TITLE: DEFENSE INDUSTRY SUBJECT COUNTRY(IES): RUSSIA POST OF ORIGIN: RUSSIA SERIES: INTERNATIONAL MARKET INSIGHT (IMI) ITA INDUSTRY CODE: DFN DATE OF REPORT (YYMMDD): 990331 DELETION DATE (YYMMDD): 200331 AUTHOR: MICHAEL NIKOULICHEV APPROVING OFFICER: DAVID KNUTI OFFICER'S TITLE: COMMERCIAL OFFICER NUMBER OF PAGES: 14 INTERNATIONAL COPYRIGHT, U.S. & FOREIGN COMMERCIAL SERVICE AND U.S. DEPARTMENT OF STATE, 1999. ALL RIGHTS RESERVED OUTSIDE OF THE UNITED STATES Summary The Russian defense industry is undergoing changes, which include: a shift from production of military to commercial goods; the restructuring of firms into a mixture of holding companies, joint ventures, and small spin-offs; a shift towards integration into the world economy. The defense budget dropped to below four percent of GDP, which is insufficient to support more than 1700 existing defense industry firms, 1.2 million armed forces and defend 22,000 km of borders. Opportunities for American business lie mostly in joint production at enterprises included in the defense conversion program or in dual-use technologies. The following IMI is based on the FCS and Embassy report oDiversification and Defense Trade Opportunitieso. A. DEFENSE INDUSTRY ENVIRONMENT The Russian defense industry remains in a state of disarray. Traditional sources of support u the defense budget and orders from former Soviet satellites and allies u have almost evaporated over the past 10 years, and very few new sources of income have emerged. Most defense plants reside in old, deteriorated buildings and rely on obsolescent and often worn equipment. Defense industry pay is in arrears by up to 10 months in some cases. When paid, it has not kept up with inflation and many engineers and production workers have left defense firms for small technology firms or the private sector. Many are working in the retail sector, operate kiosks, or drive taxis. Arms Exports Russia currently is the world's fourth largest arms exporter, behind the United States, Britain and France. Back in 1980's, the Soviet Union's arms exports amounted to $20 billion a year. In 1998, the nation's main arms trader, the Rosvooruzheniye company, exported only $2 billion in arms. The sales primarily focused on a new generation of Sukhoi (Su) planes, upgrades of MiG fighters, and air defense missile complexes. Market Prospects The Russian economy is plagued by a serious non-payments problem, and inefficient and decaying infrastructure, severe environmental problems, inadequate housing, and poor quality consumer goods. These were compounded by the financial crisis that developed in 1998. As long ago as the Brezhnev era, the Russian government turned to its defense plants for production of needed civilian products. During the Gorbachev era, specific defense sectors were directed to focus on commercial sectors. For example, biological weapons plants were told to focus on medicines, and enterprises of the space complex started producing sailboats, microwaves and other consumer goods. The Primakov government places a high priority on reviving the defense industry and ensuring that it gets more resources. However, the financial crisis worsened an already existing wage arrears and tax revenue problem, and it is doubtful that the government will have the resources to meet its obligations to the defense plants for past years, to fund any conversion plans, or even to place significant new orders for defense equipment. Russian defense firms, while strong in engineering and manufacturing, still lack expertise in marketing, management, and financial analysis. U.S. firms could work with spin-off enterprises of Russian defense firms to jointly produce goods for Russian and regional markets. Although short-term barriers are numerous, several factors may make joint ventures attractive in the long run. Low Manufacturing Costs: Russian defense enterprises operate at lower costs than Western ones, although the recurring problems related to non-payments throughout the economy make it difficult to know or predict real costs. - Pockets of superior technology and expertise: Russian defense plants usually appear poorly maintained and obsolete. However, Russian scientists developed unique approaches and capabilities often unrecognized in the West. In 1990, an interagency technology assessment group identified Russian sectors with advanced military technology, which include: Chemical/allied products Rubber and plastic products Small nuclear power reactors Industrial/commercial machinery Electronic components Transportation equipment Photographic, medical, and optical instruments Space launch and payload services Metallurgy, primary metals Aerospace, rocket engine design Lasers and optics Software design Defense Budget Information This year's federal budget allocates only 3.2 percent of the GDP for defense u the lowest in the post-Soviet history of Russia. Historically, Russia spent an estimated 20-plus percent of its gross domestic product on defense. In more recent years, this figure has dipped below 4 percent of a smaller domestic product. Furthermore, from1993, the government began to withhold a large part of the budgeted amount. In 1996, allocations for the entire year were one-third short of the budgeted amount, while in 1997, MOD sources claimed to have received only 55.6 percent of their budget. Russian defense figures are easily misinterpreted and have become less transparent with renewed concealment of the budget in 1998. Much defense budget money actually goes for civilian production and social services for defense workers. Many defense plants and defense bases receive hidden subsidies from regional and city governments in the form