On October 18, 2014, a rollout ceremony for the Mitsubishi Regional Jet (MRJ), the first-ever small jet airliner built in Japan, was held at Mitsubishi Heavy Industries, Ltd. (MHI)'s Komaki South Plant in Aichi prefecture. The vividly colored curvy lines on the elegantly streamlined white body, imitating the kumadori make-up of traditional kabuki theater actors, and the wings angled upward toward the tips are particularly eye-catching. Functionally, MRJ has achieved significant advances both in fuel economy and aerodynamic performance, while featuring superior interior and noise comfort. Its first flight is slated for the spring of 2015 (Note 1).
However, while time ticks away toward its planned delivery in the first half of 2017, the MRJ project continues to face mounting challenges. To begin with, there are technical hurdles--i.e., a long list of tests and safety checks--that need to be cleared before the aircraft is shipped off to the customers, while, at the same time, an additional number of orders must be obtained in order to secure the profitability of the project, and further cost-cutting efforts must be made with an eye on expected competition with rival companies (Note 2). Furthermore, as I will discuss in this article, the commercial success of the MRJ, namely, after clearing all of the above hurdles, will give rise to a completely different set of challenges.
Role of government support in the aeronautics industry
The MRJ project was launched under the initiative of the government. Originally conceived by the Ministry of Economy, Trade and Industry as a project to develop an environmentally friendly high performance small jet aircraft, it materialized as a subsidized project under the New Energy and Industrial Technology Development Organization (NEDO) with MHI selected as the developer, which was then followed by the establishment of the Mitsubishi Aircraft Corporation in 2008 to undertake the MRJ business. Approximately 50 billion yen or one-third of the total development cost was financed by the government (Note 3). In addition, a group of municipalities designated as the Special Zone to Create Asia's No. 1 Aerospace Industrial Cluster, including Aichi prefecture, supported the project in various ways such as helping prepare the manufacturing site and providing subsidies for investment in facilities (Note 4).
Successful aircraft industries in other countries have developed into what they are today through stages, i.e., starting as a government-led project or state-owned enterprise (SOE) and then becoming privatized. Examples include the Airbus Group in the area of large aircrafts and Embraer S.A. which is a potential competitor of the MRJ. Among the newer players, Commercial Aircraft Corporation of China, Ltd. (COMAC) has the majority of its capital furnished by the government of China and the city of Shanghai. Following the rise of emerging economies--particularly China--in recent years, state capitalism has been drawing much attention with strong concerns voiced about a non-level playing field resulting from benefits available exclusively to SOEs ranging from massive state funds to preferential tax and regulatory treatment. This is the reason why the United States has been calling for strict SOE rules in the negotiations for the Trans-Pacific Partnership and under its recently-concluded free trade agreements (FTAs).
However, SOEs have their unique social and economic significance. For instance, they can rectify the failure of capital markets in areas where sufficient private-sector investment cannot be expected due to the sheer scale of investment required and risks involved. SOEs and the use of state capital in the aircraft industry can be defined as such. In other words, the amount of initial investment in research and development (R&D) and production facilities is enormous and becomes a sunk cost. Also, it is necessary to produce various models of airplanes in large numbers (economies of scale and scope), in order to derive the effect of the learning curve in which the unit cost of production would decrease in inverse proportion to the number of units produced, and because airlines seek to find commonalities among the airplanes they operate for the sake of greater efficiency in their maintenance as well as in having pilots trained to fly them. Furthermore, as the investment cycle is quite long (it typically takes more than a dozen years to recover the initial cost of investment in the case of a large commercial aircraft), throughout which period the developer would remain exposed to various external risks including economic crises and terrorist attacks. On the other hand, it is expected that technology spillovers from within the aircraft industry will have a positive impact not only on related industries (e.g., material industry) in its home country but also on those in other countries through value chains.
WTO Agreements and government support for aircraft industries
As such, the use of state capital and the provision of government support for the aircraft industry have valid reasons on the one hand. However, such government interventions are subject to strict regulations under the Agreement on Subsidies and Countervailing Measures (SCM Agreement) and other relevant rules under the World Trade Organization (WTO). As argued by the Japanese government, the provision of subsidies is lawful as a general rule and is not limited to those to the MRJ project. But Article 5 of the SCM Agreement prohibits WTO members from causing "adverse effects" to other members by providing subsidies. In particular, "serious prejudice" referred to in Article 5(c) (and defined in Article 6) may arise, for instance, in the case where a like product of another member economy is displaced by the subsidized product or if the subsidized product is deemed to have caused a significant decrease in the price and/or sales volume of a like product of another member country.
In addition, as aircraft finance plays a critical role in the case of multibillion-yen aircraft transactions, the development and provision of trade finance is indispensable for any country seeking to expand its shares in the global market. However, Article 3 of the SCM Agreement prohibits the provision of export subsidies. In particular, according to items (j) and (k) of the Illustrative List of Export Subsidies in Annex I to the SCM Agreement, governments are not allowed to provide export insurance or credit guarantees that do not adequately cover the operating costs and risk premiums involved, except for those export credits in compliance with the Organisation for Economic Co-operation and Development (OECD)'s Arrangements on Officially Supported Export Credits (Note 5).
