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A Strategy to Prepare Embraer for the Restricted Proex Financing System

  An Approach to End the Aircraft Subsidies Dispute

 

Saulo Nogueira

 

Master’s Project
Commercial Diplomacy

Monterey Institute of International Studies

 

Advisors:

Professor William Arrocha
Professor Geza Feketekuty
Professor Bill Monning

 

Edited By Janell Jenkins

 

This paper was researched and written to fulfill the M.A. project requirement for completing the Monterey Institute of International Studies’ Master of Arts in Commercial Diplomacy. It was not commissioned by any government or other organization. The views and analysis presented are those of the student alone. Names of people, corporations, businesses and governments are used only as examples. in order to depict a realistic, albeit fictional, scenario. This does not represent any knowledge of these examples, nor does it in any way represent an endorsement by an individual, corporation, business or government. The general background and information related to the relevant laws, regimes and agreements is factual, although students will need to supplement the information on specific WTO agreements and cases through their own research.

 

All material in this document is that of me, and does not reflect the views of anyone in the aircraft industry. This document is exclusively the work of the author. The reproduction of any material within this document is prohibited without the prior written permission of the author.

 

 

Table of Contents

 

Scenario 

Issue       

Executive Summary

Introduction              

Background         

            Dispute Over Proex Subsidies   

   History of Legal Proceedings       

            History of the Dispute           

            Canada’s Indirect Retaliation              

   Commercial                 

            The Growth of the Regional Aircraft Industry          

            Embraer         

            Bombardier    

            Research & Development           

            Comparing the Two Aircraft Manufacturers            

   Economic

            Comparing Economic Conditions           

            Facts About Embraer             

   Policy    

            Research and Development in Brazil            

            The Information Technology Law     

   Political Significance of the Dispute                 

            Stakeholders  

Analysis Section 

   Policy Analysis   

            How the Tax Credit Should Work            

            ‘Brazil Cost’   

   Commercial Analysis                      

            Changing Proex            

            Calculations of Impact From Using Proex III            

            Applying the R&D Tax Credit             

            Scenarios For Different R&D Tax Bills            

            Overall Result From Changes to Subsidies   

  Economic Analysis   

            External Debt          

           Effect of Restricting Proex        

           Effect of Granting R&D Tax Credits       

           The IT sector         

Accounting for Taxes foregone    

   Political Analysis   

            How Politics Work in Brazil                            

            Restructuring Proex            

            Pushing for Tax Credit for Research and Development            

            Pushing the Canadians to Reform Their Subsidies            

   Legislative Analysis           

   Legal Analysis   

            Domestic Laws            

            International Laws            

  Recommendation   

Comprehensive Strategy

 

   International Strategy  

            Cooperating with the Ministry of Foreign Relations            

            Recommended Negotiation Process            

            Negotiation Strategy            

            Supporting Canadian NGO’s       

            Justifying the R&D Tax Bill to The WTO            

   Domestic Strategy  

            Action Plan     

            Establish a Business Coalition            

            Establish a Legislative Coalition         

            Legislative Strategy   

            Research Strategy  

            Institutional Strategy

            Public Relations Strategy 

    Building Domestic Consensus on the Proposal

            Political Coalition  

            Political Opponents

   Timetable

 

Budget   

Appendix A: The Brazilian Political System  

Appendix B: Proposal for a Tax bill promoting R&D   

Appendix C: Survey on Companies’ R&D investment expectations 

Appendix D: Media Advisory  

Appendix E: Acronyms

 

Bibliography

 

Scenario

            For the purpose of this project, I assume the role of a strategic planner of Embraer, a Brazilian regional aircraft manufacturer, addressing the WTO subsidies dispute with Canada. After 5 years of discussions and attempts to negotiate a solution regarding both Brazilian and Canadian government subsidies to aircraft producers, the CEO of Embraer assigned me with the task of finding an alternative solution to move the negotiations along or settle the dispute of the WTO Dispute Settlement Body (DSB) proceedings.

For the purposes of this project, I assume the timeframe to be May 2001. As of August 2001, the DSB Panel ruled Proex (Brazilian export financing program) to be legal thereby changing the legality of my arguments. Thus, I assume my analysis and recommendation to take place before this ruling.

 


Issue

            On 14 April 1999, the WTO/DSB Panel ruled that Proex, the Brazilian export-financing program, was illegal and had to be changed.  This ruling has been met with contention by the Brazilian government. The Government of Brazil eventually made the required changes to Proex; however, the Canadian government is not satisfied with the extent of these amendments and is requesting further modifications to be made to the export financing program. Meanwhile, Brazilian government and industry are demanding that the Canadian government modify the subsidies system benefiting the Canadian aircraft manufacturer, Bombardier. The dispute intensified when, as a form of retaliation, other Canadian interest groups adopted a ban on the import of Brazilian beef to Canada and the entire NAFTA market.

