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Defence groups agree $75bn ofsweeteners to win big contractsBy Carola Hoyos in London

Western defence companieshave agreed $75bn of sweetenerdeals, ranging from helpingOmani fishermen to financingan Emirati beachfront metropo-lis, to win lucrative arms con-tracts, a Financial Times inves-tigation has found.

The FT probe – based on dataprovided by IHS Jane’s, thedefence industry analyst –reveals the scale of the out-standing promises or “offsets”made by the world’s 12 largestdefence companies to win ordersfrom countries seeking invest-ment, jobs and technology.

Defence companies havetraded Tunisian olive oil for mil-itary transport aircraft; investedin fledgling airlines in Kaza-khstan and Jordan; created adomestic aerospace industry forTurkey; and sent the firstMalaysian astronaut into space.

In Oman, BAE Systems satisfiedpart of its offset obligation byluring fish to big, brightly col-oured buoys, easing the work oflocal fishermen.

Lockheed Martin alone is onthe hook for at least $27bn ofoffset deals – 10 times its netprofit last year – while Boeinghas $12.6bn of such obligationsand Raytheon has $7.9bn. InEurope, EADS has the biggestobligations with $7.6bn in prom-ises, while the UK’s BAE Sys-tems and Sweden’s Saab havepledged close to $4bn each.

The numbers represent thevalue assigned by governmentsto companies’ outstanding obli-gations under the side deals.Their actual costs vary anddepend on how each companychooses to fulfil its obligation tobenefit the local economy.

Executives say these sidedeals are increasingly crucial towinning big defence contracts

as developing countries rankbids by companies’ willingnessto commit billions of dollars totheir economic development.

Penalties for not delivering onside deals – which can run intothe tens of millions of dollars –are kept even more secret thanthe deals themselves. In 2010alone, Greece applied penaltiesto 70 offset programmes, whilein India 13 of 18 offset contractsagreed between 2005 and 2013were subject to penalties.

Fears over these deals goesbeyond the boardrooms of thebig defence contractors. Critics– including the US government,EU, World Trade Organisationand campaign groups such asTransparency International –say they distort the market,leading governments to orderarms they do not need, and cre-ate opportunities for corruption.

In the spotlight, Page 16

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© THE FINANCIAL TIMESLIMITED 2013 No: 38,363

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Printed in London, Liverpool, Dublin,Frankfurt, Brussels, Milan, Madrid,New York, Chicago, San Francisco,Washington DC, Tokyo, Hong Kong,Singapore, Seoul, Abu Dhabi

Copper supply setto outstrip demandCopper output could exceeddemand next year as a waveof new projects beginsproduction, leading minersand traders said, in aprediction that points tolower prices for thebenchmark metal. Page 13;‘Dr Copper’ on recovery, Page 24

IMF fears bond lossesThe International MonetaryFund has warned thatmonetary tightening in theUS threatens to exposefinancial excesses andvulnerabilities that couldwipe up to $2.3tn off bondmarkets. Page 2; Tony Barber,Page 9; Lex, Page 12

Telecoms power playThe proxy shareholderstatement lodged by Verizonsheds light on the complexnegotiations behind the$130bn Vodafone stake sale –the third-largest-deal incorporate history. Page 13

Bank bailout tax pushPlans for a Europeanfinancial transaction tax aregaining a new lease of lifebefore Germany’s coalitiontalks, as chancellor AngelaMerkel’s most eligiblegovernment partners pushfor the disputed levy to payfor bank failures. Page 4

US drones gain cloutBackroom political pressurein Congress has kept fundingfor the use of drones topatrol US borders intact,despite doubts over theunmanned aerial vehicles’reliability. Page 5

Nobel chemistry prizeThree naturalised Americanscientists – Martin Karplus,Michael Levitt and AriehWarshel, who begun theirwork at Harvard – have wonthe Nobel Prize for chemistryfor “taking experiments tocyberspace”. Page 3

S Korea skills surplusSouth Korea tops the leaguewhen it comes to producingtoo many overeducatedworkers, and the subsequentskills surplus and labourunderutilisation are taking atoll on the economy. Page 6

