The Push and Pull of Offset in the Development of Malaysia’s Defence and Security Technology Park

Defence offsets have long been practiced by Malaysia as part of its strategic development plans, but the results have been mixed. In an effort to improve the impact of offsets, the government has institutionalised its countertrade and offset policy

28th Jan 2013

The Push and Pull of Offset in the Development of Malaysia’s Defence and Security Technology Park

Byline: Ron Matthews & Tracy Yip / Singapore

Defence offsets have long been practiced by Malaysia as part of its strategic development plans, but the results have been mixed. In an effort to improve the impact of offsets, the government has institutionalised its countertrade and offset policy - in harmony with its more systemic and coordinated defence procurement strategy. As with most emerging states, Malaysia has sought creative ways to exploit offset opportunities. Accordingly, in 2010, an ambitious plan was announced to develop a Malaysian Defence and Security Technology Park (MDSTP). This would function as a regional defence hub, generating high technology investment and synergies, particularly through the synchronization of existing and future Malaysian offset programmes. In effect, the MDSTP represents a new paradigm, in which defence offsets are used to both ‘pull’ in investment to the defence-industrial hub and ‘push’ out output destined for global customers facilitated by offshore vendor offset obligations.

Defence offsets, defined as industrial compensation conditional on the purchase of defence products or services, lie at the heart of Malaysia’s efforts to forge indigenous defence and aerospace capabilities. Offsets offer the potential of not only meeting focused microeconomic investment benefits but increasingly also the more macroeconomic benefits associated with addressing the country’s national interests, be they political, social or economic. The principal government goals as highlighted by the Ministry of Finance are reduced offshore technology dependence and currency outflow, raised global market accessibility, and encouragement of foreign Direct Investment (FDI). From both theoretical and policy perspectives, the advantages of offsets spread beyond economic diversification and Gross Domestic Product (GDP) growth. Along with technology transfer, offsets are held to create employment opportunities and infrastructural development.

To optimise such development benefits, Malaysia has sought to transform its economic capacity from primarily commodity-based activities to higher forms of capital-intensive manufacturing and knowledge-based endeavour. In this respect, the defence and aerospace sector is viewed as a vehicle for acquiring high-end technology to move Malaysia up the ladder of development in order to become a high income nation. However, there are profound challenges in achieving this goal. Malaysia’s labour costs over recent years have been rising, reducing competitiveness, and, in turn, its ability to move up the value chain. This is the so-called ‘middle-income trap’, symptomatic of the plight facing the local defence sector, where there is an inability to compete in either the low- or high-end segments. Prime Minister Najib Razak’s solution has been to promote what is termed the Economic Transformation Plan, which, for defence, translates into high value added investment, partially through foreign technology partnerships. However, for this plan to work, higher defence outlays are an imperative.

To this end, Kuala Lumpur has been increasing its defence expenditure in parallel with its GDP growth rate over recent years. In 2000, defence expenditure amounted to RM2.6 billion [US $820million], representing 11% of the country’s development expenditure, but by 2011, the defence spend had almost doubled to RM4.4billion [US $1.4billion], reflecting a slight fall at 9% in its proportion to development expenditure. However, over a much longer period, Malaysia has been actively engaged in defence capacity creation, with the Ministry of Defence increasingly believing that offsets can be used as a means of extracting advanced technology from the major defence economies.

Thus, in conjunction with Dr Mahathir’s Vision 2020 concept, reflecting the year when Malaysia would realise its technological aspirations and become an advanced country, offsets have become a sine qua non of the defence procurement process. From 1990 to 2004, 43 offset programmes were tied to major defence equipment procurement programmes. Yet, Malaysia’s offset requirements were often cross-meshed with counter-purchase obligations, diluting the impact of technology transfer efforts. Palm oil, for instance, had been used as the settlement method in the country’s purchase of 18 MiG 29s from Russia in 1994, 28 Hawk fighters from the UK in the late 1990s, and for the procurement of two Scorpene submarines in 2003.

Nevertheless, some of Malaysia’s offset programmes have been associated with the creation of viable commercial undertakings. Local companies have benefited from the offset policy, opening the door to opportunities in the global defence business. For example, Composite Technology Research Malaysia (CTRM) is a first-tier supplier to BAE Systems, GKN and Vought Aerospace equipment and components. AIROD is a certified C-130 centre, and an internationally recognized Maintenance, Repair and Overhaul (MRO) organization, attaining numerous credits and authorizations from various civil, military and OEM firms for the services provided. Sapura Defence has also become widely-known for its expertise in computer-based simulation systems.

It would be surprising, however, if Malaysia’s countertrade and offset practices did not suffer negatives. They have often proved ad hoc in nature, uncoordinated, and dependent largely on the negotiation skills of individual project teams. As a result, the policy on the composition of offsets has frequently shifted, further complicating the management of the country’s programmes. In fact, there was neither an official definition of offsets nor a formal offset policy delineating the credit targets, countertrade composition or the standard operating procedures until 2005 when the Ministry of Finance finally approved and institutionalised the country’s countertrade and offset policy. This lack of a coordinated strategy in managing and utilising offsets in the early years impeded Malaysia’s efforts to develop a sustainable defence industrial base. Offset programmes were invariably short-term, leading to problems with product continuation for commercial viability. Investment was left unattended or unutilised when the offset project was completed.

