THE AUSTRALIAN CIVIL OFFSETS PROGRAM: AN EVALUATION OF ITS ECONOMIC RATIONALE

bY THE0 PAPADOPOULOS*

1. Introduction This paper presents an economic analysis of the Australian Civil Offsets

Program (ACOP). Offsets are a form of countertrade in that they mandate reciprocal commitments from Overseas firms supplying goods andlor services to the Australian government. Offsets trade access to domestic markets for overseas firms in exchange for access to internal markets (intermediate goods and technology) and international markets for local firms. "bchno- logical change and shifting comparative advantage contribute to shifting shares in international trade for individual firms and countries. This dynamism, and the recognition that governments can influence the interplay between technology, comparative advantage and national wealth, is the underlying motive for offsets as an industry development strategy.

'Ib be welfare improving, the activities encouraged by offsets must have some underlying or latent comparative advantage not presently being exploited because of some pre-existing distortion or impediment. Otherwise offsets will be little more than a short-term stimulus to particular activities where policy is driven by Australia's position in international trade but does little or nothing to address this. Under these circumstances offsets will be imposed at some cost. This paper's objective, therefore, is to determine the extent to which offsets address the perceived market failures and thereby represents an economically rational form of intervention.

2. The Civil Offsets Program: Key characteristics and criteria The Australian government has operated an offsets policy since 1970,

initially sought for defencerelated government purchases. The program has since been expanded to include civil government procurement. Offsets are set at 30% of the imported content of a contract price, subject to some variation on individual contracts. An offsets threshold of $A2.5m of the imported content of the contract price has been established. Purchases that fall below this figure are not subject to offsets.'

* Victoria University of Technology. Theauthor wishes to thank, with the usual caveat, Prof. R. Snape for many useful comments and suggestions. This paper was submitted in January 1993.

1. In March 1991 the government raised this threshold to $10 million. (Ministerial Statement, J. Button, March 1991.)

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Activities acceptable in discharging offsets obligations are: technology transfer; research and development: training; venture capital expenditure: purchase of Australian-made products, components and services for export; overseas marketing: collaborative ventures: provision of facilities: admini- strative expenses: and insurance.

The explicit objectives of the ACOP as outlined in the Australian Civil Offsets Program (including Partnerships for Development) Annual Report 1989190 (AGPS, Canberra) are: (a) technology transfer; (b) stimulate R&D activity: (c) gain access to the internal markets of MNEs, and global marketing

(d) promote exports of value added goods and services; and (e) contribute to the globalisation of the Australian economy by developing

internationally competitive export oriented industries. Offsets activities undertaken must meet all of the following criteria: offsets

should be internationally competitive in terms of price, quality and delivery (commercial viability criterion): should not result in any increase in the prime contract price (price criterion); should be of a level of "technological sophistication" commensurate with the goods andlor services purchased (technology criterion): and should be in addition to or an extension of activities presently undertaken (new work criterion).

Overseas suppliers may choose, instead of offsets, to enter into a long- term agreement with government, known as the Partnership for Development Program (PFD).Z The broad aims of the program are to increase the com- mitment of multinational enterprises (MNEs) to Australia (that is, encourage foreign direct investment (FDI); and to link RhD with export activities and industry development. MNEs entering PFD agreements commit themselves to achieve, within seven years: local R&D equal to at least 5 % of Australian turnover; export of goods and services equal to at least 50% of imports into Australia; and an average of 70% local value-added content in exports. For its part the government commits to ensure an adequate supply of skilled labour and infrastructure. This will require public investment in education, labour market programs and capital works.

facilities:

3. Critical appraisal of the perceived market failures

the existence of some market failure that inhibits these activities. Implicit in the specification of a range of acceptable offsets activities is

In markets where the Government possesses significant power, its purchasing policy may be used to help local industry to exploit any advantages it has. The Partnerships for Development Program in the information industry, for example,

2. Partnership agreements are now compulsory for overseas firms in the Information Bchnology sector with annual sales to the government in excess of $40 million. (Ministerial Statement, J. Button, March 1991.)

