Challenges Ahead for Indonesia’s First Defence Offset Policy

Byline: Ron Matthews, Curie Maharani and Fitriani (Chair, Defence Economics and Associate Research Fellows, RSIS – Nanyang Technological University, Singapore)

Offset is a ubiquitous characteristic of the contemporary arms trade. Yet, Indonesia, surprisingly, is one of the few countries engaging in defence acquisition without formal requirements for offset. This will soon change, with Jakarta reportedly due to launch the country’s first national offset policy in June this year. Lessons learned from the offset experiences of other countries suggest that the policy should firstly be crafted to reflect Indonesia’s unique economic and security environment and secondly weaved within a broader defence-industrial tapestry.

Nearly all arms-importing countries have offset policies, aimed at extracting reciprocal benefits from overseas arms vendors on the basis that ‘if I scratch your back, you must scratch mine.’ Indonesia is one of the few countries without a formal offset policy, but its Defence Facilities Directorate has a mandate to quickly put this right. The imminence of Jakarta’s first formal offset policy has aroused much debate and expectancy, but the reality is that most countries struggle to realise its hyped potential. Indonesia is reportedly seeking advice from both Australia and India, and there is merit in comparative evaluation, but emulation of these two countries’ approaches should be qualified by their differing contextual experiences. Canberra abandoned its formal offset policy some years ago, arguing that it did not work, and whilst New Delhi’s 2005 offset policy is still ongoing, it has attracted criticism on several counts, including its over-rigid focus on defence, non-inclusion of offset multipliers, and an insistence on leaving technology transfer outside the formal offset framework.
The proposed launch of Indonesia’s offset policy is timely. The economy has been growing at 4-6 percent for the past 7 years, and as defence expenditure tends to move pari passu with economic growth, the outlook for Indonesia’s TNI is positive. Indeed, the defence budget has already started to rise from around 0.8 percent of GDP in 2010 to 1.2 percent this year, with the expansion rising to a target 1.5 percent of GDP by 2014. In parallel, there are ambitions that defence acquisition funding will rise by more than 70 percent between 2011 and 2014, hitting US$ 2.14 billion by 2015. Compared to the Malaysian and Singaporean defence budgets of US$ 8.3 billion (2011) and US$ 4.3 billion (2011) , respectively, the projected rise in Indonesia’s defence spending to US$ 9 billion will place it amongst South East Asia’s biggest defence hitters.

Indonesia’s rising acquisition budget along with continued use of what are termed ‘export credits’ (foreign defence export loans and local bank finance) will act to beef up Jakarta’s growing shopping list of military hardware. Indonesia’s defence doctrine of ‘Minimum Essential Force’, introduced in 2004, represents a measured strategy of acquiring the appropriate level of capability to address a broad spectrum of security threats. The problem with this model is that cost-effectiveness will always be difficult to achieve given the inevitable constrained level of procurement. Low scale robs countries of the leverage to extract substantial offset concessions from offshore vendors, undermining local defence industrial ambitions. India provides the contrast to this dilemma. It is a mega-defence economy, reflected by the fact that its 2011-12 US$ 36 billion defence budget is expected to rise to US$ 50 billion by 2015. Further, between 2012 and 2017 it is anticipated that New Delhi will spend a similar sum on military acquisition, equipping it with the acquisition muscle to demand sizeable work packages and technology transfer from the major global defence primes.
Jakarta does not possess this leverage, but, nevertheless, has recently revealed a range of weapon systems that it seeks to acquire, and cooperation will dominate acquisition policy. This will either be through offset or other forms of cooperative procurement, such as joint venture production or even mutual development programmes. Possible collaboration with foreign contractors is certainly viewed as a vehicle for transferring work and technology to revitalise Indonesia’s ailing strategic industries, but it is overseas capital, expertise and commercial acumen that are additionally seen as essential in transforming the backyard industrial culture of local defence producers.
Indonesia should consider crafting an offset policy appropriate to its own unique conditions. It needs to make a fresh start, dispensing with the ad hoc-ism prevalent since the 1960s. Indonesian acquisition has often been:
– detached from defence policy (for example, the sudden procurement of two Su-27SKs and two Su-30MKs under the 2002-04 Megawati regime, and paid for via coffee, palm oil, cement, rubber and bauxite)
– driven by discounted sales opportunities (illustrated, especially, by the 1994 acquisition of 39 ships from the former East Germany’s naval inventory at the heavily discounted price of US$125m)
– delinked from reciprocal technology transfer or work packages (the fact is that most recent major procurements have not incorporated any offset, but some deals, such as the planned 2005 US$75m acquisition of 10 Polish M-28 Skytruck aircraft, promised offset work, but were of such low value that the acquisitions eventually failed).

