IMPACT OF OFFSETS IN DEFENSE-RELATED EXPORTS

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CIA-RDP87M00539R002303720001-1
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December 22, 2016
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December 23, 2009
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December 13, 1985
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MEMO
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Sanitized Copy Approved for Release 2009/12/23: CIA-RDP87M00539R002303720001-1 Compt EXECUTIVE SECRETARIAT D/OGI/DI cutive Secretary 17 Dec 85 Date Sanitized Copy Approved for Release 2009/12/23: CIA-RDP87M00539R002303720001-1 Sanitized Copy Approved for Release 2009/12/23: CIA-RDP87M00539R002303720001-1 EXECUTIVE OFFICE OF THE PRESIDENT OFFICE OF MANAGEMENT AND BUDGET WASHINGTON. O.C. 20503 DEC 13 1985 MEMORANDUM FOR: DISTRIBUTION FROM: Alton G. Keel, Jr. Associate Director National Security nd International Affairs SUBJECT: Impact of Offsets in Defense-Related Exports Section 309 of the Defense Production Act (DPA) Amendments of 1984 mandates an annual report on the impact of offsets in defense-related exports on various aspects of the U.S. economy. The Office of Management and Budget (OMB), through a staff level interagency committee, has been coordinating the preparation of the first report that was due in mid-October, 1985. Executive Order 12521 sets forth the responsibilities of the various departments and agencies. As you may know, there was a significant delay in transferring data collected from industry for this report from the International Trade Commission (ITC). As a result, the decision was made to delay submission of the report beyond the statutory date by approximately two months. The interagency committee has now completed the penultimate draft of the first report. This version includes an executive summary, which should be of special interest to senior reviewers. Concerning legislative strategy for fiscal year 1987, OMB believes that the Administration position should be that Section 309 of the OPA Amendments should not be reenacted with the rest of the DPA. The argument would be that the present report demonstrates that offsets are not a significant problem and therefore future reports would be of little value. Such a position would obviate the need to collect data from industry during calendar year 1986. If Congress is determined to continue the reporting requirement next fall, a new data collection effort would be impractical in time for the second annual report. The purpose of this memorandum is to secure policy level views on the committee product that is attached and the 1986 legislative strategy described above. Written comments must reach OMB by COB on December 20, 1985, as the report will be sent to the Congress during the following week. Attachments /... ep~? Sanitized Copy Approved for Release 2009/12/23: CIA-RDP87M00539R002303720001-1 Sanitized Copy Approved for Release 2009/12/23: CIA-RDP87M00539R002303720001-1 DISTRIBUTION Interagency Comment/Clearance Honorable Kenneth L. Adelman Director, Arms Control and Disarmament Agency Honorable Julius W. Becton Director, Federal Emergency Management Agency Honorable William Casey Director, Central Intelligence Agency Honorable Fred C. Ikle Under Secretary of Defense for Policy Honorable Thomas Moore Member, Council of Economic Advisers Honorable David C. Mulford Assistant Secretary of Treasury for International Affairs Honorable John M. Poindexter Assistant to the President for National Security Affairs Honorable William Schneider, Jr. Under Secretary of State for Security Assitance, Science and Technology Honorable Bruce Smart Under Secretary of Commerce for International Trade Honorable Dennis E. Whitfield Under Secretary of Labor Honorable Clayton Yeutter United States Trade Representative Internal OMB Comment/Clearance John H. Carley General Counsel Kathryn M. Eickhoff Associate Director for Economic Policy Wendy L. Gramm Administrator for Information and Regulatory Affairs Bryce L. Harlow Associate Director for Legislative Affairs Sanitized Copy Approved for Release 2009/12/23: CIA-RDP87M00539R002303720001-1 Sanitized Copy Approved for Release 2009/12/23: CIA-RDP87M00539R002303720001-1 DRAFT DEC 111985 Honorable Thomas P. O'Neill, Jr. Speaker of the House of Representatives Washington, D.C. 20515 Dear Mr. Speaker: I am pleased to submit the first annual report on the impact. of offsets in defense-related exports as required by Section 309 of the Defense Production Act Amendments of 1984. It consists of assessments of the impact of offsets in defense-related exports on the defense preparedness, industrial competitiveness, employment, and international trade position of the United States and provides other information as required by the statute. This report was prepared by an interagency committee. As anticipated by the Conference Report accompanying the bill, the Office of Management and Budget (OMB) coordinated the work of this group. The President delegated the reporting responsibility under this section to the Director, Office of Management and Budget in Executive Order 12521. This report is based, in part, on data submitted by 139 United States companies whose cooperation is greatly appreciated. The International Trade Commission collected this information on behalf of the interagency committee. The core assessments are primarily the work of the Departments of Defense, Commerce, and Labor, as shown in the Table of Contents. These departments and nine other Executive Branch agencies collaborated on the remainder of the text. Sincerely yours, James C. Miller III Director IDENTICAL LETTER SENT TO PRESIDENT OF THE SENATE Sanitized Copy Approved for Release 2009/12/23: CIA-RDP87M00539R002303720001-1 Sanitized Copy Approved for Release 2009/12/23: CIA-RDP87M00539R002303720001-1 DRAFT DEC 111985 IMPACT OF OFFSETS IN DEFENSE-RELATED EXPORTS December 1985 This report is published pursuant to Section 309 of the Defense Production Act Amendments of 1984 (P.L. 98-265). Inquiries and requests for additional copies should be addressed to Mr. Antonio Chavez of the Office of Management and Budget at (202)395-3664. Copies of the questionnaire used for the survey are also available upon request. Questions about sections of Part II may also be directed to the appropriate Department as listed in the Table of Contents. Sanitized Copy Approved for Release 2009/12/23: CIA-RDP87M00539R002303720001-1 Sanitized Copy Approved for Release 2009/12/23: CIA-RDP87M00539R002303720001-1 Table of Contents Page List of Tables ....................................................... iii List of Charts ....................................................... vi Executive Summary .................................................... vii Part I - Introduction to the Report .................................. 1 A. The Legislation ............................................. 1 B. Executive Branch Process .................................... 2 C. Definitions ................................................. 4 D. A Short History ............................................. 6 E. United States Policy ........................................ 8 F. Foreign Policy Context ...................................... 12 G. Economic Setting ............................................ 14 H. The Market .................................................. 19 Part II - Assessments of the Impact of Offsets ....................... 21 A. Defense Preparedness (Department of Defense) ................ 22 B. Industrial Competitiveness (Department of Commerce) ......... 37 C. Employment (Department of Labor) ............................ 58 D. International Trade ......................................... 103 Part III - Other Information About Offsets 112 A. Types, Terms, and Magnitude ................................. 112 B. Bilateral and Multilateral Negotiations ..................... 127 C. Memoranda of Understanding .................................. 132 Sanitized Copy Approved for Release 2009/12/23: CIA-RDP87M00539R002303720001-1 Sanitized Copy Approved for Release 2009/12/23: CIA-RDP87M00539R002303720001-1 List of Tables Page I.G.1 Free World Export Trade, 1975-1984 ......................... 17 I.G.2 Average Annual Value of Defense-Related Offsets Relative to High-Technology Exports and Productions .................... 18 I.G.2 Average Annual Value of Defense-Related Offsets Relative to Exports and Production of Engines and Turbines and Aerospace Industries ................................................. 18 II.A.1 Capital Expenditures ....................................... 24 II.A.2 1983 Aerospace Capacity Utilization by Functional Area ..... 30 II.A.3 FY 1984 Defense-Related Trade Balance Summary .............. 33 II.A.4 Overseas Distribution of Defense Subcontracts .............. 35 II.B.1 Reason for Engaging in Offsets ............................. 38 II.B.2 Role of the Foreign Government in Offset Contracts ......... 41 II.B.3 Parties to the Specified Agreements ........................ 41 II.B.4 Total U.S. and Aerospace Balance of Trade, Calendar Years 1973-1984 ................................... 47 II.B.5 Total Aerospace Industry Military Export Sales and Offset Obligations by Standard Industrial Classification .......... 51 II.B.6 U.S. Military Aerospace Trade .............................. 53 II.C.1 Direct Employment Impact of Military Sales and Offsets: Based on Responses by Prime Contractors Holding Contracts with Offset Obligations Greater Than $2 Million (Imprecise Responses Interpreted as Total Employment Effect) 66 II.C.2 Direct Employment Impact of Military Sales and Offsets: Based on Responses by Prime Contractors Holding Contracts with Offset Obligations Greater Than $2 Million (Imprecise Responses Interpreted as Employment per Year) ... 67 Sanitized Copy Approved for Release 2009/12/23: CIA-RDP87M00539R002303720001-1 Sanitized Copy Approved for Release 2009/12/23: CIA-RDP87M00539R002303720001-1 Page II.C.3 Military Sales Implementations for'Contracts with Offset Obligations Greater Than $2 Million: All Survey Respondents 69 II.C.4 Military Sales Implementations for Contracts which Gave Numerical Labor Impact Estimates ...........:............... 70 II.C.5 Offset Implementations Based on Actual Implementations for Contracts with Offset Obligations of Greater Than $2 Million 73 II.C.6 Offset Implementations Based on Actual Implementations for Contracts Which Gave Numerical Labor Impact Estimates ...... 75 II.C.7 Dollar Value of Military Sales Obligations, by Year and Industry: All Respondents ................................. 77 II.C.8 Estimated Military Sales Implementation Values, by Year and Industry ................................................... 78 II.C.9 Employment Effects of Military Sales by Industry: All Respondents ............................................ 80 II.C.1O Direct Employment from Military Sales Implementations for Contracts which Gave Numerical Labor Impact Estimates ...... 82 II.C.11 Estimated Offset Implementations by Type: Exports, Imports, and Domestic Production .................................... 84 ?II.C.12A Direct Employment Effects of Offsets by Type: Exports, Imports, and Domestic Production ........................... 87 II.C.12B Total Employment Effects of Offsets by Type: Exports, Imports, and Domestic Production ........................... 89 II.C.13A Estimated Range of Total Employment Effects of Sales and Offsets, 1980-1984 Inclusive ............................... 91 II.C.13B Net Total Employment Effect of Military Sales and Offsets, 1980-84 .................................................... 92 II.C.14 Annual Average Monthly Employment in Industries Effected by Military Sales and Offsets, 1980-1984 ...................... 96 II.C.15 Industries Grouped into Miscellaneous Category by Type of Transaction'................ ................................ 100 Sanitized Copy Approved for Release 2009/12/23: CIA-RDP87M00539R002303720001-1 Sanitized Copy Approved for Release 2009/12/23: CIA-RDP87M00539R002303720001-1 Page: I.D.1 Direction of Trade ........................................ 106 II.D.2 Impact of Offsets on Trade -- Upper-Bound Estimates (Model I) ................................................. 108 II.D.3 Changes in Import Volume of All Other (Non-Offset Related) Commodities ................................................ 109 11.0.4 Impact of Offsets on Trade -- Upper-Bound Estimates (Model II) ................................................. 110 III.A.1 Arms Exports ............................................... ? 113 III.A.2 Total Sales of Companies Responding to the Questionnaire ... 113 III.A.3 Total Sales of Companies Reporting Offset Obligations ...... 114 III.A.4 Sales Value by Year ......... 117 III.A.5 Value of Sales and Average Periods of Implementation by Country, 1980-1984 ......................................... 118 III.A.6 Value of Offset Obligations and Average Periods of Implementation by Country, for Sale Years 1980-1984 ........ 119 III.A.7 Value of Offsets Implemented by Country, 1980-1984 ......... 120 III.A.8 Value of Offset Obligations by SIC and Year 121 III.A.9 Value and Percent of Offset Obligations by Type and Year ... 