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is predicated on the assumption that local industry is competitive in certain fields but, in the absence of intervention, imperfections in the market would prevent it from exploiting its competitive position. (DITAC 1990) The DITAC report fails to specify explicitly the alleged market failures

and the specific areas in which Australian industry is internationally competitive.

The approach taken here is to investigate the existence of market failure for those activities that are promoted by the ACOP. The efficacy of offsets in addressing the perceived market failure is then critically analysed.

Intra-industry trade and transaction costs An objective of the ACOP is to access the internal markets of MNEs in

intra-industry trade. Offsets encourage overseas firms to use local firms as sub-contractors in the supply of intermediate goods giving the latter access to a ready-made market. By choosing counterp~rchase~ to discharge offsets obligations, an overseas firm will source intermediate goods which might otherwise be sourced overseas from established local firms. Alterna- tively, an overseas firm may choose to locate the production of the inter- mediate good in Australia by either FDI or co-production. Production capability thus established generates intra-industry trade that may stimulate domestic production, employment and exports. While these may be desirable outcomes, the imposition of offsets can only be justified on economic criteria if they address some pre-existing market failure.

In this regard, Liesch (1990) portrays the government as a “broker” between local and overseas firms, thereby removing the uncertainty resulting from imperfect information. By absorbing the information search costs the government reduces costs that may discourage arms-length transactions. Given the criterion that local firms must be competitive in terms of price, quality and timely delivery, Liesch (1990, p. 426) argues that:

. . . it must be assumed that the reason for the successful local firm not uniting with the foreign supplier in a cooperative arrangement, in the absence of an offsets obligation, was the lack of information about each other’s activities. If this is the case, and competitive prices and qualities prevail, then an offsets program has been successful in fulfilling its brokerage role. He concludes that the resulting convergence is evidence of a successful

offsets policy. This may be criticised on two points. Firstly, it is an empirical matter to determine whether Australian firms are competitive in price and quality. While Liesch provides no empirical data there is some evidence of price premia or forgone discounts by government purchasing departments. For example, a European manufacturer has been cited as stating that “the cost of placing offsets work can be as high at 25% of the 30% value of the

3. Counterpurchase transactions involve two parallel money-for-goods transactions where the overseas firm is required to purchase goods or services from the importing firm or country.

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offsets” (Advisory Groups on Australian Airlines 1988, p. 75). A separate report into the aerospace industry cites cases where prime contract prices rose from 1.6% to 14.3%, suggesting that the cost to Overseas firms of placing offsets work could range from 5.5% to 71.5% of offsets activities undertaken by local firms (BIE 1986, p. 325). Secondly, the assumption that convergence of demand and supply is proof that imperfect information has caused the market to fail is tenuous. The foreign firm is coerced into entering an offsets arrangement, which may not have taken place in the absence of compulsion. For Liesch‘s conclusion to hold, this convergence should take place by rectifying the market failure: that is, by improving information flows (government absorbing the search costs by playing the role of broker) without the imposition of mandatory offsets obligations.

The suggestion that the ACOP is simply an information service is simplistic and ignores the by-product distortions that might be introduced by govern- ment intervention. Where a by-product distortion is created the costs associated with these may exceed the gains from correcting the target distortion. The provision of brokerage services itself can only be justified if the costs to the government (taxpayer) are less than the national benefits resulting from the transactions generated, for the provision of information is not costless. The transactions costs argument does not provide a justi- fication, on economic efficiency grounds, for offsets.

Export promotion and access to global marketing networks An objective of the ACOP is to encourage exports of value-added products

from Australia. One means of doing this is to facilitate access for local firms to the established international marketing and distribution networks of MNEs. This is encouraged by the specification of facilitated exports as acceptable offsets activities. That is, MNEs may discharge obligations by exporting locally-produced goods or by facilitating the export of products made by other local firms.

It has been suggested that there is imperfect information in the inter- national market about the competitiveness of Australian products. This general lack of knowledge of local productive capabilities is allegedly inhibiting exports and the ACOP may go some way to addressing this information gap. By specifying facilitated exports as an acceptable offset activity MNEs are forced to investigate this option amongst other activities permitted under the program. That facilitated exports take place in preference to other activities may suggest that the program has been effective in filling the information gap. More importantly, the argument may follow that this is evidence of internationally competitive local supply.

