Steps must be taken to boost SMEs’ role in arms industry
The average lifespan of those in defence is just five years
THE Defence budget was tabled in Parliament for final approval on July17.
We were informed that the defence allocation has been reduced by close to R5 billion (accumulatively) over the last five years through National Treasury-imposed budget cuts).
This means there is much less funding available to maintain and renew defence equipment in line with the requirements of the SANDF. The defence industry is therefore severely affected by such reductions.
Historically, South African defence companies were built from the bottom up using government funding allocated for defence research and development.
The Department of Defence (DoD) spent up to R6bn a year (in 2017 rand terms) in research and development (R&D) in the late 1980s, which allowed the formation of a number of companies for strategically essential defence capabilities.
Such capabilities included mine-protected and armoured vehicles, artillery systems, guided munitions, tactical communication systems and high-end defence electronics.
The beneficiaries of R&D funding soon developed cutting-edge-technology products that looked attractive to the global defence markets as soon as the arms embargo was lifted in the early 1990s. The result was a thriving local defence industry.
In the late 1990s the DoD concluded a huge defence transaction in the form of “Strategic Defence Packages” (SDPs) worth R45bn. The SDPs entailed the acquisition of frigates and submarines for the Navy, as well as fighter jets and utility helicopters for the Air Force.
Multinational defence organisations partnered with local entities to ensure compliance to counter-trade and/or offset requirements. Apart from the large local defence prime contractors, other beneficiaries in the SDP programme were smaller entities that sprung out of technology transfer arrangements. Such smaller companies participated in both acquisition and maintenance stages of the programme as intermediaries with niche capabilities. However, a number of these small entities did not survive past the SDP programme due to an insufficient order pipeline from the local market.
Furthermore, the envisaged participation in the international supply chains of multinational entities did not materialise as anticipated.
Today’s local defence industry has a fairly concentrated structure. Out of more than 300 companies registered with Armscor as defence equipment suppliers, less than 10% are considered prime defence contractors.
These companies receive more than 70% of the defence orders, thereby taking the lion’s share of the R10bn annual budget for equipment renewal and maintenance. The rest of the companies, the majority of which are small and medium-sized, participate through sub-contracting to the prime contractors. The challenge with such a model of contracting is that if the prime contractor suffers any adverse setback, the sub-contractors are also affected. The recent example of Denel is a case in point.
The sustainability of smaller defence companies is at risk, because whenever the prime contractor finds itself under financial pressure, one of the first areas they consider for cost savings is the intermediary suppliers. This leads to a situation where a number of intermediaries are pitched against one another in a vicious price war that is bound to yield several casualties.
It is a small wonder therefore that the average life-span of defence SMEs is less than five years. At the time this article was written, a number of these were reported to be in financial distress, under business rescue or in the process of liquidation.
A situation where SMEs are either stillborn or suffer from a high mortality rate is not good for the economy; not least because they are a source of job creation and economic growth.
There are few ways in which the effects of such an unfavourable state of affairs could be mitigated. One way is to have Armscor contract at levels lower than tier 1 and 2, ie component and sub-system level.
In other words, instead of Armscor contracting with the tier 1 prime supplier, and leaving the sub-contracting process entirely to the latter’s discretion, let it rather oversee the sub-contracting process and ensure that appointed sub-contractors do not get the wrong end of the stick when things go wrong. In the same vain, SMEs would do well to arrange themselves in the form of a cluster with complementary capabilities, thereby maximising participation in defence product value chains.
Another possible solution is to get SMEs involved in technology development projects from the early stages. They could be given work packages in R&D projects that allow them to develop technology blocks up to “demonstrator” level, thereby attaining and horning sharp technical capabilities in the process.
This would not only increase their meaningful participation in local product acquisition projects, but would also make their capabilities more attractive internationally; especially to countries that focus on manufacturing defence products.
Such countries usually look for mature cutting-edge-technology products to produce locally, thereby indigenising the manufacturing of foreign technological content via licensing agreements. This arrangement would suit the techno-centric defence SME community here.
A lack of finance is a spoiler in the defence sector.
The defence industry association and Armscor recently launched a Defence Industry Fund (DIF) in collaboration with the private investment sector. Some defence projects do not take off because there is inadequate funding allocation over the delivery period of the project.
DIF could bridge the funding gap by ensuring that the suppliers are paid within schedule, while recovering the monies from the government over a longer period. This would require a collaborative effort between the government, industry and financiers in a “South African Inc” approach.