Offshore rupee bondsIndia is making a big moveto internationalise itscurrency through a deal withthe World Bank to launchthe first offshore rupee bondprogramme. Page 2

Climate change scoresThe OECD is to start scoringcountries on how well theyare tackling climate changeas it steps up a push towean governments off thefossil fuels it says have puthumans on a “collisioncourse with nature”. Page 6

RBS sends forex dataRoyal Bank of Scotland hashanded over to regulatorsrecords of instant messagestrings sent by and to aformer currency trader, amida deepening sector-wideprobe into the suspectedmanipulation of foreignexchange rates. Page 13

Trade deficit narrowsA surge from exporters anda fall in gold imports hashelped India post its lowesttrade deficit in more thantwo years during September,cutting pressure on therupee. Page 2

Gaza gas push

A long­mooted $1bn project todevelop gasfields off the GazaStrip is being revived in a driveto develop the economy of thePalestinian Territories.Benjamin Netanyahu’sgovernment is ‘very supportive’of the project, which would seethe fields exploited on behalfof the Palestinian Authority byinvestors led by BG Group, anIsraeli official involved in thedeal told the Financial Times.

Report, Page 6

News Briefing

In your FT today

Arab World:Banking &FinanceFortunes recover asstates prime the pumps

Separate section

Twitter’s IPO looks like abonanza for speculatorsRichard Waters, Page 14

The nimble travellerWhy superjumbos will become obsolete, Page 9

US fearslift defaultinsurancemarketBy Tracy Alloway andVivianne Rodrigues in New York

Growing fears that Washingtoncould miss a payment on itsdebt have led to a surge in activ-ity in the once-sleepy market forderivatives which insure againsta US default.

Average daily trading ofcredit default swaps, which giveinvestors protection on US gov-ernment debt, has jumped to€150m in the past week fromabout €1.6m in recent months,according to the trading desksof two major European banks.

With the government shut-down now in its second weekand no sign of a deal beforeOctober 17 – the day the USTreasury has said it will run outof funds to meet its debt obliga-tions – the surge in CDS tradingis the latest evidence that stressis creeping into markets.

For investors, buying CDS caneither be an insurance policy ona country’s debt or a way ofmaking a speculative bet on themarket’s perception of the sov-ereign’s creditworthiness. Sell-ers of the CDS contracts have tocompensate buyers of the deriv-atives when a credit event, suchas a sovereign default, occurs.

The spike in trading activityis unusual for US sovereignCDS, which is traditionally athinly traded market.

“It’s pretty incredible to seethis market suddenly goingfrom zero to 100 in just oneweek,” said one CDS trader.

The cost to insure €10m worthof US government bonds over ayear has jumped more than ten-fold, from about €6,000 in recentmonths to €66,000 yesterday,according to prices from Markit,the data provider. At the sametime the banks which makemarkets in CDS have sharplyincreased their activity in con-tracts on US government bonds.

Investors continued to sell offTreasury securities that theydeem most vulnerable to amissed payment. The yield onthe Treasury bill maturing onOctober 17 jumped to 38 basispoints on Tuesday, up from lessthan zero in September.

Fed split highlights toughchallenge awaiting YellenBy Robin Hardingin Washington

Policy makers at the US Fed-eral Reserve were split over themerits of slowing its $85bn amonth asset purchases in Sep-tember, highlighting the diffi-cult task facing Janet Yellen asshe prepares to take the chair-manship of the central bank.

Calling her “one of thenation’s foremost economistsand policy makers”, PresidentBarack Obama nominated MsYellen to the most powerful jobin the world economy in a cere-mony at the White House, justone hour after the release of theminutes from September’sFederal Open Market Commit-tee meeting.

“She doesn’t have a crystalball but what she does have is akeen understanding of how themarkets and the economywork,” said Mr Obama. “She’stough, and not just becauseshe’s from Brooklyn.”

The minutes showed why shewill need that toughness as sheseeks to forge consensus at aFed that was split down themiddle on tapering in Septem-ber, between policy makers whofelt the economy was still tooweak, and those who felt a deci-sion not to taper would costthem their credibility.

