According to some estimates, India is likely to spend close to USD 100 billion on capital acquisitions during the current plan period of 2007-12. Presently, imports account for nearly 70 percent of the total requirements. Thus, the import bill will be close to USD 70 billion. With the stated policy of demanding minimum 30 percent offsets, the total inflow of offset package would be a whopping USD 21 billion. This figure could go up in case the Government raises the offset threshold. Consequently, offsets have come to acquire enormous importance in India’s defence imports.
In the post Soviet Union era, India has moved from single source procurement regime to purchasing military hardware from multiple sources after open competition. Today, sheer enormity of Indian planned procurements has attracted the attention of the world’s top defence manufacturers. They are vying hard to bag the big ticket deals.
Not all offsets are duly published. Sellers are generally reluctant to reveal the quantum of offsets they had to offer to clinch a deal. They term it as commercially sensitive information.
With the recent issue of global Requests for Proposals for the procurement of 126 Medium Multi-Role Combat aircrafts at an anticipated cost of USD 10.4 billion, India has caused immense excitement amongst all major aero-defence conglomerates in the world. The Government has raised the quantum of associated offsets to 50 percent. Of the six invitees, two are from the US, i.e. Lockheed Martin with its F-18 Super Hornet and Boeing with F-16s. India is aware of the technological superiority of the US weapon systems and wants to develop a long-lasting defence relationship with the US.
However, many Indian policy makers are not clear about the US policy with regard to offsets in defence deals, especially if sales are routed through the ‘Government to Government’ route. They are apprehensive that they may lose out on valuable offset benefits if they opt for the US equipment. Such apprehension is totally misplaced as discussed subsequently.
Despite being the oldest and the largest provider of offsets in the world, the US has no declared policy on offsets. It is generally estimated that the US defence industry has offset obligations of over USD10 billion. Nonetheless, the US feels that offsets go against its stated promotion of ‘free and fair’ trade. For the first time in 1984, the Congress addressed the subject of offsets in defence trade under Section 309. It requires the President to submit an annual report on the impact of offsets on the US defence industrial base.
As the leading exporter of arms, it considers offsets as a burden on its economy and a necessary evil. The Congress in 1999 had opined that unilateral efforts by the US to prohibit offsets may be impractical in the current era of globalisation and would severely hinder the competitiveness of the US defence industry in the global market. It accepts that offsets are a part of the current defence trade environment and cannot be wished away.
It has a very exhaustive system in place to compile data on offsets and to monitor them closely to minimise their adverse effects. The US Department of Commerce (Bureau of Industry and Security) submitted its latest report to the Congress in July 2004. The Report covered a ten-year period from 1993 to 2002. During the above period, the US companies entered into 434 offset agreements with 36 countries. In 2002, new US offset-related defence export contracts were valued at USD 7.4 billion. The value of attached offsets was USD 6.1 billion or a whopping 82.3 Percent of the total value.
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Not all offsets are duly published. Sellers are generally reluctant to reveal the quantum of offsets they had to offer to clinch a deal. They term it as commercially sensitive information. They are wary of the future clients getting wiser and upping their demands. They are also wary of adverse local opinion, which may view it as leading to job losses as many suppliers undertake to place orders for sub-assemblies on the local vendors in the importing country at the cost of the original vendors in their own country.
Routes of the US Arms Sales
The US sells military items through two basic routes – Direct Commercial Sales and Foreign Military Sales. Though subjected to the same licencing regime, both have their distinct characteristics.
The US Government also provides equipment on lease for a period up to five years. It is always a case specific agreement, generally to meet an immediate requirement of the indenting nation till bulk procurements materialise. Additionally, stocks held in excess of the requirements of the US forces are also offered at highly reduced rates (5 to 50% of original cost) to selected countries.
Direct Commercial Sales (DCS)
These are pure commercial transactions between a buyer government and the industry. The role of the US Government is limited to the grant of licence by the Office of Defence Trade Controls of the State Department. This route facilitates open competition amongst various producers world wide. DCS route is preferred when the performance parameters of the equipment sought are materially different than the US military specifications. Parameters of the equipment sought can be determined by the buyer to suit his country’s operational requirements. The buyer may ask them to submit techno-commercial proposals for evaluation.
There are no middlemen in the FMS. The buyer nation is saved considerable effort and expenditure, as the US Government procures the item as per its well established acquisition procedure.