This argument is, however, unsustainable as a justification for offsets. MNEs do not choose but are compelled to concede reciprocal commitments. That export takes place suggests that this may be the least cost method of discharging offset obligations rather than evidence of internationally competitive supply. If the market failure is in the form of imperfect information then this is the distortion that should be addressed. In the case

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of facilitated exports, offsets go beyond this by mandating countertrade. XI the extent that offsets result in the export of poor substitutes, this outcome is no different to crude countertrade, such as the disposal of surplus goods, and may be dismissed as an inefficient mode of international trade.

Alternatively, overseas firms may discharge offset obligations by facili- tating the commercialisation of indigenous innovations. This may take the form of a collaborative venture. Commercialisation by local firms may be inhibited because of inexperience, insufficient funds, or the absence of production and marketing networks. In this respect MNEs have much to offer smaller indigenous firms and these links may facilitate the commercialisation of indigenous innovations. Once again we must ask the question-what inhibits the collaboration from taking place voluntarily? Possible reasons are the existence of imperfect information or alternatively the innovation is something of a poor substitute. If it is the latter it should not be encouraged (misallocation of resources), while the former does not justify compulsion.

Research and development and technology markets Internalisation enables a firm to maximise the economic rents flowing

from an innovation while minimising free rider opportunities and external benefits to others. The incentives for internalisation include: information asymmetry between the buyer and seller; the generation of external economies; and market powerlleadership. These imperfections and the response to internalisation by technology owners may impede the diffusion of technology. For our purposes these will be considered as the market failures that the ACOP attempts to address.

(i) Information asymmetry Information asymmetry between a buyer and seller of technology may

result from a number of factors owing to the nature of technology itself. These include ambiguously defined technology, a lack of technical expertise required by the buyer to evaluate the likely benefits flowing from the technology, and insufficient information revealed by the seller for fear of duplication or imitation.

An inability to evaluate a technology’s potential may cause a market to fail. This is a classic principal-agent problem where the resulting risk aversion may lead to a small volume of transactions. Moreover, search costs and the costs of negotiating comprehensive and “water-tight’’ contracts may be prohibitive where information asymmetry is acute.

The problem of information asymmetry may be addressed by initiatives that bridge the information gap, for example, the provision of technical expertise to local buyers. This would be equivalent to a subsidy given that the buyer could have purchased this service (advice) via the market. Offsets go some way to bridging the information gap by providing information services to both local buyers and overseas suppliers. As already suggested, however, offsets go beyond this by mandating countertrade and the existence of information asymmetry does not justify this compulsion.

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(ii) External economies External economies can be described as spillovers or benefits flowing to

third parties and may arise from the utilisation andor dissemination of technology. Innovation is knowledge that may be disseminated to competitors via a demonstration effect andor to upstream and downstream producers via vertical industry linkages. This suggests that the social benefit derived from investment in technology and human capital may be greater than the private benefits. That is, a divergence between marginal private benefits and marginal social benefits may result in an under-investment in innovative activity and skills formation. This divergence may provide an economic rationale for the imposition of a policy that facilitates the socially desirable level of R&D, innovation and diffusion. The first-best policy to correct such a distortion is a direct subsidy to the activity that generates important external economies.

’kchnology markets are becoming increasingly international, where economies of scale in R&D dictate the establishment of large centralised R&D centres. By mandating technology offsets the ACOP has the potential of encouraging local productive activities that generate important external economies and thereby increase welfare. Offsets counter the internalisation strategies employed by firms by mandating the local sourcing of intermediate goods and technology transfer and provide an alternative policy for encouraging local activities likely to generate external economies.

The importance which the ACOP attaches to R&D and the transfer of technology is evidenced by a weighting of 300% applied to offset obligations discharged in either of these forms. Overseas firms may choose to discharge offset obligations by undertaking R&D within local subsidiaries, by contracting out R&D to indigenous firms, and by encouraging collaborative ventures andlor research between MNEs and local firms and academic institutions.