“Conditional on their respec-tive economic outlooks, mostparticipants judged that itwould likely be appropriate tobegin to reduce the pace of thecommittee’s purchases of long-er-term securities this year andto conclude purchases in themiddle of 2014,” the minutessaid. But they offered little clar-ity on what economic condi-tions would trigger a taper.Mounting concern over gridlockin Washington and the risk of aUS default mean that the Fed’sviews from mid-September mayalready be out of date.

Markets were taken by sur-prise and rallied last monthwhen the Fed chose to keep itspurchases unchanged.

Ms Yellen, a strong proponentof the Fed’s ultra-loose mone-tary policy, said yesterday theeconomy had made progress,but had further to go. “The Fedhas powerful tools to influencethe economy and the financialsystem, but I believe its great-est strength lies in its power toapproach important decisionswith expertise and objectivity.”

Ms Yellen will be the firstwoman to lead the Fed. Hernomination will now go to theSenate where she is expected tobe confirmed. The presidentalso paid tribute to Ben Bern-anke, the outgoing chairman,

saying that he had led “the Fedthrough some of the mostdaunting economic challengesof our lifetime”.

According to the minutes, theno-taper side of the FOMC“viewed incoming data as hav-ing been on the disappointingside”, feared the effects ofhigher interest rates on housingmarkets and downgraded itseconomic forecasts.

Those on the FOMC whowanted to taper thought thatrecent data were in line withguidance the Fed gave in Juneand worried about the reactionshould there be no slowdown inpurchases. “Concerns wereexpressed that a delay couldpotentially undermine the cred-ibility or predictability of mone-tary policy,” say the minutes.

Future of the Fed, Page 2Obama steps up debate, Page 3Editorial Comment, Page 8Lex, Page 12The Short View, Page 13Collateral crunch, Page 22Global Overview, Page 23

Janet Yellen with Barack Obama as the president announced her nomination for the Fed top job Getty

The no­taper side ofthe FOMC ‘viewedincoming data ashaving been on thedisappointing side’

The doctrine . . .

On taperingAs market perceptions of theprospects for the economy vary,so too should expectations ofthe pace and duration of assetpurchases(March 2013)

On employmentIt will be a long road back to ahealthy job market. It will beyears before many workers feellike they have regained theground lost since 2007(February 2013)

On communicatingI believe further improvementsin the Federal Open MarketCommittee’s communication arepossible, and I expect they willcontinue(April 2013)

●Minutes show divide over asset purchases ●Little clarity for markets

OCTOBER 10 2013 Section:FrontBack Time: 9/10/2013 - 21:32 User: robertss Page Name: 1FRONT USA, Part,Page,Edition: USA, 1, 1

16 ★ FINANCIAL TIMES THURSDAY OCTOBER 10 2013

OFFSETS IN THE SPOTLIGHT

For the past few years, BAE Systems,Europe’s biggest defence contractor,has reaped some of its biggest divi-dends from an investment that hasnothing to do with military equip-ment.

Eager to sell radars to Kazakhstan,BAE in 2001 improved its offer byagreeing to help President NursultanNazarbayev start a domestic airline.

In the end, Moscow intervened andBAE never sold the equipment toKazakhstan. But, unusually for thesesorts of side deals, its 49 per centstake in Kazakhstan’s Air Astanabecame one of the company’s highest-yielding investments.

Even when successful, defence exec-utives and government officials onlyreluctantly talk about such deals. Butkeeping these sweeteners shrouded insecrecy may prove increasingly diffi-cult as they become the main weaponfor defence companies battling toovercome the sharp downturn in west-ern military expenditure.

In the past three years, Nato coun-tries have cut $120bn from their com-bined defence budgets and executivesexpect tough times to continue foranother decade. This has led to com-panies aggressively expanding over-seas, courting countries that demandthe kind of side deal – or offset – thatBAE made in Kazakhstan.

Over the next decade, the globalvalue of the offset market is expectedto reach $500bn, according to Avas-cent, the management consultant.And countries are becoming far moresophisticated in their demands,threatening sizeable fines for non-compliance.