Although offset policy was perceived as ineffective, it was also recognised that this was partially due to Malaysia’s low level of defence industrial and technology capacity. This weakness limited its technology absorption capability, necessarily confining the defence economy to mainly build-to-print activities. Of course, operating under this defence industrial constraint meant that Malaysia’s offset recipients were still dependent on foreign sources of technology, components, parts, and process machinery.

An example of this dependence is the offset programme associated with the 2002 acquisition of six AS 555 SN Fennec helicopters for the Malaysian Navy. Albeit that 20 Malaysian companies had become subcontractors to SME Aerospace, a remarkable achievement, the fact remained that the local supply chain was still technologically shallow, with local ‘production’ remaining highly dependent on European sources, not untypical for developing economies. Malaysian offset programmes have thus attracted criticism for not promoting higher value-added activities, such as stimulating in-country research and development (R&D), effecting technology transfer that is cost-effective, and creating high-skilled jobs. It is telling that as recent as the mid-2000s, Malaysian defence companies possessed not a single patent, around 90% of them had inadequate in-house R&D facilities, and some 70% of local defence contractors spent less than 10% of annual revenues on R&D. However, again, this is consistent with the relatively sparse levels of defence and civil R&D generated in the developing parts of the world. In this regard, Malaysia’s national R&D budget is no better and no worse than the global average in this respect, spending around 0.60% to 0.65% of its GDP on R&D between 2002 and 2006, compared to the 2.11-2.28% spent by its more advanced neighbour, Singapore, over the same period.

Realising that the country was not benefitting from Malaysia’s ad hoc and inconsistent countertrade and offset approach, policymakers sought to institutionalise offset arrangements via the 2005 Policy and Guidelines on Offset Programmes in Government Procurement, with governmental agencies captured in 2011. The formalised offset policy defined the scope of offset, specified the relevant processes as well as implementation procedures. Historically, offset in the Malaysian context was simply categorised into direct and indirect offset. However, under the new definition, a finer granularity was applied, decomposing and prioritising direct offset into key elements, such as technology transfer to the local defence industry, the creation of domestic value chains, and the promotion of production networks and systems development. The Indirect offset dimension was also emphasised via, again, the transfer of technology and know-how, driven by the need to generate patents and intellectual property rights. Other indirect offset goals included research, development and commercialisation for economic development, engagement of local manufacturers in the supply chain network vis-à-vis local content, access to global markets for local exports, and inclusion of FDI for offset credit. Additional stipulations required establishment of the offset threshold at RM50million [US $15.8mn] and a 100% offset credit value for the Main Procurement Contract.

In an effort to address these revealed deficiencies and energise Malaysia’s defence industrial and technological base, the government announced a 2010 plan to develop a Malaysian Defence and Security Technology Park (MDSTP). The MoD’s ambition is to develop a defence regional hub that will act as a magnet for defence industrial investment carrying the potential for technological spin-offs into the broader economy. Located in Sungkai, a small town in Perak, the MDSTP is planned as a mega public-private partnership project aimed at developing by 2014 an integrated civil-military industrial centre. The project would occupy an area of 3,115 acres, forming a high technology township comprising of R&D facilities, manufacturing amenities, commercial and enterprise entities, education and healthcare centres, as well as a residential area. It is envisaged that the MDSTP will act to open-up access to the global defence industry, specifically for investors in the six targeted sectors of aerospace and avionics, automotive, maritime, information communication technology, weapon systems, and general defence products.

A joint venture between Masterplan Consulting Sdn Bhd, a local systems integrator, and Blenheim Capital, a foreign offset finance and trading enterprise, was formed with the title of Blenheim Capital Malaysia to manage the MDSTP. The Memorandum of Understanding between the two parties, signed in early 2011, specified the division of labour as Masterplan Consulting being responsible for asset management and Blenheim Capital generating the finance to develop the zone. The government acting as the third principal stakeholder would importantly offer tax incentives to foreign companies intending to invest in the project, with a total of RM6billion [A$1.9bn], ring-fenced for MDSTP infrastructural projects.

From the start, policymakers have viewed offset investment as a key ingredient in the success of the MDSTP concept. Increased offset investment derived from substantial new defence equipment acquisition earmarked within the 10th Malaysia Plan (2011–15), some 10% of which has been allocated for procurement, would be employed to leverage the growth and development of the MDSTP. Significantly, though, defence expenditure is set to decline slightly from the RM27.2billion [A$8.7bn] in the 9th Five-Year Plan (2006-10) compared to the RM26.8billion [A$8.5bn] in the present 10th Five Year plan, emphasising the importance accorded to direct offset to make-up the shortfall.