The aircraft industry is characterized by an international oligopoly market structure that fits into a typical strategic trade policy model, as seen in the small aircraft market that is led by Bombardier Inc. and Embraer S.A. as well as in the large aircraft market where Airbus Group and Boeing Company are in head-to-head competition. As the provision of subsidies to one company translates into a loss in the market share of its competitor in a zero-sum manner, such a move has been often countered by the provision of countervailing subsidies. Also, as shown in the table below, there have been a series of WTO disputes with governments on both sides of the competition filing complaints against each other in a bid to deter the provision of subsidies by the other.
| Respondent/ Complainant | Title of Incident (No.) | Decisions (Date) | Brief Description of Incident and Judgment |
|---|---|---|---|
| Brazil / Canada | Civil aircraft (DS46) |
| Brazil's Programa de Financiamento às Exportações (PROEX) scheme, under which interest rate equalization payments are made to foreign purchasers of Embraer aircrafts, constitutes export subsidies and thus is a violation of Article 3 of the SCM Agreement. |
| Canada / Brazil | Civil aircraft (DS70) |
| Credit guarantees provided by the Export Development Corporation of Canada for the export of Bombardier aircrafts and funds provided to the civil aircraft industry under the Technology Partnership Canada program constitute export subsidies and thus are a violation of Article 3 of the SCM Agreement. |
| Canada / Brazil | Civil aircraft (DS222) |
| Continuation of the DS70 case. |
| EU / U.S. | Large civil aircraft (DS316) |
| Research and technological development funding, launch aid, grants relating to manufacturing sites and facilities, corporate restructuring measures, and other support provided to Airbus companies by the EU and the governments of four member states--i.e., Germany, France, Spain, and the United Kingdom--constitute subsidies and have brought "adverse effects" and/or "serious prejudice" under Articles 5 and 6 of the SCM Agreement to the United States. |
| U.S. / EU | Large civil aircraft (DS353) |
| Tax breaks offered by the states of Washington, Kansas, and Illinois and municipalities therein, research and development support by the National Aeronautics and Space Administration (NASA) and the U.S. Department of Defense, and other support measures provided to Boeing constitute subsidies and have brought "adverse effects" and/or "serious prejudice" under Article 5 and 6 of the SCM Agreement to the European Union. |
Under this situation, it is unlikely that Brazil and Canada will sit back and watch the entry of the MRJ into the global aircraft market. Indeed, Brazil has been urging Japan to disclose more information on the MRJ project and requesting consultations to discuss its concerns by taking various occasions such as the February 2011 trade policy review of Japan and the October 2013 meeting of the Committee on Subsidies and Countervailing Measures at the WTO (Note 6). In a show of his company's ambition, Mitsubishi Aircraft President Teruaki Kawai said that he enthusiastically aims at "capturing more than half of the global market" for small aircrafts, which is bound to expand in the coming years (Note 7). He estimates that there will be demand for 5,000 small aircrafts in overseas markets in the next 20 years. By simple arithmetic, that means that 250 aircrafts will be delivered every year. As aircraft transactions are conducted in such a small order, a change in the market shares that represents a difference of only several dozens of aircrafts per year became a problem in the Airbus and Boeing cases. If the MRJ successfully captures a large market share, it would be easy for Brazil and Canada to prove "adverse effects" under the SCM Agreement. Also, considering the difficulties that the MRJ project has experienced to date such as several delays in the development schedule, it is hard to believe that the aircraft would have been completed by the same time, and at the same performance level as would have been achieved without any public support. And, if so, Brazil and Canada would be able to argue, when making any impact on market shares, that there exist causal relationships between the financial support provided by the central and local governments and the technological and price competitiveness of the MRJ as well as between such support and damage suffered by competitors.
Meanwhile, regarding the trade finance that has been provided by the Japan Bank for International Cooperation (JBIC) and the Nippon Export and Investment Insurance (NEXI) to help Mitsubishi Aircraft secure orders, the Prime Minister's Office states explicitly on its website that such support is "consistent with the international rules" (Note 8). Whether or not this will turn into a dispute depends on the specific contents of the support program.
Japan should call for redefining state support for aircraft development while abiding by the international rules in providing export support
At the same time, however, the current rules for government support to the aircraft industry under the SCM Agreement appear to be disputable. As aforementioned, SOEs and state capital in the aircraft industry have positive externalities. Also, in a duopoly market such as the one for aircrafts, the provision of subsidies work to lower the prices of aircrafts, bringing them closer to a competitive level. However, if the SCM Agreement continues to ignore those aspects and focuses solely on changes in the market shares and sales volume, etc., any subsidy provided in the duopoly market for aircrafts would readily be concluded to have "adverse effects." Furthermore, with the exception clause for R&D subsidies (Article 8.2(a)) long gone (Article 31), the current SCM Agreement effectively prohibits any subsidy to the aircraft industry. Given the fact that it is extremely difficult for newcomers to enter the aircraft market without public support, the SCM Agreement as it stands today is competition restrictive, inhibiting new players from coming into the market while providing the incumbent players--those who entered the market as SOEs prior to the launch of the WTO--with a virtual guarantee to maintain their dominant status.
In addition, parts and components suppliers constituting the global value chain of the aircraft industry are being supported by their respective governments, and Japan is no exception. Two Japanese companies manufacturing wings and bodies for Boeing aircrafts--i.e., Fuji Heavy Industries Ltd. and Kawasaki Heavy Industries, Ltd.--are receiving support from the Japanese government. As such, it is meaningless to regulate only those government subsidies provided in the home countries of aircraft manufacturers.
As competition for aircraft development intensifies with the entry of MRJ, COMAC, and Russia's Sukhoi Company, a new wave of trade disputes will inevitably arise in the next five to 10 years. As set out by the Prime Minister's Office, Japan should abide by the relevant international rules in providing export support for the MRJ. At the same time, however, it should seek to redefine the role of national governments in the area of R&D support and launch aid to the aircraft industry in light of the problems with the current rules discussed above, for instance, by means of amending the SCM Agreement or setting additional rules under the framework of the OECD. Furthermore, the Japanese government should act strategically, aggressively filing complaints with the WTO in cases where other countries provide support to competitors to the MRJ.