124 III.A.10 Value and Percent of Offset Obligations Implemented by Type and Year .............................................. 125 III.A.11 Value of Offset Obligations by Method of Enforcement and Industry ................................................... 126 Sanitized Copy Approved for Release 2009/12/23: CIA-RDP87M00539R002303720001-1 Sanitized Copy Approved for Release 2009/12/23: CIA-RDP87M00539R002303720001-1 List of Charts Page I.G.1 U.S. Merchandise Trade Balance, 1967-84 .................... 15 I.G.2 Export Share, U.S. Share of World Manufacturing Exports .... 16 II.A.1 Profit/Sales ............................................... 26 II.A.2 Profit/Assets .............................................. 28 II.B.1 Aerospace Industry Segment Sales 45 II.B.2 Total Aerospace Industry Sales ............................. 46 II.B.3 Export Quantity of Military Aircraft ....................... 48 II.B.4 Export Value of Military Aircraft .......................... 49 Sanitized Copy Approved for Release 2009/12/23: CIA-RDP87M00539R002303720001-1 Sanitized Copy Approved for Release 2009/12/23: CIA-RDP87M00539R002303720001-1 DRAFT DEC 111985 Executive Summary This report on the impact of offsets in defense-related exports was prepared in response to the requirement in Section 309 of the Defense Production Act Amendments of 1984 (P.L. 98-265). Section 309 states: "Not later than 18 months after the date of the enactment of the Defense Production Act Amendments of 1984, and annually thereafter, the President shall submit . . . a report on the impact of offsets on the defense preparedness, industrial competitiveness, employment, and trade of the United States. Such report also shall include a discussion of bilateral and multilateral negotiations on offsets in international procurement and provide information on the types, terms, and magnitude of the offsets." The effort to prepare an appropriate response to Section 309 began almost immediately after the DPA Amendments of 1984 were approved. After discussions within the Interagency Group on International Economic Policy, a separate staff level committee, chaired by OMB, was formed. This approach was anticipated by the Conference Report: "Since there is no clear lead agency in the Executive Branch on the subject of offsets, it is anticipated that the Office of Management and Budget will coordinate the efforts of the Executive Branch . . . in producing such reports." Members of the working group represent the Departments of State, Treasury, .Defense, Commerce, and Labor; the Federal Emergency Management Agency (FEMA); the Arms Control and Disarmament Agency (ACDA); the Central Intelligence Agency (CIA); the United States Trade Representative (USTR); and the National Security Council (NSC) staff. They meet under the unofficial title of Coordinating Committee on DPA 309 Reports. The Council of Economic Advisers (CEA) assisted by reviewing the draft report. The following definition of offsets was adopted for this report. "Offsets include a range of industrial and commercial compensation practices required as a condition of purchase of military-related exports (i.e., either Foreign Military Sales (FMS) or commercial sales of defense articles and defense services, as defined by the Arms Export Control Act (AECA) and the International Traffic in Arms Regulations (ITAR)." The various types of offsets are: coproduction, licensed production, subcontractor production, overseas investment, technology transfer, and countertrade (which includes barter, counter-purchase, or buy-back). Offsets in defense-related exports are frequently divided into direct and indirect classes. Direct offsets are contractual arrangements that involve goods and services Sanitized Copy Approved for Release 2009/12/23: CIA-RDP87M00539R002303720001-1 Sanitized Copy Approved for Release 2009/12/23: CIA-RDP87M00539R002303720001-1 addressed in the sales agreement for military exports. Included among direct offsets are coproduction, licensed production, subcontractor production, overseas investment, and technology transfer. Indirect offsets are contractual arrangements that involve goods and services unrelated to the exports referenced in the sales agreement. Some forms of foreign investment, technology transfer, and countertrade are included among indirect offsets. A database for this report was developed from responses to a questionnaire sent to U.S. industry. The list of questions, which was developed by the Coordinating Committee on DPA 309 Reports after extensive consultation with industry groups and formal public comment, was sent to 212 U.S. corporate entities including subsidiaries and subcontractors. The database covers five calendar years 1980-1984, and consists of four major elements: narrative responses to selected questions, sales information concerning the respondents, information on sales with offset obligations of over $2 million, and summary information on offsets of $2 million or less. For those offset obligations greater than $2 million, the database includes a breakdown of offset contracts executed during the reporting period. The database reveals some interesting facts about the types, terms, and magnitude of offsets. For the defense-related exports covered by this database, offsets totalled $12 billion and sales totalled $22 billion. In the period 1980-1984, about $2.4-billion, or about 20 percent, of the offset obligations were implemented. Nearly 90 percent of the respondents to the survey stated that offsets were a necessary condition for the sale. Most of the offset obligations occurred in three product areas, namely aircraft, engines, and electronics. Most of the sales and. related offset obligations were with either .NATO countries or other countries with whom the U.S. has special defense security arrangements. Finally, the overall magnitude of offset obligations does not appear large in the context of either total exports by the companies reporting or in the context of the value of total military production by these companies. Some U.S. foreign policy goals are traditionally pursued through arms transfer policy. Offsets can affect the nature of the arms transfer tool. Foreign policy objectives which are traditionally pursued with arms transfers include: o deterring aggression by enhancing the preparedness of allies and friends; o increasing the ability of the U.S. to project power; o supporting interoperability with the forces of friends and allies; o enhancing U.S. defense production capacity and efficiency; and o strengthening collective security arrangements. Sanitized Copy Approved for Release 2009/12/23: CIA-RDP87M00539R002303720001-1 Sanitized Copy Approved for Release 2009/12/23: CIA-RDP87M00539R002303720001-1 The U.S. Government does not normally enter directly into offset agreements, and consequently there is little immediate effect of offsets on Government procurement. World macroeconomic conditions make it difficult to isolate and measure the precise impacts of offsets on U.S. trade, employment, competitiveness, and defense preparedness. The size of defense-related offsets relative to the U.S. economy and relative to various sectors of the economy must be taken into consideration in any analysis of offsets. In this regard, the importance of defense-related offsets depends upon the frame of reference. The average annual value of defense-related offset obligations between 1980 and 1984 ($2.4 billion) is trivial relative to U.S. GNP ($3,125 bill.ion), total U.S. exports ($217 billion), or exports of manufactured goods ($143 billion). The workings of the international arms trade market are governed more by the objectives and policies of purchasing and selling governments than by traditionally defined market influences. This unique situation highlights the difficulties associated with trying to analyze international arms trade from a traditional "market economics" orientation. For this reason, the international arms market may be more accurately characterized as an arena of managed trade, than as a true market in which economic influences are the primary determinants ,of the terms a seller must offer to remain competitive. Part II of this report consists of assessments of the effects of offsets in defense-related exports on the defense preparedness, industrial competitiveness, employment, and international trade position of the United States. These assessments are based in part on data collected from U.S. corporations .concerning offset obligations incurred during the period 1980 through 1984. The general findings of these assessments are: o Defense-related industries are characterized by a small number of government buyers who exert a disproportionate influence on the institutionalized market for defense products. Due to the "buyers'-market" situation, producers may have no choice but to accept the offsets requirements when demanded in order to obtain sales contracts. Consequently, policy alternatives typically used for industries that are closer to perfect competition may not be applicable to this case. o Government-mandated offsets may introduce inefficiencies since the most efficient producer may not be the one to win a given contract. Rather, the producer who offers the best offset package may win the foreign business, despite the producer's efficiency or the appropriateness of its weapon system. o Inefficiencies caused by offsets may also be passed to producer levels below prime contractors (i.e., to subcontractors) and could result in a multiplied effect. Sanitized Copy Approved for Release 2009/12/23: CIA-RDP87M00539R002303720001-1 Sanitized Copy Approved for Release 2009/12/23: CIA-RDP87M00539R002303720001-1 o Offsets apply two opposing forces to short-run production costs (and hence weapon systems prices): (1) costs may be lowered by the increased size of production runs due to increased sales (assuming economies of scale exist); and (2) costs may be increased due to the expenses of countertrade commodity liquidation, foreign research and development investments, and higher foreign subcontracting prices. o Long-run production costs are faced with opposing forces: (1) costs may be lowered by an increased number of producers both here and abroad (particularly in the case of rationalization, standardization, and interoperability (RSI) goals among NATO members); and (2) costs may increase if the amount and complexity of offsets demanded by purchasing nations increase over time. o Offsets can be an effective foreign policy tool for both producing and purchasing nations. Consequently, the topic is both economically and politically sensitive. The specific findings resulting from the four assessments are: Concerning the impact of offsets on U.S. defense preparedness: o In a majority of circumstances, offsets had either positive or no impact on the productivity of defense-related industries. o Insofar as capacity utilization rates affect investment decisions, offsets appear to have had very little impact. o Available evidence suggests that the profitability, and hence the strength, of defense-related industries has not been damaged by offsets. o Available evidence suggests that no serious capacity problems are present. Surge difficulties that do exist can be traced to a number of causes, but generally not to offsets. o Evaluation of the impact of offsets on subcontractors is difficult because data regarding both the negative effects (business lost due to offsets) and the positive effects (business which would have been lost had the offset not been offered to close the deal) are generally not known to the subcontractors. Concerning the impact of offsets on U.S. industrial competitiveness: o American defense base industries are often obligated to offer offsets in order to participate in and remain competitive in the international marketplace. Sanitized Copy Approved for Release 2009/12/23: CIA-RDP87M00539R002303720001-1 Sanitized Copy Approved for Release 2009/12/23: CIA-RDP87M00539R002303720001-1 o Offsets are a factor in the competition for international defense sales, and are being used by foreign purchasing governments as a trade management tool for the purposes of preservation of foreign exchange, the targeted development of selected industrial sectors, and the enhancement of the capability of domestic industries through technology transfer. o Offsets are increasing foreign competition, particularly at the subcontractor level. However, without offsets, U.S. industry faces the prospect of losing business. o While offset-related sales of defense systems contribute to the marginal income of defense firms, the health of the industry depends primarily upon U.S. Government purchases. Concerning the impact of offsets on U.S. employment: o The employment effects of the sales exceed by far the adverse effects of offsets. Even when one considers the upper-bound estimates, the study finds that the positive effects of sales exceed the adverse effects of offsets by about 62,000 job opportunities. o The effects of both sales and offsets are felt principally in the aerospace and avionics industries, industries that are fairly healthy by most standards. o The above-named industries aside, the effects