of free land, electricity, food supplies, and other services. In 1998, the military budget continued to shrink both in percent of GDP and percent of overall expenditures, despite Government statements about committing 3.5 percent GDP to military funding. Out of the budgeted amount of 7.00 billion dollars (for three quarters of 1998) only 4.66 billion dollars or 66.5 percent of the budgeted amount was fulfilled. The planned 1999 expenditure, based upon debate in the Duma, has increased from an original figure of 2.3 percent to up to 3.2 percent of GDP. Brief Description of Domestic Industry Structure The Russian defense industry consists of over 1,700 firms and in 1997 employed some 2.5 million workers. While defense enterprises are found throughout the country, a significant portion is concentrated in twelve cities and regions, where over one-third of the labor force works in defense. The industry needs modernization and many defense enterprise managers are eager to learn about the basics of marketing, finance, and modern business practices. A Russian defense plant is also, in some ways, a throw-back to a U.S. factory-town. The defense plant is really a mini-city in itself, with its own apartments, doctors, clinics, restaurants, and power plants. Outside of Moscow and St. Petersburg, defense plant employees usually live in company apartments, shop in company stores, and eat in company cafeterias. Up to 80 percent of a defense plant's budget goes to maintaining these social services. The plant manager is often as concerned with making deals to bring in potatoes and bread to feed his people as with joint venture agreements, and these and other transactions are often conducted on a barter-basis. Most Russian defense enterprises would be considered bankrupt in Western terms, and the situation has been worsened by the financial collapse of 1998. The Ministry of Economy reports that 400 defense enterprises are unable to pay their debts. Russian defense plants have lost nearly 80 percent of their funding from the Russian government in the past ten years. Defense orders have almost disappeared in the last two years. At the same time, defense plants have lost export earnings due to loss of traditional Soviet bloc markets and the general decline in the world arms market. Plant managers have often attempted to maintain production even without budget authority to keep workers busy. This has led to an excess inventory of weapons, which plant managers try to sell, even as the downsizing armed forces also sought to sell off now surplus military equipment. Many defense plants have reduced operations to only a few days per week at most. Russian defense industry wage increases have not kept pace with inflation, meaning that most Russian defense enterprises have steadily lost their best workers (estimates range from 800,000 to 1 million lost per year) to Western companies or the emerging Russian private sector. Restructuring the Industry By November 1, 1997, the core of the defense industrial sector (not counting those organizations affiliated with the Ministry of Nuclear Energy) comprised 1,700 institutions and enterprises employing nearly 2.5 million individuals in eight defense related industrial sectors spread across 72 locations in Russia. Currently, the Ministry of Science and Technology, the Ministry of Defense, and the Ministry for the State Property are working to identify 670 strategically important enterprises that will form the basis of the reformed defense core by 2005. Government priorities will be given to those industries that produce dual-use technologies, especially in aerospace, electronics, and communication markets. The Government intends to auction off state-owned blocks of shares in the remaining enterprises, which are often small and difficult to manage. At present, the preliminary institutional break-down is as follows: between 1999 and 2000, the share of state-owned enterprises in the defense industrial sector will decrease from forty to thirty percent; the share of joint stock companies with participation of the state will increase from thirty to sixty percent; and the share of fully private enterprises will decrease from thirty to ten percent. The Russian government goal has been to target limited budget funds and Western assistance to a small number of key, technology-rich research and design institutes. Last year, President Yeltsin overturned a government decision that would have allowed unprofitable firms to go bankrupt. Meanwhile, Deputy Prime Minister Maslyukov has tried to act on behalf of those in the Duma who press for government action to preserve defense industry firms and retain government control if not ownership of many of these "strategic enterprises." Traditional Suppliers of Defense Equipment Nearly all Russian defense equipment is produced by domestic firms. In the recent past, Russia was a part of the Soviet bloc military-industrial complex, with interrelated units throughout Eastern Europe and the former Soviet Union. Today, most supplies and equipment are produced within Russia, with limited purchases from its former partners. Historically, Russian defense firms have always sought and managed to acquire Western military and dual-use technology. This interest can be expected to continue, with limited commercial purchases sometimes substituting for espionage. The Department of Commerce, through the Bureau of Export Administration has published several editions of the Russian Defense Business Directory, which provides more detailed information on major Russian defense and aerospace firms. II: OPPORTUNITIES IN ONGOING DEFENSE-RELATED ACTIVITIES Pure defense industry opportunities in