Sector switches on offset - dealing with cuts to defence spending

Total defence spending around the world may have topped $1.5 trillion in 2012, but the figure represented an annual decline, the first in more than a decade according to the Stockholm International Peace Research Institute. Cuts made by the majority of NATO nations have driven a worldwide downturn in military expenditure, despite increases in China, Russia,and many states within the Middle East.

The decrease was exacerbated by the US's withdrawal of ground troops in Iraq, contributing to a 6% drop in funding for that nation's military in 2012, while the country made further cuts of $87 billion the following year. In the UK, defence spending dropped by 7% to £37 billion between 2011 and 2013. Across the West, governments are under pressure to continue making cuts to military budgets and explore other methods to boost the sector.

One set of tools available is budget offsets, where one party agrees to buy products from another while stipulating that its own merchandise is supplied in return, thereby offsetting the outlay and righting the balance of trade. Although such contracts are often agreed with complete discretion, an investigation by The Financial Times revealed that globally, defence companies had about $75 billion worth of agreements outstanding. The practice has become an integral part of the international defence trade.

Offsets aren't a new concept; many believe the first contract to have been agreed in the 1950s when West Germany was forced to buy American-manufactured equipment as compensation for the cost involved in stationing troops across Europe. More recently, countries such as Turkey have successfully used offset programmes to build advanced and ambitious national defence capabilities.

It started with the purchase of 160 F-16 fighter jets from General Dynamics in 1984, which also meant the assembly of nearly all aircraft was subcontracted to the newly formed Turkish Aerospace Industries. The country's defence sector now registers annual exports in the region of $1 billion.

Flights of fancy
Elsewhere, in 2001, BAE Systems was keen to secure a deal to sell radars to Kazakhstan, and to sweeten the deal promised the Kazakhstani President Nursultan Nazarbayev that it would help establish a domestic airline. The partnership later collapsed on account of Moscow's involvement, but it was indicative of how offset agreements had taken hold of the sector and how for governments acquiring enhanced military capabilities is only part of the appeal.

Spending vast amounts of public money on military equipment is easier to justify when it secures work and contracts for local suppliers and citizens in the country, as well as guaranteeing a long-term source of income. Knowing this has seen many of the offset demands from emerging countries become more sophisticated, the end goal being the creation of their own defence industry.

"Clearly, the high-growth countries today that we are all courting are setting pretty high hurdles for contractors in terms of offsets," says Christian Scherer, EADS's chief salesman for the defence side.

Agreements are not just limited to two parties, with large-scale collaborations growing in popularity. Despite Lockheed Martin's F-35 Lighting II fighter jet being principally funded by the US, many other countries, including the UK, Italy, Australia and Canada, are contributing billions of dollars to the project and taking an active role in its development. The plan was for nine of the major partners involved in the programme to purchase more than 3,100 jets by 2035.

For manufacturers and defence contractors, offsets are viewed as loyalty reward programmes and represent a powerful marketing tool that enables them to shore-up commercial relations with the purchasing country. Contractors are also able to generate revenue from the extensive maintenance needed for the duration of such programmes.

Lockheed Martin is believed to be the manufacturer with the largest proportion of current offset obligations, with an estimated $27 billion, while Boeing's $12.6 billion makes it the second-largest beneficiary. Raytheon, EADS and BAE Systems are just a few of the other defence companies with multi-billion-dollar offset commitments. In an intensely competitive market, these agreements offer defence companies stability as well as opportunities for growth.

It's a widely adopted practice, but some critics, particularly factions within the US, German and French Governments, believe the agreements are a form of protectionism, that go against free-market rules, distort competition and encourage inefficiency. Despite this, the US's Buy American Act is perhaps one of the best-known examples of an offset agreement, one that isn't exclusive to the defence sector and stipulates that at least half of all military equipment must have been manufactured in the country.

Treading a fine line
More vocal critics have suggested these deals are akin to bribery and corruption; a claim bolstered by the lack of openness and divergence surrounding the agreements. While the defence sector is the only industry permitted by the World Trade Organisation to use offsets as a tool for evaluating contracts, many feel greater transparency and more stringent regulations are required.

"Because of the sheer size and magnitude of the growth right now, there's going to have to be a greater deal of transparency on the part of both sides: the buyer and the seller," says Grant Rogan, founder of Blenheim Capital, a provider of offset consulting, advisory and transaction services to governments and corporations.
"And it is going to happen through self regulation or it will come down to imposed regulation. I don't think anyone expected offsets to become as big as they are today. The mechanics to track, manage and report them have not kept up with their growth."

Despite these criticisms, the use of offsets is likely to continue, with many analysts expecting future deals to dwarf early agreements in value. Many businesses fear that resisting the temptation to engage in such activities could have a detrimental effect on their revenue, leading to an 'if you can't beat them, join them' mentality.

"If you are not having to deal with offsets, you are probably not selling internationally," said Thomas Culligan, former head of international business at Raytheon. "Yes, it's a challenge. Yes, it's a problem. But it sure beats the alternative."
With governments under increasing pressure to reduce spending, and overcome the political connotations of doing so, any programme that offers revenue and job security, potential reductions in national debt, and safeguards a vital industry is likely to curry favour with citizens as well as corporations.