of offsets while widespread are small relative to total employment in any individual industry. This conclusion holds notwithstanding the fact that the study included under adverse effects offset arrangements that cannot realistically reduce domestic production and employment. Concerning the impact of offsets on the U.S. trade position: o The effects of military trade on the U.S. economy as a whole are likely to be.close to zero, because any imbalances in such trade are likely to be counterbalanced by capital flows that effect both interest rates and exchange rates, thereby generating changes in domestic production and flows of goods and services. o Under partial equilibrium analysis, the effect of sales and offsets is a net positive effect on the U.S. trade position in each of the five years covered by the DPA 309 survey. o Under general equilibrium analysis, the U.S. trade balance is unaffected by defense-related offsets. Sanitized Copy Approved for Release 2009/12/23: CIA-RDP87M00539R002303720001-1 Sanitized Copy Approved for Release 2009/12/23: CIA-RDP87M00539R002303720001-1 DRAFT r-r1 i ?' r I. INTRODUCTION TO THE REPORT Part I consists of a brief review of the legislation and a description of the Executive Branch process leading to this report, a list of definitions, a short history of the phenomenon and the Government's interest in it, an explanation of current United States policy, and a discussion of the foreign policy context and economic setting surrounding the issue. These sections provide the background for the analyses and other data required by the statute and the Conference Report accompanying the bill presented in Parts II and III. A. The Legislation Section 309 of the Defense Production Act (DPA) Amendments of 1984 (P.L. 98-265) approved April 17, 1984, reads: "Not later than 18 months after the date of the enactment of the Defense Production Act Amendments of 1984, and annually thereafter, the President shall submit ... a report on the impact of offsets on the defense preparedness, industrial competitiveness, employment, and trade of the United States. Such report also shall include a discussion of bilateral and multilateral negotiations on offsets in international procurement and provide information on the types, terms, and magnitude of the offsets." The Conference Report on the DPA Amendments of 1984 (House Report 98-651) dated April 5, 1984, adds an additional requirement: "The conferees intend that information provided on the types, terms, and magnitude of the offsets in each report shall include the number of relevant offset agreements required by contracts, the total dollar amount of value of offsets required by such contracts, a breakdown of offsets by category of defense material or defense services involved in such contracts, and a breakdown of such offsets by recipient countries. "In addition, each report shall contain a summary of relevant Memoranda of Understanding between the United States and foreign countries which provide the official framework within which foreign offset commitments incurred'in private sales can be fulfilled. Copies of actual Memoranda of Understanding involving such offsets shall be made available to the House and Senate Banking Committees upon request, after each report has been submitted by the President." Sanitized Copy Approved for Release 2009/12/23: CIA-RDP87M00539R002303720001-1 Sanitized Copy Approved for Release 2009/12/23: CIA-RDP87M00539R002303720001-1 2 Since Section 309 was approved on April 17, 1984, two hearings have been conducted by the Subcommittee on Economic Stabilization of the House Committee on Banking, Finance, and Urban Affairs. The first, on. May 22, 1984, included testimony by officials from the Office of the U.S. Trade Representative (USTR), the Department of Treasury, and the Department of Commerce. A second hearing on July 24, 1985, involved witnesses from the Departments of Defense and Commerce and the private sector. In addition, the Subcommittee on Oversight and Investigations of the House Committee on Energy and Commerce conducted a hearing on October 10, 1985, on offsets associated with foreign aircraft sales which included testimony by the International Trade Commission (ITC), the General Accounting Office (GAO), and the Departments of Commerce, Labor, and Defense. .B. Executive Branch Process The effort to prepare an appropriate response to Section 309 began almost immediately after the DPA Amendments of 1984 were approved. After discussions within the Interagency Group on International Economic Policy, a separate staff level committee, chaired by OMB, was formed. This approach was anticipated by the Conference Report: "Since there is no clear lead agency in the Executive Branch on the subject of offsets, it is anticipated that the Office of Management and Budget will coordinate the efforts of the Executive'Branch ... in producing such reports." Members of the working group represent the Departments of State, Treasury, Defense, Commerce, and Labor, the Federal Emergency Management Agency (FEMA), the Arms Control and Disarmament Agency (ACDA), the Central Intelligence Agency (CIA), the USTR, and the National Security Council (NSC) staffs. They meet under the unofficial title of Coordinating Committee on DPA 309 Reports. In addition to designing the report format and assigning writing responsibilities, the Coordinating Committee decided that a mandatory survey of U.S. corporations was necessary for the development of a database on offsets in defense-related exports. Consequently, the Coordinating Committee developed the data collection instrument, arranged for the questionnaire. to be sent to industry by the ITC, and devised a scheme for processing the data that was sensitive to the business confidentiality of this information. The Coordinating Committee also undertook extensive discussions with individuals and groups representing the: o Aerospace Industries Association (AIA). o American League for Exports and Security Assistance (ALESA). o Defense Industry Offset Association (DIOA). Sanitized Copy Approved for Release 2009/12/23: CIA-RDP87M00539R002303720001-1 Sanitized Copy Approved for Release 2009/12/23: CIA-RDP87M00539R002303720001-1 DRAFT o Defense Policy Advisory Committee on Trade (DPACT). o Department of Commerce Industry Sector Advisory Committee on Aerospace (ISAC #1). o Steering Committee of the Labor Advisory Committee for Trade Negotiations and Trade Policy (LSAC). o Electronics Industry Association (EIA). In addition, two status report briefings were given to the staff of the House Subcommittee that initiated the legislation. As a group, the Coordinating Committee did not participate in the negotiations with other governments on the subject of offsets, which are summarized in Part III of this report. However, some committee members were involved in these discussions as representatives of their departments and agencies. After operating informally for over a year, relationships among the various agencies were formalized by Executive Order 12521 of June 24, 1985: "The functions conferred upon the President by Section 309 of the Defense Production Act, as amended, with respect to the preparation and submission of reports to Congress concerning offsets shall be performed by the Director of the Office of Management and Budget '(OMB). The Director may further delegate to the heads of executive departments and agencies responsibility for preparing and submitting for his review particular sections of such reports. The heads of executive departments and agencies shall, to the extent provided by law, provide the Director with such information as may be necessary for the effective performance of these functions." Since the ITC was conducting a study very similar in terms of data requirements to the DPA 309 report, the decision was made in November 1984 to combine the data collection efforts in the interest of reducing the Government's demands on the private sector. In accordance with this agreement, the ITC was designated as the ".central collection agency" for offset data by OMB's Office of Information and Regulatory Affairs, using its authority under the Paperwork Reduction Act. This assignment was reiterated in Executive Order 12521: "In order to ensure that information gathered pursuant to this authority shall be subject to appropriate confidentiality protections, the International Trade Commission, which previously has been designated a "central collection agency" in gathering this information under 44 U.S.C. 3509, is authorized, pursuant to Section 705 of the Defense Production-Act, as amended, to collect the information required for compilation of the database to be used in the preparation of the first such report to .Congress." Sanitized Copy Approved for Release 2009/12/23: CIA-RDP87M00539R002303720001-1 Sanitized Copy Approved for Release 2009/12/23: CIA-RDP87M00539R002303720001-1 DRAFT Notice of a proposed combined questionnaire was published in the Federal Register on December 4, 1984. After taking into account extensive comments by industry groups, a final questionnaire was mailed to U.S. companies on February 11, 1985, with responses due by the end of March. On April 12, 1985, OMB provided ITC with a computer format for tabulating the data for transmission to OMB. The purpose was to develop a database for use by those members of the Coordinating Committee charged with producing sections of this report. At this juncture, a dispute developed as to the type of data ITC was to furnish OMB under the November arrangement. After lengthy negotiations, this issue was resolved after a formal demand was sent to the ITC on June 13, 1985. Consequently, on July 22, 1985, the ITC forwarded the agreed elements of the database in the specified format. On October 3, 1985, the decision was made to delay submission of this first report beyond the statutory date. This action resulted primarily from the time lapse between receipt of the data from industry and its release by the ITC. Most of the analysis and writing for this report was accomplished in August-November, 1985. During December, the draft of this first report was reviewed and approved by senior Administration officials. The Coordinating Committee will be meeting soon to develop an approach to the next annual report which is due in October 1986. C. Definitions Since the offset phenomenon is a relatively new subject, there has been little research or literature and no agreed definitions on the topic. This difficulty was clearly outlined by Stephanie G. Neuman of Columbia University in an essay sponsored by ACDA which appeared in 1985 edition of World Military Expenditures and Arms Transfers. - "Essentially, offsets in arms trade are arrangements which use some method of reducing the amount of currency needed to buy a military item or some means of creating revenue to help pay for it. ...Offsets often involve a reverse trade flow, under which the buyer's cost for a military purchase is at least partially compensated by the seller's acceptance of the buyer's products in return. The literature on such trade arrangements uses 'offset,' 'barter,' 'buy-back,' 'counterpurchase,' 'countertrade,' and 'compensation,' among other terms, often interchangeably, to the confusion and consternation of those who wish to understand the process." In consultation with industry, the following definitions were developed for this report: o Offsets -- A range of industrial and commercial compensation practices required as a condition of purchase of military related exports, i.e., either Foreign Military Sales (FMS) or commercial sales of defense articles and defense services, as defined by the Arms Export Control Act (AECA) and the International Traffic in Arms Regulations (ITAR). The various types of offsets are defined as follows: Sanitized Copy Approved for Release 2009/12/23: CIA-RDP87M00539R002303720001-1 Sanitized Copy Approved for Release 2009/12/23: CIA-RDP87M00539R002303720001-1 DRAFT Coproduction -- Overseas production based upon government-to-government agreement that permits a foreign government or producers to acquire the technical information to manufacture all or part of a U.S.-origin defense article. It includes government-to-government licensed production. It excludes licensed production based upon direct commercial arrangements by U.S. manufacturers. Licensed production -- Overseas production of a U.S.-origin defense article based upon transfer of technical information under direct commercial arrangements between a U.S. manufacturer and a foreign government or producer. Subcontractor production -- Overseas production of a part or component of a U.S.