Taking a strategic perspective, the 2005 formalisation of Malaysia’s offset policy represents just the start of a strategic plan aimed at progressive development of ‘sustainable’ indigenous defence industrial capacity. The plan is for offset and the MDSTP to operate synergistically, but for this to happen, institutional mechanisms would have to be put in place. In the past, offset programmes had been put on autopilot without a central coordinating and long-term planning agency responsible for offset management. However, following the introduction of the MDSTP, Blenheim Capital Malaysia would become the central strategy and marketing company responsible for development of the entire project, ranging from technology and sector prioritisation to financing strategy. The joint venture company would also provide training and consultancy services in capacity building, aimed at facilitating communication and coordination amongst the relevant government agencies and departments.

The objective of the MDSTP is to catalyse development of Malaysia’s indigenous defence industrial base. Uniquely, outstanding offset programmes would drive and finance the project. From offset clauses in Malaysia’s previous defence equipment procurements, the country has accumulated a total of RM500 million offset obligations. The government took the decision to channel these obligations towards the stage 1 project costs covering the investment of infrastructure and facilities in the park. For example, Russia’s Irkut, which supplied Malaysia with 18 Su-30MK fighters, has agreed to build a RM15.3billion original equipment manufacturing (OEM) plant to licensed-produce an array of parts and components for both the Malaysian and global market.

Other foreign investors include China’s Huawei technologies and ZKZ Technologies, and at the 2012 UK Farnborough Airshow, Italy’s Finmeccanica also threw its hat into the ring. This huge defence and aerospace conglomerate signed a MoU to participate in the MDSTP. The agreement covers nine of Finmeccanica’s subsidiary companies, including AgustaWestland, Alenia Aermacchi and Selex Galileo. The MDSTP has attracted investors from the United States, Europe, Japan and South Korea to commit an initial capital of RM3.1billion at the beginning of 2011. Additionally, these foreign companies, as well as local firms, have pledged RM15.3billion for the park over the next five years. With participation from these mainly defence-based foreign investors, the MDSTP is set to be an important platform for Malaysia to integrate its defence industry within global OEM supply chains.

Malaysia’s policymakers have been smart in their conceptualisation of the synergistic relation between offset and the MDSTP. Not only do they see offset funding as the sponsor of MDSTP high technology capacity, but in turn the Park lies at the heart of Malaysia’s efforts to expand and upgrade local technology absorptive capacity. It is anticipated that this will lead to the promotion of civil-military integration and the intensification of defence R&D, providing the in-country capacity and expertise to increase the effectiveness of defence offset investment.

Moreover, the MDSTP represents an embryonic defence and aerospace high technology cluster. The history of clusters is that as they grow and intensify inter-industrial linkages, foreign companies are incentivised to geographically locate to the cluster, coerced to some extent by offset directives and the lure of major future defence contracts. However, with the passage of time, and the broadening and deepening of technological expertise, overseas and local subcontractors will voluntarily be attracted to join the cluster.

The overarching objective of this clustering process is to generate indigenous innovation through the proximity of appropriate resources and the competition and cooperation of stakeholders at both the horizontal and vertical industrial levels. An essential policy-element in this innovational-push is the focus on human capital development. Thus, embroidered into the MDSTP planning assumptions is that up to 15,000 high-skilled jobs will be created in the defence sector. To achieve this employment goal, the project plans to foster cooperation with local higher education institutions, especially the National Defence University and the Technology University of Malaysia. Moreover, it is expected that cooperation with local universities will occur to spur the development of underpinning defence R&D capacity to contribute to upgrading the country’s domestic technology absorptive capacity.

Fundamental weaknesses existed in Malaysia’s offset approach at the start of the country’s 1970’s defence industrialisation push, especially the lack of a master strategic plan and formalised offset policy. Notwithstanding the country’s huge defence procurement expenditure, its uncoordinated offset programmes have likely proved costly, producing sub-optimal economic benefit, and leading to the view that offset strategy remains a work-in-progress. The government’s 2005 initiative to institutionalise its offset policy was an important move in reflecting not only a commitment to incorporate defence industry as a strategic development node in its own right, but also as a transmission mechanism for technology spin-offs to the wider civil economy.

The thrust of Malaysia’s contemporary policy position is that offset policy reform, whilst necessary to address the technology ‘transfer’ variable in the technology development calculus, is insufficient to ensure the effectiveness of technology assimilation. Thus, to reap the benefits of offsets, it is also essential for Malaysia to possess adequate technology absorptive capacity, encompassing diversified dual-use technology industries to encourage civil-military integration, raised levels of investment in defence R&D, and genuine commitment to local human capital development. In this respect, the MDSTP provides a sound and comprehensive master plan for upgrading Malaysia’s absorptive capacity whilst at the same time exploiting offsets in the development of an incipient defence and aerospace industry. It is too early to judge whether the venture will prove successful. However, whatever the outcome, Malaysia’s bid to employ a novel offset-push (local investment inputs) and -pull (integrating local outputs into offshore vendor supply chains) model to generate both local absorptive capacity and enhanced offset effectiveness is a truly novel and creative way of kick-starting defence innovation in the pursuit of a sustainable defence industrial base.

Authors: Tracy Yip is a researcher and Ron Matthews a professor at the S. Rajaratnam School of International Studies (RSIS), Nanyang Technological University, Singapore.


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