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Bureau of Export Administration
U. S. Department of Commerce

 

Testimony of R. Roger Majak
Assistant Secretary for Export Administration
U.S. Department of Commerce

Before
The U.S. House of Representatives
Committee On Government Reform

Subcommittee on Criminal Justice, Drug Policy, and Human Resources

June 29, 1999


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Mr. Chairman and Members of the Subcommittee, thank you for inviting me to testify today on the topic of offsets in defense trade. We are pleased that you have decided to review this critical issue which impacts our economic and national security. This hearing is an opportunity to inform the subcommittee on this growing problem. We view it as an important next step to the staff report prepared for Representative Tierney on this issue last October.

The Bureau of Export Administration (BXA) has a long history of involvement in defense industrial base issues. Apart from our export licensing and regulation mission, BXA is involved in a number of programs designed to maintain and enhance the competitiveness of the U.S. defense manufacturing infrastructure. BXA regularly conducts assessments of various key sectors and provides the results to the Armed Services and industry groups; assists communities in base closure and reuse; and matches technology needs of small- and medium-sized businesses with the resources of the federal laboratories.

As you are aware, in the mid 1980s, Congress enacted 309 of the Defense Production Act of 1950, as amended. This legislation tasked the Administration to prepare annual reports to Congress on the effects of offsets in defense trade on U.S. industry. The Office of Management and Budget chaired an interagency team, to which BXA belonged. In 1992, Congress amended the Defense Production Act and shifted the responsibility to the Department of Commerce where it was delegated to BXA.

To date, we have prepared three annual reports and are working on a fourth, which will be submitted later this summer. These reports are based largely on data collected from U.S. prime contractors, supplemented with data gathered from other surveys and outside research. As with the reports prepared by OMB, BXA coordinates this process with the Departments of Defense, Labor, State, and Treasury, and the Office of the U.S. Trade Representative.

To begin, I'd like to provide the offset definition that we use in the preparation of our annual reports: Offsets are industrial compensation practices mandated by foreign governments when purchasing defense-related articles and services. They can include coproduction, licensed production, subcontractor production, technology transfer, overseas investment, and countertrade.

Offsets can be either direct or indirect. Direct offsets, as the name implies, are forms of compensation directly related to the weapon system or other defense article being purchased. An example of a direct offset would be the production of a wing component for a fighter in the purchasing nation. Indirect offsets, in contrast, are those fulfilled in a wide variety of ways not related to the system that is purchased. Examples of indirect offsets include the sale of non-defense products manufactured in the buyer country or the development of non-defense industries, such as software.

What is the problem with offsets? Why has BXA and the rest of the interagency community focused so much attention on the issue? There is no doubt that offsets are a reality of the international defense marketplace. Practically every country that purchases modern weapon systems demands offsets, whether they call them offsets or, as our British allies prefer, "industrial participation," or, as our friends to the north refer to them, "industrial regional benefits," or, in Israel, "industrial cooperation." Regardless of the label attached to the practices, the fact is that a U.S. prime contractor cannot even hope to bid in most cases without offering an offset package along with its sales proposal.

The official U.S. Government policy, developed during the Bush Administration, views offsets as economically inefficient and market distorting. Offsets introduce a new element into the purchase decision unrelated to the price or quality of the products. The policy directs that the U.S. Government will not encourage or enter into any such agreements itself nor provide financing for such arrangements. The decision whether to engage in offsets, and the responsibility for negotiating and implementing offset arrangements, resides with the companies involved. U.S. policy also calls for consultations with our friends and allies regarding limiting the adverse effects of offsets in defense procurement. In light of some of our activities and consultations with our allies, which I will describe, I will later offer a statement of principles to be considered which will strengthen our position in negotiating for an end to offsets.

As the Committee will hear today, some argue that offsets facilitate U.S. exports and improve U.S. competitiveness; that they are a reality of the marketplace; and that they promote national security by enhancing weapon system interoperability. Others will counter that offsets are a misuse of the national security waiver for government defense procurement; they enhance the position of foreign competitors; and they have adverse employment, industrial, and technological impacts on the U.S. subcontractor base. All of these arguments have merit. The real question is, can we and should we do something to control offsets?

The prime contractors see offsets as a necessary evil, a reality of doing business in the international marketplace. They will continue to agree to offset arrangements as long as they are a mandatory condition of the sale, and they fear any unilateral moves on the part of the U.S. government to limit the use of offsets in international defense trade. Their position is understandable, as their actions are based on self interest.