-origin defense article. The subcontract does not necessarily involve license of technical information and is usually a direct commercial arrangement between the U.S. manufacturer and a foreign producer. Overseas investment -- Investment arising from the offset agreement, taking the form of capital invested to establish or expand a subsidiary or joint venture in the foreign country. Technology transfer -- Transfer of technology that occurs as a result of an offset agreement and that may take the form of: research and development conducted abroad; technical assistance provided to the subsidiary or joint venture of overseas investment; or other activities under direct commercial arrangement between the U.S. manufacturer and a foreign entity. Countertrade -- In addition to the types of offsets defined above, various types of commercial countertrade arrangements may be required. A contract may include one or more of the following mechanisms: -- Barter -- A one-time transaction only, bound under a single contract that specifies the exchange of selected goods or services for another of equivalent value. -- Counter-purchase -- An agreement by the initial exporter to buy (or to find buyer for) a specific value of goods (often stated as a percentage of the value of the original export) from the original importer during a specified time period. -- Compensation (or buy-back) -- An agreement by the original exporter to accept as full or partial repayment products derived from the original exported product. Sanitized Copy Approved for Release 2009/12/23: CIA-RDP87M00539R002303720001-1 Sanitized Copy Approved for Release 2009/12/23: CIA-RDP87M00539R002303720001-1 6, Countertrade may also arise, indirectly, through other mechanisms such as blocked currency, which is a foreign government action that prohibits hard currency payments to foreign companies. Offsets in defense-related exports are frequently divided into direct and indirect classes. o Direct offsets -- Contractual arrangements that involve goods and services addressed in the sales agreement for military exports. Included among direct offsets are coproduction, licensed production, subcontractor production, overseas investment, and technology transfer. o Indirect offsets -- Contractual arrangements that involve goods and services unrelated to the exports referenced in the sales agreement. Some forms of foreign investment, technology transfer, and countertrade are included among indirect offsets. D. A Short History - Although the concepts which underlie offset agreements are as old as barter itself, actual production of U.S. weapon systems in foreign countries began in Europe and Japan in the 1950's. Coproduction of U.S. equipment began with-the- T-33 aircraft in Japan in the 1950's and the F-86 aircraft later in that decade. In the years that followed, an increasing number of significant coproduction programs were undertaken within the North Atlantic Treaty Organization (NATO) as well as with Japan, Korea, and Taiwan. The largest program, the purchase of the F-16 by Norway, Denmark, Belgium, and the Netherlands for $2.8 billion (in 1975 dollars), involved these countries in the production of 10 percent of the value of the initial U.S. Air Force purchase of 650 aircraft, 15 percent of the value of all third country F-16 purchases from the United States, and 40 percent of the value of their own purchases from the U.S. Buyers were guaranteed that these offsets would total a minimum offset level of 58 percent of their initial purchase, and the U.S. Government was committed to seek a 100 percent offset by using third country sales of aircraft and other offset work of comparable technology. These sales benefitted both the United States and the purchasing nations through increased exports of U.S. systems, enhanced standardization, second-source establishment, modernization of allied forces, and strengthened U.S. ties to the buyer countries. The net effects of offsets were less clear; to the extent that they helped promote the sale of U.S. systems in competition with foreign weapons, they may have had a positive impact. But early offset arrangements uncovered some drawbacks, such as the difficulty purchasing nations faced in establishing and maintaining efficient production lines for coproduction contracts. Weapon systems were often tailored to U.S. operational requirements and perhaps biased toward the use of domestic technology. Sanitized Copy Approved for Release 2009/12/23: CIA-RDP87M00539R002303720001-1 Sanitized Copy Approved for Release 2009/12/23: CIA-RDP87M00539R002303720001-1 Such drawbacks led the European nations to require other types of offsets from the United States in addition to the coproduction of systems as compensation for the economic problems associated with weapon procurement. Research and development investment, technology transfer, foreign subcontracting, and indirect offsets were alternative methods of obtaining these additional offsets. More recently, codevelopment projects have allowed European nations and the United States to define system requirements jointly and perform system engineering while arranging for production in both the U.S. and Europe. In 1975, the U.S. and Swiss governments signed a Memorandum of Understanding (MOU) guaranteeing 30 percent combined government and industry offsets on Switzerland's purchase of 72 F-5 aircraft for $400 million. Due to a Swiss decision to limit participation in large-scale coproduction of the F-5, additional offsets beyond coproduction were demanded. Strong pressure to fulfill the goals of this program by the Swiss and difficulties experienced by the U.S. Government in administering the project led to the most important U.S. policy decision on offsets in defense-related exports. The Department of Defense (DOD) decided not to obligate the U.S. Government to satisfy offset commitments or those for compensatory coproduction following the Swiss F-5 deal. Since 1978, the responsibility for negotiating and satisfying offset commitments has rested solely on the commercial firms making the sales. Mil.i.tary.sal..es ` agreements negotiated in the last ten years have typically served U.S. security interests. However, the number of offset obligations agreed to during this period has become a cause of concern. Recently, the form of weapon procurement agreements has changed as programs involving varying degrees of European participation with the U.S. in weapon systems development have been started and ..the use of licensed production and codevelopment has increased. In 1982, the AIA and the EIA, at the suggestion of the Treasury Department staff, conducted a survey of their members' experiences in dealing with offset requirements. The results, published in May 1983, showed that for the period 1975 to June 30, 1981, 143 contracts involving offset commitments were reported. The total value of the contracts was $15.2 billion, and the total value of associated offset commitments was $9.55 billion. The greatest percentage of both totals represented sales of military aircraft. The largest recipient was Canada. The average period for implementation of offset commitments was seven and one-half years. That survey, which was similar in purpose to the present report, was useful in suggesting a rough magnitude for offset commitments, the sectors and countries in which offsets were most frequently required, the relative frequency of use of the various forms of offsets, the role of the U.S. Government in offset transactions, and some industry views. It was, however, a small sample survey to which response was entirely voluntary. It did not request dates on which offset commitments were made, which might have permitted some conclusions about trends. Nor did it include questions dealing with the effects of offsets on Sanitized Copy Approved for Release 2009/12/23: CIA-RDP87M00539R002303720001-1 Sanitized Copy Approved for Release 2009/12/23: CIA-RDP87M00539R002303720001-1 employment, subcontractors, or technology flows, since it. was felt such issues would be too difficult to address in a voluntary survey and would have discouraged response. Three other Government reports played a major role in raising the degree of consciousness about the subject of offsets in defense-related exports. These are an Analysis of Recent Trends in U.S. Countertrade (Report on Investigation No. 3397-125), published in march 1982 by the ITC; t e Report of the Department ofvDeferise Task Group on International Coproduction/Industrial Participation Agreements, published in August 1983; and Report NSIAD-84-102 of April 13, 1984, entitled Trade Offsets in Foreign Military Sales. On October 25, 1985, the ITC released Assessment of the Effects of Barter and Countertrade Transactions on U.S. Industries (Report on Investigation No. 332-185) which was prepared in part from responses to the same questionnaire sent to industry in connection with this report. The ITC report, which covers a broader range of activities and uses a different set of definitions from this analysis, was produced in response to the ITC's own motion of June 11, 1984. There are some minor differences in interpretation of the defense-related offset data between the ITC paper and this report which are discussed in Part III. E. United States Policy The most important statement of U.S. policy on offsets in defense-related exports is a memorandum from then Deputy Secretary of Defense Charles Duncan on May 4, 1978. This memorandum noted the increased frequency of offset arrangements, designated management responsibility for evaluating and monitoring such agreements within the Department of Defense, and established the following basic "...policy with respect to compensatory coproduction and offset agreements with other nations....": "Because of the inherent difficulties in negotiating and implementing compensatory coproduction and offset agreements and the economic inefficiencies they often entail,-DOD shall not normally enter into such agreements. An exception will be made only when there is no feasible alternative to ensure the successful completion of transactions considered to be of significant importance to United States national security interests (e.g., rationalization of mutual defense arrangements)." The same document specifies that when compensatory agreements are necessary, they should: o be as broad as possible to obtain maximum credit for U.S. purchases of defense goods and services. o avoid offset targets whether stated in percentage or money terms. Sanitized Copy Approved for Release 2009/12/23: CIA-RDP87M00539R002303720001-1 Sanitized Copy Approved for Release 2009/12/23: CIA-RDP87M00539R002303720001-1 o be used to reduce administrative barriers to defense trade by all parties. o encourage equal competition between U.S. and foreign firms concerning bidding on contracts. o specify that the burden of fulfilling any commitment rests with the U.S. firms directly benefiting from the sale. Section 42(b) of the AECA prescribes that appropriated funds may not be -used to finance coproductioh or licensed production of any defense article of U.S. origin outside the United States unless the Secretary of State notifies the Congress in advance of the effects of the proposed transaction on employment and production within the United States. The Defense Security Assistance Agency (DSAA) has established additional guidelines concerning the use of appropriated funds in connection with offset agreements. A significant portion of any item which is sold through a Foreign Military Sales (FMS) credit (loan or grant) program must be of U.S. origin unless otherwise approved by DSAA on the basis of carefully prescribed circumstances. The most recent iteration of the Guidelines for FMS Loan Financing of Direct Commercial Contracts, issued on October 9, 1985, contains the following with respect to offsets: "Loan financing is discouraged for purchases containing offset provisions as a condition for securing the purchase. Offset provisions are agreements by the seller to make investments or procurements in a country other than the U.S., either concurrent with or subsequent to the purchase for which financing is being requested. No FMS loan funds will be authorized or disbursed to pay for mandatory direct offsets. Mandatory direct offsets are procurements of a foreign-made component required by the foreign government as a condition of sale, for incorporation or installation in a U.S.-produced end item being sold. While FMS loan funds will not be authorized for foreign-produced content resulting from mandatory direct offsets, such funding can be authorized for the U.S. content." There are two classes of exceptions to the policies on offsets outlined above. The first concerns offset agreements already in force at the time the 1978 Duncan Memorandum was promulgated. U.S. Government guarantees were sometimes involved in these agreements, and those guarantees continued to be honored after Government policy changed. The most notable programs in this category were the Swiss purchase of the F-5, the F-16 coproduction program with our NATO allies, and the Australian program which involved the purchase of ships and other defense equipment. Of these, the Australian program has been the largest and the most complex. Under a commitment made in 1972, DOD recognized an obligation to provide up to 25 percent offsets through the Australian Industrial Participation for all Australian defense purchases from the United States. Sanitized Copy Approved for Release 2009/12/23: CIA-RDP87M00539R002303720001-1 Sanitized Copy Approved for Release 2009/12/23: CIA-RDP87M00539R002303720001-1 DRAFT 10 The second class of exceptions involves an outright waiver of the rules, and this has happened in only one case. The FMS credit guidelines pertinent to Israel, a separate document effective August 8, 1985, includes the following paragraph. "There is an exception for Israel to direct offsets related to its commercial purchases. Direct offsets are procurements of an Israeli-made component required by the GOI as a condition of sale for incorporation or installation in a U.S.