History of Legal Proceedings

            On 3 November 1996, pursuant to the WTO Dispute Settlement Body rules, Canada requested consultations with Brazil in the WTO  to discuss the specifications and legality of Proex. The fruitless discussions and negotiations caused Canada to open a panel in the WTO/DSB to evaluate the fairness of Proex, claiming that Proex was negatively affecting Bombardier's sales and its aircraft industry. Brazil complied with the Panel’s requests for data related to its exports. On 14 April 1999, the Panel ruled that Proex constituted an unfair subsidy, and requested that the Brazilian Government remove it.  After further consideration, the Panel narrowed its decision on August 20 1999.  The Panel found that the conditions of the equalization program were too favorable, and ruled that the financing conditions be restructured to match Organization for Economic Cooperation and Development (OECD) standards, which are legally accepted by the WTO. The Brazilian trade representatives resorted to Article 21.5 of the DSU to appeal the ruling, arguing that the panel did not fully comprehend the function of Proex, which is to account for the higher interest rate set on loans used to purchase or invest in Brazilian exports.  Also, they argued that the OECD terms were established by developed countries, and did not suit developing countries’ contexts.

Even though the WTO Annex of Trade in Aircrafts has special terms applying to trade in the aircraft-manufacturing sector, these rules did not have any significant effect on the ruling of the DSB Panel in this dispute.

            The WTO Agreement on Subsidies and Countervailing Measures (ASCM) prohibits most subsidies, especially the export-related ones, though certain types are allowed by Member States based on certain conditions. ASCM does not have specific clauses dealing with the Proex type of financing program. Indeed, Proex is unique in that the subsidy is neither allocated to the exporter or importer, but is paid to the financial institution providing the loan for purchasing the Brazilian good. The DSB Panel analyzed how the Agreement stood on the use of Proex, and ruled that it constituted an unfair subsidy under Article 3.1 (a). The ASCM allows developing countries to have an eight-year phase-out period of their subsidies. However, this was based on the assumption that the level of subsidies would not increase above their 1991 level. Brazil had increased its expenditures on Proex since 1991, yet Brazil argued that the subsidies budget was not increased during the period. However the panel found that the actual expenditure value did increase, regardless of the budget level appropriated for the loans. Additionally, the Panel found that Brazil failed to phase-out Proex by the end of the transition period. Consequently, the Panel recommended that Brazil withdraw the subsidies within 90 days.

The original ruling against Brazil to eliminate the Proex system was changed in August 1999, so that the applied interest rates satisfied OECD standards (or some other appropriate market benchmark). Changes to Proex will have to be approved by the Ministry of Development, Industry, and Commerce (MDIC), before it can be redesigned by the BNDES bank. The following table shows the financing terms of the new Proex, which matches the US Federal Reserve market benchmark:

 Proex Export Financing Terms

History of the Dispute

* On Nov. 19^th, 1999, the Brazilian Central Bank issues a circular letter reducing the Proex interest rate from 3.8% to 2.5% (10 year). Resolution No. 2,667: interest rate must equal US Treasury Bond (10 year) + 0.2% spread per year.

Canada’s Indirect Retaliation

            The tension caused by the trade dispute regarding aircraft has expanded to impact other sectors of both economies, exemplified when Canada imposed a ban on Brazilian beef, claiming the presence of the ‘Mad-Cow’ disease (which leads to the ‘Jacob Spongi-form’ disease in humans after its consumption). The loss of market access to NAFTA countries roused bitterness and anger among Brazilian beef exporters, and the Ministry of Agriculture demanded that the President retaliate accordingly. The Canadian government’s ban on Brazilian beef was an extremely controversial move, considering the potential negative consequences of a trade war to Canadian businesses in comparison to Brazilian companies. While there are around 90 Brazilian companies in Canada, there are 1.2 thousand Canadian businesses in Brazil. Canadian exports to Brazil amount to US$ 720 million annually, in comparison with US$ 93 million of Brazilian exports to Canada.  The nature of Canada and Brazil’s trade relations heightens the need to resolve the dispute before it becomes an all-out bi-lateral trade war, which would not benefit either party.

