Find­ing the bal­ance:

What it takes to fill the deficit of modern ar­ma­ment in Ukraine

The Ukrainian Week - - CONTENTS - Olek­sandr Kra­mar

The cur­rent de­fense in­dus­try in Ukraine is not a com­plex that was de­signed to be in­de­pen­dent, but a frag­ment of the uni­fied Soviet de­fense in­dus­try. This caused a deep cri­sis im­me­di­ately af­ter Ukraine be­came in­de­pen­dent, with the out­put and em­ploy­ment plung­ing in the 1990s. That hardly changed through­out the years of in­de­pen­dence.

Ac­cord­ing to Econ­omy Min­is­ter Stepan Ku­biv, the anal­y­sis of the state-owned mil­i­tary and de­fense in­dus­try en­ter­prises by the Min­istries of Econ­omy and De­fense re­vealed that there were as many as 3.500. These were split into three cat­e­gories: ef­fi­cient com­pa­nies, com­pa­nies that can be pri­va­tized, and in­ef­fi­cient com­pa­nies that “re­quire le­gal so­lu­tions, in­clud­ing liq­ui­da­tion”. The lat­ter cat­e­gory in­cludes more than 1,000 com­pa­nies. The birth in the soviet sys­tem turned to be a curse for Ukraine’s de­fense in­dus­try: Ukraine is on the lists of the largest mil­i­tary ex­porters and pro­duc­ers, yet it can­not sup­ply its own armed forces with weapons in full and in a bal­anced man­ner.

Place in the world

SIPRI placed Ukraine’s UkrOboronProm, the state de­fense con­cern, as No64 in its Top 100 arms-pro­duc­ing and mil­i­tary ser­vices com­pa­nies in 2011, right af­ter it was es­tab­lished. It moved up to 58 in 2012-2013. Un­til 2013, the Top 100 list fea­tured no com­pa­nies from Poland or any other coun­try in Cen­tral Europe. In the next two years, how­ever, Ukrainian de­fense in­dus­try com­pa­nies de­clined on both in­ter­na­tional and re­gional scales, even if Ukraine still looks rel­a­tively well com­pared to other coun­tries in the re­gion. Its cur­rent weight as ex­porter on the world mar­ket of mil­i­tary goods is equal to that that of Italy, Spain, South Korea, Swe­den, Switzer­land, the Nether­lands, Turkey and Canada. Ac­cord­ing to SIPRI, Ukraine’s mil­i­tary ex­ports of the past decade were fairly equally split be­tween air­craft prod­ucts, en­gines and ar­mored equip­ment. In the past years, this bal­ance has been fluc­tu­at­ing.

IM­PORT RE­PLACE­MENT AND DE­PEN­DENCE ON RUS­SIA

SIPRI lists Rus­sia as the top buyer of Ukraine’s mil­i­tary prod­ucts in the past years. It was buy­ing 32% of them in 2016 (mostly en­gines), fol­lowed by 17% pur­chased by China, 13% by Thai­land and 6% by Viet­nam. Quite pos­si­bly, Rus­sia re­mains a top des­ti­na­tion for such ex­ports, even if this is now done through com­plex schemes in­volv­ing third coun­tries. For in­stance, part of the en­gines sold to a Rus­sian-Chi­nese joint ven­ture in China of­fi­cially counts as ex­ports to that coun­try. Yet the prod­uct can end up in Rus­sia even­tu­ally. Also, the me­dia have re­ported on a scheme used by Mo­tor Sich to by­pass Ukraine’s sanc­tions against Rus­sia and sell its mil­i­tary-pur­pose prod­ucts to Rus­sia through in­ter­me­di­aries in Be­larus. As long as Ukrainian and Rus­sian de­fense in­dus­try com­pa­nies have no al­ter­na­tive buy­ers or sup­pli­ers for the crit­i­cal el­e­ments or ma­te­ri­als, they will con­tinue to find ways to by­pass re­stric­tions and bans.

Ac­cord­ing to a 2014 state­ment from UkrOboronProm, Ukraine’s de­fense in­dus­try needed al­ter­na­tive sup­pli­ers for at least 30,000 com­po­nents to com­ply with the pro­gram of re­place­ment of Rus­sian el­e­ments. When the war broke out, only 55% of com­po­nents in Ukraine’s mil­i­tary equip­ment and weapons were pro­duced do­mes­ti­cally. 10% was im­ported from Western coun­tries and 35% came from Rus­sia. By the sec­ond half of 2014, Ukraine fully stopped this co­op­er­a­tion