-produced item being sold. In all instances the item must be over 51 percent U.S. content, with final assembly in the United States. FMS credit funds normally cannot be used under subcontracts for operations and maintenance services, overhaul, translation services, warranties, training, storage, testing, and other services of this nature." For the last several years, Israel has sought to require offsets in commercial contracts with American companies supplying goods and services that are financed by FMS credit appropriations. Prior to 1984, this Israeli policy was largely ignored by the United States Government as the dollar value was of minimal significance. As dollar value rose and U.S. Government cognizance of the problem increased, the need for a policy was recognized. Consequently, for fiscal year 1984, Israel was allowed to take "directed - offsets" on up to 15 percent of the total value of Israeli purchases of items on a commercial basis. This decision gave the Israelis over $225 million worth of offset business. For 1985, Israel was allowed to take a lesser amount in offsets, this time expressed as a specific dollar ceiling of $200 million rather than a percentage of purchases. The Administration plans to reduce this program again for fiscal year 1986 and a further reduction for fiscal year 1987, after which it will be terminated. In the unique Israeli program, the term "directed offsets" means those activities that are termed Subcontractor Production in this report except for those items which are of Israeli origin, and are financed by grants from the FMS credit appropriation. Excluded from these limitations are offset requirements negotiated between Israel and U.S. corporations that are not financed by the U.S. Government. On July 29, 1983, the USTR-chaired Trade Policy Staff Committee (TPSC) established a formal set of policy guidelines on Countertrade and Barter which, like offsets, condition the completion of an import transaction on a separate purchase or exchange of goods from the importing country. While explicitly not applicable to military sales offsets, these guidelines are applicable to civilian countertrade related to government-mandated defense-related offsets which are not directly contributing to U.S. national security goals. Sanitized Copy Approved for Release 2009/12/23: CIA-RDP87M00539R002303720001-1 Sanitized Copy Approved for Release 2009/12/23: CIA-RDP87M00539R002303720001-1 DRAFT 11 "U.S. Government policy toward the private sector i. The U.S. Government generally views countertrade, including barter, as contrary to an open, free trading system and, in the long run, not in the interest of the U.S. business community. However, as a matter of policy, the U.S. Government will not oppose U.S. companies' participation in countertrade arrangements unless such action could have a negative impact on national security. ii. Since U.S. businesses must compete in an environment in which they are voluntarily or involuntarily confronted with countertrade, U.S. Government agencies may provide advisory and market intelligence services. However, U.S. Government officials should not promote the use of countertrade, including barter, and they should advise U.S. businesses that countertraded goods are subject to U.S. trade laws including quotas. This information should be provided to U.S. businesses by our embassies overseas, by Department of Commerce district offices, and by U.S. Government officials in Washington. iii. When dealing with foreign government officials and foreign businessmen, U.S. Government officials will draw upon the guidance set in this section with regard to barter and countertrade, especially when these practices are mandated by governments. iv. The U.S. Government will advise U.S. companies that countertraded goods imported into and sold in the United States are subject to U.S. trade laws. These statutes include Sections 201 and 406 of the Trade Act of 1974, providing import relief from injurious or disruptive imports as well as the antidumping and countervailing duty statutes. V, The U.S. Government will continue to review financing for projects containing countertrade/barter on a case-by-case basis, taking account of the distortions caused by these practices. U.S. Government policy towards foreign governments i. The U.S. Government should continue to oppose Government-mandated countertrade. ii. The TPSC subcommittee on antidumping and countervail should examine U.S. trade laws to ensure that they adequately cover countertraded goods. Most of these goods are disposed of in third country markets at present, but trade patterns may change in the future resulting in an influx of countertraded goods into the U.S. iii. The U.S. Government should exercise caution in the use of its barter authority, reserving it for those situations which offer advantages not offered by conventional market operations. Sanitized Copy Approved for Release 2009/12/23: CIA-RDP87M00539R002303720001-1 Sanitized Copy Approved for Release 2009/12/23: CIA-RDP87M00539R002303720001-1 DRAFT 12 iv. In the context of the trade debt link, the U.S. Government should explore what measures the IMF might take to discourage countertrade, and the U.S. Government should lend its support to these efforts. v. The U.S. representative to GATT should consider raising the question of countertrade imposed by governments in the CG-18 and pursue the possibility of a working group on this subject in the GATT." There is another special situation where the U.S. Government has established a policy concerning offsets in defense-related export trade. On June 14, 1985, the Administration proposed legislation establishing a new type of international procurement arrangement called a NATO Cooperative Project. This bill included a change to the AECA prohibiting offset demands on contracts pursuant to this new procurement scheme unless specified in the government-to-government agreement that establishes the cooperative project. The provision became law on August 8, 1985, and become effective on October 1, 1985. Section 27(c)(3), AECA, now contains this limitation: "Such agreements shall provide that no requirements for work sharing or other industrial or commercial compensation in connection with such agreement shall be imposed by a participant that is not in accordance with such agreement." Although the number of potential offsets that will be prohibited by this section is estimated to be very small, the fact that the potential problem was recognized and that there was a concrete Government response is evidence of .increased sensitivity to the offset issue.. F. Foreign Policy Context Some U.S. foreign policy goals are traditionally pursued through arms transfer policy. Offsets can affect the nature of the arms transfer tool. Foreign policy objectives which are traditionally pursued with arms transfers include: o Deter aggression by enhancing the preparedness of allies and friends -- Offsets are intended to enhance the preparedness of allies by supporting rationalization, standardization, and interoperability (RSI) but do not alter significantly the extent to which this foreign policy goal is advanced through arms transfers. Increased preparedness will take place regardless of extraneous industrial or financial conditions in the transaction if countries continue to invest in defense preparedness. However, in a broader sense, inefficient offsets can have the effect of reducing the total resources available for enhancing preparedness. o Increase the ability of the U.S. to project power -- Power projection capabilities are enhanced through arms transfers when such transfers are agreed to in whole or in part as consideration for the granting of basing Sanitized Copy Approved for Release 2009/12/23: CIA-RDP87M00539R002303720001-1 Sanitized Copy Approved for Release 2009/12/23: CIA-RDP87M00539R002303720001-1 DRAFT 13 or access rights for U.S. forces on foreign soil. Offset arrangements are not primary factors with regard to this objective. On a secondary level, however, to the extent that acceptance of offsets is a condition without which the transfer cannot take place, (and without which advantages external to the sale itself, such a base or access rights would not be granted), offsets can have a bearing on U.S. power projection capabilities. o Support interoperability with the forces of friends and allies -- The primary effect of offsets is negligible. To the extent that acceptance of offsets is a condition of sale, and that in the absence of a U.S. sale the customer would acquire equipment from another supplier which would not be interoperable with U.S. equipment, offsets can have a positive effect. .o Enhance U.S. defense production capacity and efficiency -- To the extent that offsets involve the transfer of production to foreign customers that would otherwise have taken place in the U.S., American production capacity and efficiency probably are reduced. If the sale would not have occurred without the inclusion of offset arrangements, then offsets support this objective in that they allow some U.S. defense production/export to take place. o Strengthen collective security arrangements -- Offsets can enhance collective security arrangements by making purchasing governments better able to defend such arrangements on grounds other than security alone. Our NATO partner's concern about the essentially one-way flow of defense trade has given rise to the concept of the two-way street. To the extent that offsets lead to increased defense production in other NATO countries, they have the same effect as U.S. purchases of foreign manufactured defense goods. However, many offsets are taking the form of trade or investment in non-defense goods, making the contribution of offsets to the improvement of the defense trade balance problematic. In any case, foreign government leaders are better able to assert that the Alliance is truly mutually beneficial. Offsets can alter the nature of arms transfers. Offsets can introduce rigidities and increased costs into the procurement process because they may prevent the supplier from obtaining needed commodities from the most cost-effective sources. They can cause a diversion of resources which may enhance military capability at the expense of efficient resource use. Viewed in political terms, offsets can be seen as a response to the concerns of allies over the arms trade imbalance. Information on current foreign government policies pertaining to offsets in. defense-related exports was gathered by a Department of Commerce survey of 26 U.S. Foreign Commercial Service Posts during the first four months of 1985. The responses suggest several trends in foreign government policies: Sanitized Copy Approved for Release 2009/12/23: CIA-RDP87M00539R002303720001-1 Sanitized Copy Approved for Release 2009/12/23: CIA-RDP87M00539R002303720001-1 .. 1 14 o Military offsets have increasingly become a central factor in awarding military contracts by foreign governments. o The range and magnitude of offsets. demanded by foreign governments has increased significantly in the last five years. o The nature of military offsets demanded has increasingly tended toward arrangements which include targeted technology transfer (direct and indirect) and production/management know-how. o Offset requirements also take the form of technical assistance to non-military industries selected for growth and development. o Foreign governments have begun to codify official policies and procedures concerning offsets in military trade. G. Economic Setting World macroeconomic conditions make it difficult to isolate and measure the precise impacts of offsets on U.S. trade, employment, competitiveness, and defense preparedness. "Global Competition," The Report of the President's Commission on Industrial Com etitiveness,-lanuary-..1 , found -tat urtng the last eca e, the U.S. has become increasingly dependent on its competitiveness in international markets, for its continued economic growth and high standard of living. Approximately 20 percent of this nation's current industrial production is shipped to foreign markets, and almost 70 percent of goods the U.S. produces at home compete with foreign merchandise. U.S. imports and exports have more than doubled over the last ten years, and now U.S. international trade accounts for nearly 14 percent of GNP. While becoming more dependent on foreign trade, the U.S. has also experienced a gradual but steady erosion in its ability to compete successfully in international and domestic markets. For example, the U.S. trade deficit has increased during the past 10 years. In 1984, U.S. merchandise imports exceeded $340 billion, while exports were more than $220 billion. Chart I.G.1 illustrates the significant downturn in the U.S. trade balance. Despite an increase in the size of the world market, the U.S. share of world manufacturing exports has also declined both in terms of volume and value. Chart I.G.2 highlights this decline over the period 1962-1982. Sanitized Copy Approved for Release 2009/12/23: CIA-RDP87M00539R002303720001-1 Sanitized Copy Approved for Release 2009/12/23: CIA-RDP87M00539R002303720001-1 CHART I.G.1 U.S. Merchandise Trade Balance, 1967-84 (billions of U.S. dollars) 1!i! it 72 74 i6 is io Li 44 Source: U.S. Department of Commerce, International Trade Administration. Sanitized Copy Approved for Release 2009/12/23: CIA-RDP87M00539R002303720001-1 Sanitized Copy Approved for Release 2009/12/23: CIA-RDP87M00539R002303720001-1 16' CHART I.G.2 Export Share, U.S. Share of World Manufacturing Exports SOURCE: Report of the President's Commission on U.S. Industrial Competitiveness, 1984. Sanitized Copy Approved for Release 2009/12/23: CIA-RDP87M00539R002303720001-1 Sanitized Copy Approved for Release 2009/12/23: CIA-RDP87M00539R002303720001-1 DRAFT In terms of value, the U.S. share has remained approximately 12 percent of the market in the period 1976-1984. Similarly, the U.S. volume share of exports has declined from 15 percent to 12 percent of the world market. TABLE I.G.1 Free World Export Trade, 1975-1984 (in billions of estimated current dollars Total Year Free $ 166.8 279.9 791.2 900.8 1,023.5 1,175.4 1,492.8 1,829.4 1,804.1 _ 1,655. 