Commercial Aspects

The Growth of the Regional Aircraft Industry

            To better understand the vigorous efforts by Bombardier to have the Proex subsidies removed, we need to examine the market size and growth of regional aircraft production. The constant growth of the regional aircraft market has made it a very attractive industry--one in which huge sales explain the ferocious competition between Embraer and Bombardier. Since the late 1980’s, airline companies have increasingly preferred jet engine aircrafts over smaller turbo-prop airplanes. The advantages of jet engine aircrafts over turbo-props earned them significant popularity amongst passengers and airlines because of their speed, comfort and perceived safety relative to turboprops.[1] Regional jets are perceived as a solution to the growing problem of airport congestion, due to growing air travel frequency, by replacing turboprops, expanding hub operations, allowing ‘hub-bypass’ operations, and offering new point-to-point flights[2]. Forecast International predicts that the demand for regional aircraft in the next couple of decades will be as follows:

We can see that the market for jets of up to 60-seats will be worth US$ 61.6 billion in the next two decades, while the market for jets between 60 and 90 seats will be worth US$ 44.3 billion. Another source predicts that the regional aircraft market will be worth US$ 96.1 billion in the next 10 years.[3]  As can be seen, there is huge market potential for the sale of such aircrafts around the world, and since there are presently only 2 significant players in this sector, it becomes clearer why the subsidies dispute between Canada and Brazil has been so heated. It also shows that the sooner this dispute is settled and the subsidies are brought into line with WTO rules, the greater the sales Embraer will win in the future, assuming that the value of Embraer  jets will have an overall advantage over Bombardier’s.

Embraer

The new Proex financing conditions would raise the cost of Embraer's aircraft. According to Instituto de Estudos para o Desenvolvimento Industrial (IEDI), the price of one plane would rise by approximately US$ 1.0 million. Considering that the average price of its jets is US$ 17 million, the rise represents a 6% increase. Moreover, since the expected sales volume of Embraer for 2002 is approximately 240 jets, the overall cost increase will be less than US$ 240 million (Note: some aircraft sales may not use Proex at all).

Bombardier

Bombardier has long been manufacturing transportation parts and products, and it has a subsidiary specifically related to aircrafts called “Bombardier Aerospace”. Although this subsidiary was selling more aircrafts than Embraer in 2000, it was not as profitable as that of Embraer. While the Canadian subsidiary’s profit was US$ 281 million in 2000, Embraer’s was US$ 353 million.
 

Research and Development

            As a high-technology industry, the aircraft industry is known to invest heavily in R&D activities because manufacturers are constantly striving to improve their aircrafts’ technical features to make them safer, faster and more efficient. Historically, large commercial jet producers have been heavily subsidized by their respective governments. Indeed, this was the reason behind the Annex ‘Agreement on Trade in Civil Aircraft’ to GATT. Regional aircraft firms also spend a lot on R&D; however, their government support has not been as intensive as with the large commercial jet manufacturers.

Comparing Bombardier and Embraer

            The fact that Bombardier and Embraer are the only two significant players in the regional aircraft market, and are competitively so close means that competitiveness is intense and pricing becomes a key determinant of better value. In 1999, the regional aircraft market sold 247 aircrafts. Bombardier had 41% (101 jets) of the regional aircraft market, while Embraer had 38% (94 jets), and Fairchild Dornier (a German-American firm) had 21% (52 jets). Although there is differentiation in features of each manufacturer’s airplanes, the differences are small. The following table compares the main qualities of each company’s 50-seat aircrafts: Embraer’s ERJ 145 ER and Bombardier’s CRJ 200 ER.

* Price before any government subsidy/support

** Flugrevue Rating: 1: highest, 10, lowest

*** Planebusiness article

            The following table compares the aircraft prices of the two companies with different financing programs:

Price in US$ Millions

Note: Prices take into account all lending terms provided through government programs available to the companies.

