Економіка 2020-02-06 00:01 Крамар Олександр

Drive, not drag

What kind of military-industrial complex could become the driver of economic and technological growth in Ukraine

The history of technological progress and economic development, especially under capitalism, is tightly intertwined with war and the manufacture of weapons and materiel. Defense procurements and supplies for armies generate financial resources for start-up capital to set up production facilities that then serve as locomotives driving economic growth. The technology developed in the military-industrial complex is often then applied to civilian production and services.

This was especially true through the 19thand 20thcenturies, when great powers concentrated and channeled serious funding to rearm their armies and build the necessary infrastructure. Military industrial needs drove the rapid development of metallurgy and chemical industries, later the nuclear industry – all the most progressive segments of the economy at the time. Defense priorities also sped up the development of railways, telegraph and telephone communications, aviation, space technology, satellites, and the internet. Progress in medical technology was no exception, as it, too, was needed to save the lives of soldiers.

From this perspective, being forced to fight Russia’s aggression militarily has been both a challenge and a great opportunity. The country’s military-industrial complex (MIC) has been growing dynamically and could become a major driver of economic growth, especially the high-tech segment.

Of course, Ukraine’s potential is very different from Russia’s. Russia’s army is at least four times larger than Ukraine’s, and its GDP is almost 10 times higher. But if Ukraine succeeds in deterring Russia’s assault long-term, the country could gain an advantage in both arming itself and in establishing a far stronger and more advanced economy on a per capita basis.

To do this, Ukraine can and must use the opportunities offered by the temporary cover offered by the West. But it’s just as important to recognize that, unlike the threat from Russia, this support is not permanent. A strong army and defense industry, with a greater role and higher share in Ukraine’s economy compared to Russia, are the only long-term factors that can ensure the country secure and successful growth.

From derelict to driving

All this requires a critical examination of the military-industrial complex Ukraine has today. In its current state, it is just remnants of what it was in soviet times. In fact, it was far bigger even in the early 1990s, comprising as it did of 700 associations and R&D centers employing over 1.5 million. This is more than what all of Ukraine’s processing industry employs today.

Yet, the soviet system Ukraine inherited depended on cooperation with the military-industrial complexes of other soviet republics, especially Russia, between 40% and 95% depending on the type of weapon. With rare exceptions, Ukraine designed and produced parts and components for the armaments and materiel that were then assembled in Russia. And so, individual components produced at Ukrainian enterprises were designed and produced in cooperation with Russian R&D companies. Over 70% of all suppliers of components for Ukraine’s military-industrial complex were in Russia. This led to a deep crisis in the 1990s, when output and employment crashed – a trend lasted until the last few years.

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For many years, this dying industry was seen in Ukraine as a cash cow because of the capacities inherited from soviet times. All that interested those involved was to make money on exporting arms, servicing equipment sold abroad earlier, and embezzling inventory. Their strategy was primarily focused on finding the best ways to monetize existing facilities with a minimum of investment and taking advantage of domestic defense contracts instead.

After almost three decades of independent development, Ukraine remains a far bigger exporter of arms than Turkey, Sweden or Canada, according to SIPRI. Among arms-trading countries with a smaller population, Ukraine is second only to Israel and the Netherlands. In terms of GDP share of defense exports, Ukraine is far ahead many market leaders, including the US, France, the UK, German, and Italy.

The origin of Ukraine’s military-industrial complex is also its generational curse: while one of the biggest arms exporters in the world, Ukraine has not managed to build proper, balanced supply for its own armed forces, as most of the armaments it needs were never manufactured domestically: fighter jets, air defense systems, attack helicopters, and so on. As Ukraine mostly ended up with aircraft maintenance enterprises—Antonov produces military transport and civilian aircraft—, all the plants making bombers and fighters remained in Russia.

Russia’s aggression has changed attitudes towards public funding of the defense procurements in Ukraine, which got were worth only about $100 million in 2013, before the war. In recent years, it has gone up tenfold to least US $1bn. Still, the priorities of this substantially higher budget are hard to understand, both in terms of improving Ukraine’s defense capacity, and in terms of expanding its military-industrial complex. Right now, the main role is being played by lobbyists for various types of weapons, who aren’t necessarily looking at the real needs of the Army, or contributing to the high-tech aspect of production or to overall economic development. 

According to somewhat outdated financial reports on the website of UkrOboronProm, the state umbrella monopolist for various clusters in the defense industry, aircraft and shipbuilding companies get the lion’s share of defense contracts. By contrast, clusters that manufacture high-precision weapons and ammunition, radars and radio systems, and missile defense systems have the lowest production. This demonstrates the strange structure of Ukraine’s military-industrial complex, reflecting available capacity rather than the priority of upgrading equipment for different divisions of the military. This is hardly surprising, since Ukraine has failed to establish new production facilities or modernize existing ones for three decades now.

New opportunities on the horizon

What this means is that Ukraine needs to effectively establish its military-industrial complex as a potential economic and technological driver from scratch. Using available talent and some of the most viable bits of what’s left of its soviet defense inheritance, Ukraine needs to rebuild the sector based on the needs of its Army and potential demand for certain weapons on the global market. What it should not do is simply adjust to the available assets, but rather only use those assets that fit into the architecture of a fundamentally new defense industry and prove their worth in contemporary conditions.

