Thursday, January 8, 2015

XLT: Ukraine, NATO, and Ruble Crisis Blamed for State Defense Order Fulfillment Issues

Deputy Minister of Defense Yuriy Ivanovich Borisov
                                                  [Translation of Izvestiya online news article]

December 30, 2014

In an interview with Izvestiya, Yuriy Borisov, deputy minister of defense and executive secretary of the RF Military-Industrial Committee, talked about challenges in fulfilling the State Defense Order (SDO), deliveries of components from NATO countries, and foreign exchange issues in the defense-industrial complex.

— Yuriy Ivanovich, 2014 was very complicated for the defense military in many areas. How did these difficulties impact the fulfillment of the State Defense Order?

— On average, fulfillment of the State Defense Order this year exceeded last year's figures. In 2014, we were allocated 125% more budgetary funds; in addition, the volume of military products grew 165%. Based on 2014's results, we placed nearly 100% of the orders under the State Defense Order. As for executing the SDO, it can never be 100%. There are thousands of events, and somewhere there are always contract breaks which are most often linked to external circumstances — specifically, import substitution. But, be that as it may, in 2014 we placed nearly 95% of the SDO. At the beginning of the target period (2011), that figure was 82–84%.

— On the one hand breaks in contracts with Ukraine spurred our industries; on the other — they stalled the production of several types of import-dependent armaments and hardware. What's you assessment of the substitution process?

— The say there are several items that affect fulfillment of our obligations. Above all, it's the delivery of helicopter engines from the Ukrainian Motor Sich factory — OAO Klimov was beginning to work on replacing them even be the events in Ukraine. In order to avoid dependence, we had to speed up, to double or triple engine production.

— But there are even more problematic issues...

— Yes, it's deliveries of Ukrainian-produced main power plants for the Navy — primarily for escort ships and frigates, which Yantar Shipyard is building. This very serious item was difficult for us. Saturn Scientific Production Association in Rybinsk is currently undergoing retooling. The company will be ready to replace this item in 2017. We were forced to introduce adjustments in fulfilling the State Armaments Program (SAP) — we will wait for the Russian engines.

This doesn't mean that the Navy has stopped receiving ships; we simply regrouped — we increased orders where there is no dependence [on foreign products], and slowed down here. At Yantar, we have a contract for six escort ships — for three of them, we received the main power plants, but later began the Ukrainian government's bans on deliveries. We found a way out of this situation — this will not affect product manufacturing timelines.

For two types of aviation hardware, two types of ships, and two types of ordnance, timelines for SDO fulfillment have been delayed by 1-1.5 years. The Russian defense industry sector is already prepared to replace other Ukrainian-produced components.

— What issues are being created by the import policies and sanctions of other governments?

— We are particularly concerned about deliveries from NATO countries, since we have received and even now are receiving a proportion of components from them. We are part of a global economy — there will be no iron curtain. Not one country, including America, produces all the products it needs in its own country. For example, a majority of memory chips are not manufactured in America, but rather come from Southeast Asia. Problems with pirated goods and with imported components not meeting the stated specifications exist for all of the world's leading producers of armaments and military hardware – it's just that for us these problems are more prominent.

— Since the 2011-2010 SAP was formalized, and the State Defense Order was planned out for the coming years, the economic situation has radically changed. How is this reverberating in the defense budget and fulfillment of the future SDO?

— We are very concerned with the rise in the dollar exchange rate. We planned SDO price parameters for 2015, 2016, and 2017 in a stable economic situation, laying out purchases of imported components based on the exchange rate from this past summer. Today the situation has changed. We will ask the government about avoiding risks connected to price differences due to the change in exchange rates. If the government does not compensate us for exchange rate losses, we will have to either reduce the number of munitions or forgo certain items. 
But this does not take away our obligations, established by the President under the May decrees, which are connected to levels for arming the military with modern types of armaments.

— What is the main problem in setting prices in the defense industry?

— The problem is with the strategic planning of SAP activities using an incorrect forecast of price parameters for a ten-year period. When we consider the initial price of a product, in accordance with forecast inflation [which the Ministry for Economic Development publishes annually. — Izvestiya], we calculate the cost for each year of the SAP. But the real level of inflation in the defense-industrial complex is higher than forecast, due to, among other things, the fact the forecast is based on civilian industry sectors with no consideration given to the defense sector. Because of this, the State Defense Order is "growing thin." Therefore, we appealed to the Supreme Commander-in-Chief to order the Ministry for Economic Development to calculate the level of inflation separately for defense-industrial complex companies, and if the forecast levels aren't consistent with what transpires, then the question of compensation needs to be considered.

