Shadow World of Economic–Offsets– An Anomaly in Business Practice: Cost to Compete for International Trade Agreements…

Offsets are ‘terms in a sale’ that leverages the sale to obtain compensatory benefits for the buyer, generally in many international trade arrangements… 

Offsets are an integral part of trade agreements between companies (i.e., suppliers) and governments (i.e., buyers); whereby suppliers must agree to buy products or provide other forms of commitment to the buying countries, in order to win the contract. 

Offsets are mechanisms to compensate typically, governments for outflow of their countries economic resource…

Their use is becoming increasingly important with more than 120 countries having international trade offsets policies… Even though the definition of ‘offsets’ is often disputed the main concept is simple: A country (buyer) that wishes to purchase and import, say, $100 Million worth of military arms from another country or company… and presumably the only economic value gained in return, for the purchase, is the putative national security-value of the imported arms.

Therefore, to increase the ‘economic exchange value’; the importing country (buyer) stipulates that the exporting country-company (seller) contractually must take a percentage (offsets) of the $100 Million purchase, and set-up a ‘flow-back’ to the buyer, e.g.; provide for co-production facilities in the buyers country, or commit to a variety of other possible activities that would secure the ‘flow-back’ percentage, of the $100 Million, to the importing country (buyer). This ‘flow-back’ or ‘offset’ is part of the trade contract… The importing country’s advertised benefit are; they obtain the necessary arms, plus the country’s public funds that are spent on the purchase remain in the country for use in other domestic activities, such as; stimulating the country’s economic development…

Countries use offsets for a variety of reasons, e.g.; ease the burden of large purchases on their economy, increase-preserve employment, obtain desired technology, promote industrial sectors… It’s interesting to note: Developed countries with established defense industries use offsets to channel work or technology to their domestic defense companies.

Countries with newly industrialized economies are utilizing both military and commercial related offsets that involve the transfer of technology and know-how… The developing countries with less industrialized economies generally pursue indirect offsets to help create profitable commercial businesses and build infrastructure. Overall, offsets continue to be an important and necessary factor in a climate of increased international competition…

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In the article Market Trends and Analysis of Offsets by Asif Khan writes: Offsets are industrial compensation practices that are required as a condition of purchase. The seller is required to compensate the buyer for perceived losses to the local economy. This practice has been part of international trade for more than fifty years… Offsets are also used in other industries, such as; power generation, telecommunications, infrastructure projects… For example, Pepsi signed an agreement with the Ukraine to expand its bottling plants and, in return, marketed approximately US$1 Billion worth of shipments of goods over an eight-year period… 

There are many who favor the practice of offsets, and there are many who oppose this practice. Some refer to offsets as kickbacks and as being counter to the free market approach, while others, especially some people in the defense industry, view offsets as a reasonable component of market practices and as a business development tool without which there would be no sales: The World Trade Organization (WTO) permits only civilian offsets (civil-civil) for developing countries only…

Offsets are now an accepted practice in the international business arena, and this is especially true in the defense industry. Many countries see offsets as a means of enhancing their local economies, and politically justifying spending on defense items and acquiring the latest technologies… Marketers should be aware of offset policies and practices of their foreign customers and governments to better prepare for the competitive bidding process. Defense firms should be aware of the trends in offsets and the demands of the respective markets, such as; local partnerships and production…

Three approaches are prominent when considering offsets policies: 1) policy adaptation requiring a mandatory offset component, 2) flexible case-by-case approach based on mutual benefits, and 3) best endeavor approach based on a partnership. Some countries start with one strategy, then after having some experience they might change the approach… Defense contracting firms have two options; engage in offsets or walk away from the deal... The defense industry views offsets as counter-balance for trade distortions imposed by government interventions… Also, as a tool for risk mitigation, access to capital, markets, technologies, and enhanced local workforce skills…

In response to a survey of U.S. defense firms conducted by the U.S. Commerce Department; 59% of respondents agreed with the concept that offsets are essential to win contracts, and based on the past transactions, offsets have proved to be a key decision criteria in international defense sales... Offsets exist in formal and informal forms: Some countries have adopted mandatory offsets, while others have adopted flexible offsets policies that focus on, e.g., long-term partnerships, dual-use technology, regional approaches…

Countries with skilled workforces, public-private enterprises, and developed international business relationships are better positioned to absorb the transfer of technologies than countries without these attributes. Based on the last fifteen years of U.S. export data, the overall trend shows that there has been a steady increase in the demand for offsets…

How Do Offsets Work? International offsets activities are directly related to the size of the international exports trading businesses: According to Stockholm International Peace Research Institute(SIPRI); the world’s 100 largest arms dealers, excluding China, sold weapons and military services worth US$411.1 Billion dollars in 2010… U.S. firms dominated the Top 100, with sales by 44 US-based companies accounting for over 60% of the market, or US$246.6 Billion…

Assume that the offsets on these export agreements might average about 90%, and then the U.S. exports of US$246.6 Billion would result in about US$222 Billion of future offset obligations, as the export contracts are fulfilled… Here is an example of a typical ‘offsets’ proposal: Consider a hypothetical case of ‘NationP’ (buyer) buying 300 tanks from defense company ‘CompanyS’ (seller).