2 1,619.4 1,715.7 $ 27.5 43.2 107.7 115.2 121.2 143.7 181.9 220.6 233.6 212.2 200.5 217.9 SOURCE: Department of Commerce, International Trade Indicators, and Economic Report of the President, 1984. Using the country groupings contained in the World Development Report 1985, published by the International Bank for Reconstruction and Development World Bank), the database developed for this report indicates the percentage of the value of sales going to developed countries during the 1980-1984 period to be 67 percent, while 77 percent of the value of offsets obligations were with these countries. Offsets have been increasingly used by these countries to serve economic and political purposes. The size of defense-related offsets relative to the U.S. economy and relative to various sectors of the economy must be taken into consideration in any analysis of offsets. In this regard, the importance of defense-related offsets depends upon the frame of reference. The average annual value of defense-related offset obligations between 1980 and 1984 ($2.4 billion) is trivial relative to U.S. GNP ($3,125 billion), total U.S. exports ($217 billion), or exports of manufactured goods ($143 billion). U.S. Share United States (in percent) Sanitized Copy Approved for Release 2009/12/23: CIA-RDP87M00539R002303720001-1 Sanitized Copy Approved for Release 2009/12/23: CIA-RDP87M00539R002303720001-1 The importance of offsets to some high-technology sectors of the economy is more significant. The value of high-technology offset obligations under two definitions of high-technology industries is presented in Table I.G.4 together with exports and production in the corresponding categories. The narrow definition used below is the Department of Commerce "DOC 1" definition which includes drugs and medicine, computers and office machines, electrical equipment, aerospace products, and scientific, engineering, and medical instruments. In the narrow measure shown on Table I.G.4, offset obligations are the amounts implemented or fulfilled during 1980-1984. The broader definition (the Department of Commerce "Technology Intensive" definition) includes all of the products in the narrow category plus all other transportation equipment, machinery, and chemical products. TABLE I.G.2 Average Annual Value of Defense-Related Offsets Relative to High-Technology Exports and Production ($ in billions) Narrow Measure Broad Measure Average Offset.-Obligations ...-....... 0.48 1.33 Average U.S. Exports ................ 56.81 117.20 U.S. Production ..................... 330.21 730.25 Offsets/Exports ..................... 0.8% 1.1% Offsets/Production .................. 0.1% 0.2% The industries in which offsets loom largest relative to U.S. production or U.S. exports are aircraft industries and engines and turbines. Even in these industries, offsets are still fairly small. Offset obligations are less than two percent of shipments and less than eight percent of exports in both industries. TABLE I.G.3 Average Annual Value of Defense-Related Offsets Relative to Exports and Production of Engines and Turbines and Aerospace Industries ($ in millions) Total Aircraft Engines and Turbines Average Offset Obligations ...... 790 268 Average U.S. Exports ............ 15,675 3,582 U.S. Production (1982) 61,877 13,997 Offsets/Exports ................. 5.0% 7.5% Offsets/Production .............. 1.3% 1.9% Sanitized Copy Approved for Release 2009/12/23: CIA-RDP87M00539R002303720001-1 Sanitized Copy Approved for Release 2009/12/23: CIA-RDP87M00539R002303720001-1 DRAFT Defense-related offsets are much larger relative to trade in defense goods and services. The average annual value of defense-related offset obligations ($2.4 billion) is 19.4% of annual defense-related deliveries ($12.4 billion) in the 1980-84 period. Offsets incorporate inefficiencies associated with the absence of a medium of exchange, such as increased transaction costs, and the time required for liquidation. These inefficiencies explain why those involved in an exchange of goods usually prefer cash, as opposed to taking back goods or to giving away part of the production such as in coproduction., Therefore, central to any discussion of offsets in defense-related exports is an understanding of the market and the motivations of U.S. corporate sellers and foreign government and international organization buyers for entering into an offset agreement. H. The Market As might be expected, one effect of offset programs has been to expand foreign defense industrial bases which, in turn, has increased the number of arms exporters. Two kinds of exporters are apparent: "industrial base" nations which manufacture weapons for export and the "subterranean market" countries which sell used arms to other countries. Arms producers fear that the expanded number of exporters will further increase competition in the arms market via larger and more complex offset arrangements. Moreover, offsets mandated by foreign governments have the potential of diverting business away from U.S. subcontractors and of establishing new foreign competitors over the long run. The international arms market most closely resembles an oligopsony, in the sense .that the market is characterized by a relatively small number of purchasers. The market also exhibits some characteristics of oligopoly, is also characterized by a relatively small number of sellersnthat alsoemayat it exert a disproportionate influence on the workings of the market. The buyer in an international arms market is almost invariably a government. The seller is either a government, or a government-regulated private sector entity. Transactions are further complicated by the fact that some purchasing governments also function as sellers within the same market. Consequently, the workings of the international arms trade market are governed more by the objectives and policies of purchasing.and selling governments than by traditionally defined market influences. This unique situation highlights the difficulties associated with trying to analyze international arms trade from a traditional "market economics" orientation. For this reason, the international arms market may be more accurately characterized as an arena of managed trade, than as a true market in which economic influences are the primary determinants of the terms a seller must offer to remain competitive.. Sanitized Copy Approved for Release 2009/12/23: CIA-RDP87M00539R002303720001-1 Sanitized Copy Approved for Release 2009/12/23: CIA-RDP87M00539R002303720001-1 The objectives of a government making an arms purchase are far more complex than the basic objective of procuring arms at a cost-effective price. Considerations of the political acceptability of arms purchases from a foreign source, the maintenance and development of domestic defense and commercial industries, and preserving foreign exchange, are often overriding, if exogenous, considerations in the development of weapons procurement policies of purchasing governments. In like fashion, the export arms sale policy of the U.S. Government is influenced by foreign policy/national security considerations which often override economic efficiency. Some forms of offsets (e.g., coproduction) have become a basic component of achieving defense sales and of furthering national policy goals for both foreign and U.S. governments. This fact has several connotations for the U.S. firms which engage in arms sales to foreign governments which require offsets. The selling corporation may be faced with both discretionary and non-discretionary choices in completing a defense sale: it can elect not to offer offsets, which may result in the loss of the sale; it can elect to offer offsets and proceed with the bargaining, in hopes of reaching an agreement which will both meet the requirements of the purchasing government, and serve its own interests; or, it may be obligated to provide offsets as an integral part of a foreign policy/national security objective. Sanitized Copy Approved for Release 2009/12/23: CIA-RDP87M00539R002303720001-1 Sanitized Copy Approved for Release 2009/12/23: CIA-RDP87M00539R002303720001-1 DRAFT II. ASSESSMENTS OF THE IMPACT OF OFFSETS Part II consists of assessments of the effects of offsets in defense-related exports on the defense preparedness, industrial competitiveness, employment, and international trade position of the United States. These sections are based in part on data collected from U.S. corporations concerning offset obligations incurred during the period 1980 through 1984, a summary of which appears in Part III of this report. The greatest barrier to analysis of defense-related offsets is the difficulty in determining the alternatives to offsets. Unless we have some idea of how affected industries would differ in the absence of offsets, it is difficult to answer any question along the lines of "How much higher (or lower) would aerospace exports (or employment, profits, etc.) be without offsets?" The effect of defense-related offsets depends in part upon the extent to which the offset requirements are binding. In some cases, the offset agreements might be non-binding; they require U.S. companies to do nothing more than the U.S. would do in the absence of an offset agreement. An example of this might be an indirect offset agreement which requires that the U.S. import goods from the country purchasing the defense systems that it would import from the purchasing country or some other-country-even-'without-the-offset agreement.- Offset -'' agreements simply reallocate U.S. imports among source countries in this case. Offset agreements may also be nonbinding or only partially binding if the enforcement mechanism for the offset agreement is "best efforts." In.this case, the U.S. company is under a moral obligation to try to fulfill the offset .agreement, but is not subject to any contractual penalties should it fail to fulfill the agreement. In other cases, offset agreements might be completely binding; none of the goods and services purchased in the offset agreement would have been purchased in the absence of the offset agreement. Countries demand defense-related offsets for a variety of reasons: perceived employment gains, changes in the industrial structure, national security, national prestige, domestic political, etc. In any case, countries are willing to spend more on foreign-designed defense goods in exchange for defense offsets. Conversely, if offsets were not possible, the importing countries would be willing to spend less on foreign-designed defense goods. This would unambiguously lower sales of U.S.-designed defense goods in cases where countries demand indirect offsets. The effect would be ambiguous in cases where countries demand direct defense offsets because total spending on defense goods would fall while the fraction of value accounted for by U.S. producers would rise. The market share of U.S.-designed defense products falls if offsets by U.S. firms are not possible. Sanitized Copy Approved for Release 2009/12/23: CIA-RDP87M00539R002303720001-1 Sanitized Copy Approved for Release 2009/12/23: CIA-RDP87M00539R002303720001-1 22' The preceding discussion assumes that countries either obtain defense-related offset agreements from the U.S. or they reduce their foreign defense purchases. This neglects the alternatives of producing the defense-related goods domestically or purchasing the defense-related offset commodities from third country suppliers willing to enter into offset agreements. Both of these possibilities would lower the absolute level of U.S. defense exports, U.S. global market share in defense goods, and the global market share of U.S.