Sunday, October 14, 2012

Caveat emptor: The challenge in implementing defense offset in Indonesia

Jane’s “2012 Defense Market Report” calculated that the Indonesian arms market has the potential to be one of the worlds largest. Under the Minimum Essential Force (MEF) procurement program stage one (2010-2014), a combined rupiah and foreign loan of Rp 156 trillion (US$16.25 billion) will be disbursed.

Small domestic industrial capacity means that the bulk of spending will go to foreign procurement, but Jakarta wants to make sure the economic ripple is felt at home. Countertrade, joint collaboration and offset are among the strategies to serve the objective right.

The recently issued Law on Defense Industry (LoDI) demanded a form of mandatory countertrade equal to 85 percent of contract value of foreign procurement, 35 percent of which is offset (with a 10 percent increase per subsequent year). The law also mandated the implementation of an offset of 18 months behind the law issuance at the latest. Mechanism and details of countertrade will be arranged further in a government regulation (PeraturanPemerintah); a much-anticipated standalone offset policy.

Offset is arguably about hitting two birds with one stone: it allows sunk cost of defense procurement to generate economic benefit back at home. In the international arms trade, defense offset has become a norm rather than an exception. Offset managing firm Blenheim Capital estimated that offset value from 2010-2014 would reach about $150 billion; more than twice its value compared to previous five years.

Offset has pros and cons. Among the benefits, economists discovered that offset could be used to promote local subcontracting activity including: maintenance, production of parts and components, local assembly, generating employment, promoting global partnership and to create a “spin-off “from defense to civil sector, taking form of technology, facilities and most importantly, human resources.

The extent of offsets success in the defense sector is hard to pin down. Lack of standardized valuation contributes to the difficulty in appraising offset results. Assessing technology is the core issue, which was made more complicated when conducted in arms procurement, an area that has traditionally been secretive. The cost premium of offset, in Belgium for example, could reach up to 30 percent of total contract value — this seems to outweigh the benefit of offsets. This particularly happens when the technological gap between the offset transferor and transferee is too broad.

Offset does not terminate dependency to foreign technology, as in the case of South Korea and Taiwan. Technological lags will always exist since only mature technology is transferred. Offset sustainability is questionable; most of the benefits cease once the offset program is fully discharged as in the case of Philippine’s license production of Simba armored personnel carrier. Australia abandoned offset after a series of failed technology transfers and chose global partnership as the core of its current industrial participation policy.

A certain risk is associated with developing countries lacking good governance in defense management: corruption. In such circumstance, arms procurement has the potential to breed corruption. Offset, with lack of standardization in objective, threshold, control and evaluation, seems to strengthen the risk. This is why Transparency International in 2010 advocated offset ban. Implementation of offset in Indonesia needs to take into account the aforementioned challenges.

Economists identified that some preconditions are necessary in order for offset to succeed. The first is commitment from the supplier. Technology leaders will always try to prevent newcomers, preventing the proliferation of intellectual property rights (IPRs) and critical technology.

Even close allies like Americans and the British are in feud over the IPRs in Joint Strike Fighter program. The strategy to circumvent this varies from engaging the supplier in an obligatory offset and to set a penalty for failure in delivery, or allowing the supplier the freedom to choose the type of offset that is mutually beneficial. Either way, the transferee needs to prepare the strategy to “steal” the technology while convincing the supplier about the benefit of the offset program.

The potential offset transferor should be made aware of the objective and principles pertaining to offset discharge mechanism. Offset objective, organization, type of offset, threshold, cost premium, multiplier, deadline, penalty, valuation, and so on, are important to be clarified in advance, so the potential transferor knows the rule of the games. With that knowledge, comes the confidence to move forward.

Second discriminator is the technological absorptive capacity (TAC) of the buyer country. The catch up hypothesis postulates that the bigger the backlog, the bigger the leap a latecomer country could achieve- this cannot be taken at face value. Technology is a contextual concept.

Adopting foreign technology implies the need for adjusting the transferee local condition with the transferor, including understanding of social technology, which is embodied in organizational forms, bodies of law, public policies, codes of good business and administrative practice, customs, and so on. It is the precondition for the effectiveness of operations as well as transfer of physical technologies.

Third discriminator is the management and oversight capacity of the offset receiver. The real offset value is the discrepancy between offset valuation results and cost premium. The cost appropriateness could be justified through a fair comparison of offset proposals from other prospective suppliers, but the arms market characteristics make this unlikely to prevail. As much as cost premiums is acceptable, there should be guideline on the appropriateness of the cost and how the burden should be dispersed with the supplier.

Offset has never been and will never be a free lunch. Indonesia needs to make sure that the premium cost is worth the benefit — that is, the sustainment of the defense industry and strategic sovereignty.

Sezsy Yuniorrita, a trained aerospace engineer working at Indonesian Aerospace, holds masters degree in defense management. Curie Maharani is a PhD Candidate at Cranfield University, UK. Both focus their research on defense offset.

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