 The aircraft subsidies dispute must be brought to an end for the following reasons:

·       It is harming the image of both aircraft manufacturers, Embraer  and Bombardier;

·       The respective governments’ intransigence and failure to negotiate an acceptable solution must be brought to an end before further damage occurs to their diplomatic relation;

·       The contention may lead to other retaliation, as exemplified by the ban of Brazilian beef to NAFTA markets;

·       Both governments are diverting significant resources to this dispute, which could be otherwise be applied to other pressing trade issues;

·       A solution to the issue of aircraft subsidies must be found within the next few years before the two aircraft producers enter the wider, more competitive global commercial aircraft market which will present further complex and contentious issues for both companies;

·       To avoid a repeat of the case in which the Canadian government overtly subsidized Bombardier sales to the American airlines. The reason the Canadian government gave was ‘to counter the Proex system’. The result was that Embraer missed the opportunity to win a significant set of contracts for 125 jets and over 100 options, worth a total of US$ 4 billion


. Executive Summary

To:     Mr. Maurício Botelho, President & CEO of Embraer

From: Mr. Saulo Nogueira, Strategic PlannerEmbraer

Re:    Strategy to Prepare Embraer for the New Restrictions of Proex

Date: 24 April 2002

 

Issue

Embraer is at a competitive disadvantage because the WTO Dispute Settlement Body (DSB) has recently applied restrictions to the Brazilian export-financing subsidy, Proex.  Our disadvantage is compounded by the fact that our chief rival, Canadian aircraft manufacturer, Bombardier continues to receive illegal subsidies. Since 1996, the Canadian and Brazilian governments have been challenging each other’s subsidies to their respective aircraft manufacturers. The tension of the dispute has escalated and led to indirect retaliation, hurting Embraer’s performance and other sectors of the Brazilian economy.

Embraer needs to find a way to compensate for the burden from the new restrictions.  Proex accounts for the higher country risk interest rate for purchasing charged by banks in Brazil.  By pushing for a research and development (R&D) tax incentive, Embraer will be able to level the playing field with the Canadians, and other competitors, while compensating for the higher end prices resulting from using the new Proex. Economic estimates show that Embraer has a price advantage over Bombardier's aircraft when no government-backed financing programs are involved. Therefore, Embraer should support the Ministry of Foreign Relations in reaching an agreement by both Governments to restructure their aircraft subsidy programs according to World Trade Organization (WTO) rules as soon as possible.

 

Background

          Canadians initially took the issue of Proex subsidies to the WTO in 1996, when the Dispute Panels first ruled that the financing programs of both Canada and Brazil be redesigned so as to satisfy international lending standards. The Canadians have changed two programs to the satisfaction of the DSB, but still have three programs under investigation.  It is expected that the DSB will require the programs under investigation to be restructured as well.  Brazilians have changed Proex to fit with the Panel’s specified international standards, yet the Panel still needs to confirm that the changes comply with international standards. The Canadians are not satisfied with the new terms of Proex (Proex III) and demanded that an additional ‘exposure fee’ be added to the Proex loans, to account for lender and country risks. While Embraer’s aircrafts are of high quality, a special attraction to its customers has been Embraer’s price, facilitated, in part, by the financing terms of Proex. The new financing terms of Proex III would reduce the value of Proex financing by 70%, raising the overall price of each airplane by approximately US$ 1 million, compelling Embraer to seek out ways to compensate for the negative impact to its competitive advantage.

Embraer’s large R&D investments are an inherent part of competing in the aircraft industry. However, there is a lack of government policy that encourages R&D in Brazil making it an expensive part of business operating costs. Canada, and many other developed countries have long had tax incentives for investing in R&D. These policies encourage companies to develop new technologies and products that bring benefits to their performance and to other industries through spillover effects.  Another level where the Canadian’s context is noticeably better than Brazil’s is the transportation infrastructure and costs. While the Canadians can rely on efficient transportation infrastructure to move their goods, Brazilian businesses are weighed down by high transportation costs. Several government and private agencies have recognized the importance of R&D in these industries, yet the Government of Brazil fails to adopt policies to support R&D.

            The symbolic status of Embraer as Brazil’s national aircraft manufacturer, and the strong political ties to it, has turned the restriction of Proex into a serious debate in the Brazilian political scene. Being the biggest exporter since 1998, Embraer is revered by many Brazilian politicians who admire its success in a sector that is so technologically advanced for a developing country. The WTO Panel ruling against Proex reinforced growing criticisms of the WTO, with the notion that WTO rules only serve the developed nations. The Ministry of Development (MDIC) designed Proex and has been especially reluctant to concede to the mandated changes to the export subsidy. Unfortunately, WTO pressure on the Ministry of Foreign Relations has restricted Brazilian trade representatives’ negotiating options. Indeed, Brazilian trade representatives have taken a very stern position on Proex by delaying mandated restructuring of the export program.  These delays in turn provoked the Canadians to behave similarly by delaying compliance with the Panel’s requests for data regarding Canadian subsidies under investigation. Thus, there is an urgent need for Embraer  to find a way to compensate for the new Proex burden so that Brazil’s trade representatives have more flexibility in negotiating Proex with the Canadians.