Moreover, the long-term paucity of acquisition funding has acted to starve local defence industry of essential investment required to modernise process technologies, promote indigenous R&D capacity, upgrade worker skills and, importantly, generate sufficient output scale to reduce acquisition cost. Of equal concern, though, is the absence of local specialist subcontractor industries. This subcontractor vacuum acts to suppress competitiveness and assuage the emergence of an international ‘brand’ required to effectively market Indonesian weapon systems.

However, it was not always like this. The much maligned Dr. Habibie, Indonesia’s long-serving (1978-1998) State Minister for Research and Technology (Menteri Negara Riset dan Teknologi), was the architect of Indonesia’s ‘strategic’ industries, including PT IPTN (aerospace), now re-named PT Dirgantara, PT PAL (shipbuilding), PT Pindad (land systems), and PT LEN (electronics). Dr Habibie conceptualised that these strategic industries would power Indonesian defence industrialisation, leading to the emergence of a local specialist supply chain through ‘trickle down’ effects. This development process would reverse conventional consumption-led industrialisation, replacing it with an interventionist capital goods-led strategy, a process coined by Habibie as … ‘beginning at the end, and ending at the beginning’ (berawal dari akhir, berakhir di awal).

Had this interventionist model been allowed to run its course, it would probably have worked (government-sponsored sustainability rather than independent profitability, but this is not unusual in the developing world), primarily because in Habibie’s era abundant government funding was available. Demand is always key, however, and this all but disappeared in 1998 when the Asian economic and financial crisis hit Indonesia hard. Skilled employment shrank alarmingly, sales and profits disappeared, and, in the absence of offset, foreign technology infusion and the provision of work packages simply dried-up. Two years ago, PT PAL pleaded for bail-out funds to stay afloat, and recently it was revealed that PT Dirgantara was on the verge of bankruptcy. If the Indonesian government is serious about wanting a robust indigenous defence industry, then this state of continuous crisis cannot be allowed to persist.

Indonesia’s defence industrial malaise is now so deep-seated that an offset policy, by itself, is unlikely to be effective. Of course, offset has the potential to contribute to defence industrial ambitions, but it needs to be set within a broader overarching defence industrial strategy. The formulation of this strategy should encompass the following nine action points:

1. Given Indonesia’s huge defence commitments, it is obvious that its low military expenditure to national income ratio needs to be increased, but the question is by how much. Singapore’s 2010 defence budget, for instance, represents 4.3% of GDP, and this is to defend constrained territorial boundaries and a population barely above 4 million people. Indonesia, by contrast, spends a meagre 1.2% of its GDP to defend an archipelagic territory comprising over 17,000 islands and a population exceeding 242 million. Perhaps, a non-contentious MILEX/GDP target might be the 2010 ASEAN average ratio of 2%.

2. Indonesia must implement policies to secure the critical mass of demand for ensuring technological vibrancy in its defence industrial base. For this to happen, its acquisition budget has to rise, enabling military capability requirements to be met in a cost-effective way. In the absence of scale, benchmarking Indonesia’s incipient offset policy with that of India’s will be a nugatory exercise. India’s current generous US$ 30 billion acquisition defence budget allows stretched but simultaneous acquisition of 126 European Medium Multi-Role Combat Aircraft (MMRCA), 250-300 Indo-Russian Fifth Generation Fighter Aircraft (FGFA), 272 Russian Sukhoi SU-30 MKI fighters and nearly 200 Tejas Lightweight Combat Aircraft (LCA), dwarfing Indonesian procurement struggling to reach even double figures, eg the 2003-08 procurement of 10 SU-27/30 combat aircraft. Moreover, Indonesia’s low-scale procurements allow overseas contractors to circumvent any Indonesian offset requirements, not least because they are patently commercially non-viable.