            Even though the cash price of Embraer’s aircraft is one million US dollars less than Bombardier’s, the Canadian aircrafts are more attractive because of the financing terms.  Unlike in Brazil, government backed financing programs exist in Canada that offer: loan guarantees, equity guarantees, residual value guarantees and first year loss deficiency guarantees (provided by Investissement Quebec), all of which create more favorable lending terms to the foreign buyer.  Additionally, there are a few government-backed loans programs, such as the EDC, which acts as a prohibitive subsidy.[4] It becomes clear that if the Canadian subsidies are removed or restructured, the pricing of Embraer’s jets becomes more attractive.  

Economic

Comparing Economic Conditions in Canada and Brazil

Brazil and Canada have significant differences in their economic conditions and infrastructure. Other than higher performance by Canada in economic indicators, such as standards of living and social welfare, there are a few specific differences affecting the aircraft manufacturers illustrated below:

The significant gap in transportation costs and R&D incentives between the two nations highlights the setback to Embraer caused by the Brazilian economic conditions

Facts about Embraer

Embraer is the largest Brazilian exporter since 1998, with exports valued at US$ 2.7 billion in the year 2000. It employs 12,400 workers in its four manufacturing locations around the country, though 9,000 are located at headquarters in Sao Jose dos Campos, São Paulo. It imports many parts from various countries for strategic reasons, especially reciprocal contract obligations. Reciprocal contract obligations is when foreign countries agree to a buy certain number of jets in exchange for their supplying specific parts. In 1998, the company imported US$ 886 million in parts, with tariffs that are paid upon entry into the country, but returned upon export according to the ‘duty drawback Law R.6.197.’ The Brazilian Government therefore does not actually receive tariffs from the imports of Embraer on the parts that become part of the final plane. The Government does benefit from the company’s exports because it owns 30% of its shares, a result of privatization in 1994.  In 2000, net profit was US$ 353 million, from which the government earned some profits.

More importantly, Embraer 's success has been considered symbolic of Brazil’s high-tech capacities. It has been used to show that a developing country like Brazil can compete internationally in a sector that involves highly specialized skills and technology. Indeed, it has been showcased to foreigners as a standard of manufactured goods 'Made in Brazil'. The chief of the Commercial Policy Division of Itamaraty, Minister Alcides Prates, called Embraer the Brazilian “Swiss Watch” at the Intermodal South America Conference in 2000.[7] Many developing countries have been drawn to the company's performance as a reminder of what their companies may also be capable.

It is clear that the Brazilian Government, especially Itamaraty, has great interest in the performance of Embraer. It has become a stop on country tours of foreign ministers and representatives, as happened in March of 2001 when British Prime Minister Tony Blair visited Brazil to reinforce UK-Brazil relations. Also, Itamaraty has used the aircraft producer in arguments that developing countries’ economic strengths are not limited to the traditional sectors, such as agriculture, garments, or raw material extraction.

Policy

For these reasons and others Itamaraty has been reluctant to oblige by the new Proex restrictions imposed on Embraer by the WTO DSB. The other main reason is the need to question Canada's own export assistance tools and subsidies. Embraer has sent documents to Itamaraty stating the types of Government support that it believed Bombardier was receiving. The Brazilian trade representatives then requested a panel to evaluate programs like the Canada Account and TPC. These panels were opened on 23 July 1998. The panel ruled on the legality and the specific changes that need to take place on August 20^th 1999. Although the Canadians complied with the DSB requests, the Brazilian representatives were not satisfied and complained that full compliance had not been reached. Another panel was convened 23 May 1999 to review Canadian compliance with the previous ruling on its subsidy programs. As we can see, Itamaraty has been and will continue to push to ‘level the playing field’ for subsidies with Canada.

