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LONDON — With US and European defense spending cuts clouding future prospects, contractors have been hitting the export trail in an effort to retain their order backlogs. But as new research shows, there is a price to be paid for companies in the shape of a ballooning offset bill running into hundreds of billions of dollars.
Offset is the practice in which contractors agree to invest in a country, hopefully creating much needed sustainable employment in return for big arms deals.
The cumulative value of offset obligations among the world’s top 20 military offset markets could top an eye-watering US $424 billion between 2012 and 2021, according to analysis released recently by Frost & Sullivan.
Asian countries, such as Indonesia, South Korea and Taiwan, will show the highest compound growth in offset obligations, but the US market forecaster reckons Saudi Arabia is set to remain the biggest market with commitments totaling US $62.6 billion by 2021.
The survey covered countries such as Brazil, India, Poland, the United Arab Emirates and South Africa, but didn’t include the US because it imports little defense equipment.
The new report follows last year’s study by management consultant Avascent that put a US $500 billion price tag on offsets obligations by 2017.
Grant Rogan, chief executive of the UK-based offsets and finance advisers Blenheim Capital, said he is increasingly spending time talking to firms about the rising amount of balance sheet risk resulting from offset deals.
Speaking at a Blenheim Capital offset roundtable recently at Blenheim Palace near Oxford, Rogan said industry is struggling to meet offset expectations.
“We are dealing with a major issue, reputational risk and now financial risk. This is going to become a major balance sheet issue for corporations where penalties associated with non-performance, liquidated or not liquidated damages, are on the rise,” he said.
Baroness Liz Symons, the former UK defense procurement minister and a participant in the roundtable, warned the scale of the offset demands raises big challenges.
“The big issue is whether offsets at this level [are] sustainable in the long term. We are seeing extraordinary levels of escalating cost and, with it, huge risks of liability on the balance sheet. That is accompanied with increasing pressure from government, society and the media for greater transparency. There is huge moral pressure to ensure those costs are more open to scrutiny than some companies are comfortable with,” Symons said.
Part of the problem, Rogan said, is that many countries aspire to become a Tier 1 supplier overnight in a marketplace of “shrinking defense budgets and that’s very hard for the companies involved.”
Desire for Technology
The Blenheim boss said the rising amount of technology transfer being demanded by customers could have serious consequences for industry.
“Technology transfer is a very challenging area and there has to be balance. In many respects, customers are asking for the technological crown jewels, which isn’t possible, and governments sometimes need to be a bit more realistic and innovative in what they can do with offsets. For the seller, they have to work out how to deliver value without giving it [technology] all away,” Rogan said.
Symons said the danger is that industrialized countries are equipping client countries to become competitors.
“In the short term, that may not seem a very big risk. In the longer term, it is going to become an increasingly difficult position. Many states [in the Middle and Far East] have healthy balance sheets and trade surpluses. If they really want to take us on, that could be a devastating issue,” she said.
Despite the concerns, many in industry see their offset offerings as a key discriminator in winning export business.
“We certainly wouldn’t describe offsets as an evil, but it is an opportunity. In winning exports, it’s key. It’s also become an important way to engage with local industry well in advance of any contracts” said roundtable speaker Jonathan Key, the head of indirect offset and collaborative programs at the Finmeccanica company Selex ES.
Companies tend not to disclose much about their obligations and there is no requirement to include the figures in reports and accounts, although some think there should be given the potential risk of penalties for not meeting contractual obligations.
US Commerce Department figures for 2011, published in February, reported nine US firms had secured $10.7 billion of exports, resulting in offset obligations totaling $5.58 billion, compared with $4.4 billion the previous year.