Assume that the total contract is US$400 Million and NationP (buyer) requests 120% of offsets. Hence, the defense CompanyS (seller) is obliged to fulfill these offsets, if they want to win the contract. Then, NationP and ConpanyS agree on a list of specific offsets items, i.e., deals, programs… The offsets agreement includes both direct and indirect offsets. NationP also assigns a credit value for each typology of offsets offered by CompanyS.

The credit value for the offsets obligations is not the ‘actual value’ but it’s the ‘actual value by a multiplier’, which expresses the degree of interest of NationP in the proposed offsets. In other words, something that is deemed very valuable by NationP will have a high multiplier, which expresses the importance and the value to NationP for that type of offset. The multiplier (e.g., 2, 5, 7…) translates NationP‘s ‘attached value’ into the ‘credit value’, and that eventually accounts for the fulfillment of the agreed sum of US$480 (120% offsets).

Most offsets are divided into ‘direct’ and ‘indirect’: Here is a hypothetical proposal between CompanyS and NationP using both ‘direct’ and ‘indirect’ offsets:

Direct Offsets:

  • Co-production: NationP chooses one or more local companies to manufacture some components of the tanks, such as turrets and some of the internal components. The actual value of the components is US$70 Million. NationP assigns a multiplier of 3, since this develops capabilities of its military industrial base and creates jobs in NationP. The total credit value for the fulfillment of the overall offset obligation is US$70 Million x 3 = US$210 Million.

Indirect Offsets:

  • Foreign Direct Investments: CompanyS makes investments in 5 (defense or non-defense) companies in NationP. The total value of investments is US$14.5 Million, and the multiplier is 4, a high multiplier, since NationP suffers from a chronic lack of ‘Foreign Direct Investments’. This makes an additional credit value for CompanyS of US$58 Million.
  • Technology Transfer: CompanyS provides water desalination technologies to one NationP company. This technology is particularly appreciated by NationP. Its actual value is US$20 Million, but the credit value is 7 times the actual value, which equals US$140 Million.
  • Export Assistance and Marketing: CompanyS provides commercial assistance to market products and services of a NationP’s company in a difficult market… The assistance is offered for 8 years, at the value of US$3 Million per year. NationP considers this assistance important to create new revenue streams and jobs for its company, and sets multiplier of 3. Credit Value US$72 Million. CompanyS may not be  expert on marketing and export assistance, so it may hire a subcontractor for the job. Such a subcontractor is also known as an ‘offset fulfiller’.

In these agreements, NationP controls-manages not only the supply of the deliverables, but also the implementation of the offsets according to the offset agreement, included or related to the main supply contract. This control is within the Minister of Defense and/or Ministry of Economy or Finance, or Ministry of Industry and Trade. Often arms importing nations establish special agencies for the supervision of their defense offsets…

Welcome to the murky world of ‘offsets’… The practice came of age in the 1950s, when Dwight Eisenhower forced West Germany to buy U.S.-made defense gear to compensate for the costs of stationing troops in Europe. Since then it has grown steadily and is now accepted practice in 120 countries…

According to the Global Offset and Countertrade Association; the industry could double in size over the next few years. Yet its very structure serves to mask the build-up of unrecognized financial liabilities of companies… also, critics argue that it fosters corruption, especially in poorer parts of the world…

According to ‘Avascent’, consultants; estimates that defense and aerospace contractors have accrued offsets obligations, i.e., investments they have promised but not yet made– that amount to about $250 billion today, and could increase to almost $450 billion by 2016… However, the industry’s own estimates are lower, but all agree that the trajectory is upward

In a survey of 200 international business leaders; respondents were nearly unanimous on the importance of international business to their organizations, and equally convinced of the value of strong ‘offsets plans’ for the success of their business development efforts… However, the character of offsets– seen as either obligation or opportunity– was more contentious… The pressure to do more and better on offsets is clear…

Meanwhile, many investors that invest in  companies that trade internationally are unaware of the role and risks of offsets— despite the importance of international growth… In addition, many governments using offsets; lack transparency, effective decision-making, little communication… leaving stakeholders to rely on informal networks to navigate the role and risks of offsets in their countries…

Remarkably, offsets are now said to be the main criterion in international trade contract evaluation… offsets may be little-noticed side deals that are negotiated in the shadows, but when it comes to weighing up bids they are at the front of decision-makers’ minds…