Ukraine's defence sector apprehensive over pro-Russian foreign policy

By bne IntelliNews March 18, 2010

Graham Stack in Kyiv -

Despite shared technologies with its eastern neighbour, Ukraine's booming defence industry is not thrilled about the prospect of a pro-Russian foreign policy by the new government.

Ukraine's annus horibilis of 2009 did not extend to its defence sector. In fact, being almost entirely dependent on exports, with state procurement playing a negligible role, the 60% devaluation of the hryvnia proved a major competitiveness booster - and output accordingly grew by 58%, probably making Ukraine the world's sixth biggest arms exporter.

The success of 2009 was down to a string of big-ticket export contracts: to modernize Antonov An-32 military cargo planes for India worth $400m; to deliver 100 Antonov AI-20 5 engines to India worth $110m; to deliver Zubr air-cushion landing ships to China, worth $315m; and to supply to Iraq six Antonov An-32 worth $100m and to supply 420 BTR-4 armoured personnel carriers for $400m. The largest output growth was reported by aircraft builders (77%), shipbuilders (71%) and armaments (16%).

With Ukraine desperately needing to diversify its economy away from commodities, like Russia it is turning to the defence industry as the most likely candidate. The sector has been whittled down to a core of competitive companies - down from nearly 2,000 Soviet Ukrainian defence companies to 300 today, of which only 60 have a real mid-term strategy, according to Valentin Badrak of the Centre for Army, Conversion and Disarmament.

According to former top Defence Ministry official Oleksiy Melnyk, it is not yet clear whether the new Ukrainian defence minister, Mykhailo Yezhel, will be able to source greater budget funds for defence spending and shift defence expenditure from personnel to weapons systems, which would stimulate the defence sector and the overall economy. This is the policy that Russia has pursued, and one that Melnyk advocates for Ukraine. With fiscally conservative Mykolai Azarov installed as prime minister, however, Melnyk thinks it unlikely it will be implemented, leaving Ukraine's defence sector reliant on exports for the foreseeable future.

East or West?

This makes the orientation of foreign policy crucial to the defence sector's prospects. In the past, arms exports have landed Ukraine in political hot water - with the US over radar exports to Saddam Hussein's Iraq in 2002, and with Russia over exports to Georgia in 2008. With the "pro-Russian" Party of Regions' Viktor Yanukovych now installed as president in Ukraine, and apparently aiming for non-aligned status instead of joining Nato, Ukraine's defence industry is puzzling over the implications.

The West has a lot to offer Ukraine's defence sector. US lobbying, for instance, was vital for the award of the huge half-billion-dollar Iraq contract to Ukraine. "Everyone understands that although Iraq is an independent state, the US is paying for these purchases, and the decision to award the contract to Ukraine was a sign of appreciation for Ukraine's support. But it was also of course dependent on Ukraine having something to sell," says Melnyk.

Similarly, Ukraine has been looking to collaborate with western defence companies in the framework of offsetting - where an order placed abroad has to source components from domestic manufacturers. Ukraine's Black Sea shipyards are currently building corvette ships for the Ukrainian navy, but which source 50-80% of components from western companies. This will hopefully make it possible in the future for western countries to place orders for such ships with Ukraine, supplying the advanced technology components Ukraine lacks.

On the other hand, around 20% of Ukrainian defence sector exports consistently go to Russia. But in recent years, Russia has threatened to start up its own substitute production facilities should Ukraine move closer towards Nato membership. In particular, it has threatened to stop sourcing aviation engines from star Ukrainian enterprise Motor Sich, Russia's sole supplier of helicopter engines - for which Motor Sich in its turn sources component parts from Russia. Motor Sich owner and director Vyacheslav Bohuslayev, is thus, not surprisingly, a close ally of Yanukovych and actually a Party of Regions MP. Similarly, Russia is a key partner for aircraft designer Antonov. With Ukraine stepping back from trying to join Nato, Moscow is more likely to push on with joint plans for a new military transport aircraft model An47.

However, Melnyk plays down the likelihood of any real Ukrainian shift away from joining Nato. "It would also not change significantly anything regarding defence sector cooperation with Russia," he argues, "since Russia is trying to close its defence production cycle in any case. But until the close cycle is completed (if ever), Russia will be doomed to purchase a number of items 'made in Ukraine' - aircraft engines, for example."

Russian companies have also been trying to acquire their Ukrainian counterparts. Russian state-owned helicopter and engine-building holder Oboronprom has openly declared its interest in acquiring Motor Sich. Russia's national aviation firm United Aircraft Corporation has likewise suggested a share swap with Ukrainian state-owned Antonov - which would first need to be corporatised, however.

This highlights a potentially thorny issue. With the notable exception of Motor Sich, most Ukrainian defence enterprises - 90% - are still state owned. "State management at a number of aviation and rocket plants has compromised itself in recent years," say Badrak. "Privatisation is needed, but there is a threat that in such a case Russia could attain complete control over the sector."

According to Badrak, Russian companies would be interested in Antonov, Artem rocket and missile producers, Feodessiya shipyards, and Kharhov and Kyiv aviation plants. With Ukraine's state coffers empty, it would be tempting for the Yanukovych administration to score brownie points both from the International Monetary Fund and Russia by moving ahead with privatization of such assets. But this would meet with stiff opposition from Ukraine's pro-Western security establishment.

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