THE BIRTH OF UKRAINE'S DE­FENSE IN­DUS­TRY AS A FRAG­MENT IN THE SOVIET SYS­TEM TURNED INTO A CURSE: UKRAINE IS A TOP MIL­I­TARY EX­PORTER, YET IT CAN­NOT SUP­PLY ITS OWN ARMED FORCES WITH WEAPONS IN A FULL AND BAL­ANCED MAN­NER

with Rus­sia. By then, 70% of com­po­nents were pro­duced in Ukraine and 30% came from the West. To­day, ac­cord­ing to UkrOboronProm, Ukraine does not trade with the ag­gres­sor state di­rectly. In 2016 alone, nearly 400 com­pa­nies from across Ukraine, both pri­vate and state owned, joined the im­port re­place­ment pro­gram. The most suc­cess­ful ex­am­ples in­clude the pro­duc­tion of ar­mored ve­hi­cles and tanks with 87% of Ukrainian-made el­e­ments and 13% bought in the West. Or a shift to com­plete re­jec­tion of Rus­sian­made de­tails in the pro­duc­tion of Antonov An-178, mil­i­tary trans­port air­craft, in 2016 com­pared to 48% of its de­tails bought in Rus­sia and 11% in other coun­tries in 2015. To­day, Ukraine pro­duces 78% of the de­tails it needs for the air­crafts and buys the other 22% from else­where, ex­clud­ing Rus­sia.

What Ukraine in­her­ited from the Soviet de­fense in­dus­try are air­craft re­pair com­pa­nies. Antonov spe­cial­izes on the build­ing of mil­i­tary trans­port and pas­sen­ger air­craft, while the pro­duc­ers of at­tack air­planes re­mained on the ter­ri­tory of Rus­sia. In May 2016, Vla­dyslav Shostak, Deputy Head of the Ar­ma­ments De­part­ment at the Armed Forces of Ukraine, re­ported that the state was or­der­ing the pro­duc­tion of a com­bat air­craft in Ukraine. The sub­con­trac­tor would be Antonov, while the en­gines would be supplied by Mo­tor Sich. The prob­lem is that such prod­ucts are not the spe­cialty of Antonov, and Ukraine lacks the fa­cil­i­ties that could pro­duce the nec­es­sary elec­tronic equip­ment. Its do­mes­tic ca­pac­i­ties are not nearly suf­fi­cient to make the com­plete cy­cles of modern avion­ics.

MOV­ING BY IN­ER­TIA

Es­tab­lished in 2010, UkrOboronProm cov­ers only part of Ukraine’s de­fense in­dus­try with 133 com­pa­nies that are part of it, albeit the big­gest ones. Based on the state­ments avail­able from its web­site for three quar­ters of 2015, the lion’s share of all of its work was com­pleted over that pe­riod by the air­craft and ship­build­ing com­pa­nies (their de­liv­er­ies were worth UAH 5.53bn and 3.15bn re­spec­tively). Those in­volved in the ar­mored equip­ment and ar­tillery am­mu­ni­tion ac­counted for only UAH 1.75bn of de­liv­er­ies, fol­lowed by the clus­ter of high-pre­ci­sion weapons and am­mu­ni­tion with the de­liv­er­ies worth UAH 1.31bn. Ra­di­olo­ca­tion, ra­dio com­mu­ni­ca­tion and air-de­fense sys­tem com­pa­nies ac­counted for UAH 0.56bn.

This shows that the amount of the re­spec­tive work is not large for the size of the coun­try. It also proves that the struc­ture of this work is dic­tated by the ca­pac­i­ties avail­able in Ukraine, rather than the pri­or­i­ties of the mil­i­tary. This is hardly sur­pris­ing: it takes huge in­vest­ment to re­fo­cus Ukrainian de­fense in­dus­try, cre­ate new and ex­pand or mod­ern­ize the ex­ist­ing fa­cil­i­ties in the ar­eas that are ac­tu­ally cru­cial. There are no re­sources for such in­vest­ments now, nor are they ex­pected to ap­pear any­time soon.

The de­pre­ci­a­tion of equip­ment at UkrOboronProm plants ranges be­tween 60% and 80%. The bud­get al­lo­cates a mere UAH 0.4bn to pre­pare those fa­cil­i­ties for pro­duc­tion. An­other UAH 1-1.3bn is es­ti­mated to come from the cuts of the share of the con­cern’s in­come paid to the state bud­get (it’s paid by all state en­ter­prises) from 75% to 30%, as per the re­cent de­ci­sion by the Gov­ern­ment.