Let me provide an example: The United States provides Israel with grant money to purchase U.S. defense systems. Right now, Boeing and Lockheed Martin are in a virtual dogfight over a $2.5 billion contract with the Israeli government for the purchase of fighter aircraft. The focus seems not to be on whether Boeing's F-15 or Lockheed Martin's F-16 is the better plane. Rather, the decision seems to hinge on who can promise the most offset work in Israel. The Israeli government was expected to announce its selection a month ago; instead, both contractors were asked to augment their bids. Now, the decision is on hold, waiting for the incoming government. American taxpayers provided the grant aid for this purchase, and the U.S. economy will bear the further cost of the offset arrangements, as the deal may result in technology transfer and displacement of U.S. subcontractor work.

Let me spend a few minutes going over some of the data from our 1998 report to Congress to give you an understanding of the scope and magnitude of offsets. New offset agreements with all foreign countries totaled $15.1 billion and supported $29.1 billion in export contracts from 1993 to 1996. This is about 52 percent of the value of the export contracts. For 1995-1996, the average offset jumped to about 80 percent. Preliminary figures for 1997 indicate that the average offset as a percent of export contract value is above those reported for 1993-1996. Based on our discussions with U.S. prime contractors, we expect that average to continue to climb toward 100 percent or more in the near future.

We also measure offset transactions, which are activities, like coproduction, technology transfer and countertrade, carried out by U.S. companies to fulfill agreements entered into in the same year or earlier. Transactions reached $9.2 billion between 1993 and 1996. About 38 percent of the transactions were direct offsets, 58 percent indirect, and 4 percent unspecified. About three-fourths of the actual value of all transactions were subcontracting activity, purchases, or technology transfer arrangements with our allies. This contradicts the notion that offsets do not have a widespread impact on our nation's industrial base; many offset-related transaction result in displacement of U.S. subcontractor work, lost revenue, and inevitably lost jobs for U.S. suppliers.

The adverse impact of offsets goes beyond the suppliers in the defense prime contractor's sector. Between 1993 and 1996, over 90 percent of the new offset agreements and offset transactions referenced exports of U.S. aerospace weapon systems, primarily aircraft, engines, and missiles. However, almost half of the offset transactions were fulfilled with non-aerospace products. This means that our aerospace prime contractors are fulfilling their offset responsibilities through activities in other sectors of the U.S. economy. We have heard complaints from groups like the American Shipbuilders Association, whose members have lost potential sales due to offset arrangements. In fact, our database shows almost $800 million in shipbuilding-related offset activities between 1993 and 1997. This industry has been impacted by offsets, despite not having offset agreements of their own or even defense export sales.

Another illustration of the widespread impact of offsets on our defense industrial base is that nearly 83 percent of the more than $9 billion in offset transactions were manufactured products. Three-fourths of the offset transactions fell into three major industry groupings:

1. SIC 37 Transportation Equipment (48 percent); a sub-group,  SIC 372 - Aircraft and Parts, alone accounted for 33 percent

2. SIC 36 Electronic and Electrical Equipment (16 percent); and

3. SIC 35 Industrial Machinery (9 percent).

Overall, 40 major U.S. industrial groupings - most not involved in the manufacture of weapon systems - were impacted by offsets. Most of the groups are far from defense-related production; they include food & food products; apparel; printing & publishing; and cut stone & stone products.

In our 1997 report to Congress, we reviewed the impact of offsets on two key subsectors of the U.S. economy: machine tools and shipbuilding & repair. For 1993-1995, there were $113 million offsets for machine tools and $350 million for shipbuilding parts and services. What does this really mean? The small businesses who supply machine tools and shipbuilding parts and services lost a small but significant share of their business to offset fulfillment. The quality and price of their products were not the cause of this loss of business; rather, the loss resulted from offset agreements which they did not enter into in the first place.

In the post-World War II period, offsets were justified on national security grounds - coproduction was needed to rebuild war-damaged defense industrial bases in Europe and Japan to enable them to resist the spread of communism. Today, with more than half of the offset activities identified as indirect or unrelated to the weapon system being purchased, these countries are taking advantage of offsets to pay for economic development initiatives, rather than in support of national security.

Canada's offset program is probably one of the best examples of the shift from a national security to an economic development focus. Its mandatory program of 100 percent offsets is primarily indirect. When selling to Canada, U.S. primes are required to set up non-related industries in targeted provinces. Canada learned many years ago that it was not cost-effective to duplicate defense manufacturing facilities, so instead they rely on U.S. industry to develop and expand Canadian non-defense industry into the U.S. and other markets. This, despite the fact that the United States has had a significant merchandise trade deficit with Canada for the last several years. What's more, Canada has a special relationship with the United States and is considered part of the North American defense industrial base. Canadian defense firms have special access to the U.S. marketplace - and Canadian firms are not required to fulfill offset agreements to do business here. In contrast, we have had a number of complaints from firms who were barred from the Canadian defense market unless they agreed to the required offsets despite a significant percentage of Canadian content already in the weapon system.