3. Government procurement practices suffer from endemic corruption. This has myriad negative implications, ranging from the loss of budgetary funding, due to illegal price mark-ups, commissions and hidden bribes, to the corruption-driven acquisition of weapon systems delinked from defence policy and strategic requirements. Transparency International’s Corruption Perceptions Index ranked Indonesia 110th out of 178 countries in 2010. Rampant corruption has pressured the Yudhoyono administration to raise ethical and professional standards of public procurement. Since 2002, the Komisi Pemberantasan Korupsi (KPK), an Indonesian version of the UK’s powerful Audit Commission, has been tasked with rooting out graft from the public sector. It has been instrumental in the January 2011 signing of the Declaration on Anti-Corruption by the three Chiefs of Staff under the auspices of the MoD. This allows the KPK to monitor procurement activities, reinforcing progressive centralisation of defence procurement designed to facilitate transparency, accountability and greater civilian oversight of acquisition programmes. However, Jakarta should also consider the introduction of an anti-corruption clause into its fledging offset policy. The clause might be drafted along the lines of India’s Anti-Corruption Articles 16 and 17 within its 2005 offset policy, specifically aimed at eradicating corruption from the procurement/offset process.

4. Jakarta’s policymakers should consider more broadly defining defence industrial boundaries, because whilst advanced countries mostly have mature, diversified defence industries, possessing a wide array of subcontractors, this is not the case for Indonesia. Nor is it generally the case for developing countries, including India, and, arguably, not even for 3rd-tier industrial players, such as Australia. Accordingly, it makes sense to broaden the offset policy-envelope to capture ‘dual-use’ industries, especially those producing information technologies, computerised equipment, microelectronics, avionics and telecommunications systems, representing around 70-80 percent of the value of modern weapon systems.

5. Indonesia should prioritise the design of a flexible rather than rigid bureaucratic offset policy. The aim should not be to coerce offshore vendors into contractual ‘bondage’, rather it should be to nurture profitable and therefore sustainable long-term industrial partnerships. In this regard, the British ‘Industrial Participation’ offset model, based on openness, transparency, and mutually beneficial cooperation, may be the appropriate way forward rather than India’s prescriptive approach.

6. Indonesia needs to reinforce its defence-related R&D capacity. Offset can act as a necessary policy vehicle to transfer technologies on the back of expensive arms acquisition, but it is unlikely to be sufficient to construct a robust and durable indigenous Indonesian defence industrial capability. For this to happen, parallel funds must be found to create a strong domestic defence R&D infrastructure, going beyond the present miniscule commitment of less than 0.5 percent of GDP.

7. Development of a viable Indonesian defence industry will require complementary ‘absorptive technology’ pillars to be constructed, additional to the creation of local R&D capacity. Policies must be implemented to aggressively foster innovation through domestic industrial and technological clusters, such as Singapore’s incipient aerospace cluster at Seletar airfield and Malaysia’s maritime clusters at Selangor, Trengganu, Sarawak and Sabah.

8. Instead of operating in isolation, Indonesia’s offset policy should be incorporated within an appropriate defence-industrial strategy, where defence and technological imperatives are precisely defined. However, this presupposes the existence of a defence policy that articulates strategic threats as well as the military capabilities required to address them.

9. Finally, Indonesia’s predilection for prioritising defence industrial self-sufficiency objectives needs urgent revision. In an era of defence globalisation, no country, except possibly Russia, comes close to achieving defence-industrial self-sufficiency. The range of required capabilities are technically too demanding, and hence non-affordable. Instead, as part of a centralised defence-industrial strategy, countries are increasingly ‘selectively’ prioritising 1st-order indigenous high-technology capacities, encouraging international cooperation at 2nd-order levels of acquisition, and only then globalising at the 3rd–order level of low value generic ‘commodity’ procurements. This is the complete opposite of what is happening in Indonesia. High technology systems are (necessarily) procured off-the-shelf from overseas vendors, with limited collaboration sought from foreign partners, such as in the mooted submarine programme with South Korea, and low value items are sourced locally, reflecting the labour-intensive nature of Indonesian development.

Policy Implications
Indonesia‘s Defence Minister Yusgiantoro has rightly committed to launching an offset policy, but whilst it is a necessary step forward, it will be insufficient to revive the bankrupt strategic industries, and, more broadly, the ailing Indonesian defence economy. Implementation of an integrated civil-military industrial strategy, inclusive of an offset policy, is now an urgent imperative, alongside a determination by the government to provide the required resources to make the strategy work. If the Indonesian government is serious about wanting a strong indigenous defence industry then it must be prepared to pay the price, bearing in mind that the alternative, foreign dependence, is likely to be far more expensive in the long-run.


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