Russia for U.S. firms are very limited, even without technology transfer concerns. The Russian government intends to use limited defense funds to maintain Russian defense capabilities and is unlikely to invest in weapons systems from the West. Some opportunities exist through U.S. Government aid programs that help the Russian military and government to safely dispose of nuclear, chemical, and biological weapons and prevent proliferation of Russian weapons technology. There is some U.S. Government money available to help in this effort. Specific activities include: - Destruction of nuclear weapons; - Improvements in nuclear weapon security and accountability systems; - Safeguards against weapons proliferation. Another potential service is education and training. Russian industrial managers and military leaders are anxious to learn about the management and manufacturing methods of the West. 1. New Defense-Related Commercial Projects: Many of the Russian Ministry of Defense's major new initiatives are commercial, not military and might offer potential upgrade, replacement or spare parts, maintenance, logistics, service opportunities for military equipment converted for civilian purposes. Major projects within the Russian defense sector are listed below: - Next generation commercial airliners: Ilyushin and Tupolev are developing a new generation of commercial airliners for NIS and global markets. - Merchant Marine: Russian shipyards are re-equipping the Russian oil tanker and cargo vessel fleet. - Telecommunications: Russian defense firms are building equipment for a major upgrade of Russian telecommunications system. - Global Navigation System: The Russian Space Agency is overseeing the Russian work on the GLONASS global satellite system to improve aircraft navigation across Asia. The system, which is run by the Strategic Rocket Forces, is a rival of the U.S. Global Positioning System (GPS). The Government intends to enforce its use in new telecommunications in Russia. - The U.S.-Russia space station: Russian aerospace firms are working with American partners on the international space station. 2. New Systems Development Under severe budgetary constraints, government defense procurements have been drastically cut. A further constraint has been significant surplus of used military equipment on hand as a result of efforts to downsize the armed services. It has been reported publicly that in 1998 no major equipment items were procured. Plans for future procurements are reportedly focused on minimal replacements of existing inventory when needed, possible procurement of "one-of-a-kind" prototypes, and eventual re-equipping of the services with new systems after 2005 at the earliest. To date, the attention of the MOD remains focused on traditional suppliers (such as MiG, Sukhoi, Mil, Tupolev, and Kamov) for aircraft, as well as the other Russian manufacturers of various types of ground and naval equipment. 3. Military Operations As of 1 January 1999, the authorized peacetime strength of the Russian Armed Forces is 1.2 million, following massive personnel cuts and reduction of peacetime billets over the past two years. Strength accounting is complicated by the fact that Russia maintains several militarized formations subordinate to non-Defense security services, such as the Ministry of Interior, the Federal Border Guards Service, the Ministry of Emergency Situations (EMERCOM), the Federal Security Service, the Federal Agency of Government Communications and Information (FAPSI), the Federal Service of Railroad Troops, and the Presidential Security Regiment. Russia's current economic crisis and predicted fiscal austerity programs has put most reform projects within the Armed Forces on hold and aggravated what was already a dismal fiscal situation for the Armed Forces. It was estimated that Russia's present economy can adequately support only 550,000 servicemen out of its present 1.2 million. Combat training has become virtually non-financed, with the military receiving only 6 percent of the resources required for combat training in 1998. Even this amount was apportioned only for maintaining infrastructure, forcing the military to finance fuel, ammunition, and training equipment costs from other sources. The Russian Armed Forces' living standards remain at the low end of the country's socioeconomic scale. Throughout 1998, the government remained 3-4 months' delinquent in paying service members' wages, although many units were finally current on pay by the end of the year. 4. Country efforts to reduce and restructure military spending Over the past year, Minister of Defense Sergeyev has continued to move forward with implementing reform and restructuring to develop a force that can be manned, equipped, and sustained at a high level of combat readiness under existing and projected funding limits. As a result of the military's financial restrictions, both force modernization (acquisition and procurement of new equipment) and plans to transition from conscript to all-contract Armed Forces have been deferred until well into the next decade. The Ministry of Defense estimates that, even if fully funded, defense orders will meet only the most urgent requirements (foremost, in the Strategic Rocket Forces). Consequently, it is focusing on upgrading and repairing the Armed Forces' current inventory to extend the life of existing systems. 