consolidation and downsizing in the U.S. industrial base. As stronger competitors, U.S. firms have increased their share of an ever-decreasing international defense market. In addition, the United States spends three times more on military R&D than European nations, contributing to the U.S. lead in sophisticated weapon systems, which was so critical in our recent involvement in Kosovo.

Another argument presented in favor of offsets is that the U.S. has a positive, but declining, defense trade balance with Europe. However, as with Canada, the U.S. has a negative balance in merchandise trade with Europe, which includes both commercial and military trade. The defense surplus has ranged from $2-3 billion since 1993, while the merchandise deficit was $15.2 billion in 1996 and grew to $16.7 billion in 1997. When offsets are included in the calculation, the U.S. defense trade surplus is effectively cut in half.

Additionally, the U.S. General Accounting Office reported in November that the Department of Defense has undercounted the value of foreign content in U.S. weapon systems. This would also erode the defense trade surplus total. As these figures show, it is important to look at the entire trade picture rather than focusing on one sector.

Where do we go from here? For the last three years, BXA's annual report has had as one of its goals international consultations on offsets, both bilateral and multilateral. We have worked hard over the last two years to develop a domestic consensus for such an effort through discussions with the interagency community, prime contractors, subcontractors, labor, and trade associations. While there are differences of opinion among these groups, one thing that we have all agreed on is the need for a dialogue with our allies on this complex subject. BXA also co-funded a series of conferences on offsets and the aerospace industry through the National Research Council. Again, our objective was to focus attention and spur thinking on solutions to the issue.

In the last year, we have made progress in the area of international consultations, as well. First, we believe that it is important to address the issue with our European allies, since they are our largest defense trade partners and demand the highest offsets. We are pursuing this both multilaterally and bilaterally.

Secondly, a DOD-led interagency group met with Canadian representatives to see what headway we can make in reducing offsets. More detailed discussions are being planned. As our closest neighbor and largest trading partner, and because of that nation's role in the North American defense industrial base, it was important to make progress with Canada.

Third, we will be meeting with representatives of the Dutch government in September, following up on an earlier meeting, again with the objective of eliminating or reducing offsets in exchange for improved access to the U.S. market. We've also had very preliminary discussions with the Swedes, the Danes, and the French, who are interested in discussing alternatives to offsets as well.

On a different front, offsets are mentioned as a concern in the USTR Title VII report on unfair government procurement practices (see attached). Through this report, we have put governments around the world on notice that we are looking for a new way to conduct defense trade - without offsets.

Similarly, my organization has participated in offset conferences around the world, speaking to audiences of foreign offset officers and prime contractors. Our message has been surprisingly well-received: I think that most parties would readily back away from the offset system if an acceptable alternative was available.

While we have made great strides in opening communications on offsets, there will be no quick solution. It is a buyer's market for defense systems, and weapon sellers in France, Britain, and the United States are confronted with ever-increasing offset demands.

It will be difficult to stifle the demand for offsets, at least in the short term. However, it may be easier to come to an agreement among the sellers to limit or eliminate offsets. While our goal is to eliminate offsets, we may wish to consider some principles which could increase our leverage.

Based on our extensive discussions with foreign governments, and U.S. and foreign industry representatives, I believe we should consider the following possible approaches as we move forward in our consultations with our allies:

1.

2.

We should continue our efforts toward international negotiations on offsets rules. Our bilateral discussion in the past year suggest there is growing receptivity to this idea. We should focus both on trans-Atlantic trade with our European allies and on third country markets where we compete with EU manufacturers.

More accurate information on all foreign sourcing of parts and components in U.S. weapon systems down to the subcontractor level would provide better data upon which to base our bilateral and multilateral defense trade discussions and negotiations.

Additionally, we want to take a closer look at the British program I described earlier, which may place U.S. companies at a disadvantage in the global marketplace. The key features of this new program would be:

1.

2.

3.

4.

The government assumes no liability or obligation for the offsets.

It brings senior level officials' support in facilitating offsets.

British companies gain a competitive advantage in the international defense
market place.

Government assistance has been designed to meet unavoidable offset demands
with minimum damage to suppliers and their employees

Such measures were designed to match and neutralize competition in the marketing of offsets. The increased efficiency of companies in dealing with offsets would greatly reduce business prospects of competing foreign firms.