-designed products. A. Defense Preparedness (Department of Defense) Some forms of offsets contribute to obtaining rationalization, standardization, and interoperability of American forces with those of its allies. Cooperative weapon production programs assist major alliance partners in creating a defense base that enables them to share in the defense of the alliance in which all are members. Most offsets occur in the NATO nations, and the impact of offsets toward achieving U.S. national objectives is felt to the largest extent within NATO. The United States has followed a policy of maintaining the capability to produce any weapon system it purchases overseas. Although the offset policy of America's allies has generally been less demanding than this, the two-way flow of trade stemming, in-part, , from offsets has-hel ped to-'build' an industrial "base in foreign nations which is often capable of sustaining the projection of U.S. power. These benefits must be balanced against any potential adverse economic -consequences of offset deals and against potential domestic industrial base erosion arising from offsets. In the defense arena, one possible negative effect is a loss of subcontractor work resulting from the granting of offsets for overseas production. However, this potential loss must be weighed against the benefits of being able to sell the weapon in the first place (which might not have been possible without offsets) and against the alliance and other foreign policy objectives which offsets fulfill. Because of the Duncan Memorandum, the U.S. Government does not normally enter directly into offset agreements, and consequently there is little immediate effect of offsets on Government procurement. However, the general effect of offsets occurs in two areas. First, in the short run, weapon sales which are made possible because of participation in offset agreements tend to increase the length of production runs and, therefore, to lower unit costs. In this regard, a 1983 report entitled, Offset/Coproduction Requirements in Aerospace and Electronics Trade: Report of a Survey of Industry, the Department of .t e Treasury explained that three-fourths of survey respondents felt the sale would have been lost if offsets had not been offered. Moreover, nearly 90 percent of the DPA 309 database respondents felt that offsets were a necessary condition for the sale. However, it is possible that they may introduce inefficiencies which have the opposite effect. Sanitized Copy Approved for Release 2009/12/23: CIA-RDP87M00539R002303720001-1 Sanitized Copy Approved for Release 2009/12/23: CIA-RDP87M00539R002303720001-1 DRAFT Second, by creating new foreign manufacturers of arms, offsets have the long-run potential to alter procurement patterns by lowering the rate of growth and reducing the ultimate size of the United States' industrial base. a 1984 U.S. Air Force study, Blueprint fo r Tomorrow, indicated that 75 percent of all foreign-sourced items used in the aerospace sector were supplied as a result of offset requirements. It is difficult to determine the extent to which this is due to offset deals alone, as opposed to reflecting a need to procure items which were in short supply or were non-competitive in the U.S. before the offset. However, the possibility also exists that if the sale requiring an offset had not been made, U.S. productive capacity in the sector producing goods for which offset items were substituted would have shrunk anyway due, for example, to depressed demand. These items will be covered in greater detail in the sections which follow. However, it should be kept in mind that the period covered by the report was one of large fluctuations in the business cycle as well as substantial growth in the defense sector due to the military buildup initiated by the Reagan Administration. The effects of business cycle swings and the buildup were much longer than the effects of the offsets. This section will discuss the relationship of offsets to defense-industry productivity, investment, profitability, surge capacity, foreign source dependency-, and defense- contractors,--A -brief- summary-of'reverstr'techrrol-ogy ?'-- transfers which may affect offsets concludes the discussion. Relationship to Defense-related Industry Productivity Since higher output affects productivity, offsets may have an impact on the productivity of defense-related industries. This occurs because of the relationship between longer production runs and learning curves. Over 40 percent of the prime contractor respondents to the questionnaire associated with this report and five percent of the subcontractor respondents indicated that sales agreements associated with offsets had a positive impact on their capacity and utilization rates. Typical respondent statements included the following: "The sales and offset agreements have caused more efficient utilization of existing plant and equipment with increased production", and, "The existence of this contract ensures the continuing economic utilization of...production capacity." Furthermore, none of the'prime contractor respondents, and less than one percent of the subcontractor respondents said that these sales and related offsets agreements had a negative effect; however, nearly 50 percent of the prime and 89 percent of the subcontractor respondents said that these agreements had either no effect or an insignificant effect. These responses, therefore, support a conclusion that in the majority of circumstances, offsets had either positive or no impact on the productivity of defense-related industries. Sanitized Copy Approved for Release 2009/12/23: CIA-RDP87M00539R002303720001-1 Sanitized Copy Approved for Release 2009/12/23: CIA-RDP87M00539R002303720001-1 24 Relationship to Defense-related Industry Investment Table II.A.1 was constructed from data in the Defense Financial and Investment Review (DFAIR) published by the Department of Defense in June 1985. TABLE II.A.1 Capital Expenditures ($ millions, adjusted for inflation) Year Defense-Related Durable Goods 1975 365.3 13,937.4 1976 385.4 14,123.7 1977 500.2 17,042.8 1978 672.1 18,870.6 1979 827.3 19,854.5 1980 1,111.7 21,169.6 1981 1,239.9 22,162.4 1982 1,444.0 NA 1983 1,494.9 NA Average Percentage- ?Inc-rease Including data on both defense industries and durable goods industries provides a basis for comparison. Rather than using total manufacturing industries data, the category "durable goods" industries eliminated those industries not doing work comparable to that performed by defense contractors in the negotiated contract environment. The industry groups deleted were: stone, clay and glass products; primary metals industries; lumber and wood products, furniture and fixtures; and miscellaneous manufacturing industries. Because contracts with the shipbuilding industry contain different financing provisions and different pricing/profit mechanisms, they were eliminated from the category "defense-related" industries. Furthermore, data collected for services contracts was also deleted because it cannot be compared to data for durable goods manufacturers. Durable goods capital expenditures data for 1982 and 1983 were not available from the Census Bureau at the time of the DFAIR report. The data reveal that not only has capital investment increased, but it did so at a substantially faster rate in defense-related industries than in durable goods manufacturing. DFAIR also analyzed the degree to which firms are replacing their assets. It found that defense contractors are replacing older equipment at a much faster rate since 1980 than they did from 1975 through 1979. Sanitized Copy Approved for Release 2009/12/23: CIA-RDP87M00539R002303720001-1 Sanitized Copy Approved for Release 2009/12/23: CIA-RDP87M00539R002303720001-1 25 With regard to practical non-wartime plant and equipment capacity and utilization rates, responses to the industry questionnaire generally indicate that offset agreements had very little impact. Generally speaking, responses to the questionnaire sent to industry in connection with this report indicate that offset agreements had very little impact on their practical (non-wartime) plant and equipment capacity and utilization rates. Almost half of the prime contractor respondents and nearly 90 percent of the subcontractor respondents indicated that offsets either had no impact or only an insignificant impact. One of the prime contractor respondents and less than one percent of the subcontractor respondents said that offsets had a negative impact. Therefore, .insofar as capacity and utilization rates affect investment decisions, offsets appear to have had very-little impact. Once again, over 40 percent of the prime contractor respondents, but only five percent of the subcontractor respondents, indicated that the sales agreements associated with the offsets had a positive impact on their capacity and utilization rates. Typical respondent statements included: "This sale agreement... avoided the elimination of...production capability" and "the existence of this contract ensures the continuing economic utilization of...production capacity". Only about five percent of the prime contractor respondents and less than three percent of subcontractor respondents said that the sales agreement actually caused them to increase their investment in plant and equipment. Against a backdrop of generally increasing rates of growth in defense-related industry capital investment shown in the DFAIR analysis, the DPA 309 database supports a conclusion that sales agreements and their resulting offsets are a -relatively insignificant factor in the investment decisions of defense-related industries. However, profitability (to be discussed in the next section) is another important determinant of investment. If the inferences on profitability drawn from the DFAIR study are valid, then offsets, if necessary to make the sale, may have had a beneficial effect on defense-related industry profitability; and if this is indeed the case, then offsets may have had an indirect, but positive, impact on the investment decisions of these same industries. However, available data do not enable us to rigorously test the degree of these relationships. Relationship to Defense-related Industry Profitability Chart II.A.1 was constructed from DFAIR data and compares profit/sales of defense-related industries to that of comparable durable goods manufacturers. For the 10-year period 1970-1979, the average returns-on-sales were fairly close. For the recessionary period 1980-1983, however, durable goods manufacturers experienced substantial losses, while defense-related industry profitability declined only slightly. Sanitized Copy Approved for Release 2009/12/23: CIA-RDP87M00539R002303720001-1 Sanitized Copy Approved for Release 2009/12/23: CIA-RDP87M00539R002303720001-1 CHART II.A.1 PROFIT/SALES 78 DEFENSE-RELATED E R 2 C E ---tt. T 1 70 71 -3 72 73 74 75 81 DRAFT 26 82 83 % I DURABLE GOODS ~v SOURCE: Defense Financial and Investment Review, June 1985, p. V-41. 76 77 Sanitized Copy Approved for Release 2009/12/23: CIA-RDP87M00539R002303720001-1 Sanitized Copy Approved for Release 2009/12/23: CIA-RDP87M00539R002303720001-1 27, Chart II.A.2 compares profit/assets for both groups. The 10-year average returns are very similar; but again, during all recessionary periods but especially for the 1980-1983 period, durable goods manufacturers experienced significant losses while defense-related industries' return-on-assets declined only moderately. Both figures, therefore, show that profitability of defense-related businesses were somewhat similar to that of durable goods manufacturers during the 1970-1979 period, but substantially better during the 1980-1983 period. As to the question of prime versus subcontractor profits, DFAIR indicates that profits on DOD subcontracts are slightly less than on DOD prime contract work. We have no evidence that offsets change this relationship, nor is there evidence that overall profit trends exhibited in the charts were substantially different between primes and subcontractors. DFAIR concluded that defense industries were able to maintain their profitability primarily because of the increase in defense outlays and the decline in inflation. Nevertheless, DFAIR also concluded that profits from foreign military sales are even greater than they are on direct DOD sales. This supports the view that offsets, if necessary to make the sale in the first place, enhance defense industry profitability. Furthermore, as pointed out earlier, the 1983 Treasury study as well as the DPA 309 summary responses reported strong evidence that- offset-s?arerrecessary-to--successful-Ty=cl e=arariy=-= defense deals. At the very least, therefore, available DFAIR evidence suggests that the profitability, and hence the strength, of defense-related industries has not been damaged by offsets., Sanitized Copy Approved for Release 2009/12/23: CIA-RDP87M00539R002303720001-1 Sanitized Copy Approved for Release 2009/12/23: CIA-RDP87M00539R002303720001-1 CHART II.A.2 PROFIT/ASSETS 10 P E 4 R C 3 E -3 -5 -6 70 71 72 73 74 75 76 77 78 79 1 80 81 82 83 YEAR 1 I I I I DURABLE GOODS SOURCE: Defense Financial and Investment Review, June 1985, p. V-42. Sanitized Copy Approved for Release 2009/12/23: CIA-RDP87M00539R002303720001-1 Sanitized Copy Approved for Release 2009/12/23: CIA-RDP87M00539R002303720001-1 Relationship to Wartime (Surge) Capacity Approximately 50 percent of Department of Defense purchases of manufactured products and 70 percent of U.S. defense exports come from the aerospace sector. Hence, close scrutiny of aerospace industry can provide an understanding of the relationship of offsets to surge capacity. Table II.A.2 shows the rates of capacity utilization for both prime and subcontractors in aerospace industries. These capacity figures are based on a 3x8x5 shift workweek (three eight-hour shifts per day for a five-day week). This type of workweek is normally used for planning high volume production because it permits the use of the sixth day for overflow work and the seventh day for maintenance, if required. The table presents these data in three ways: average capacity used on a 3x8x5 workshift, the range of capacity used across the plants surveyed, and capacity used by number of 1x8x5 workshifts worked. As the table demonstrates, there is a great deal of excess capacity in the aerospace industry. Although this table does not show potential problems which may exist for specific products, capacity in the aerospace industry does not appear to be a problem. The DPA 309 database reveals that the military sector comprises only about one-fourth of total sales of companies reporting offset obligations, and the military export share amounts to less than four percent of the total .sales of- these companies.