As for the struc­ture of the out­put, Antonov, de­spite its dif­fi­cult state, sells more (pro­duce worth UAH 2.6bn in the nine months of 2015) than the en­tire clus­ters of com­pa­nies in UkrOboronProm fo­cus­ing on other prod­ucts. Antonov’s sales are twice the scale of the high-pre­ci­sion weapons and am­mu­ni­tion clus­ter, and vir­tu­ally five times higher than those of the ra­dio lo­ca­tion and air-de­fense equip­ment clus­ter. The key en­ter­prises of the ar­mored ve­hi­cle and tank clus­ter per­form the works worth a dozen or so mil­lion dol­lars each a year. For ob­vi­ous rea­sons, they fo­cus on the re­pair and mod­ern­iza­tion of such equip­ment.

Ukraine’s de­fense in­dus­try is of­ten crit­i­cized for ex­port­ing new and in­no­va­tive ar­ma­ment. Why is it not go­ing to the Ukrainian army in­stead, the ar­gu­ment goes? UkrOboronProm of­fi­cials claim that “with­out in­vest­ment into pro­duc­tion and tech­nolo­gies, the state can cur­rently cover only min­i­mal needs” with the funding cur­rently avail­able. UkrOboronProm di­rec­tor Ro­man Ro­manov says that the state or­der for the con­cern was un­der­funded by around UAH 1bn in 2016. The to­tal sum of the state con­tract for the mod­ern­iza­tion and re­pair of mil­i­tary equip­ment and the pro­duc­tion of new ar­ma­ments amounted to a mere UAH 4.4bn last year.

Since the state con­tract is so re­stricted, the strat­egy of ex­port­ing the new­est equip­ment is con­sid­ered to be the best-case sce­nario on the top level. Pres­i­dent Poroshenko’s re­cent state­ment on the topic ex­presses this: “we are fac­ing a choice be­tween buy­ing one Oplot or ten pro­foundly up­graded and re­paired T-64 or T-80. It takes at least 18 months to build an Oplot, while the cy­cle of a T-80 mod­ern­iza­tion is 2.5 months. There­fore, the ques­tion is whether we get a full tank unit or one tank. While the re­source is avail­able, we must ur­gently mod­ern­ize the above­men­tioned tanks, fully sup­ply tank units with up­graded and re­paired ve­hi­cles within the short­est time­frame pos­si­ble.”

UkrOboronProm works with state-funded con­tracts, fo­cus­ing on re­pairs and less so on mod­ern­iza­tion. Apart from that, many pri­vate com­pa­nies op­er­ate in Ukraine. Ac­cord­ing to es­ti­mates by of­fi­cials, the ra­tio of state and pri­vate com­pa­nies in­volved in de­fense con­tracts is 50% to 50%. The big pri­vate sub­con­trac­tors work­ing with state-funded con­tracts in­clude en­ti­ties con­trolled by Petro Poroshenko’s Prime As­sets Cap­i­tal and ZNKIF VIK, a closed non-di­ver­si­fied cor­po­rate in­vest­ment fund, of Ihor Kononenko, an MP with the Petro Poroshenko Bloc. In 2017, Kuznya na Ry­bal­skomu (re­named from Lenin­ska Kuznya), a ship­build­ing and ar­ma­ment com­pany, will build four small ar­mored ar­tillery Gurza-M boats, two Cen­taur as­sault boats, and one spe­cial-pur­pose aux­il­iary ve­hi­cle. The com­pany also won the ten­der to re­pair the Het­man Sa­haidachnyi frigate. As the com­pany re­ori­ented to state

con­tracts, it needed an ur­gent per­mis­sion to im­port and ex­port mil­i­tary-pur­pose prod­ucts for its own pro­duc­tion pur­poses.

An­other ma­jor pri­vate sub­con­trac­tor for the state or­der in 2017 will be the Kre­menchuk Au­to­mo­bile Plant or KrAZ. Ac­cord­ing to Va­leriy Holovko, head of the Poltava State Oblast Ad­min­is­tra­tion, Av­toKrAZ is ex­pected al­most UAH 2bn, a fifth of the to­tal state de­fense con­tract. Deputy Econ­omy Min­is­ter Yuriy Brovchenko says that this year’s or­der will be for 500 heavy ar­mored cars. This is vir­tu­ally half of the yearly out­put of cars by this Kre­menchuk plant. In­ter­est­ingly, in the past years the me­dia of­ten re­ported an al­leged con­flict be­tween the fac­tory owner Kos­tiantyn Zhe­vaho and the gov­ern­ment. It was re­port­edly caused by the de­sire of some peo­ple linked to the Pres­i­dent to force him to give this as­set away.