We are unlikely to restrain or eliminate offsets by just complaining about them, or by unilaterally restricting ourselves and our defense contractors. While that might set a good example, it would be tantamount to unilateral disarmament, leaving our competitors free to exploit offsets even further. As we learned in the 1970s and 1980s when our competitors were using predatory export financing to capture markets, it's sometimes necessary to fight fire with fire. For many

years Congress authorized a "War Chest" at the U.S. Import-Export bank to be used to counter and match below-market export financing when our competitors insisted upon using it. The result of our willingness to match and even trump our competitors with financing terms eventually brought our competitors to the negotiating table and resulted in international agreements to limit such financing. If we are serious about constraining offsets, we need at least to consider a similar strategy. The concepts and options I've outlined could move us in that direction.

Thank you, Mr. Chairman. I would be pleased to answer any questions.

ATTACHMENT

Excerpt from

ANNUAL REPORT ON DISCRIMINATION IN FOREIGN GOVERNMENT
PROCUREMENT

Office of the United States Trade Representative

April 30, 1999

Offsets in Defense Trade

When purchasing defense systems from U.S. defense prime contractors, many U.S. trading partners require compensation in the form of offsets as a condition of purchase in either government-to-government or commercial sales of defense articles and/or defense services. Offsets include mandatory coproduction, licensed production, subcontractor production, technology transfer, countertrade, and foreign investment. Offsets may be directly related to the weapon system being exported, or they may take the form of compensation unrelated to the exported item, such as foreign investment or countertrade.

Prime contractors view offset arrangements as a necessity for success in the international marketplace. However, offset requirements cause prime contractors to select subcontractors based on their being located in the country requiring the offset versus best value, thereby adversely affecting potential U.S. subcontractors. Originally designed to enhance allied national security, offsets increasingly have become economic development tools for the countries that demand them. Furthermore, there has been a recent trend to fulfill offset requirements with nondefense products versus defense products.

Mr. MICA. Thank you for your testimony. We will withhold questions until we have heard from the Honorable Alfred Volkman, who is the Acting Deputy Under Secretary of Defense for Commercial and International Programs with the Department of Defense.

Welcome, sir. You are recognized.

Mr. VOLKMAN. Good morning, Mr. Chairman, members of the subcommittee. I appreciate this opportunity to participate in these discussions on the subject of offsets in international trade.

As almost all of our panelists have noted this morning, there is no consensus on the subject of offsets. Government agencies have a range of views on the topic, and industry opinion on the matter is also divided. There is no definitive evidence of the effect of offsets on the U.S. economy. Views on their effect are generally divided between those who accept offsets as an unavoidable cost of doing business overseas and those who believe that offsets negatively affect the defense industrial base and other U.S. interests.

It is difficult to accurately measure the impact of offsets on the overall U.S. economy and on specific industry sectors that are critical to defense. The GAO reports that U.S. defense companies advised them that without offsets, most export sales would not be made and the positive effects on the U.S. economy and defense industrial base would be lost. In addition, company officials indicated that export sales provided employment for the defense industry and orders for larger production runs, thus reducing unit costs to the U.S. military. They also noted that many offset deals created new profitable business opportunities for themselves and other U.S. companies.

Critics, however, charge that offsets have effects that limit or negate the economic and defense industrial base benefits that claim to be associated with defense export sales.

In response to concerns raised by the impact of offsets, the President issued a policy statement in 1990 that reaffirmed DOD's longstanding policy of not encouraging or participating directly in offset arrangements. This policy statement also recognizes that certain offsets are economically inefficient, and directed that an interagency team led my DOD, in coordination with the Department of State, consult with foreign nations on limiting adverse effects of offsets in defense procurement.

The Department of Defense fully supports the policies articulated by the Congress and the administration concerning the need to negotiate with friendly and allied governments to eliminate the harmful effects of offsets in defense trade. My office has been actively engaged in discussing offsets with key allies during our regular meetings on reciprocal defense procurement activities. In addition, we have cosponsored seminars, organized by independent organizations such as the National Research Council, to better understand and deal with the complex and growing world of offset demands in international trade.

More recently, we initiated action to lead an interagency team, including representatives from the Department of State, Department of Commerce, Department of Labor, and the Office of the U.S. Trade Representative that has met bilaterally with officials from Canada and the Netherlands on the subject of the harmful effects of offset demands in defense trade.