R&D is becoming increasingly expensive, especially in the relatively new high technology industries. This exposes the firm to even higher risk and in some cases the cost and risk may be too high for an individual firm. This has given rise to a number of collaborative ventures or “strategic alliances” between firms with the view to sharing costs, risks and any resultant innovation. These alliances are a response to “characteristics of much modern technology and to the ineffectiveness of market mechanisms and (vertical or horizontal) integration” (Centre for lbchnology and Social Change (CTSC), 1990, p. 11). Strategic alliances may take the form of pre-competitive research, technical co-operation, production andor marketing arrangements (CTSC, 1990, p. 16). all of which are acceptable offsets activities.

In any collaborative venture all parties must take a positive contribution and it is the perceived mutual benefits that bring parties together voluntarily. That collaborative ventures do not take place voluntarily suggests that the costs of involving local firms outweighs the expected benefits. Where overseas firms choose to discharge offset obligations by initiating a collaborative venture, this could suggest that imperfect information may have

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been an impediment. Once again, however, imperfect information does not justify the compulsion inherent in offsets arrangements.

A prime focus of the ACOP is to encourage the development of a local information technology (IT) industry. The IT industry is a good example of what is considered a “strategic industry”.

High technology industries such as the IT industry with its data-processing and communications segments for instance, provide the systems which are crucial to the productivity and hence competitiveness of most manufacturing, mining, service and even modern agricultural enterprises. (BIE 1989, p. 54) A dynamic IT sector is thus depicted in some quarters as an essential

component of the industrial structure of an economy. The implication is that a local IT sector is essential in generating spill-overs to other sectors, and that the social benefits exceed the private benefits. As private investment is likely to ignore the social benefits government intervention may be required to stimulate the IT sector (BIE 1989).

Information technology may represent generic technology that improves the productive efficiency of other sectors. What is not clear in the BIE paper is why an indigenous IT sector is necessary when generic technologies and sector specific innovations are available via the international market. Government assistance to establish an indigenous IT sector may be warranted where the international IT sector is oligopolistic and results in the transfer of technology at monopolistic prices (rents accrue overseas) andlor a low volume of transactions results. However, a policy that encourages the same economic actors that dominate the international market (MNEs) to form the basis of the local IT sector (via FDI), is unlikely to generate a higher volume of transactions because there is no reason to presuppose that “local” technology vendors will price technologies more favourably than would “overseas” technology vendors.

The externalities argument for the establishment of an indigenous IT sector might be. justifiable where local production of IT is necessary for externalities to flow to local firms. On this basis, technology offsets may be justifiable where they encourage “high-tech” industries that generate significant external economies for Australian industries which they would not have been able to secure without the offsets. It could be argued that a divergence between the socially optimal rate of international technology diffusion and application and the private benefits resulting from the unregulated flow of technology leads to a trade policy. Such a policy could be mandated technology offsets. It would need to be demonstrated, however, that this policy was the most effective in obtaining the technology because it is possible that equally beneficial technology may have been secured by alternative means at a lower price.

Assuming one can make a case for subsidising externality generating activities, a serious problem still remains in identifying and quantifying the externalities thus generated and comparing these with the likely costs. Technological spillovers do not command a market price and it is therefore difficult to quantify their importance.

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(iii) Market powerlleadership %&nology represents only one part of a larger package of production

knowledge that includes technology embodied in capital equipment, per- sonnel and information systems. In some cases these components may be inseparable and firms may be unable or even reluctant to “unbundle” the technology package. ’kchnology is an asset that provides firms with a competitive edge and an opportunity to generate economic profits. Firms will be reluctant to transfer “leading edge” or “core” technologies which provide a firm with a competitive advantage over rivals. This strategic behaviour by innovating firms may inhibit the diffusion of technology. This will especially be true for a process innovation which, unlike some product innovations, cannot be reverse engineered.

