What is the Real Value of Offsets and Technology Transfer?

Barry Pailen Hsiung is a Colonel of the Republic of China Air Force (ROCAF) and is currently completing his doctoral degree in the field of Management of Research and Development at George Washington University in Washington DC. Col. Hsiung has been in service more than 20 years in the ROC military. He has extensive experience in weapon systems acquisition management, project management, defence planning, systems analyses, maintenance and logistic management. Col. Hsiung has participated in Taiwan's Indigenous Defense Fighter (IDF) development program for several years, and was Coordinator of the ROCAF Mirage 2000-5 fighter procurement program. He served as the ROCAF's deputy head of the program planning and control office for the IDF. In addition, Col. Hsiung was a manager responsible for a $ 400-million source selection project for IDF's Increased Performance Engine (IPE). He also has been involved in the ROCAF's billion dollar aircraft procurement programs and has played significant roles for contract management from 1992 to 1994. Col. Hsiung holds a BS degree of Aeronautical Engineering in Taiwan from Chung-Cheng Institute of Technology and received his MS degree (System Analysis and Management) in the US from George Washington University.

Offsets and technology transfer issues now impact on most major defence deals. Colonel Barry Pailen Hsiung PhD, Republic of China Air Force, looks at recent examples of programmes in Asia and elsewhere and examines their relative merits.

THE US IS THE LARGEST offset provider in the world. Some nations, like the UK, France, and Germany are both the offset provider and receiver. Most of the other countries are the offset receivers. The purposes of this study are: (1) to clearly define the means of offsets and technology transfer, (2) to depict the evolution of offsets, (3) to discuss current offsets environment and trends in defence procurement, and (4) to explore the F-16 procurement cases with regard to the applications of offsets in several nations and then to get some lessons learned and findings.

The term "offsets" describes a form of countertrade: a compensatory trade agreement which incorporates some methods of reducing the amount of foreign exchange needed to buy an item or some means of creating revenue to help pay for it. Offsets are a form of countertrade obligation required by a purchasing nation of the exporter of military, high technology, and aerospace products or services to reduce or to "offset" the purchase price.

This obligation involves the exporter's agreement: to develop the importing country's defence industrial base by transfer of technology and/or management techniques through licensed production, coproduction, subcontractor production, and/or the establishment of local infrastructure; or the counterpurchase of related or unrelated products from the importing country; or to help the importing country sell its products to third countries; or to provide substantial other benefits to that country. Offsets can be differentiated into two forms -- direct and indirect offsets. Direct offsets are export product related, while indirect offsets are non-export related.

Technology transfer is one of the most highly valued offsets.

An ancient Chinese proverb may best capture the essence of technology transfer: "If you give a man a fish, he will survive only a short period by swallowing the fish one time; but if you teach him to fish, he will never starve." In other words, technology is knowledge. In the industrial world, technology is the knowledge necessary to produce industrial materials, components, and end products. Technology transfer includes these activities designed to help one party acquire that knowledge from another.

When the term technology transfer was first used, the meaning was restricted to the transformation of the results of R&D in the basic sciences into commercial technologies. In current usage this movement of knowledge is now called vertical technology transfer. However, technology transfer is now universally used to mean the movement of technology from one country to another, which is also called horizontal technology transfer

The use and application of offsets has evolved over the years.

Offset programs in the form of coproduction began with the production of US weapons systems in Europe and Japan in the 1950s. The US, eager to bolster both its and its allies' defences, based its decision to implement offsets on its goals of "Rationalisation, Standardisation, and Interoperability" (RSI) of the weapon systems and its desire to make military trade more reciprocal within NATO. To promote this policy, the US had to improve the allies' defence industrial capabilities, modernise their forces, and strengthen their economies through contract agreements on selling military hardware to various European countries and Japan, and then, later, to Taiwan and South Korea.

Other offsets have been in effect since the early 1960s to assist in sales of US aircraft abroad. The use of offsets increased dramatically during the 1960s for a variety of reasons; including buyers' desires to create a national defence industrial base, to acquire modern technologies and management techniques, and to solve balance of payment problems. In particular, the NATO countries continuously imposed strong political and economic pressure to maintain their share of employment, national income, and foreign exchange earnings associated with their national defence procurement. These procurement practices have pressed for maximum involvement of domestic industries.

Additionally, the Western Europeans have also become more insistent upon the quality of offset procurement assigned to them. In the early 1970s, those European countries were anxious to develop indigenous defence industries. However, high technology weapons became too risky and too costly to produce. Moreover, most countries had insufficient demand and defence budgets for "go-it-alone" production. Thus, to push for licensed production or coproduction of US weapons was the natural solution. Apart from France, which is not a member of NATO and has independently developed its weapons systems, some European governments, like Britain, Germany, and Italy, still have sought to reduce their dependence on the US for weapons procurement and, ultimately, for advanced technology. Thereby, they hope to enhance their own defence-related industries' share of global markets and to develop indigenous design engineering capabilities.

