Drive, not drag

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

The Ukrainian Week - - CONTENTS - Olek­sandr Kra­mar

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 19th and 20th cen­turies, 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.

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 71st in the list of top 100 sell­ers of arms in 2018, be­hind more than a dozen spe­cial­ized com­pa­nies in key arms­mak­ing 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, Rus

sia 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.

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.

The MIC’s Achilles’ heel. World-fa­mous Antonov spe­cial­izes in man­u­fac­tur­ing mil­i­tary trans­port and civil­ian air­craft: all the plants mak­ing bombers and fighters re­mained in Rus­sia af­ter the USSR broke up

Turk­ish ex­pe­ri­ence. A role model is the devel­op­ment of the de­fense in­dus­try in our im­me­di­ate neigh­bor

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