5. Identification of Key Ministries, Bid Procedures The Russian Defense Ministry has procurement procedures similar to the United States. Information about procurement is becoming more readily available, especially public tenders for food, uniforms, etc. With many Russian defense factories idle, the Russian Ministry of Defense is unlikely to give major defense contracts to non-Russian firms. However, this may not rule out bidders with Russian partners or participation, depending upon the commodity. III: DIVERSIFICATION/ COMMERCIAL OPPORTUNITIES Despite a challenging economic and political environment, the Russian market offers a variety of trade opportunities for U.S. firms. Working with a Russian defense firm is one way U.S. firms can attempt to gain toe-hold in Russian and NIS markets. Defense firms are becoming more adept at marketing and they have access to vast networks of suppliers and sub-contractors within the Russian defense establishment. Many also have political connections and clout that can help to reduce barriers to trade and eliminate government obstruction. On paper, the Russian government has developed a defense conversion plan identifying up to 14 areas for conversion efforts. However, the government has thus far allocated a mere 3 billion dollars to stimulate this conversion process. In these areas, Russian defense firms will need Western products and technology to succeed in conversion efforts even though mutual technology transfer concerns and issues may complicate such contacts. Some of the most potentially fruitful areas include: - Civil Aviation: Russian manufacturers need Western engines and avionics to bring the Russian civil fleet up to world standards. - Civil Shipbuilding: Russian shipyards need to build oil tankers, fishing trawlers, cargo ships, and pleasure craft. - Oil and gas industry equipment: Russian missile equipment and tank plants are now building oil drilling pumps, excavation equipment, air compressors, and gas liquefies. - Housing: The Russian defense sector may begin to address Russia's severe housing shortages through producing homes, apartment buildings, internal equipment, and appliances. - Consumer goods: The Russian defense sector produces nearly all of Russia's televisions, video cassette recorders, and cameras, plus most washing machines and vacuum cleaners. - Medicine and Medical Equipment: Defense plants produce 80 percent of medical equipment produced in Russia. Biological weapon plants are now converting to produce vaccines and medicine. Other high priority industry sectors include the following: Food processing Textile industry equipment Communications and information equipment Timber industry equipment Electronics Pollution control equipment 1. Opportunities Arising from the Privatization Many Russian defense enterprises recognize the need for Western investment and partners. The Russian government at one time planned to privatize about three-fourths of its more than 2000 defense enterprises by the end of 1994. About 700 of Russia's defense enterprises have already to some degree been privatized although the government retains a significant if not controlling interest. About 450, mainly research institutes and design bureaus, will remain government-owned. Many talented Russian scientists and engineers are setting up spin-off companies to market commercial applications of defense and other technologies. To survive as privatized firms, most Russian defense enterprises will need Western management help, investment, and cooperation. 2. Opportunities in Dual Use or Related Technology Fields Telecommunications Equipment The Russian telecommunications market suffers from a lack of installed lines, outmoded switching equipment, and inadequate revenues to finance investment. As an example, only 15 percent of the local networks' total access lines are digital. Upgrades of the Russian network over the next few years are estimated to be worth around 2 billion dollars. The current strategy of the State Committee for Communications and Informatization (Goskomsvyaz) is construction of new digital trunk lines, network digitalization, expanding the range of services, introducing new management technologies, and re-organization of the accounting and billing systems in keeping with international standards. Goskomsvyaz is dedicated to bringing the telecommunications infrastructure up to international norms, and many multinational firms are looking for the opportunity to help in this undertaking. The issue of financing is critical in the implementation of existing projects in the field of telecommunications. According to the experience of telecommunications companies in Russia, there are a number of issues that need to be resolved, including legal and regulatory instability and uncertainty of enforcement; improvement of the process of certification of telecommunications equipment and services; improvement of licensing procedures for provision of telecommunications' services in Russia; improvement of availability to user of the frequency spectrum and transparency in allocations; and legal protection of investments in the Russian telecommunications sector. Medical Equipment Because domestic medical equipment production can meet only 30 percent of total demand, imports play a significant role in the market. Government purchases of foreign medical equipment are usually financed by foreign loans, foreign credit lines, and internationally-sponsored development projects. The Ministry of Health no longer makes centralized purchases. Instead, regional health authorities, or hospitals whose funding is at least partially provided by local companies, are the principal buyers. Large manufacturing enterprises which opened up their hospitals and medical units have become the most active purchasers of medical equipment. The most promising medical subsectors include: diagnostic equipment; ultrasound equipment; electro-cardiographic equipment; laboratory equipment; dental equipment; test