Recent trends and developments

The Russian Defense and Aerospace (D&A) industry managed, after the troublesome decade of the 1990s, to make the transition from the “cost no object” Soviet philosophy to the global market at an extraordinary pace, sometimes even outperforming the Kremlin’s own expectations and enlarging the ever-increasing Russia’s positive trade-balance, which is based (though not exclusively) on oil, gas, and related goods exports. Will international cooperation be beneficial for Russia and how?

Reasons behind the growth

All this growth in the defense sector has become a reality thanks to a complex set of factors. First, the incoming money from Russia’s energy exports enabled the D&A industry to materialize several of its (very often Soviet-era) stagnated projects, like the extraordinary new Tupolev bomber. The consolidation of most of the defense industry under state control, including tighter control over production lines, materialization of projects, and the increase of salaries across the industry, also helped the overall performance. Also, partial privatization of certain small and medium-size enterprises (SMEs) helped the management bypass its socialist approach in some successful cases.

New defense-sector revenues from the late 1990s were poured back into the industry, helping scientists and analysts to advance research and development. Another major reason is the international geopolitical developments after the 9/11 attacks that opened new markets for Russia. The Russian foreign policy in general allowed the country to continue steadily gaining leverage in regions of Southeast Asia, Africa, parts of the Middle East, and much of the Commonwealth of Independent States (C.I.S.). Russia also used its dominance in oil and natural gas exports and transportation systems to expand its military sales by arranging deals involving the sales of weapons in exchange for the acquisition of energy fields or participation in C.I.S. energy companies and transportation.

Finally, the money coming from the state budget has been steadily increasing. Foreign sales that poured money back into the D&A industry’s research and development (R&D) sector increased significantly over the last decade or so. The country’s foreign sales order backlog reached

USD 23 billion during 2006 having fluctuated between USD 15 billion and USD 16 billion in recent years. At the same time, export sales in 2006 reached a record USD 6.126 billion, more than USD 1 billion ahead of Moscow’s own calculations. The figure climbed to USD 7 billion in 2007.

New policies

Creative financial arrangements, such as debt forgiveness and access to recipient countries’ oil and gas fields, have helped Russia to secure foreign markets beyond China and India, which still are the main buyers of Russian weapons. One example of debt-forgiveness, as well as access to the buyer’s oil and/or gas fields, is Algeria. In March of 2006, Russia and Algeria signed a multi-billion-rouble deal that includes 40 T-90 main battle tanks (MBTs), 8 battalions of S-300 PMU2 SAM systems, 16 Yak-130 advanced jet trainers, 40 MiG-29SMT fighters, as well as 20 SU-30MK interdiction aircrafts. Aside from debt-forgiveness, Lukoil and Gazprom secured access to the country’s natural reserves. In other African countries, the Russians plan similar deals. Rosoboronoexport, Russia’s state-controlled weapons export company announced back in September 2006 that counter-deliveries of products such as diamonds, lumber, cotton, palm oil, and coffee could underpin future deals.

In spite of these developments, there are still several pitfalls. One of them is the malfunction of several SMEs which have failed to adopt new managerial approaches and organizational structures. These entities have not lent themselves to free market economic principles. Also, the larger companies must consider how they will access financing to fund R&D and maintain a competitive edge over foreign companies. Finally, as Russia’s Economic Minister suggests, industry leaders should consider opening up their companies with listings on foreign stock exchanges in order to keep their position on the world market. Some, like the company Irkut, the Sukhoi maker, and the Volga-Dnepr Group expressed interest in being listed on the London Stock Exchange (LSE) as early as 2006, but neither has followed through with those plans.

The consolidation process

In light of such developments, it comes as a surprise that the Kremlin has moved away from market-orientated policies and is proceeding to consolidate the weapons industry. The FSB, Russia’s intelligence agency, Director Nikolai Patrushev said in December 2005 that there were “suspicions” that foreign capital could have been at the root of attempts to force defense companies into bankruptcy”.

These remarks were followed by State Duma legislation prohibiting foreign participation of more than 50% in 39 key (strategic) Russian industry sectors (or 550 ventures) including the defense industry. One of the main vehicles used by the government in expanding its control over the D&A industry overall is Rosoboronoexport. The company has a near-monopoly on international sales. In 2005, it was responsible for around 80% of all foreign sales. Rosoboronoexport acquired a controlling stake (which is believed to be between 51 and 62%) in vehicle manufacturer Autovaz.

Autovaz’s plans may soon cause a significant impact in the international military vehicle market, as the company is getting ready to release a military scout car under the Kalashnikov brand name. Another significant development that Rosoboronoexport is a part of occurred in 2006 when the company acquired a 41% stake (USD 1.5 billion) in VSMPO-Avisma, the world’s largest producer of titanium and key supplier to Boeing and EADS. Moscow also wants to have its representatives serving on the EADS board of directors, as Boris Alyoshin, head of the Russian Federal Industry Agency, said.

The Russian state through the state-owned bank VTB acquired a 5% stake in the European Aerospace, Defense and Space corporation within the framework of Russia’s cooperation with the Europeans in defense and aerospace sectors.

What lies ahead

Many critics say that Russia’s policies will only result in harming its own domestic D&A industry, as well as significantly limiting FDI coming into the defense industry. There are reasons to believe that extended state consolidation may result in negative actions by the West, such as restrictions on the percentage of companies that can be floated on a foreign exchange. Furthermore, it became clear that should the Volga-Dnepr Group plan to be listed on the LSE, it will also be obliged to float on Moscow’s stock exchange, the RTS. If consolidation proceeds further (this is the mood the Kremlin is in right now), Western opponents will have justification for their reaction. In this pessimistic scenario, further partial exclusion or various restrictions on Russian defense companies from international markets (mainly the LSE and the NYSE) will be a reality.

Should pragmatism prevail, the Russian military complex will have much to gain. It will not happen through the direct participation of foreign companies in Russian prime military projects – joint production of planes like the formidable Su-37 or any new MiG fighter jet by Russian and European or U.S. companies will never take place. However, special projects for counter-terrorism or logistic support could come out from an EADS-Russian cooperation. Western know-how could prove highly beneficial to several Russian companies, especially SMEs.

Future projects that even resemble futuristic Hollywood war movies (like robot artillery systems) will need Western technical, managerial, marketing, and production-related contribution. That does not necessarily mean that Russia should in any case give up vital defense sub-sectors or even reveal military projects by involving foreign companies.

Apart from the new markets, Moscow also has what it lacked only several years ago – financial resources. Should the Russian leadership take advantage of all the prospects without irritating the West – or creating any problems for people from around the world who have invested or want to invest in its major companies listed abroad – Russia will only stand to benefit.