Recommendation

Embraer should campaign for a new tax law that grants tax credit to companies investing in research and development. The law will be two-tiered: a higher credit for the transportation industry and a lower credit for all other industries in the Brazilian economy. Meanwhile, the government will negotiate with the Canadians to push for reforms of their subsidies to the aircraft industry, on condition that Proex is modified according to the standards set by the DSB Panel decision.

Strategy  

Domestic

                  Embraer should build a business coalition of supporters of a tax bill that grants tax credits for R&D expenditures in Brazil. This coalition will firstly approach the Ministry of Development, Industry and Commerce to explain the purpose of our proposal, and gain their support to introduce the bill to Congress. Meetings will then be held with the other Ministries to gain their full support. To expand our political coalition beyond the executive level, we will demonstrate the benefits of the R&D tax proposal to regional politicians who in turn the legislative members will perceive the demand for the bill by their constituents and political colleagues. A media campaign will then amplify the presence of the R&D issue in Brazil. Meanwhile, our coalitions will be lobbying the Deputies and Senators to approve the bill when the votes take place at the different levels of Congress. Our action plan will have a 15-month schedule so that the President ratifies the bill at the very latest by August 2002, a couple of months before the Presidential elections.

International

                  Embraer should continue to provide trade data regarding Proex to the Ministry of Foreign Relations while also researching more on the Canadian EDC subsidies that are benefiting Bombardier. We will also convince the Ministry to push the Canadians to reform their subsidies according to future DSB Panel rulings. In exchange, the Ministry can offer the Canadians that the specific changes they want to see made to Proex III will be made, on condition that these changes are removed if the Panel determines these changes to be unnecessary.

 


Introduction

            Since its privatization in 1994, Embraer , a regional aircraft manufacturer, has become Brazil’s largest exporter.  The company’s success became evident in two ways: it developed into Brazil’s largest exporter in a short period of time, and it came to succeed in a hi-tech sector in which developing countries normally fail. Indeed, the company has been glorified by key political and business figures alike, both domestically and abroad. Brazilian President Fernando Henrique Cardoso has repeatedly named the company as a symbol of the quality of Brazilian products.

            However, Embraer ’s success in the international aircraft market has also led to its ongoing subsidies dispute with Canadian rival Bombardier. Seeing its market share slipping away to Embraer , Bombardier decided to investigate possible areas of controversy in the Brazilian company’s activities. Bombardier questioned a Brazilian export financing subsidy called ‘Proex’. Bombardier requested its government to meet with Brazilian negotiators to gain an understanding of the use of Proex and attempt to negotiate the removal of Proex. Bi-lateral negotiations having failed, Canada filed to open a WTO/DSB Panel in 1996. The dispute continues to this day.

            While the Canadians have managed to put Proex under investigation by the WTO Panel, their efforts have also resulted in the DSB’s evalutation of their own subsidies to Bombardier. The Canadian subsidies grant attractive lending terms to airlines, which is the main reason that Bombardier maintains its present market share. Purchasing aircraft is an expensive ordeal and the financing terms have a significant impact on the overall price (price and interests owed for loan) to the customer. Embraer  and Bombardier are competitors, and research shows that if the Canadian subsidies did not exist, Embraer ’s sales would be more favorable to the customer. The Brazilian government does not offer similar exporting subsidies to that of the Canadians. To compensate for the lack of subsidies, Embraer  will seek ways to maintain its performance internationally, while demanding that the DSB rule against the subsidies benefiting Bombardier.

Background

 

Dispute over Proex Subsidies

            In 1991, the Brazilian Ministry of Foreign Relations set up an export financing system called Proex, which offers foreign buyers of Brazilian exports direct loans or interest equalization subsidies. Since 1994, Embraer has used the latter type of financing on its sales of regional aircrafts. Proex was created to account for higher interest rates charged by banks over purchases made in Brazil, also known as ‘Brazil Risk.’ Indeed, Proex has been interpreted by the Minister of Foreign Relations, Luis Felipe Lampreia, as a means to level the playing field with foreign companies. Embraer has used Proex on 85% of its exports, totaling 726 aircrafts to date (Dec. 2000). The export subsidy is available for exports of capital goods, automobiles and auto parts, and consumer goods.

 

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