-- Offsets -are -a small --part ?of ~sobcontractor`- production; therefore, one would expect them to have little impact on capacity utilization. Sanitized Copy Approved for Release 2009/12/23: CIA-RDP87M00539R002303720001-1 Sanitized Copy Approved for Release 2009/12/23: CIA-RDP87M00539R002303720001-1 30 TABLE II.A.2 1983 Aerospace Capacity Utilization by Functional Area Large Aircraft Fighter/ Attack Other Aircraft Propulsion Missiles Fabrication *42% 40% 26.5% 57% 43% **10-80 (25-66) (8-50) (31-75) (20-66) ***1.5 1.0 1.6 1.3 Process/Paint 39% 45% 31.5% 64% 43% (9-80) (25-60) (8-70) (28-100) (20-66) 1.5 1.0 1.2 1.3 Assembly 41% 40% 27% 51% 43% (8-80) (33-80) (11-45) (28-65) (20-66) 1.5 1.0 1.2 1.3 Test and 40% 40% 26% 57% 70% Check out (22-80) (20-75) (11-45) (28-65) (40-100) 1.8 1.0 1.0 2.1 Avionics Materials Structures fabrication 44.50% 53% (4-90) (27-81) 1.43 1.80 Process/ 41.90% 33% 37% Paint (25-60) (11.42) (12-75) 1.22 1.30 1.70 Assembly 38.60% Total 32% (25-50) Manufacturing (14-70) 1.20 Functions 1.40 Test and 58.30% 41% Check out (40-81) (18-70) 1.91 1.50 * ** Average percent capacity on a 3x8x5 shift basis. Range of percent capacity utilized on 3x8x5 shift basis. Average number of shifts utilized on 1x8x5 basis. Sanitized Copy Approved for Release 2009/12/23: CIA-RDP87M00539R002303720001-1 Sanitized Copy Approved for Release 2009/12/23: CIA-RDP87M00539R002303720001-1 3 ]< Within the aerospace industry, offsets appear to have had a limited effect on surge capacity outside of the foreign-sourcing arena. Moreover, in the large aircraft sector, where business has been adversely affected by the drop in export sales resulting from financial problems of aircraft purchasers, the suggested corrective action made by the Air Force in the 1984 study, Blueprint for Tomorrow, was to seek innovative financing support, in both standard and non-standard transactions, to include countertrade and offset. When queried by the U.S. Air Force in late 1983, the materials sector of the aerospace group was the only sector which reported that it had been noticeably affected by offsets. This sector reported that offsets create foreign competitors for future procurement and force overseas technology flow. The following remedies for this situation were suggested by the same study: o Restrict flow of technology offshore as part of coproduction. o Improve list of restricted technologies by making it more specific. The questionnaire sent to industry in connection with this report defined wartime (surge) capacity as the ability of a firm to double production within 12 months. Two-thirds of the prime contractor respondents to the questionnaire felt that offsets had either no effect or an insignificant effect on their surge capacity. Almost 28 percent- felt 'that-offsets-?had a--tsertefltiay'-bffect"betaUse- ` they allowed sales to occur, while less than three percent felt that offsets had a detrimental effect on their surge capacity. Thus, although a number of factors have adversely affected the industrial base in the aerospace sector over the last few years, and although problems with the 'industrial base can lead to surge problems, for the aerospace sector at least, available evidence suggests that no serious capacity problems are present. Surge difficulties that do exist can be traced to a number of causes, but generally not to offsets. Relationship of Offsets to Foreign Sourcing Foreign sourced items are of concern because, depending on the source, they may affect the ability of the U.S. to sustain weapon production in time of war. According to Blueprint for Tomorrow, offsets are one reason that foreign-sourced items are used in the aerospace sector. Of these items, only eleven specific cases are sole source while the rest have some production capability located in the United States. Furthermore, foreign sourcing seems to follow the large offset contracts (Israel and the NATO countries are prominently featured) and Canada, which is part of the North American (U.S. and Canada) domestic industrial base, is a major participant. Sanitized Copy Approved for Release 2009/12/23: CIA-RDP87M00539R002303720001-1 Sanitized Copy Approved for Release 2009/12/23: CIA-RDP87M00539R002303720001-1 DRAFT However, when one considers the number of parts used in modern aircraft, the total number of foreign sourced items is very small. In addition, virtually all of this sourcing takes place in areas such as NATO or Israel where U.S. policy is to support a strong foreign industrial base. Similar foreign source data are available for Amy procurements. Again, with very few exceptions, the NATO countries are the suppliers. There is no indication of the amount of this trade which is based on offsets. Impact on Defense Contractors _ The 1983 Treasury report cited subcontractor production as comprising 24.9 percent of the total offsets reported in its survey. The DPA 309 database yielded a slightly lower result -- 21.2 percent of offset obligations being subcontractor production. There are several reasons for the importance of subcontractor production in offsets. First, prime contractors are hesitant to make offset agreements which will ruin their markets over the long-term. Second, if the foreign country has the technological and production capabilities to do the work of the prime, one would assume that the foreign country would have built the weapon itself. As a corollary, most of the countries which demand offsets can only accomplish production tasks of a simpler nature (e.g., the type of task usually associated with subcontractors). A review of where U.S-.-defense-rei;ated?-goods -and-servrces -arp'suld demonstrates that most of the purchasers will not be capable of the sophisticated production techniques necessary to assume the role of a prime contractor. Note that the buyers fall into two general categories: NATO countries and the LDCs. While the LDCs cannot assume the role of the prime through offsets, it is obvious that the non-U.S. NATO countries, under many conditions, could assume this role. It is U.S. policy to encourage NATO in this endeavor, but the two-way defense trade statistics between the United States and other NATO countries demonstrate that the U.S. gains a good deal more in terms of trade from the relationship than other NATO countries do from the relationship with the United States. Concurrent with this, the United States maintains a policy of establishing domestic production capabilities for any major weapon system it purchases overseas. In fact, in those cases where the United States buys weapons from one of the NATO countries whose technology and productive capability could be a threat to our own prime contractors, the United States requires that it also be allowed to produce the weapons. This policy is used to keep our industrial base capable of supporting the weapons we use. Table II.A.3 shows the U.S. balance of defense-related trade with NATO. Note that this trade currently flows in favor of the United States by a 2.8 to 1 ratio. Sanitized Copy Approved for Release 2009/12/23: CIA-RDP87M00539R002303720001-1 Sanitized Copy Approved for Release 2009/12/23: CIA-RDP87M00539R002303720001-1 DRAFT 33 TABLE II.A.3 FY 1984 Defense-related Trade Balance Summary (thousands of current dollars) Country Total U.S. Exports 1/ Total U.S. Imports 2/ From Foreign Subcontracts DOD Computed FY 84 Ratio 3/ - Belgium 202,826 114,139 10,545 1.78 Denmark 48,053 49,281 44,189 0.98 France 68,027 47,601 11,626 1.43 FRG 402,728 307,590 47,853 1.31 Italy 104,862 65,009 10,036 1.61 Luxembourg 1,561 1,486 -- 1.05 Netherlands 485,798 38,975 28,529 12.46 Norway 230,897 43,743 20,794 5.28 Portugal 27,562 1,245 22.14 Spain 101,446 24,973 892 4.06 UK 1,595,714 492,865 84,794 3.24 Total Europe ~ 259,258 2.75 Canada 4/. 1,306,525 875,400 -- 393,700 "' 1.49 Total Europe Plus Canada 4,565,999 2,062,307 652,958 2.21 1/ Estimated totals of FMS and commercial exports licensed under the Arms Export Control Act. These totals represent the dollar value of Government and commercial sales on a delivery basis. 2/ Figures do not include subsistence, petroleum, construction, and support services awarded in FY 84. 3/ "Total U.S. Exports" divided by "Total U.S. Imports." 4/ Data provided by the Government of Canada; the figures were adjusted to reflect FY 1984 and converted into U.S. dollars using an exchange rate of 0.8073 for the months of October through December and an exchange rate of 0.7837 for January through September. Sanitized Copy Approved for Release 2009/12/23: CIA-RDP87M00539R002303720001-1 Sanitized Copy Approved for Release 2009/12/23: CIA-RDP87M00539R002303720001-1 DRAFT A major issue in defense trade is the impact of offsets on subcontractors. The amount of subcontractor work performed in the FY 1984 trade (II.A.6) with other NATO countries is assumed to be primarily due to offsets for the reasons already given. While having this amount of subcontracting done overseas has an obvious effect on the U.S. industrial base, several points should be remembered. First, the work done by other NATO countries is done in response to a U.S.,policy to promote RSI. Table II.A.4 provides a wider context for this discussion of overseas defense subcontracts. Note that of the subcontractor work done by our NATO allies over half is done in Canada, a country that is part of the North American (U.S. and Canada) defense industrial base. All other countries with significant amounts of subcontract work are either in NATO or reflect very specific foreign policy concerns. Thus, these data show that the area of subcontracting, where one would expect offsets to have the major impact on U.S. defense industry, has experienced impacts in precisely the manner that one would have guessed, a priori, based solely on a rudimentary knowledge of our policies with regard to NATO and to Israel. These data do not support a conclusion that offsets affecting the defense industrial base have occurred in large numbers outside of the countries that are our major allies. A model developed -by- the-- Department--of -Defense -firnd'tCates that, 4n ? general , defense business comprise only a small portion of any sector's subcontractor activity. Offsets comprise an even smaller share. Evaluating the impact of offsets on subcontractors is difficult because data regarding both the negative effects (business lost due to offsets) and the positive effects (business which would have been lost had the offset not been offered to close the deal) are generally not known to the subcontractors themselves. In addition, a subcontractor from one sector may lose business while a subcontractor from another may gain -- all due to the same offset deal. In this case, the overall effect of the offset can only be measured by knowing the severity of industrial base degradation in the first instance compared to the enhancement of the base in the second. This information is, at best, subjective in nature and often inseparable from general economic conditions. Sanitized Copy Approved for Release 2009/12/23: CIA-RDP87M00539R002303720001-1 Sanitized Copy Approved for Release 2009/12/23: CIA-RDP87M00539R002303720001-1 35 TABLE II.A.4 Overseas Distribution of Defense Subcontracts (Fiscal Year 1984) Region/Category Country Millions of Dollars Percent of Total $ 653.207 91.41 Canada 393.700 55.09 UK 84.794 11.87 Denmark 44.189 6.18 West Germany 47.853 6.70 Netherlands 28.529 3.99 Norway 20.794 2.91 France 11.626 1.63 Italy 10.036 1.40 Belgium 10.545 1.48 Spain 0.892 0.12 Greece 0.249 0.03 OTHER OECD 29.177 4.08 Australia 14.104 1.97 Japan 8.273 -1.16 Switzerland 4.310 0.60 Sweden 2.048 0.29 Austria 0.442 0.06 NEWLY INDUSTRIALIZED 23.858 3.33 Korea 0.680 0.10 Taiwan 0.633 0.09 Israel 20.675 2.89 Hong Kong 1.022 0.14 Singapore 0.528 0.07 Mexico 0.320 0.04 DEVELOPING 8.367 1.17 Saudi Arabia 5.491 0.77 Philippines 0.225 0.03 Kuwait 0.119 0.02 El Salvador 0.101 0.01 Egypt 0.018