kits. Under the current crisis, though, the majority of buyers of medical equipment cannot afford new and expensive high-tech items. After the devaluation of the ruble, they will most likely be able to buy only small devices and disposable products like test kits, laboratory devices, and syringes. Many Russian medical equipment manufacturers are interested in buying modern manufacturing equipment to produce disposable and hygienic products. Distributors of medical equipment are forced to widely use barter arrangements and clearing operations to keep their business afloat. IV: COUNTRY-SPECIFIC BUSINESS STRATEGIES With abundant highly educated manpower and natural resources, Russia offers large-scale business opportunities in an environment of limited competition. This must be counterbalanced against some negative factors that include: High operating costs; Weak business infrastructure, poor roads and transport; Poor accounting and standardization in Russian firms; Political system prone to corruption; Undeveloped legal framework and unclear property rights. The major political barrier is the lack of consensus within the Russian government on the path of economic reform toward an open, market economic system. There are serious misconceptions and a deep ambivalence about whether and how to attract Western investment. While the government is generally pro-reform, many political and bureaucratic leaders are reluctant to assist in what they perceive to be the selling off of their country to the West. Many promising Western investments are sidetracked by long delays in government approval, sudden changes in regulations, or unexpected charges of illegal actions on the part of Western companies. Russian contract, property, and intellectual property protection laws are still undeveloped and enforcement of existing laws is uneven. U.S. firms generally find success by choosing their sales targets carefully. Because a lack of capital and poor cash flow are typical of Russian businesses, many firms find it expedient to rank potential customers based on their ability to pay. Possible candidates for export sales include: Russian enterprises that export for hard currency; Development projects financed by Western sources; Russian enterprises with good domestic cash flow; Regional governments in natural resource rich areas; Russian federal government; Major modernization projects by Russian enterprises; General Russian consumer market; and Upscale (albeit narrow) "new Russian" market. Export Controls In the defense sector, U.S. companies must consider both Russian and U.S. regulations. The Russian export control system provides for export control oversight over materials, equipment, and technology to produce weapons, and civilian dual-use materials and technology that can contribute to missiles, nuclear, chemical, and other weapons of mass destruction. The Department of State maintains a U.S. Munitions List that identifies defense articles and services. U.S. firms participating in defense trade must register with the State Department Office of Defense Trade Control, and seek approval for the export of any items on the Munitions List. The Commerce Department's Bureau of Export Administration administers export controls on dual-use technologies. U.S. exporters are now permitted to ship some low-level dual use goods to civilian end-users in Russia, under a license exception, without prior approval, but companies should check with Commerce as this list is subject to change. Other goods and technical data still require a license, or are not eligible for export due to their potential use in nuclear, biological, chemical, and other weapons. Controlled items include chemical weapons precursors, super computers, high-end computers capable of over 7 billion operations per second, and electronic equipment with potential military applications. U.S. exporters should consult the Bureau of Export Administration before engaging in consultations or business transactions involving the export of controlled commodities or technical data. VII: U.S. Government of Points of Contact The following is a list of useful contacts for firms interested in the Russian market. U.S. Government Contacts: U.S. and FCS Moscow Edgar Fulton, Senior Commercial Officer Bolshaya Molchanovka, 23/28 121069 Moscow Tel: (095) 737-5030 Fax: (095) 737-5033 E-mail: OMoscow@cs.doc.gov Office of the Secretary of Defense Strategy and Threat Reduction Policy Cooperative Threat Reduction Policy Mark Palevitz, Action Officer Tel: (703) 693-0289 Fax: (703) 614-4365 Useful Russian Government contacts: Ministry of Defense Committee for Military Technical Policy General Major Viktor Mironov, Deputy Chief Tel: (095) 296-6535 Fax: (095) 202-5615 Ministry of Defense Department of Defense Industry Conversion Dr. Gennady Kuzin, Director Tel: (095) 292-2012 Fax: (095) 202-5615 Special Equipment Research Institute Ministry of Internal Affairs Viktor Andreyevich Khimichev, Director Malaya Lubyanka Ulitsa, 16/4 10100, Moscow, Russia Tel: (095) 222-6253 Fax: (095) 924-2714 Russian Space Agency Yury Nikolayevich Koptev, General Director Tel: (095) 975-4632 Fax: (095) 288-9063 Boris Dimitriyevich Ostroumov, Deputy General Director Tel: (095) 971-9141 Ministry of Emergency Situations Department of Certification of Rescue Equipment Abay S. Maurin, Head Tel: (095) 443-8305 Fax: (095) 449-9004 Ministry of Nuclear Energy (MinAtom) International Nuclear Safety Center Sergey Ye. Bugaenko, Director Tel: (095) 263-7309 Fax: (095) 264-4010 Rosvooruzheniye company Yevgeny Ananiev, General Director Tel: (095) 202-4590 Fax: (095) 202-4594Source: U. S. Department of Commerce - National Trade Data Bank, June 21, 2000