Christian Scherer, chief salesmanfor the defence side of EADS, the pan-European aerospace and defence com-pany, says that offering countries flex-ible offset deals was part of his com-pany’s DNA.

“Clearly the high growth countriestoday that we are all courting aresetting pretty high hurdles for con-tractors in terms of offsets,” he says.

Few companies reveal the extent ofthis business to their investors andmost do not include it in their annualreport’s list of risks, even though theyare on the hook for millions of dollarsin potential fines if they fail to keeptheir promises.

But the Financial Times, using dataprovided by analysts at IHS Jane’s,has for the first time calculated therelative size of the obligations towhich top western defence companieshave agreed. Even with a very con-servative methodology, their totalobligations are more than $75bn, withLockheed Martin of the US leadingthe pack at $27bn and EADS toppingthe European rankings with a $7.6bnobligation.

Grant Rogan, founder of BlenheimCapital, which advises both compa-nies and governments, says the indus-try is at a turning point.

“Because of the sheer size and mag-nitude of the growth right now,there’s going to have to be a greaterdeal of transparency on the part ofboth sides: the buyer and the seller.And it is going to happen throughself-regulation or it will come down toimposed regulation,” he says.

That could prove tough for some.Jon Barney, partner at Avascent, com-pared the task of measuring offsetobligations to pouring sand from adump truck into an hour glass.

“I don’t think anyone expected off-sets to become as big as they aretoday. The mechanics to track, man-age and report offsets have not keptup with their growth,” he says.

The contest between westerndefence groups looking to offer a

country the best offset deal is fierce;competing with powerful state-owneddefence companies in Russia andChina is even more difficult.

Guy Anderson, analyst at IHSJane’s, says it is difficult for westerncompanies to match their state-ownedcompetitors’ freedom of manoeuvre.

“To win the Algerian orders, Russiaforgave billions of dollars of sovereigndebt and opted for energy exploitationrights in lieu of straight cashreturns,” he says. “To put a deal likethat together, it helps when yourmajor banks; energy companies anddefence giants are all under state con-trol.”

Offsets come in two forms, directand indirect. BAE’s Kazakh invest-ment is an example of an indirect

offset, because it had no direct link tothe radar it was trying to sell.

Other indirect offsets includeRaytheon, the missile maker, settingup a shrimp farm in Saudi Arabia; agroup of defence companies helpingthe UAE buy 10,000 European petrolstations and five refineries; andEADS’s offer to help South Korea kickstart its civil aerospace industry if thecountry buys the European com-pany’s Typhoon jet fighter.

While indirect offsets can be costlyin the short term, direct offsets,which force defence companiesto shift much of the eco-

nomic benefits of producing theirequipment to the country buying it,have a more pernicious long-termeffect.

The end goal for many countriesdemanding direct offsets is the crea-tion of their defence industry. Turkey,Brazil and India insist defence compa-nies manufacture part of their equip-ment domestically to build up thenations’ supply chains and labourpool, while also handing over valuabletechnical knowhow and intellectualproperty.

Fabrizio Giulianini, chief executiveof Selex ES, the defence electronicsarm of Italy’s Finmeccanica, saysindustrial participation is unavoida-ble. “We have to do it. We would bevery happy to ship it [from Italy] butunfortunately we can’t,” he says, add-ing that the secret to survival is tocome up with new technologies fasterthan they give away the old ones.

Even in the shorter term, buildingcomplex defence equipment in foreigncountries adds costs and creates qual-ity control challenges – as France’sDassault Aviation is finding amid pro-tracted negotiations with India overwhere and how to build a $10bn fleetof Rafale fighter jets.

The most efficiently addressed localdemands add costs of 3 to 5 per centto a contract, but bad managementcan quickly make them spiral beyondthe 7-10 per cent profit margin on bigdeals, defence executives say.

But the reputational costs of directand indirect offsets can be evengreater, analysts say. Critics arguethat offsets prompt governments tospend money they do not have onweapons they do not need and thatthe secrecy surrounding them createshavens for corruption and bribery.

