May 7 (Bloomberg) -- As Russian President Vladimir Putin positions his army along the border with Ukraine, his eyes are trained on more than former Soviet territory.
The parts of Ukraine where separatists and loyalists face off in ever-more violent clashes are home to the most valuable assets of the nation’s defense industry. More than 50 factories form an arms cluster that caters to Russia based on a trade accord from two decades ago, churning out air cargo transporters, helicopter engines and other hardware.
“Taking Ukraine’s eastern and southern regions would be hugely beneficial for Russia from a military and economic point of view,” said Mikhail Barabanov, the editor-in-chief of the Moscow Defense Brief magazine. “Russia will have control of the very important and valuable defense companies and plants.”
The Russian government’s $15 billion agreement with ousted Ukrainian President Viktor Yanukovych in December included a trade pact that set out to further intertwine the two countries’ defense industries. Putin has since warned that disruption to supplies would harm his military’s capability. Last week he said it would also be catastrophic for the Ukrainian arms industry.
More than half of Russia’s nuclear arsenal was built in Ukraine or is equipped with a Ukraine-made navigation system, according to analysts including Serhiy Zgurets, the chief editor of Defense Express, a Ukrainian military consultancy.
The factories in the eight regions of Ukraine form the strategic backbone of an industry with $1.3 billion in annual exports. As well as Antonov air cargo transporters, Mi-8/17 and Mi-26 attack helicopter engines, they produce equipment for Albatros submarine chasers and service ballistic missiles.
“We hope the situation won’t develop into a complete interruption of cooperation,” Putin said on April 28 in Petrozavodsk, Russia. “In any case, we are working on all issues related to the replacement of imports.”
Ukraine, whose government in the capital Kiev is struggling with a burgeoning budget deficit and counting on the International Monetary Fund for a $17 billion bailout, needs the revenue from its defense industry more than ever.
State-run companies like attack helicopter engine maker Motor Sich, turbine producer Zorya Mashproekt, and ballistic-missile services company Yuzhmash are located in the most volatile areas of Ukraine.
From Kharkiv and Donetsk, the center of Ukraine’s industrial heartland, to the port city of Odessa, pro-Russian militants have battled Ukrainian forces. More than 70 have been killed since April 20. The government will hold its weekly meeting in Kharkiv today, while in Donetsk it said tax office employees were evacuated after people flocked to the building.
Russia won’t seek to annex the region because of the risks of getting bogged down in a civil war, capital flight from Moscow and having to rescue the local economy, according to Barbara von Ow-Freytag, who advised the German government from 2008 to 2013 on Russian issues.
“Putin’s main goal right now isn’t an invasion of eastern Ukraine,” she said in a May 4 interview. “He’d do it if he could pull it off, but it would be far too expensive.”
The prospect of losing access to Ukrainian defense products may also be daunting.
While Russia may survive without Ukraine’s cheese, candy and railroad cars, goods it has banned over the years during trade disputes, arms are different. It would struggle without the 400 Ukraine-made engines it imports every year for its military helicopters or the $10 million it pays Ukraine to service its intercontinental ballistic missile system.
If supplies stop, there will be “a very serious problem with some weapon systems,” Siemon Wezeman, a senior researcher at the Stockholm International Peace Research Institute, or SIPRI, said yesterday. Production of new helicopters in Russia stalled until around 2020 as the country spends millions to retool domestic factories, Barabanov in Moscow said.
Ukraine was the world’s eighth-biggest supplier of arms in 2009-2013, according to SIPRI. Russia was the fourth-biggest buyer of Ukrainian defense-related products in 2009-2013 after China, Ethiopia and Pakistan, SIPRI said.
The ironclad Russian trade relationship forged in a 1993 treaty two years after the collapse of the Soviet Union would be hard to unravel, even as the crisis shreds political ties.
If the more than 20 contracts that make up the mass transfer of goods and expertise to Russia were canceled, Ukraine would stand to lose at least $600 million a year, while Russia’s defense budget might swell by more than $2 billion a year as it looks for replacements, according to Defense Express.
At DK UkrOboronProm, the state-run umbrella company that unites most of the defense industry, Chief Executive Officer Yuri Tereshchenko is drafting worst-case scenarios, studying alternate markets and whether some products can be adopted for domestic use to keep revenue flowing.
A moratorium on Russian sales “is a responsible decision in the current state of bilateral relations,” he said. “We realize that there are possible negative consequences for some companies because of a halt in cooperation with Russia.”
Ukraine is now looking to shift the direction of its defense exports further eastward, First Deputy Prime Minister Vitali Yarema said on April 30.
That would mean seeking new clients for Motor Sich, which has a contract to produce about 1,000 helicopter engines this year, 400 destined for Russia. Yuzhmash generates $10 million a year providing service and maintenance for Russia’s SS-19 missile system, according to Defense Express.
As much as 80 percent of Russia’s nuclear warheads are loaded in missiles designed or manufactured in Ukraine and originate from the former Soviet Union, according to Wojciech Luczak, the editor in chief of Polish magazine Raport.
Putin may yet find a peaceful end to the crisis and prevent disruption to supplies, said analysts Igor Sutyagin and Michael Clarke, who authored a report for the U.K.’s Royal United Services Institute for Defense and Security Studies.
An invasion “would be a very 19th century way of looking of looking at a 21st century relationship,” they wrote. “However, even that cannot be ruled out in the current circumstances.”
To contact the editors responsible for this story: Balazs Penz at email@example.com Rodney Jefferson