Most importantly, the new MIC cannot not develop if it depends on extensive use of available but very outdated technologies. It needs to focus on innovation, and that means building new companies and new production lines. This path is not as difficult as it might seem, as the existing capital assets are extremely worn out and have long needed replacement in any case. From a business standpoint, it is far easier to invest in new equipment for basically new production.

Still, Ukraine should also immediately focus on setting up full-cycle production clusters to manufacture finished products from scratch or based on viable existing facilities. This means rethinking the country’s approach to the defense industry and rejecting soviet-style methods of pricing arms or restricting trade in them. In addition, Ukraine needs ease access to credit for producers, offer tax incentives for reinvesting in development, and encourage experiments with new designs. For now, conventional investment in new R&D is low in Ukraine – industry experts say that over 90% of developments are currently driven by exports.

The reason why Ukraine’s defense industry is so dependent on exports is because it is so small. According to SIPRI, UkrOboronProm was 71stin the list of top 100 sellers of arms in 2018, behind more than a dozen specialized companies in key arms-making and exporting countries. UkrOboronProm’s 2018 global sales were just US $1.3bn out of a worldwide total of US $420bn, while UK companies sold US $35.1bn in arms and Russian companies exported US $36.2bn.

Ukraine also has an extremely small domestic market, as the government is the main domestic buyer for absolutely all the major domestic manufacturers and exporters of arms, and, therefore, the driver of the defense industry. According to SIPRI, the seven top countries spent between US $50bn and US $650bn on defense in 2018. These countries generated the lion’s share of global demand for arms but their own manufacturers, with the exception of Saudi Arabia and India, met this demand.

By comparison, Ukraine’s defense spending in the recent years has remained in the US $3.5-0.5bn range, with less than US $1bn going to weapons. This figure could – and should – be far higher. As it is, however, Ukraine, like most other components of the once-integrated soviet complex, finds itself in a situation where its domestic market remains secondary for manufacturers, while their primary turnover and profits come from foreign governments. Given the way competition works on the global arms market, this seriously stifles the prospect of growth for Ukraine’s military-industrial complex.

According to Ukrainian law, at least 0.5% of GDP is supposed to be allocated to the development of the defense industry. In the past, it received a slightly higher share of official GDP, but much of the country’s economy is still grey to this day. By contrast, Russia has been spending 1.5-1.8% of GDP on public defense contracts in recent years, with at least 60-65% of that money going to serial procurement of modern weapons and equipment, not repairs or upgrades, as in Ukraine. Ukraine needs to raise the spending norm for the production and procurement of new weapons to at least 3% of GDP for as long as it takes to seriously upgrade the armed forces, or until it can successfully move towards the same goal with a smaller share of a bigger GDP.

Ukraine could look to Turkey as a model for how to develop the defense industry. Ankara was importing most of the weapons it needed in the late 1990s and early 2000s and had virtually no defense industry of its own. The Turkish government was spending several billion dollars every year to buy weapons and began to encourage Turkish companies to set up joint production with foreign partners rather than to simply buy finished products from them. By 2018, over two thirds of defense procurements from Turkish companies were on the domestic market, instead of imports covering the lion’s share of the Turkish army’s needs in the early 2000s. Turkey invested nearly US $40bn in the development of its military-industrial complex. This resulted in a strong defense manufacturing sector that produces a very diverse range of products to meet the needs of the Turkish Army – from armored equipment to fighter jets, vessels of different classes, and radiolocation equipment.

At the same time, Ukraine’s military-industrial complex cannot rely on public spending alone. Unlike Russia, Ukraine gets far less income from the exploitation of its natural resources, so it will not be able to establish a defense industry to ensure its capacity to resist Russia’s expansion only through taxes generated from other sectors of the economy. Ukraine’s only chance for a strong military-industrial complex is alternative sources: more exports and tighter synergy with the rest of the economy. The right kind of synergy will turn the funding of the defense industry into a self-sustaining system where government spending on defense contracts drives the development of the industry and stimulates economic growth and exports. Economic development will, in turn, generate higher revenues to the treasury.

This is also why Ukraine needs to be very cautious about cooperating with foreign partners. On one hand, the country needs new technologies and equipment. On the other, it cannot grow its new industry based on an import-dependent model, where components purchased abroad form half or more of the production cost of the finished product. An even more dangerous strategy would be to allow others to buy up Ukraine’s most attractive assets from the old MIC in order to eliminate competitors or gain control over Ukrainian technologies in exchange for supporting the nominal survival of companies currently operating in Ukraine. 

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Ukraine must maintain control over the companies it has and involve specialized transnational companies in setting up new manufacturers, while leaving a controlling stake in Ukrainian hands. Regulations setting the minimum criteria for localizing component production can ensure the development of ancillary industries. This will stimulate, in turn, the development of new, more advanced facilities and production lines in the domestic steel and chemical industries, boost contracts in IT and R&D, and foster the emergence of many innovative sectors in the economy.

Unless it sets and reaches these goals, Ukraine cannot expect to boost its military capacity or turn its defense industry into a high-tech locomotive driving the domestic economy. Nor can it hope to maintain the current capacity in the sector. Existing facilities and equipment will continue to decline as a result of limited financial resources and shrinking export contracts.

 

Translated by Lidia Wolanskyj

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