Pakistan Commits to Forming Offset Policy for Defence Imports

In its latest ‘Two Years Performance Report,’ the Pakistani Ministry of Defence Production (MoDP) said that it drafted and circulated a new defence offset policy.

The offset policy is part of the MoDP’s effort to encourage private sector investment in Pakistan towards both raising new defence production capacity and drive research and development (R&D). In addition, the MoDP hopes that the offset policy would also facilitate more transfer-of-technology (ToT) arrangements from Pakistan’s primary defence hardware suppliers towards Pakistani companies.

Currently, the MoDP says it is circulating the new offset policy to the relevant stakeholders fore input, and upon completion, it will move the policy for approval by the Government of Pakistan.

What Is an Offset Policy?

Simply, an offset policy is an agreement between the government and weapon suppliers that require the latter to spend a percentage of the total contract price in Pakistan. That expenditure can take the form of foreign direct investment (FDI), buyback/countertrade, and supply-chain integration/sourcing (where the supplier sources parts or other services from Pakistani companies).

In economic terms, the main benefit of an offset policy is that it saves the buyer some of its foreign/hard currency when it imports defence equipment. In some arrangements, the offset policy may even result in hard currency gains where exports or investments exceed the cost of the contract. In fact, some countries – such as Austria, Brazil, Greece, and Germany – may aim for 100%+ offsets where possible.

Some governments may even use offsets strategically. So, for example, the buyer could require an offset in the form of investment or purchases in one of its industries, such as auto-parts manufacturing. Offset-based transactions and/or investment would allow that auto-parts base to grow and, potentially, achieve economies-of-scale and/or cost-reduction. In turn, that base could export more competitively and, in turn, generate overseas sales that match-or-exceed the offset, yet still be independent of the offset. Once that offset expires, the exports would continue, thus giving the buyer-state continuing hard currency gains.

Pakistan’s Offset Policy Efforts

The explicit mention of an offset policy by the MoDP indicates that Pakistan’s decision-makers recognize that the country’s continual shortage of hard currency is an impediment to procurement. Pakistan is not a strong exporter, nor does it attract enough foreign investment or remittances to support its imports.

Thus, the offset policy effort may be a move to both reduce the monetary cost of defence imports as well as use big programs to drive investment in various areas. In the best-case scenario, the MoDP likely hopes that offsets will result in net-hard currency gains through the long-term (e.g., through strategic or targeted investment in export-oriented sectors, growth of high-value industries, etc).

It is not an unwarranted move. In fact, most major defence powers impose offsets of varying degrees, and in some countries, agreeing to minimum terms is simply a way to qualify for a bid. Thus, at a surface level, Pakistan is taking a tried-and-conventional step towards improving both its defence and economy.

The Challenge of Implementing Offsets

While offsets may be a sound policy in theory, the desired results are generally difficult to implement. In Pakistan’s case, the challenge (or risk) of implementing offsets stems from an apparent deficit of strategic economic planning, regulatory/policy controls, executive inertia, and excessive barriers.

Strategic Economic Planning

The first step to designing and implementing an offset policy is to define exactly what the overall economic objects are and, more importantly, set granular-level benchmarks or key-performance indicators (KPI).

So, why does Pakistan want offsets? The obvious answer is to lose less of its hard currency from imports, but that is only the first goal. If one keeps it to solely that goal, then the supplier could deliver the outcome in ways that may not benefit Pakistan’s long-term economic interests.

For example, if the goal was to get a countertrade worth 30% of a $1 billion US deal, then the supplier can simply buy $300 million US in agricultural goods from Pakistan. On a raw trade balance sheet, that could be good enough. However, in reality, a surge of artificially induced exports could spike local produce and wheat prices. It may even direct local investment to local agriculture, which (while possibly stabilizing the domestic food prices) may eat into available land and cause environmental issues.

Thus, Pakistan would have to carefully define exactly where it wants the offset money to flow, and clearly set goals on which industries it wishes to support for growth.

In reality, a true ‘offset policy’ would tie into a strategic economic plan. In this case, the benefits of offsets (e.g., investment) need not tie into defence, but rather, they can go towards pharmaceutical production, automobile and auto-parts manufacturing, engineering services, IT, and other sectors.

