Emerging countries drive a hard bargain in defense market

Among the consequences of emerging countries' growing share of the global defense procurement market has been an accompanying rise in their use of offsets in the award of defense contracts. Twenty-six countries have introduced formal offset programs since 2000, bringing to 80 the number of governments imposing some form of obligation in kind on defense contractors from whom they purchase equipment.

Offsets are direct or indirect compensation intended to counter the financial burden of a defense purchase incurred by the acquiring government. And as emerging markets' procurement budgets grow, they increasingly are leveraging their position to demand offsets-often tied to economic growth objectives.

As offset programs proliferate and their conditions grow more demanding, so grows the burden on defense contractors. And as purchasers' thresholds-the minimum contract size that commands an offset- remain static, the inflation-adjusted size of such contracts shrinks, squeezing defense suppliers' profits.

Offsets may be direct (relating directly to the main procurement program through sub-contracting), semidirect (relating to analogous military domains but not the actual procurement program), or indirect (typically completely unrelated programs, often in civilian areas). Inevitably, they incorporate one or more of the following features: program joint development, direct investment/facilitation of investment, technology transfer, placement of contracts with the buyer's national industrial base, export/sales facilitation, or sub-contracting/work share.

The benefits of offset for the procuring government are many and can include gaining access to technologies, improving foreign direct investment, easing trade imbalances, and countering foreign currency outflows.

Offsets can appear expensive-with the procuring government at times requesting offsets equal to or greater than the value of the purchased equipment. In such cases, multipliers are typically used (e.g., $1 invested in, say, alternative energy earns an offset credit of $10) to steer investment to priority areas.

While emerging markets have become more assertive in attaching offsets to their defense contract awards, developed nations are moving in the opposite direction. The WTO's Government Procurement Agreement prohibits offset demands by members but allows them to be employed when deemed necessary to protect security interests. A 2011 EU directive contains a similar loophole.

The net effect is that, despite developed nations tightening rules on imposing offsets in procurement deals, they are a booming business for emerging markets. IHS estimates offset obligations of $94 billion will be negotiated between 2012 and 2022-with no slowing in sight.

Ultimately, the goal of some emerging nations is to build defense systems domestically-if not to become outright exporters in the future. Such a development would mean the loss of a portion of a very high-margin and profitable industry that has long been the province of the West.