Transfer of technology and joint production can also form an integral part of the overall package. It is for the contracting parties to draw out terms and conditions of the deal to suit their perceived interests. Delivery of the item may be faster if it is in current production or if the company has ready stocks. In other words, the US companies are required to compete with producers from other countries to clinch deals. Buyer nations can demand and negotiate compensatory offsets as per their policy.
Foreign Military Sales (FMS)
FMS is generally known as a government-to-government deal. India bought Weapon Locating Radars through this route. This route is generally followed in respect of the items which have already been inducted in the US forces. The US Government offers similar items to foreign governments at the rate at which these items had been purchased for the US forces, albeit with additional handling charges. There are three types of FMS cases: Defined Orders are meant for specific weapon systems, Blanket Orders are to cover follow-on support and Cooperative Logistics Supply Support Arrangement enables a buyer nation to invest in the US Supply System with access to the US defence stocks.
The buyer nation forwards a Letter of Request (LOR) to the US Government. It is a comprehensive document containing information about the equipment, its planned usage and support facilities. If the request is cleared, a Letter of Offer (LOO) is sent to the requesting Government. The buying Government is required to submit a Letter of Acceptance (LOA) along with the initial advance. Every LOA includes Standard Terms and Conditions as dictated by the US laws for acceptance by the buyer. The US Government may supply the item from its own existing stocks or procure it afresh from the producer.
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There are no middlemen in the FMS. The buyer nation is saved considerable effort and expenditure, as the US Government procures the item as per its well established acquisition procedure. The quality and performance parameters are assured. Deliveries may be faster in case the equipment incorporates Government furnished material, as Government orders get priority. Since the item is already in use with its forces, the US Government is in a better position to provide logistic, training and exploitation support.
The FMS route is ideal in respect to high-tech systems, which do not require comparative trials. This route is also better for complex weapon systems as a buyer can get them fully integrated and configured.
Offsets in FMS Deals
The US Defense Offsets Disclosure Act of 1999 describes offset as ‘the entire range of industrial and commercial benefits provided to foreign governments as an inducement or condition to purchase military goods or services, including benefits such as co-production, licensed production, subcontracting, technology transfer, in-county procurement, marketing and financial assistance and joint ventures.’
The general policy of the Department of Defence with regard to offsets is that they are market distorting and inefficient. The Presidential Policy statement of April 1990 mandates that ‘no agency of the US Government shall encourage, enter directly into, or commit US firms to any offset arrangement in connection with the sale of defence goods or services for foreign governments.’
India has carried out wide-ranging reforms in its procurement organisation and procedures. The new procurement procedure ensures transparency, fair play and open competition. Offsets have been made mandatory for all deals over USD 68 million.
The US Government realises that offsets have become unavoidable in modern defence deals. Therefore, it has evolved a policy of non-intervention – it neither facilitates offsets nor obstructs their inclusion. It is for the companies to decide whether to engage in offsets or not.
This ‘hands off’ approach also extends to a policy of total non-involvement in negotiation of the offset agreement between the company and the FMS customer, and no role in judging the merits of these agreements.
Some of the major aspects of the policy have been discussed below.
Recovery of Offset Costs
Earlier, the Defense Federal Acquisition Regulation Supplement (DFARS) had permitted limited recovery by a US contractor of the ‘administrative costs to administer specific requirements of its offset agreement.’ Subsequently, in May 1995, it was clarified that US contractors could recover full cost necessary to ‘implement an offset agreement’ in connection with FMS purchases. This was necessitated because the US Government feared that the defence companies may be forced to pass the offset costs to all other customers, including the US Government, in the form of indirect overheads. The US Government’s position is that the US taxpayer should not pay any offset costs in connection with a foreign military sale.
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The Government, in 1999, replaced the term ‘offset implementation costs’ with the term ‘offset costs,’ thereby widening the sphere. It allowed a US contractor to recover all costs incurred for offset agreements with a foreign government or international organisation if the LOA is financed wholly with customer cash or repayable foreign military finance credits.
As regards FMS deals financed with funds made available on a non-repayable basis, a US defence contractor cannot recover costs incurred for offset agreements with a foreign government or international organisation.
No Mention of Offsets in the US Government Communications
LOO and LOA between the US Government and the FMS customer and the contract associated with that LOA (between the US Government and the contractor) do not include any of the terms of the offset agreement (such as the delivery schedule, acceptance criteria, etc.) even though the LOA and the contract may include costs associated with the offset. Any offset contract signed between the FMS customer and the contractor remains distinct and independent of the LOA and the main contract.