In fact, these non-defence segments may be easier to work with since they do not involve natural security regulations (e.g., ITAR), which could make it simpler for suppliers.

The other offset model would be to tie into defence. In this case, Pakistan could supply defence products and services to the original seller. If Pakistan channels the offset to the private sector, it may even give an incentive to local investors to set-up production lines to support the benefits.

This would only work with a strategic partner which is amenable to sharing technology and merging its supply chain with Pakistan. Not only that, but a strategic partner may also be open to keep procuring parts and services from Pakistan after the offset agreement expires. One will see these types of arrangements between the United States and its allies, e.g., Canada, United Kingdom, and Australia.

In this case, the only countries that may be open to this arrangement are China and Turkey. China needs a strategic partner in Pakistan to divert a bulk of India’s attention. Turkey needs more economies-of-scale to support its marquee defence projects. It would not be surprising if the MoDP’s offset efforts are mainly geared towards generating returns from one or both of these countries.

However, Pakistan must have a granularly defined vision of where it wants its industry in the next 10, 15, and 20 years. It cannot afford a situation where offsets expand private sector capacity for a time, yet after that period, the private sector folds due to a lack of exports and/or domestic orders.

Regulatory Controls

For offsets to work, Pakistan must also ensure that every party involved is carrying out its obligations, and to have penalty mechanisms in place to reprimand failure or neglect.

Unfortunately, Pakistan is evidently weak on these areas. In fact, even if Pakistan had a well-defined offset policy on paper, the lack of controls and accountability could leave that paper on the shelves with zero real-world application. One need only look at the fact that Pakistan already has an offset policy (requiring a 30% return on any deal worth more than $15 million US), yet Pakistan seldom applied it.[1]

However, even if Pakistan starts pushing for offsets, there are many risks in implementation. First, it opens the door for corruption in that some may try using the offsets to benefit their own businesses. Second, it may even lead to a situation where the armed forces channel the offsets to their commercial spin-offs – i.e., Fauji Foundation, Bahria Foundation, Shaheen Foundation, and/or Defence Housing Authority.

Pakistan will need a system that aggressively audits these contracts and their implementation to prevent (or punish) unfair play. Likewise, the lack of controls may dissuade some suppliers from even engaging on offsets and, instead, see them promote discounts or loans as alternatives.

Executive Inertia

Simply, those negotiating Pakistan’s defence imports may not honour the offset policy. Pakistan already has an offset policy, but it was rarely implemented. Realistically, the top leadership of each service branch (i.e., the Chiefs of Staff) must champion offsets for Pakistan to consistently pursue them in its contracts.

Excessive Barriers

Finally, the relationship between the armed forces’ decision makers and the local private sector is far from productive.[2] In general, the local industry has complained of excessive restrictions, which are preventing it from engaging in original design work, testing, and other endeavours.[3]

If the armed forces are planning to channel offset benefits to the private sector, they will need to be more flexible with those companies. Otherwise, there would be a major risk of those companies failing to deliver on their exports/services (and, in turn, put the entire offset program in jeopardy).

Next Steps

There are risks and uncertainties to the MoDP’s offset efforts, but the fact that the MoDP had triggered a discussion in parallel to projects such as Project AZM could be a positive step. It suggest that there can be a level of lateral collaboration (e.g., Project AZM envisages major private sector involvement in Pakistan’s future aviation programs) and, at the minimum, cross-organizational support for the idea.

However, Pakistan must not underestimate the strategic planning and policy control side of the equation. Though the country has fewer resources at its disposal than other states, with the right policy controls as well as planning and implementation, it can achieve significant results in the medium-to-long-term. But it must set-up and commit to the right program.

[1] “Defence Offset Policy.” Directorate General Defence Purchase (DGDP) Pakistan. Accessed: 03 December 2017. URL: http://www.dgdp.gov.pk/documents/defoffsetpolicy.pdf

[2] Usman Ansari. “Pakistan’s private industry clashes with government over regulations.” Defense News. 10 June 2020. URL: https://www.defensenews.com/global/asia-pacific/2020/06/10/pakistans-private-industry-clashes-with-government-over-regulations/

[3] Ibid.