Monday, May 10, 2010

Profit, Loss, and Proliferation

Defense, Inc., Russian Style

Molly Cernicek and Cheryl Rofer

The Armchair Generalist drew attention last week to the Rocket-In-A-Box missile system marketed by a joint stock company of Russian defense firms at the Defense Services Asia exhibition in Malaysia. Called the Club K Container Missile System by the Russians, this system of missiles can be boxed up in a 40-ft standard shipping container and installed on coastal positions, surface ships and vessels of different classes, railway and automobile platforms. Price tag: $15 million. The mobility of this product has worried some that it could become a weapon system of choice for a terrorist organization. What should be watched closely is not so much whether a terrorist group will buy or acquire this system as whether Russia’s recently privatized defense industry can compete with the rest of the world for the biggest spending customers in the conventional weapons market. Because if it cannot, then there are more reasons to worry about Russian weaponry ending up in the wrong hands.

The Club K Container Missile System is a product of a thick web of companies whose shares are owned by both the Russian government and private entities. A joint stock company called Concern Morinformsystem-AGAT that makes the Club K includes ten additional joint stock companies and three Federal State Unitary Enterprises (FSUEs). (Concern in Russian means a group of companies.) A FSUE is a legal entity created by the Russian government that allows government enterprises to undertake commercial activities but that does not sell shares. Eleven of these participating organizations with Concern Morinformsystem-AGAT are Soviet-established military and scientific institutes dedicated for decades to shipbuilding and associated technologies; one has roots in Czarist times, and one was created post-Communism. State Corporation Rostekhnologii oversees Concern Morinformsystem-AGAT.

A state corporation is a state holding company that unites the largest enterprises of the military-industrial complex and associated civil industries. Its subsidiaries can carry out any market operations, including IPOs. It is not directly controlled by the government, its head is appointed by the president personally, profits of the corporations may not be distributed, and rules for disclosing information for such entities are less stringent than for open joint-stock companies. It’s a shadow ministry of industry.

In a massive effort to control and manage both the vertical and horizontal networks of the Soviet military-industrial complex, Putin’s government established a new management model for its defense industry. First it created the Rosoboronexport State Corporation (ROE) in 2000. ROE’s objectives included the restructuring of the military and technical system of coordination between foreign states and the Russian Federation, establishing and enhancing long term relationships with foreign customers, and to advance Russia’s standing in the international arms market. Sergei Chemzov was first deputy chief of Rosoboronexport from its creation in 2000 until he became CEO in 2004. In an earlier career, Chemzov was a KGB operative who served in the 1980s in Dresden, East Germany, with Putin. In 2005, he started to lobby for a new entity that would have more responsibility and reach than ROE.

In late 2007, Rostekhnologii was established to facilitate development, production and export of hi-tech industrial products for civilian and military purposes. It is a supercorporation that controls the production and supply chain from research and development as well as the supply of special equipment from abroad. Some of its assets include Russia’s biggest car-making company, Avtovaz; one of the world’s main producers of titanium, VSMPO-Avisma; Vertolyoti Rossia, which produces civilian and military helicopters; Oboronitelnye Systemi, which manufactures anti-aircraft and electronic equipment; steel producer RusSpetsStal, and multiple other properties.

So how is this model working so far for Russia? A quick glance looks positive as Russia’s defense products pulled in a record $7.4 billion in 2009, up 10 percent from 2008. ROE accounted for 80 percent of those sales with the remaining 20 percent coming from Russian defense companies that trade in spare parts, maintenance, and repair services. But $7.4 B is probably .2-.3% of the overall global market. And $7.4 billion is probably not enough to support the thousands of employees within ROE and Rostekhnologii. Though numbers are elusive, it is very likely that US top defense contractor Lockheed Martin has far fewer employees than these Russian state corporations. In 2009 Lockheed brought in $45.45 billion.

Presidents Yeltsin and Putin did not have the stomach to force many defense institutes out of business. Instead, they allowed them to hold on in a quasi-existence for years with no investment into research, people or infrastructure. Putin has created the public-private model where the toughest will survive and the others will go bankrupt. Soviet institutes now are joint ventures and sell shares. Many of their leaders have borrowed money against these shares to keep the old institutes on life support and then borrowed more money to pay off earlier loans at higher interest rates. Last year Chemzov, now CEO of Rostekhnologii, announced that that 30 percent of the nearly 400 firms under Rostekhnologii management were facing bankruptcy proceedings. Rostekhnologii owns up to 100 percent of these joint ventures.

There are destabilizing factors not just to Russia’s national security but to global security if Russia’s defense industry cannot maintain a competitive position in the global weapons market. In order to be competitive globally, Russia has to be competitive domestically, and that is a problem that so far has not been solved. The Russian government can no longer afford to give loans to other governments to buy Russian weapons…only to promise to forgive these loans down the road. This behavior takes the “business” out of “business model”. ROE and Rostekhnologii are also victim to entities and people within their massive organization who are selling products on their own terms, some of them violating international arms embargos and undermining the corporations’ operations and goals.

The jury will be out for a while before any clear conclusions can be drawn from Russia’s “modernized” defense industry. Thankfully, its nuclear complex is not part of a state corporation.

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