Offset deals have also sparked cor-ruption investigations into politiciansand defence companies in Portugal,India, South Africa and Austria.

“Without a doubt, offsets pose amaterial risk to investors,” says MarkPyman, director at TransparencyInternational. “It would be well in theinterest of shareholders, the overallintegrity of the defence industry andordinary citizens if offset transactionswere disclosed.”

The US Department of Commerce isworried enough about how offsetsdemanded outside the US acceleratethe shift of jobs, technology and taxrevenue from west to east, that itclosely monitors and measures thetrend.

Europe is behind the curve, saysChristian Sylvain, who heads Ecco,the closest thing Europe has to anoffsets trade group. “Each time acountry requires localisation of

production or a transfer oftechnical knowhow, we are

losing a part of our GDP,75 per cent of which is

based on knowhow,” MrSylvain says.

Sweeteners offered by contractors to win big military orders overseas are becoming increasinglyburdensome, writes Carola Hoyos, and will start to attract the attention of investors and regulators

Defence pledges come home to roostHeavy payload

EADS

Saab

BAE Systems

Sources: IHS Jane’s; Sipri

Arms sales,2011

Lockheed Martin

Boeing

Currentoffset

obligations

Photo: GettyFT graphic

$7.6bn$7.9bn

$4.0bn

$3.9bn

$3.1bn

$36.3bn

$31.8bn

$27.0bn

$12.6bn

$29.2bn

$14.6bn

Raytheon

$22.5bn

MORE ATFT.COM/OFFSETSIn­depth For full coverageof the FT’s investigation

Portuguese probeCorruption allegationssurrounding Portugal’s2004 purchase of a pair ofsubmarines from Germancontractors HDW,Ferrostaal and Thyssen for€1bn have prompted twoinvestigations

Q&A For an explanation ofoffset agreements, whythey have so manyopponents and whycompanies compete witheach other to offer them tocountries in the MiddleEast, Asia and LatinAmerica in particular

Methodology Mostdefence companies do notreveal the value of offsetobligations and the few thatdo use proprietary anddiffering methodologies.Therefore our study took abottom­up approach

Timeline For a history ofdefence offsets, frommoves by US PresidentDwight Eisenhower afterthe second world war topresent­day needs in theMiddle East and Asia, go towww.ft.com/offset­history

Slideshow For abreakdown of offsetobligations by company,including such industryleaders as BAE Systems,Boeing, Dassault, LockheedMartin and others, go towww.ft.com/offset­investigation

Video What do a UK­basedfisheries consultancy andMalaysia’s first astronauthave in common? Theirorigins lie in big arms deals.Defence correspondentCarola Hoyos explores theopaque world of offsets, setto become a half­trilliondollar industrywww.ft.com/video

Mechanicsto track,manage andreportoffsets havenot kept upwith theirgrowth

Direct offsets oftenrequire localmanufacture

United Arab Emirates

Defence companyexecutives fear they haveexposed themselves tomillions of dollars ofpenalties in the UnitedArab Emirates aftersigning investmentagreements that may nowprove difficult to fulfil.

When Abu Dhabi, themost powerful andwealthiest of the emirates,went on its recent $25bnshopping spree, defencecompanies signedambitious sweeteners –so-called offset agreements– to set up local jointventures that would createhigh-paying jobs for locals,while generating profit andexport revenue.

Analysis of contractssigned between the UAEand western defencecompanies suggests theemirate values thecompanies’ outstandingoffset obligations at morethan $15.4bn.

The UAE also seemsserious about holdingcompanies to theirpromises, demanding bankguarantees of 8.5 per centof the value of the offset.

Raytheon, LockheedMartin and Boeing of theUS, and Europeans Thales,EADS, Finmeccanica andRolls-Royce all havesignificant exposure to theUAE having signed dealsthere recently.

People with experience inthe country’s offset marketsay the UAE’s demandshave become unrealisticbecause too manycompanies are chasingjoint ventures in aneconomy not big enough tocater for them all in thetimeframe set by theregulations. One analystsaid it was akin torequiring a Silicon Valleystart-up fund to have a 100per cent success rate,meaning that every one of

its investments turns aprofit within a few years.