Japan passed industrial control laws in the early 1950s aimed at enhancing the flow of industrial technology from foreign sources to Japanese industry. Its major objectives in regulating foreign investments and licensing agreements were similar to the Western European countries: saving development costs, acquiring technology, and, ultimately, developing indigenous capabilities. The multiple aims of Japan's policy are to obtain full control of the technology, to be free to procure materials and components from Japanese or non-US sources, and to be able to adapt or change product designs to meet their requirements and production conditions. Coproduction agreements allow Japan to fulfil its goal of retaining control of high technology items and withholding critical manufacturing know-how.

Since the 1980s, interest in offset requirements among Developed Countries (DCs), Less Developed Countries (LDCs), and Newly Industrialised Countries (NICs) has been growing. NICs especially were following the precedent set by European countries to use offsets associated with defence procurement as a means for expanding and improving their home industrial base, providing additional industrial employment, and earning the large amounts of foreign exchange needed to pay for defence imports and repayable foreign military assistance credits.

Many NICs, such as Brazil, Greece, Israel, Saudi Arabia, Singapore, South Korea, Spain, Taiwan, and Turkey, have been vigorously imposing a range of offset obligations on suppliers, taking advantage of large import purchases to obtain offsets from the vendor's and thereby, foster technology transfer and increase employment and expedite the development of advanced science and technology. This situation also has made the US, which is the largest arms and aerospace product-exporting country in the world, concerned about offset arrangements which may create or strengthen future competitors and increase its job loss.

The current offset environment is one of increasing client demand along with increasing supplier trepidation.

The US is the only country which doubts that offsets have a negative impact on its economy. The US has been regularly and rigorously tracking the influence of offsets on jobs, technology, and international competitiveness. However, no conclusive evidence has been found that offsets have damaged the US economy. Here, of course, the focus has been on the impact of offsets on US exports, rather than US imports.

Over the past five to ten years, the shrinking defence environment has prompted contractors to seek export orders more aggressively. This environment has fundamentally changed the nature of the offset business and the expectation of receiving countries for obtaining offsets. Countries are more frequently expressing interest in indirect offsets, presumably because of their potential to develop a nation's industrial base and catalyse an economy as a whole. However, the requests for sharing valuable technologies are by no means limited to those for parts or subsystems. Fully industrialised and newly industrialised countries alike have often made it clear they want offsets to provide them the capability to manufacture procured systems in their entirety. For defence contractors, as well as for offset obligators, the situation must be carefully handled.

In addition, offset commitments/obligations of an extremely high percentage of contract value, defined as more than 100 percent or equal to the value of the contract itself, are now increasingly viewed as ordinary. Besides, there is no specific difference for technology transfer in offsets between the sales of military and commercial aircraft. The current trend also shows that offsets may not occur only on arms and aircraft trades: many large governmental procurements of high-tech products (such as transportation systems, nuclear powerplants, etc.) are as well involved in some kind of offset arrangements.

There is still no evidence that the current offset environment will be regulated, even with the WTO prohibiting its signatories from imposing, seeking, or considering offsets for government procurement transactions. Developing countries would be allowed to negotiate exceptions, and it is doubtful whether this provision would actually discourage countries from engaging in offsets. While many countries impose no formal offset requirement, there is, at the same time, an understanding that any contractor who wants to do business there must voluntarily submit an offset proposal. As the demand for offsets increase, so will the challenges of pursuing them. It is a new environment where fulfilment of offsets through technology initiatives will be adopted as a primary marketing mode by defence contractors and governments alike, paving the way to long-term, mutually beneficial relationships which cross geographic and national boundaries.

Successful offset programmes have certain well-defined characteristics. First, the country's motivations to acquire technology and strengthen its economic/political benefits are considered from a long-term perspective. Second, the advantages and disadvantages of the use of offsets are different in each country, depending on their environment and industrial infrastructure. Third, the negotiation to acquire more benefits from the offset package relies heavily on the buyer country's buying power, industrial capabilities, and experiences. And fourth, a government's procurement policy and activities linked closely with offsets provide the basis for promoting the nation's economic development.

The Lockheed Martin F-16 Fighting Falcon [formerly made by General Dynamics] provides a useful subject for studying procurement cases. The F-16 is the most popular fighter aircraft in the world. Over 3,500 have been produced for more than 20 air forces. Almost all the sales of this successful product have involved offset arrangements. Fourteen different forms of offsets involving the F-16 to seventeen nations have been identified, and are shown in the following table (Table 1). NATO's four EPGs (European Participating Governments; Belgium, Denmark, the Netherlands, and Norway) were the big winners in F-16 sales. They also present a good model of a successful offset arrangement.

The EPG F-16 coproduction program was the first and largest offset arrangement promoted by the US government in the mid-1970s. The commitment to a minimum offset level of 58 percent of the cost of the F-16 procurement to the EPGs as a whole was more than satisfied. The target offset of 80 percent, which included third country purchase, was also reached.

The distribution of the offset among the EPGs was not equal, due to their divergent aerospace capabilities. Belgium obtained the most promised offsets, 103.5 percent of the contract value (77.8 percent of the cost of its aircraft purchased plus third country purchases) due to the capabilities of its industrial base.