DEFICIT FUNDING

Over­all, it is dif­fi­cult to ob­tain com­plete in­for­ma­tion about the amount and the key el­e­ments of the state de­fense con­tract. When Pres­i­dent Poroshenko com­mented on this, he said that “81% of the con­tract comes from the gen­eral fund of the state bud­get. We firmly be­lieve that this 81% will be funded fully”. Money­wise, this will amount to around UAH 9bn, ac­cord­ing to Poroshenko. The Law on the 2017 State Bud­get en­tails a mere UAH 5.8bn for the de­vel­op­ment of ar­ma­ment and mil­i­tary equip­ment through the De­fense Min­istry (UAH 4.5bn in 2016 and UAH 4.75bn in 2015). This is way more than UAH 0.91bn in the pre-Maidan 2013, but clearly not enough for a coun­try with ob­so­lete ar­ma­ments and the army that is fight­ing against the Rus­sian ag­gres­sion.

By the way, the US was of­ten crit­i­cized for lim­ited mil­i­tary and tech­ni­cal as­sis­tance to Ukraine. How­ever, the amount of it is largely equal to the amount of the con­tract funded by the Ukrainian gov­ern­ment. While the Ukrainian bud­get al­lo­cated $250-350mn an­nu­ally for the re­pair of the mil­i­tary equip­ment, Deputy As­sis­tant Sec­re­tary of De­fense Michael Car­pen­ter claimed that the US mil­i­tary as­sis­tance to Ukraine amounted to $600mn in 20142015, which makes it nearly $300mn a year. Ukraine was pro­vided coun­ter­bat­tery radars, tac­ti­cal drones and field hos­pi­tals. Prepa­ra­tions are un­der­way to trans­fer to Ukraine 30-me­ter pa­trol Is­land-class boats from the US Coast Guard (Geor­gia re­ceived such boats be­fore).

Apart from the above­men­tioned spend­ing on the de­vel­op­ment of ar­ma­ments and mil­i­tary equip­ment, the bud­get al­lo­cates sig­nif­i­cant ex­pen­di­tures on the main­te­nance of the Na­tional Guard, State Bor­der Guard Ser­vice. Some of this funding may well go to equip­ment con­tracts. In ad­di­tion to that, the 2017 bud­get en­vis­ages an­other UAH 11.58bn of vir­tual “rev­enues to the spe­cial-pur­pose fund to en­sure de­fense and se­cu­rity of the state” from spe­cial con­fis­ca­tions. How­ever, this fund is un­likely to be filled as pro­jected: the amount en­vis­aged in 2016 was UAH 7.75bn, and UAH 1.5bn in 2015. None of this funding came in. The share of money from this fund was quite high in the to­tal de­fense con­tract last year. Since none of this money was avail­able, the de­fense con­tract only re­ceived 50% of the planned funding, and that came from the state bud­get.

This lack of funding for the state de­fense con­tract looks like the by­pass­ing of the 0.5% of GDP that is sup­posed to go to the de­vel­op­ment of the de­fense in­dus­try. The bud­get thus al­lo­cates num­bers close to that, but a larger share of the money is ex­pected to come from un­guar­an­teed sec­tions of the bud­get. As a re­sult, the real funding is far lower than pre­scribed. Mean­while, even 0.5% of GDP is not enough to mod­ern­ize Ukraine’s armed forces as they face the grow­ing Rus­sian threat. Rus­sia al­lo­cated 1.6-1.7% of GSP for the state de­fense con­tract in 2016-2017. 65% of this money went to buy se­ries of modern ar­ma­ment and equip­ment, not to up­grade or re­pair the avail­able equip­ment like in Ukraine.

Clearly, Ukraine can­not com­pete with Rus­sia in terms of funding. How­ever, it should com­mit to al­lo­cat­ing at least an equal share of its GDP to the rear­ma­ment of its Armed Forces. This does not re­quire ex­treme poli­cies. Based on the 2017 bud­get fig­ures, a tar­geted in­crease of VAT by 2% can add UAH 30bn to the state de­fense bud­get. If the war tax is raised from 1.5% to 3%, it could de­liver a nar­rowly lower amount of rev­enues. This would in­crease guar­an­teed funding of the state de­fense con­tract by vir­tu­ally six times (to $1.9-2bn an­nu­ally and more) and bring Ukraine closer to the share of GDP spent on the de­fense con­tract in Rus­sia. Over the course of a few years, this would sig­nif­i­cantly in­crease Ukraine’s de­fense ca­pa­bil­ity and help in­tro­duce new projects in de­fense in­dus­try, both do­mes­ti­cally and in co­op­er­a­tion with Western part­ners.

These mea­sures would not have crit­i­cal im­pact on Ukraine’s econ­omy. It would drive in­fla­tion 1.52% up, and dis­pos­able in­come of Ukraini­ans af­ter the war tax is dou­bled would fall one time by 1.5%. All this would be an ac­cept­able price for a sig­nif­i­cant progress in re­in­forc­ing Ukraine’s de­fense ca­pac­ity.

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