Defence Industry

Defence Offsets: proving detrimental to the services
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Issue Vol 25.1 Jan-Mar2010 | Date : 13 Dec , 2010

Persuasion of Vendors to Offer Required Technology. To persuade vendors to part with the technology sought, a system of assigning different multiplier values to various offset programmes is put in place. Multiplier value is a factor applied to the actual value of an offset transaction to calculate the credit value earned. For example, by undertaking an offset programme worth Rs 100 crores with a multiplier value of 3.5, a foreign vendor would earn offset credits equal to Rs 350 crores. By assigning differential weightage to offset programmes, buyer nations provide sellers with incentives to offer offsets in targeted area of buyer’s choice.

Despite repeated assertions of wanting to make India self-reliant in defence production, India does not accept technology against offsets. This aspect will be dealt with subsequently.

Offsets and Cost Penalty

One of the major misconceptions is that offsets are free add-ons. Nothing can be farther from the truth. Offsets certainly do not come for free as foreign vendors have to incur additional expenditure to fulfill them. There are a number of factors that affect offset overhead costs and it is not feasible to fix an exact yard-stick.

Value of an offset is always expressed in terms of percentage of the value of the main contract. It is generally seen that offsets up to 50 per cent inflate the cost of the main contract by close to 10 per cent. Similarly, 100 and 200 per cent offsets may result in cost escalation by 15 and 20 percent respectively.

relationship_offset_cost_peThe graph on the following page shows:-

  • Cost penalty is not directly proportional to offset percentage. Cost penalty varies with the type of programmes undertaken.
  • Initial cost of establishing infrastructure and initiating offset programmes is considerable. Once the process becomes functional and gets streamlined, rate of increase in cost penalty drops.
  • Cost penalty tends to plateau after offset percentage reaches 200 percent. It implies that beyond this stage, both the offset provider and the receiver remain engaged in programmes which make commercial sense to both.

It may come as a surprise to many that the US allows its defence producers to charge offset costs even for government to government Foreign Military Sales (FMS). Although the US Government considers offsets to be detrimental to free and fair trade, it appreciates the need for companies to recover offset costs as they are considerable. The Defence Federal Acquisition Regulation Supplement (DFARS) of May 1995, allowed US companies to recover full cost necessary to ‘implement an offset agreement’ in connection with FMS purchases. Subsequently, the scope was widened by using the term ‘offset costs’, thereby facilitating recovery of full expenditure incurred in fulfilling offset obligations. It proves the point that fulfillment of offset obligations costs a company considerable expenditure which it can not absorb and has to recover by factoring it in the sale price.

Offsets and the Indian Services

When the idea of demanding offsets was initially floated in official circles, most service officers thought it to be a harmless appendage to the procurement procedure. Very few were fully aware of its implications. Many welcomed it in the hope that offsets would result in giving an impetus to the Indian defence industry. Being terribly uncomfortable with the continued dependence on foreign vendors and the resultant uncertainties, the services did not grudge encumbrance of offsets in order to make India self-reliant. However, the services were in for a shock. The Indian offset policy is anything but self-reliance centric.

Although the US Government considers offsets to be detrimental to free and fair trade, it appreciates the need for companies to recover offset costs as they are considerable.

India allows three routes for the fulfillment of offset obligations and they are:-

  • Direct purchase of or executing export orders for defence products or services provided by Indian defence industries. For the purpose of defence offsets, services mean maintenance, overhaul, upgradation, life extension, engineering, design, testing of defence products, defence related software or quality assurance services.
  • FDI in Indian defence industries for industrial infrastructure for services, co-development, joint ventures and co-production of defence products and components.
  • FDI in Indian organisations engaged in research in defence R & D.

An examination of the viability of the above three routes is very revealing. At the face of it FDI route appears highly viable but when considered in the light of upper cap of 26 percent, the dissuasiveness of the policy becomes apparent. A foreign investor is expected to invest his resources in a venture where he has no significant control, strict capacity/product constraints, no purchase guarantee and no open access to other markets including exports. The FDI policy was announced in May 2001 and has elicited no response. Therefore, options (b) and (c) above mean little.

Export of defence goods and services is thus the only possible method to fulfill offset obligations under the Indian policy. It amounts to compensation trading which is considered to be the least beneficial form of offsets. Export of goods and services provide temporary and illusory gains, as has been the experience the world over. New markets dry up soon after the offsets are fulfilled, leaving created infra-structure idle and bereft of orders. Therefore, such trading does nothing to either strengthen the defence industrial base or promote technology upgradation. In other words, a potent tool like offsets is wasted on one-time exports.

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The views expressed are of the author and do not necessarily represent the opinions or policies of the Indian Defence Review.

About the Author

Maj Gen Mrinal Suman

is India’s foremost expert in defence procurement procedures and offsets. He heads Defence Technical Assessment and Advisory Services Group of CII.

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