A Call to Arms

Russia is pushing to rebuild its neglected defense industry

The S-300 air defense system has been the pride of Russian military engineering since Soviet times. Designed to rival the U.S. Patriot System, which was deployed in the Persian Gulf War, the missile battery made U.S. diplomats blanch when they heard it was on Iran's shopping list. China snapped it up in 1995 in answer to the U.S. military buildup across the Taiwan Strait. An S-300 deputy commander, in charge of keeping an eye on the system on display at Russia's annual aviation show, says he has operated the S-300 to shoot down 26 targets in just four minutes.

But enter the S-300's control cabin, and it's like stepping back to the 1970s. A clunky mainframe computer, run on magnetic tape instead of a hard drive, stretches across a wall some two meters long. A diesel generator to power the system chugs noisily away outside.

The S-300's combination of skillful design and woeful technology pretty much sums up the state of Russia's once-feared defense industry. It may be underfunded and technologically backward, but it still has assets that outperform Western weaponry--assets that the government of Vladimir V. Putin is determined to turn into profit. And after a decade of neglect, this may well be the country's best chance to rebuild its fragmented and beleaguered arms industry. Arms exports could reach a new post-Soviet high this year. NATO is beckoning, holding out the prospect of closer ties and perhaps even future membership and joint weapons programs. Putin is using all his charisma to forge ties with Western governments and defense companies. And he's pushing through a much-needed consolidation of the industry, though his scheme to increase the state's control is generating controversy.

No question, an overhaul is needed. Hardly any of the country's 1,700 defense plants have been shut down since the Soviet Union collapsed in 1991 and the state money pump went dry. Yet those plants are hardly busy: Average production since the end of the cold war is just 20% of capacity. Russia's arms exports, although climbing and expected to reach more than $4 billion this year, are still less than a quarter of the volumes sold in Soviet times and a fifth of U.S. arms sales, which are set to reach about $20 billion in 2001. Sales of Soviet-era systems, including the S-300, to states like China have not provided enough funds to keep the industry feeding Russia's own military needs.

NEW MARKETS. Yet in a surprising post-cold-war twist, the recent rapprochement between Putin and the West could well open up new markets for Russian arms. For example, updated versions of weapons like the S-300, once designed for use against the West and which already have better interception capabilities than the U.S. Patriot, could be used in Western security systems. British Prime Minister Tony Blair, in a Nov. 16 letter to the 19 NATO members, called for a new structure that would involve Russia more closely in NATO consultations. While falling short of an offer of membership for Russia, it could lead to greater cooperation between Russia and NATO on modernizing military forces. And Putin earlier this year offered NATO the use of Russian designs for the S-400, an updated version of the S-300, which could be used to create a pan-European missile defense shield. The Bush Administration is discussing its possible use in Western defense systems, but Russia would have to drop its opposition to the U.S. missile-defense plan first. "The only future for the Russian arms industry is cooperation with the West," says Pavel Felgenhauer, an independent military analyst in Moscow.

A few smaller-scale projects are already being discussed. European Aeronautic Defense & Space Co., maker of Airbus planes, is considering using Russian design and manufacturing for some components of the planned A400M military transport plane. EADS is already cooperating with the MiG aviation plant in upgrading the MiG-29 fighter jet.

Putin, however, is walking a fine line. Profitable, full-fledged cooperation on military projects with the West may take years to get off the drawing board. And, in return for such deals, the U.S. and Europe are bound to pressure Russia to stop selling systems designed for attack against them to countries like China and Iran. These arms sales, though, are a matter of short-term survival for the Russian defense industry, which employs 860,000. "Russia has a choice ahead: It either joins Europe and the U.S. in military cooperation, or it continues to work with China," says Alexander Pikayev, a defense analyst at the Carnegie Moscow Center.

Inside Russia, Putin's push to increase state control over the defense sector is stirring conflict. On Oct. 11, he approved a plan to consolidate Russia's 1,700 defense companies into superholdings with state ownership of over 51% and to slash the number of enterprises by half. The aim is to create defense giants able to compete with Boeing and EADS. The plan even calls for increasing state ownership over the sector by rethinking the privatizations of the past which, officials say, lost the government billions of dollars worth of intellectual property. Not surprisingly, this project faces opposition from owners of private defense companies.

Take the Irkutsk Aviation Plant, or IAPO, that produces some of Russia's Sukhoi fighter jets. Putin recently decreed that the Sukhoi Design Bureau merge with two other plants that produce Sukhoi jets in Komsomolsk-na-Amur and Novosibirsk. The new conglomerate would be 100% owned by the state. But because the Russian government only owns a 14.7% stake in IAPO, the Irkutsk plant may decide to stay on the outside. Yet Moscow is threatening to refuse to approve export contracts for companies that remain outside state holdings. "We are bound to come under pressure," says Valery Bezverkhny, IAPO's vice-president.

"STAGNATION." Certainly, the Russian arms industry badly needs to consolidate. But it's far from clear that more state ownership is the most efficient way to revitalize the industry. Some investors who moved in as the state stepped back have begun to get good results. IAPO, for instance, has diversified and created new cash flow by investing $140 million in the design of the civilian Be-200 amphibious plane. Profits last year were $20 million.

Then there's New Programs & Concepts (NPK), a private defense holding company half-owned by tycoon Vladimir Potanin's Interros group. It has stakes in St. Petersburg naval shipyard Severnaya Verf, which is building Sovremenny Class destroyers for China under a $500 million contract. It's trying to instill Western-style management and marketing techniques, cut back unwanted production lines, and coordinate production among separate enterprises. NPK output has increased 150% since the end of 1999, and revenues have been growing by a 14% to 16% annual rate since the holding was created in 1998. "The real restructuring is already happening independently from the state," says Konstantin Makienko, deputy director of Moscow's Center for Analysis of Strategies & Technologies, an independent defense think tank. "The government plan to take greater control will lead only to stagnation." For contractors who still use magnetic tape in their mainframes, stagnation is the last thing they need.

By Catherine Belton in Moscow

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