Returning to our report data: Five countries - the United Kingdom, the Netherlands, Switzerland, Saudi Arabia, and Taiwan - accounted for 72 percent of the value of new offset agreements between 1993 and 1996. Individual countries' offsets demand vary, of course. Let me focus on Europe, which accounts for the bulk of our defense trade and, not surprisingly, the majority of our offsets.

In four years, European countries entered into 94 new offset agreements valued at more than $10 billion in connection with about $11.3 billion in defense purchases. This makes the offset percentage about 90 percent.

The United Kingdom has one of the most demanding offset programs, with strict monitoring and audit procedures in place. The UK purchased about $5 billion in U.S. military equipment between 1993 and 1996 and received offsets of very nearly the same amount, mostly direct offsets. This means that instead of the United States exporting systems, parts, and components, the systems are instead being manufactured with minimal U.S. content. The Dutch purchased $1.4 billion over the period and received $1.8 billion in offsets, or approximately 126 percent, which were mostly indirect offsets. These indirect offset obligations were fulfilled with purchases of machinery, commercial aerospace parts, automotive, software, shipbuilding and repair, and primary metals.

The British have an interesting system. The U.K. Defense Export Services Organization (DESO) and the Department of Trade and Industry have joined forces to launch a new offset service, matching companies who are interested in overseas investment with companies who sell to foreign governments that require offsets. Clearly, in defense markets which require primarily indirect offsets, the British have a real competitive advantage through this strong government support of British aerospace firms.

Part of the difficulty we face in convincing foreign nations to negotiate with us is that offsets appear to be a winning proposition for purchasing nations, politically and economically. In many ways, at least in economic terms, this thinking is flawed. Offsets have the effect of increasing the cost of the exported weapon system, and this cost ultimately must be passed on to the foreign purchaser. These increased costs are incurred when shifting components production to newly established overseas suppliers, through fees for transferring technology, or through various other administrative expenses. Co-production is the most costly form of offset, as it typically involves the replication of an entire production or assembly facility to produce a limited number of military items.

In reality, it is less expensive for most nations to import weapon systems than it would be to develop and produce them domestically. Few nations can afford the cost of or have the capability to maintain a fully integrated military industrial base. For that reason, collective security arrangements develop, and trade in advanced weapon systems among allies is enhanced. Offsets are not needed to achieve this security; they simply make the import more attractive politically to the purchasing nation and may in fact lessen the security gains. Our data shows that it in many cases it is not the defense ministry that implements and monitors offset agreements; rather, it is my counterparts at the economic and trade ministries who make these decisions. This is another sign that offsets are moving away from national security justifications.

As a measure to reduce the inefficiencies inherent in offsets, the development of expensive weapon systems would better be accomplished through international partnering with allies. This would spread costs and benefits and reduce duplication. It would also provide added incentives to market the weapon systems more widely. The Joint Strike Fighter program, with British, Dutch, and Canadian participation, is one of only a few examples of this type of cooperation. All partner countries are sharing the risk of development, and all will share in eventual production activities. Because of this cooperation, there's no need for offsets.

Another factor that makes our European trading partners reluctant to discuss limits on offsets is the overcapacity and excess employment in the European defense industry. This creates political pressures to continue the practice of demanding offsets in order to maintain a workload at defense facilities. The continued use of offsets is inhibiting European cooperation and integration. U.S. prime defense contractors have become more competitive because of consolidation and downsizing in the U.S. industrial base. As stronger competitors, U.S. firms have increased their share of an ever-decreasing international defense market. In addition, the United States spends three times more on military R&D than European nations, contributing to the U.S. lead in sophisticated weapon systems, which was so critical in our recent involvement in Kosovo.

Another argument presented in favor of offsets is that the U.S. has a positive, but declining, defense trade balance with Europe. However, as with Canada, the U.S. has a negative balance in merchandise trade with Europe, which includes both commercial and military trade. The defense surplus has ranged from $2-3 billion since 1993, while the merchandise deficit was $15.2 billion in 1996 and grew to $16.7 billion in 1997. When offsets are included in the calculation, the U.S. defense trade surplus is effectively cut in half.

Additionally, the U.S. General Accounting Office reported in November that the Department of Defense has undercounted the value of foreign content in U.S. weapon systems. This would also erode the defense trade surplus total. As these figures show, it is important to look at the entire trade picture rather than focusing on one sector.

Where do we go from here? For the last three years, BXA's annual report has had as one of its goals international consultations on offsets, both bilateral and multilateral. We have worked hard over the last two years to develop a domestic consensus for such an effort through discussions with the interagency community, prime contractors, subcontractors, labor, and trade associations. While there are differences of opinion among these groups, one thing that we have all agreed on is the need for a dialogue with our allies on this complex subject. BXA also co-funded a series of conferences on offsets and the aerospace industry through the National Research Council. Again, our objective was to focus attention and spur thinking on solutions to the issue.

