment in the worldwide defense industry dictates that a selling firm must anticipate offering offsets to the buyer to have any reasonable chance of winning a sale. With the frequent use of offsets, it is logical to ask, what motives a buying nation to request or require offsets? Why would a buyer choose this type of transaction, a purchase contract accompanied by an offset agreement, when a simpler, more straightforward cash deal is available and might result in a cheaper price for the defense item? An initial response might be that the buying nation as some monopsony power and the nation uses that power in a competitive environment to win an effective price reduction. While this may be true in some cases, it is also reasonable to assume that in many cases the selling firms have to cover the costs of fulfilling their offset commitments and thus must increase the prices of the defense items accompanying these commitments. (5)

If the latter is true, and firms do increase the prices of the defense items in order to cover the offset's costs, then the purchase and combined offsets package can be equated to a form of subsidization. The buyer pays more than a straight cash price, and in return receives certain benefits (discussed below). The alternative for the buyer would be to pay a lower price for the required defense items and then provide the subsidization for the desired benefits directly out of public funds. However, the direct subsidization may not be possible due to political constraints. Thus, offsets may be considered a form of indirect subsidization, and possibly a second-best, or blunt form of government intervention or commercial policy.

THE MOTIVES

Discussion of some of the motives that buying countries may have when they require offsets from foreign suppliers of defense equipment follows. These motives go beyond that of obtaining an effective price cut, and, in several cases, appear to be efforts to subsidize certain activities.