Denmark and Norway, however, had difficulty attaining a reasonably competitive position; thus they had a smaller share in the offset arrangements. For Belgium, the only serious drawback was the final cost of the F-16, which reflected an approximately 30 to 35 percent overrun. This was almost entirely due to the offset. The US Government stressed that the overrun was mainly due to significantly higher production costs in Europe than in the US.

Turkey, the second largest beneficiary of F-16 offsets, presents another model of how a newly industrialised nation has both successfully established its aircraft industrial base and promoted the growth of its tourism and service industries though heavy use of offsets.

In addition to assembling the F-16 in its own country, like the NATO EPGs, the Turkish aircraft companies have undertaken a joint venture with US firms to manufacture parts, components, and assemble some subsystems for third countries' sales of the F-16.

South Korea has received an even more remarkable offset arrangement from its F-16 procurement, the first ever offset which not only provides the buyer coproduction of the aircraft, but also helps develop its advanced aircraft. South Korea acquired both manufacturing technologies from Lockheed Martin to produce most of the parts of the F-16 and final assembly of 108 of the total 120 purchased aircraft, as well as obtaining a commitment from Lockheed Martin to codevelop its KTX-2 advanced trainer. This offset model is considered unequalled and unlikely to be repeated.

Unlike the ROK, the ROC's (Taiwan's) effort to secure military technology has been removed from its efforts to acquire the basis for a more robust and technologically sophisticated economy. This is due, not only to the ROC's lack of diplomatic recognition and relatively weak bargaining position, but also to General Dynamics' hesitance (because of the past transfer of technology to Taiwan under its Indigenous Defence Fighter program and because co-production would be ineffective in saving US jobs). Faced with the choice of holding out for a better offset and technology deal or promptly acquiring F-16s, Taiwan chose to forego (albeit unwillingly) significant production shares in the F-16 deal in order to secure the aircraft.

However, after the F-16 and Dassault Mirage 2000-5 fighter sales were disclosed in September 1992, lawmakers in the Legislative Yuan asked the government to require offsets from suppliers. In January 1993, the lawmakers examined the two fighter deals when reviewing the budget and found that there were no substantial offset agreements included in the contracts. The furious legislators then erected a potentially serious roadblock to the government's $ 12-billion agreement to buy the fighters.

They passed a measure which required the government to renegotiate agreements with the makers of the F-16 and Mirage 2000-5 aircraft which included provision for technology transfer and local content such that at least 10 percent of the value of the total price of offsets went to locally made parts. In March, the Yuan increased the offset requirement to 30 percent of the sale value.

One leading legislator, who opposed the deals, studied South Korea's and many other countries' F-16 procurement in terms of their offset agreements with the vendors. He concluded that the US F-16 sale to Taiwan had several unacceptable features compared to offers to the other countries. Especially, since the sellers had already provided to almost all buying countries physical offset obligations. For that reason alone, it was thought, the sellers should not fail to offer similar offsets to Taiwan's local industry.

The legislators, therefore, strongly suggested that the government should retroactively demand Taiwan's first ever offset from sellers in connection with the fighter sales. The Yuan (congress) would block payments on the package unless all sellers provided Taiwan with technology and production contracts related to the aircraft. As a result, the US and French aircraft makers returned to the negotiation table and then committed to provide 10 to 30 percent of sales value for the offsets.

It should be emphasised that without the Taiwanese legislators' threats to block the deal if no offset commitments were provided, the ROC would never have had the chance to become a member of the international "offset club". This is another example of an "after-the-deal" offset agreement.

Lockheed Martin (which bought General Dynamics' aircraft business) is in danger of making too many offset commitments to its customers. The purchase of the F-16 involved at least eleven countries in some level of production (or subcontracting) of parts, components, and subsystems. With its limited workshares, it has been difficult for Lockheed Martin Tactical Aircraft Systems (LMTAS) to satisfy all those nations and fulfil its obligations.

The countries which are suffering the most are those like Turkey and the EPGs which have invested large amounts of money setting up assembly lines and production factories for the F-16, and now face shrinking demands and serious overcapacity problems. In particular, Turkey's aircraft plants, which heavily relied on F-16 part production, have been enormously impacted. Israel is encountering a similar situation.

Several lessons can be learned from the F-16 cases. Whereas many countries have used offsets extremely well as an industrial development mechanism, some nations may use them only to strengthen their technological capabilities, improve their production quality, and even promote local manufacturing as a symbol of self-sufficiency in defence.

Nevertheless, the benefits are generally short term. The nations which request coproduction on their lands should bear in mind that: (1) the total acquisition cost is much higher than via direct purchase, the percentage of the cost increase depends on the existing industrial base and its operational efficiency; moreover, technology-oriented offsets require an even higher price; and (2) lacking a guaranteed order, a factory established to manufacture a specific product may risk future market shrinkage, especially, with a declining product, such as the F-16.

In the long run, offsets are economically inefficient, even though they can certainly be advantageous for a country in the first stage of building up an infrastructure and capabilities for market entry. Future technological competence and a strong industrial base depend on further transformation and diversification. From a macro perspective, offsets have created many redundancies and overcapacities, which are highly disadvantageous.