Finding the balance

28 April 2017, 15:45

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.  

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 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 Russian-made 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.

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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 2014-2015, 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).

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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 1.5-2% 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. 

Translated by Anna Korbut

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