            Brazil’s foreign trade policy involves opening foreign markets for national goods, promoting its own exports, and liberalizing its borders to imports. In 1999, the government took a tougher stance on improving the trade balance, after deciding that exporting was an effective way to attract hard foreign currency to control the growing external debt. There are several government programs to promote and facilitate the exports by Brazilian companies. The following are Government bodies that have policies aimed at increasing exports to improve Brazil’s trade balance:

• Ministry of Finance:  sees growth in exports as a way to obtain strong foreign currency, which should help the nation to manage its external debt. Regulates the fiscal incentives given to companies in Brazil.
• MDIC:  increasing Brazilian companies’ export capabilities as an opportunity to expand their market bases, and to improve the economic climate in the country.
• BNDES (branch of MDIC): Renovating Ports program; securing funds for exports (through a joint-guarantee fund); amplifying the activities and budget of the Exim department; proposals for the exemption of taxes designated for export; and the introduction of ‘Easy Export’ a program to facilitate exporting by smaller enterprises.
• Ministry of Transportation:  has a policy to modernize Brazilian ports to reduce shipping costs.

Research and Development in Brazil

            Compared to other nations, Brazil currently spends little on research and development. A UN study released in March of 2001 ranked Brazil 43^rd out of 72 countries in the level of technological development. This result astounded many groups in Brazil, and lead several agencies to demand that the government allocate higher resources to R&D policies. In 1997, it spent only 0.7% of its GDP, compared to Canada’s 2.7%, or the OECD nations that spend on average 2.2%.[8] Moreover, the public sector provides about 75% of Brazilian R&D funding, compared to 25% in the Newly-Industrialized Countries (NIC’s). In the NIC’s, the private sector plays a major role in the development of new technologies and research, which many economists argue helped the economies develop such strong industries over the past two decades.[9] Even though there have been increases in private sector investments in R&D, there remains a weak institutional structure for joint R&D activities, poor information exchange, and inexperience in cooperation with the public sector.[10] In 1996, the Government had a multi-year plan to raise R&D investment to 1.5% of GDP by the year 2005. The main priority of this plan was to increase the percentage of R&D expenditure by the private sector, from its current 25% to 40%, while expanding the amount of resources available for science and technology.[11] The World Bank was engaged in defining this plan, and has continued to support this effort through cooperative policy dialogues. Additionally, the plan aimed to “improve tax and fiscal incentives to encourage R&D.”[12] Indeed, the only sector in Brazil that receives fiscal incentives for R&D activities is Information Technology (IT), which has the IT Law (“Lei Informática”, Law 8.248/91).

The Information Technology Law (Lei Informática)

            The IT Law program was implemented in 1991 by MDIC, and has been very effective in promoting R&D activities in the IT sector through tax credits. The concept behind the law was that if a company in the IT sector produced according to certain conditions, it would receive certain fiscal benefits. The conditions included that a company:

·       Industrialized its outputs at least to a minimum procedure standard called “Processo Produtivo Básico” (PPB);

·       Invested at least 5 % of its revenues in R&D, including 2 % towards joint programs with universities or research institutes; and

·       Obtained ISO 9000 certification for its products.

Fiscal benefits for the IT company included:

·       Exemption of the Industrial Production tax (IPI) from its output (which could amount to 15% of the product’s costs); and,

·       Income Tax credit of up to 50% of R&D expenditures.

This law motivated the IT companies to shift their production strategies for higher production levels, and get quality certification (ISO 9000), while promoting joint R&D efforts between the private sector and public research institutes and universities.

This law expired on 29 October 1999, with the possibility of being extended if approved by the Congress. The new IT Law was designed by Deputy Júlio Semeghini (PSDB-SP), and approved on 21 November 1999, with slight modifications. The tax incentive is now done through the exemption of the IPI (industrial production) tax, instead of tax credit from a company’s income tax. Both income and IPI taxes are collected both federally and locally, where 21.5% of income tax is collected by the state with the rest going to the central government. Similarly, 21.5% of the IPI tax is collected by each state, 22.5% by each municipality and the rest by the central government.

continue to next page