Christian Sylvain, headof Ecco, a European offsetsgroup, says the UAE’sfinite ability to absorb allits offsets has much to dowith the lack of qualifiedemiratis. “There is only somuch wooden furnitureyou can make in thedesert,” he said.

A meeting last month ofdefence executives andemirati officials in Londonwas one of the first signsthat Abu Dhabi is willingto entertain the companies’concerns.

“This time, the outcomeis less certain,” says oneperson who was at thetable but declined to benamed. He added that thefirst offset projects hadfailed to meet the newtarget deadlines, but thatcompanies were stillwaiting to hear whetherthe UAE would enforce thecorresponding penalties.

Turkey

Many countries have triedto use offset programmesto create an indigenousdefence industry, butTurkey is one of theclosest to succeeding.

Despite persistent doubtsabout the efficiency of thecountry’s defence industryand the realism of itsambition to be selfsufficient, Turkey’s 30-yearjourney has yielded anindigenous capabilityother developing countriesare still far from matching.

Ankara had coveted theability to rely on its owndefence industry ever sinceit was put under an armsembargo following itsinvasion of Cyprus in the1970s. It began the processin 1984 with a deal for thepurchase of 160 F-16 fighterjets from GeneralDynamics of the US.

Under the accompanying

offset agreement, GeneralDynamics subcontractedthe assembly of all buteight of the aircraft to anewly formed Turkishaerospace company,Turkish AerospaceIndustries (TAI).

TAI eventually grew toabout 4,000 employeesassembling 46 F-16s for theEgyptian Air Force andupgrading Jordan’s andPakistan’s fleet of fighterjets.

TAI’s growth has helpedspawn other Turkishdefence companies co-producing helicopters,armoured fighting vehiclesand submarines. “TAI hasbeen a successfulinvestment for Turkey,”says Haldun Solmaztürk, aretired Brigadier Generalof the Turkish Army.

Indeed, in 2012, Turkishdefence exports reached$1.2bn, a 35.7 per centincrease from 2011, puttingthe country among theworld’s top 20 defenceexporters.

But the country’s defenceindustry can still notsustain itself.

“If you look at Turkishaerospace and defenceexports, historically up to80 per cent of exports arelinked to offsets,” says GuyAnderson, analyst at IHSJane’s, the consultants.

“If you removed alloffsets today, it would belike removing life support.”

South Africa

When in the 1990s SouthAfrica agreed a $4.8bn dealto buy warships, aircraftand submarines fromGermany, Sweden, Italyand the UK, the companiesinvolved promised tocreate 65,000 jobs and togenerate revenue almostfour times the cost of themilitary equipment.

But those benefits nevermaterialised, academicsand former South Africanpoliticians say.

J Paul Dunne and GuyLamb of the University ofCape Town, wrote a studythat concluded in 2004there were “considerabledoubts about whetherSouth Africa as a wholehas or will benefit fromthe deal”.

Instead, several seniorofficials and politicianswere accused of havingreceived bribes and a studyby the attorney-generalfound unlawful practices inthe evaluation of the bids,according to TransparencyInternational, thecampaign group.

The South Africangovernment’s finalinvestigation, however,found no evidence thegovernment as a wholehad acted improperly orunlawfully, TI noted.

Andrew Feinstein, aformer deputy, has becomean outspoken critic ofoffsets. “I think it’s worthsaying that there’s a fairlyextensive academicliterature that suggeststhat there have been someoffsets successes in moreadvanced industrialcountries as a result ofarms deals, but that indeveloping countries theresults have tended to bedisastrous for the buyingcountry,” he says.

Reporting by CarolaHoyos, Antoine Amann andDaniella Tsar

The good, the bad and the ugly ...

Turkey’s defence industrystill cannot sustain itself

Contracts & Tenders

Global Appointments

OCTOBER 10 2013 Section:Companies Time: 9/10/2013 - 18:42 User: wrightj Page Name: CONEWS3, Part,Page,Edition: USA, 16, 1