Internalisation can therefore be viewed as a means of protecting firm- specific ownership advantages with the objective of remaining at the forefront of technological innovation and retaining (or gaining, as the case may be) market leadership. Vertical integration also has the potential of raising barriers to entry because it requires a larger capital investment by potential entrants and introduces the possibility of predatory tactics between upstream and downstream producers (non-integrated firms). Internal markets may effectively “lock out” potential suppliers of intermediate goods.

Imperfectly competitive international markets place local, relatively small, producers at a considerable disadvantage. The organisational structure of MNEs, combined with considerable ownership advantages and financial strength, diminishes the opportunity for many local firms to contest inter- national oligopolistic markets. The obstacles include access to technology, access to marketing networks, internal markets for intermediate goods, “learning curve” factors, and management and technical expertise (human capital). Baditional forms of protection may be limited in their effectiveness against such giants. Offsets, by mandating countertrade, lower these barriers to entry because they mandate intra-industry trade and technology transfer to local firms. This ensures local participation in industries that would only be encouraged with a simple subsidy and thereby partially removes the monopoly distortion that exists in international trade.

The imposition of offsets thus enables local firms to penetrate the internal market for intermediate goods production and generates production that might otherwise have been placed with overseas suppliers. This local production generates employment (within the protected sector), exports (components to be incorporated into the final good) and a possible share of the available economic rents. The extent to which rents accrue to local firms (and therefore the nation) will be a function of a number of factors including the competitiveness of local supply and the ability or willingness of overseas suppliers to absorb any costs imposed in fulfilling offset obligations. In the case of technology transfer and FDI the ability to extract economic rents will be difficult given the patent rights of technology vendors and the ability to implement transfer pricing (in the case of FDI).

Co-ordinated government procurement may have the potential to harness

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considerable countervailing buyer power and may provide the opportunity for small countries such as Australia to pursue objectives similar to those identified in the strategic trade policy literature. That is, co-ordinated government procurement can represent countervailing buyer power to offset partially the market power of oligopolistic firms in international markets (rent shifting case): and by mandating technology offsets that contribute to industry development and the generation of external economies (externalities case). Offsets may be welfare improving where rents are diverted to local firms producing intermediate goods and there is no premium applied to the prime contract. These gains may, however, be at the cost of introducing another, perhaps greater, distortion.

Globalisation: partnerships for development The PFD program aims to encourage MNEs to undertake local valueadded

activities, RLD, and exports, and specifies target levels for these activities, with a prime focus on the IT industry. In achieving these targets the program hopes to promote local firms as suppliers to MNEs and to facilitate the export of indigenous firms’ products via access to global marketing and distribution networks.

According to the BIE (1988, p. 85) the PFD program effectively addresses two problems crucial to the development of a competitive local IT industry. The first problem identified is imperfect information with respect to the potential for Australia to become a “global platform” from which to conduct international trade. This information constraint allegedly inhibits FDI. It is argued that the program forces transnationals to consider the locational advantages of Australia and thereby overcomes this information problem. This argument can be easily refuted. As with all other arguments for intervention on the basis of imperfect information identified in this paper, the alleged distortion does not justify the compulsion inherent in offsets and partnerships .

The second justification put forward for PFD is that the resulting FDI may encourage the development of a global IT industry where Australia is utilised as a platform to access markets in the Asia-Pacific region. Special incentives to attract MNEs may facilitate a process of further FDI as firms attempt to exploit the benefits of agglomeration. Agglomeration benefits refer to economies that ensue from geographically defined clusters of industry activity.

Many recent commentators on economic development have noted that globally competitive businesses tend to develop in clusters or “poles of development” within their host countries. These usually consist of a group of one, two or sometimes several major firms that may be strong rivals, together with many medium-sized and smaller firms that prwide the specialised goods and services inputs that the major firms need, plus a variety of institutions that supply the training and technical needs of the whole cluster. (AMC, 1990, p. 137) The opportunity to develop internationally competitive clusters locally may

be transitory because once in motion it can be self perpetuating, as other

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firms converge to reap the available agglomeration economies. As a result “there are often strong ‘first mover’ advantages in cluster development” (AMC, 1990, p. 137). Where locational advantages exist these need to be communicated early and “the need for special foreign direct investment incentives will be obviated” (BIE, 1988, p. 85).