Non-Revelation of Offset Costs
While preparing LOO and LOA, the US Government obtains estimated offset costs from the contractor and includes in the line item price for the required contracted item. They are never reflected separately. Thus a customer can never find out whether any offset costs are being charged to him. The US Government is of the view that the exact quantum of offset costs should never be disclosed as most foreign governments do not want offset costs isolated/highlighted. On the other hand, the US contractors fear that foreign governments may refuse to pay for them.
The US companies exporting defence equipment through the DCS route have to participate in competitive bidding with offset proposals as per the buyer countrys procedures.
The line item containing the offset costs is usually the first major fixed-price type line item in the LOA for the primary defence system being procured. This holds true for the resultant contract as well. In a contract document, offset costs should be accumulated, priced, and paid against a single Contract Line Item Number for the FMS customer’s deliverable item.
If a customer seeks additional information concerning FMS contract prices, the Government, after consultations with the contractor, should provide sufficient information to demonstrate the reasonableness of the price. This may include tailored responses, top level pricing summaries and historical prices.
Enforcement of Offset Obligations
The FMS customer is responsible for administering and enforcing the offset agreement. If the contractor does not perform the offset requirement in accordance with the terms of the offset agreement, it is for the FMS customer to enforce it. The US Government, through a DFARS memorandum, has clarified that it would assume no obligation to satisfy or administer the offset requirement or to bear any of the associated costs. It does not get involved at all.
Limited Government Oversight
In cases of sole source procurement, the Government reviews the offset agreement to evaluate the allowability, allocability, and reasonableness of proposed offset costs.
The contractor must provide a detailed cost estimate for the offset costs for which it wants to be paid. If the contractor is unwilling or unable to document the offset costs, then the Government does not allow the offset costs to be charged to the contract.
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After the LOA is signed and prior to the contract signature, the Government must determine whether the proposed offset costs are allowable and allocable.
Offsets in Cases of Systems Integration
There are cases where the US Government acts as a systems integrator for an FMS sale. In such cases more than one contractor would be involved as in the cases of aircraft and ships. Different contractors would need to sell the basic platform, weapons package, sensors and other sub-systems under separate FMS contracts. If the customer Government demands a written single offset agreement, the contractor selling the basic platform should act as the prime contractor and sign it. Suppliers of other add-on packages should sign internal contracts with the prime contractor undertaking to fulfill their share of offset obligations.
Offsets in Sales through Foreign Military Financing (FMF)
The US Government spends three to four billion dollars every year as Foreign Military Financing (FMF) grants. These are used by the recipient nations to purchase defence equipment from the US industry. There is no foreign competition in such deals. FMF consists of non-repayable and payable components. Non-repayable FMF funds should not be used to pay offsets as it is considered grossly unfair.
As regards repayable FMF sales, US defence contractors are permitted to recover all costs incurred on offset obligations. As per the orders issued by the DFAR in 1999, such cases are treated at par with deals financed wholly with customer’s cash.
Conclusion
India has carried out wide-ranging reforms in its procurement organisation and procedures. The new procurement procedure ensures transparency, fair play and open competition. Offsets have been made mandatory for all deals over USD 68 million. India allows discharge of offset obligations through direct purchase of defence products and services provided by Indian defence industries; or Foreign Direct Investment (FDI) in Indian defence industries; or FDI in Indian organisations engaged in research in defence R&D. It is for the vendor to select methodology and an Indian partner for the fulfillment of offset obligations.
On the other hand, despite its stated opposition to the concept of offsets in international trade, the US Government has accepted the fact that the US companies will suffer if offsets are not offered by them. It has, however, put in place an elaborate monitoring mechanism to minimise its adverse effects on the US economy. All firms with more than USD 5 million offset liability are required to report to the Secretary of Commerce.
The US companies exporting defence equipment through the DCS route have to participate in competitive bidding with offset proposals as per the buyer country’s procedures. However, in the case of FMS deals, the US Government adopts a ‘hands off’ approach. It lets the seller company charge offset costs but does not become a party to any offset agreement, which has to be signed directly between the buyer country and the contractor.
The Indian Government must acquaint itself thoroughly with all facets of the US policy while demanding offsets with FMS contracts. As the US Government assumes no responsibility for ensuring fulfilment of the offset agreement, it is imperative that foolproof and enforceable safeguards are incorporated in the offset contract.
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