In the last year, we have made progress in the area of international consultations, as well. First, we believe that it is important to address the issue with our European allies, since they are our largest defense trade partners and demand the highest offsets. We are pursuing this both multilaterally and bilaterally.

Secondly, a DOD-led interagency group met with Canadian representatives to see what headway we can make in reducing offsets. More detailed discussions are being planned. As our closest neighbor and largest trading partner, and because of that nation's role in the North American defense industrial base, it was important to make progress with Canada.

Third, we will be meeting with representatives of the Dutch government in September, following up on an earlier meeting, again with the objective of eliminating or reducing offsets in exchange for improved access to the U.S. market. We've also had very preliminary discussions with the Swedes, the Danes, and the French, who are interested in discussing alternatives to offsets as well.

On a different front, offsets are mentioned as a concern in the USTR Title VII report on unfair government procurement practices (see attached). Through this report, we have put governments around the world on notice that we are looking for a new way to conduct defense trade - without offsets.

Similarly, my organization has participated in offset conferences around the world, speaking to audiences of foreign offset officers and prime contractors. Our message has been surprisingly well-received: I think that most parties would readily back away from the offset system if an acceptable alternative was available.

While we have made great strides in opening communications on offsets, there will be no quick solution. It is a buyer's market for defense systems, and weapon sellers in France, Britain, and the United States are confronted with ever-increasing offset demands.

It will be difficult to stifle the demand for offsets, at least in the short term. However, it may be easier to come to an agreement among the sellers to limit or eliminate offsets. While our goal is to eliminate offsets, we may wish to consider some principles which could increase our leverage.

Based on our extensive discussions with foreign governments, and U.S. and foreign industry representatives, I believe we should consider the following possible approaches as we move forward in our consultations with our allies:

1.  We should continue our efforts toward international negotiations on offsets rules. Our bilateral discussion in the past year suggest there is growing receptivity to this idea. We should focus both on trans-Atlantic trade with our European allies and on third country markets where we compete with EU manufacturers.

2.  More accurate information on all foreign sourcing of parts and components in U.S. weapon systems down to the subcontractor level would provide better data upon which to base our bilateral and multilateral defense trade discussions and negotiations.

Additionally, we want to take a closer look at the British program I described earlier, which may place U.S. companies at a disadvantage in the global marketplace. The key features of this new program would be:

1. The government assumes no liability or obligation   for the offsets.

2. It brings senior level officials' support in facilitating offsets.

3. British companies gain a competitive advantage in the international defense market place.

4. Government assistance has been designed to meet unavoidable offset demands with minimum damage to suppliers and their employees.

Such measures were designed to match and neutralize competition in the marketing of offsets. The increased efficiency of companies in dealing with offsets would greatly reduce business prospects of competing foreign firms.

We are unlikely to restrain or eliminate offsets by just complaining about them, or by unilaterally restricting ourselves and our defense contractors. While that might set a good example, it would be tantamount to unilateral disarmament, leaving our competitors free to exploit offsets even further. As we learned in the 1970s and 1980s when our competitors were using predatory export financing to capture markets, it's sometimes necessary to fight fire with fire. For many years Congress authorized a "War Chest" at the U.S. Import-Export bank to be used to counter and match below-market export financing when our competitors insisted upon using it. The result of our willingness to match and even trump our competitors with financing terms eventually brought our competitors to the negotiating table and resulted in international agreements to limit such financing. If we are serious about constraining offsets, we need at least to consider a similar strategy. The concepts and options I've outlined could move us in that direction.

Thank you, Mr. Chairman. I would be pleased to answer any questions.

 

ATTACHMENT

Excerpt from
Annual Report on Discrimination on Foriegn Government Procurement
Office of the United States Trade Representative
April 30, 1999

Offsets in Defense Trade

When purchasing defense systems from U.S. defense prime contractors, many U.S. trading partners require compensation in the form of offsets as a condition of purchase in either government-to-government or commercial sales of defense articles and/or defense services. Offsets include mandatory coproduction, licensed production, subcontractor production, technology transfer, countertrade, and foreign investment. Offsets may be directly related to the weapon system being exported, or they may take the form of compensation unrelated to the exported item, such as foreign investment or countertrade.

Prime contractors view offset arrangements as a necessity for success in the international marketplace. However, offset requirements cause prime contractors to select subcontractors based on their being located in the country requiring the offset versus best value, thereby adversely affecting potential U.S. subcontractors. Originally designed to enhance allied national security, offsets increasingly have become economic development tools for the countries that demand them. Furthermore, there has been a recent trend to fulfill offset requirements with non-defense products versus defense products.