On this basis a case might therefore be made for special incentives to compensate for locational disadvantages where the external benefits resulting from the development of a cluster exceed the likely costs. The identification and measurement problems are, however, likely to be severe and this suggests that the cost of failure could be substantial. Moreover, the desire by a number of governments to establish local clusters and the offer of special incentives to achieve this will distort incentives and initiate a rivalry amongst governments with the danger of an ever increasing interventionist trading environment. If all governments compelled the establishment of local production, R&D and export activities in exchange for large government contracts (as is the case with the ACOP and PFD programs) the result would be a fragmentation of international production, a significant misallocation of resources and a reduction in global welfare.

4. Concluding comments The analysis of offsets presented in this paper suggests that many of the

activities targeted by offsets and partnerships do not justify the imposition of compulsory reciprocal obligations. Arguments that may provide the justification for the imposition of offsets include countering the monopoly distortion in international trade (internal and technology markets), and the existence of external economiestagglomeration benefits. Identification problems, however, impede the demonstration of the size of such benefits.

The introduction of non-compulsory offsets may address these concerns and would be likely to reduce the imposition of costs on participating overseas firms. Instead of the present requirement to incorporate offset proposals in all tenders submitted, offsets proposals could be made optional and represent one of a range of other factors upon which tenders would be assessed. Where an overseas firm believes it can identify competitive local activities and satisfy the commercial and price criteria then it may offer offsets as part of its tender proposal and will be preferred to overseas firms that do not offer offsets. That is, offsets could be one means by which a firm could differentiate its “product”. If offsets impose costs on overseas firms and the government is committed to the price and commercial criteria then competitively priced firms that do not offer offsets should have nothing to fear. A potential problem with this approach is the perception by Overseas firms that the government prefers offsets and tenders that incorporate these will be favoured. The end result may be little different to the present system of mandatory offsets.

Discussions between the author and officers of DITAC revealed that the Department made a decision in 1991 to discontinue offsets requirements, presumably with the consent of the Minister. Despite this there has been

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no official government statement announcing the cessation of the ACOR The Department is currently developing long-term arrangements that will replace the ACOP. These arrangements will resemble the existing PFD program and will focus on specific industry sectors. These new arrangements will be called “Fixed Brm Arrangements” (FTAs) for the information technology sector and “Long Brm Arrangements” (LTAs) for the aerospace industry. These changes seem to have little to do with the economic arguments for and against offsets. One possible reason for the transition to longer-term arrangements is that Australia is currently considering signing the GATT Government Procurement Code. Offsets requirements are contrary to this code and are an obstacle to Australia becoming a signatory. In addition, the Australian government has in recent times initiated the privatisation or “corporatisation” of the aerospace and telecommunications sectors. Offsets are even less appropriate in a deregulated environment. While there is yet no official announcement outlining the specific detail of the new long term arrangements, their objectives and economic rationale seem to be no different to the ACOP that they intend to replace and may indeed be offsets by another name. This judgement will nonetheless need to await the official announcement of these modified programs.

REFERENCES Australian Manufacturing Council (AMC) (1990), The Global Challenge: Australian

Manufacturing in the 199Os, AMC, Melbourne. Centre for Rchnology and Social Change (19901, Strategic Alliances in the International

Alliances of Australian Industry, University of Wollongong, AGPS, Canberra. Bureau of Industry Economics (1989). “Globalisation: Implications for the Australian

Information Bchnology Industry”, Research Report 30. AGPS, Canberra. Bureau of Industry Economics (1988). “Importing Rchnology”, Research Report 25, AGPS.

Canberra. Button, 7. (1991). “Building a Competitive Australia”, AGPS, Canberra, March. DITAC (1990), Annual Report, AGPS, Canberra. Liesch, R.W. (1990), “International lkade in an Imperfectly Competitive Environment: Mandated

Countertrade”, International Journal of ’kchnology Management, vol. 5. no. 4, pp. 423430.

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