Keep subsidies out of aircraft competition

Subsidies are an important form of government intervention in the market process. Their economic consequences always include some form of malinvestment: that is, economic resources diverted by government action from more valuable uses and not invested elsewhere in the economy. Such intervention not only gives rise to a costly rent-seeking process in order to obtain subsidies, it also hides the full cost of goods or services, causing an inevitable market clash. Furthermore, taxpayers are unjustly forced to gamble on the success of subsidized projects.

The legitimacy of subsidies sometimes lies merely in the fact that other countries are subsidizing their own companies. When this happens, the negative economic consequences are spread across the world economy.

This is exactly the case with the Canadian and Brazilian civil aircraft industries. The subsidies mainly take the form of export credits, loan guarantees or other financial support for the buyers of Bombardier and Embraer regional jets. Despite the fact that these companies are the two main manufacturers of this type of aircraft in the world – profitable and competitive firms both headed by competent management teams – each seemingly continues to demand government support because its competitor is receiving it.

As long as these subsidies remain available, they will continue to rely on them in order to finance their sales, because jets are very expensive items. The presence or lack of preferential loan terms can easily make all the difference between competitors.

But what if both governments mutually agreed to stop subsidizing? There is a strong case for leaving the regional jet market to evolve unhampered and without subsidies.

Canada And The Bombardier Case

In Canada, both federal and provincial governments subsidize Bombardier, supposedly in response to similar subsidies granted to Embraer by the Brazilian government.

The Canadian aerospace sector – about 27 companies in 2003, including Bombardier – is subsidized by taxpayers’ money through the federal Export Development Canada (EDC) corporation. The EDC artificially facilitates the sale of Bombardier regional jets – and other aerospace products – to foreign buyers by granting them export credits, loan guarantees or other financial support.

In 2003, total financial support (in gross loans receivable, commitments and loan guarantees) for this sector amounted to $7.4-billion, or 34% of the EDC’s commercial loan portfolio. A large part of this support went to Bombardier customers. According to Ronald Dahms, senior vice-president of the EDC, “financing support has historically ranged from 35% to 40% of Bombardier commercial aircraft sales.” The federal government intervenes directly through another EDC program called Canada Account. Since 2001, two of the program’s six transactions have financed Bombardier sales.

The government of Quebec also subsidizes Bombardier through its program of export credits and loan guarantees, Investissement Quebec (IQ). The Montreal daily Le Devoir reported in November that total financial support since 1996 would amount to $1.6-billion.

Brazil And The Embraer Case

Embraer was founded in 1969 as a government initiative and privatized in 1994. Between those years, the company received direct investments from the government. After 1994, the privately owned Embraer stopped receiving these direct investments, but another kind of financial help replaced them.

This new form of subsidies, called the PROEX-Incentive Exportations Program, was created in 1991 and finances both Brazilian exports and the foreign importers of Brazilian products. These “loans” can be paid back within two to 10 years, and are made through Brazil’s federally owned Banco do Brasil, with funding from the National Treasury. This mechanism helped Embraer position itself and its products as a competitive player in the international market.

Brazil’s government defended this policy as a way to counter the country’s high cost of manufacturing, known as “Brazil’s Costs,” arguing that the practice of subsidizing is legal and fair because it occurs only during commercialization and is not used to help production. The program was subject to minor WTO-driven changes, leading to the creation of PROEX II (in 1999) and PROEX III (in 2001), but the rationale remained the same. In 2003, out of US$430-million made available by PROEX to finance exports, Embraer itself used US$286-million.

Economic Consequences Of Aerospace Subsidies

All these indirect subsidies do indeed have economic costs.

First, whenever one lends money, there is a risk of it not being repaid. If the government supports the aerospace sector, it is because private-sector lenders judge that it is not worth the risk under current conditions. Risk is being underestimated, with government organizations assuming more than the market would, gambling taxpayers’ money on projects that may turn out to be very risky. As a snapshot of the situation, consider that EDC’s below-investment-grade loans in the sector increased from 21% of the total loan portfolio in 2002 to 26% in 2003.

Second, the escalation of subsidies between Canada and Brazil will artificially boost the aerospace sector beyond what is economically reasonable. Unnecessary investments and capital are tied up in the jet manufacturing industry. Airlines, the main buyers of Bombardier and Embraer jets, are not aware of the full cost of purchasing them. Some of these costs, associated with high risks, are hidden by government financial support, and this encourages buyers to sign contracts more readily. The smallest downturn in the sector can find airlines falling into bankruptcy and defaulting on loans.

Without government support, there are at least two other market solutions to finance jet sales. Manufacturers are capable of granting loans to their own customers (vendor financing), and have done so in the past. Private-sector lenders can give credits and loan guarantees at market prices in accordance with market-estimated risk. Government intervention only displaces these solutions and distorts the economy.

Government subsidies in Brazil and Canada negatively affect the economies of both countries, and that of the entire world. These subsidies are mostly justified only by the fact that the opposing country’s government is making an identical error. We recently learned that Canada and Brazil have initiated negotiations with the aim of simultaneously reducing their level of intervention. It is time to consider eliminating subsidies to Bombardier and Embraer and allowing these successful companies to compete in a truly free aerospace market.

Valentin Petkantchin is MEI’s Research Director and Márcio C. Coimbra is an academic counsellor at the Instituto Liberdade in Brazil.