The second factor — the escalation of prices by weapons manufacturers. We propose – independently, with the participation of the Federal Anti-Monopoly Service, Federal Tariffs Service, and the relevant ministry – reviewing each instance when companies' prices exceed the level of inflation. We will examine what the root cause is: the willingness of a manufacturer, taking advantage of an opportunity, to make excess profits, or for objective factors – let's say, prices on the world metal exchange. In 2015, considering the situation with the dollar exchange rate, special emphasis needs to be paid to this. There will naturally be a rise in prices, including for imported components. We are prepared to reconsider costs, but that's a struggle for us — the budget isn't increasing, and circumstances aren't changing.

We had no serious conflicts over the past two years in terms of price non-conformity. However, we still have to resolve issues with 2011-2012 contracts, specifically those related to the Navy.

— You're talking about the rescue ship "Igor Belousov", which was scheduled to be accepted this year?

— I'm talking about the entire series of events linked to the underestimation of work related to the outfitting of corvettes, frigates, Borey strategic submarines and Yasen multipurpose nuclear-powered submarines. "Igor Belousov" is a never-ending small part in this set – not least because this ship will undergo factory testing and is scheduled to be delivered to the Navy in 2015.

— Why was the SAP forecast budget for 2016-2015 reduced?

— Between 2011 and 2020 [under the current SAP], the task was to drastically update the Russian military's inventory of weapons and to bring the number of new types of weapons in the inventory up to at least 70%. World practice is such that a military is considered combat-capable if the level of modern types of weapons [in its inventory] reaches 60–80%. The militaries of the U.S., Germany and, to a lower extent, France, Great Britain and China, meet these figures. In 2011, the level by which our military was equipped [with modern equipment] was between 12-13% and 20-25%, depending on the military branch or service - the situation was "beyond critical." The goal of the current SAP was to restore the necessary metrics – to modernize old and deliver new types [of military hardware].

Additionally, the number of weapons types is greatly increasing. If we had ramped up deliveries of advanced types of armaments without paying attention to the reduction of older weapons types, expenses would have steeply risen, since each different type must have its own documentation, specific repair parts and repair teams. Servicing all of this hardware, according to our estimates, would have required up to 55 trillion rubles. Thus, budget expenditures on defense would have grown from today's 2.5-3.5% of the GDP to 4-5% or higher. This would have meant another weapons race, and the country would have ineffectively spent a significant portion of its resources on defense.

Now we understand which number of weapons types will define our armaments up until 2025. Examples include the Armata integrated combat platform that is under development, vessels for the Navy that are being built using a modular concept, the PAK FA advanced aviation system, the Angara space missile system, and others. Calculations have shown that by lowering the number of weapons types by 36%, fewer financial resources are required – in the area of 30 trillion rubles. This figure is huge, but in contrast to the current state program, wrapped up in that figure will be state capital investments for preparing the infrastructure and, very likely, a portion of resources linked to preparing and developing the industrial capacity of companies. Earlier this fell under the Ministry of Industry and Trade and other federal agencies that were responsible for the activities of defense-industrial complex firms. Now a possibility is being considered to include costs for preparing production to perform SAP-related work in the price of products through increased profit margins, which for us means increased prices.

The goal of the next program period will be different — the quantity of new types of weapons no longer needs to be sharply increased. What will need to be done is to maintain a desired level of equipment status and to increase the level of troops' combat-capable hardware, by which I mean repairs and modernization. We are switching over to a system where manufacturers will track equipment across the entire life cycle, all the way to scrapping.

— Speaking of life-cycle contracts — this year dozens of repair factories were removed from Ministry of Defense hierarchy and transferred to the defense-industrial complex. But many of them are in need of considerable modernization...

— The composition of equipment is changing. Repair factories, which were until recently under the jurisdiction of the Ministry of Defense, no longer meet realistic demands based on their technical capabilities, the status of their key equipment, and the qualifications of their employees — they were qualified to repair older generation equipment. We asked our industry colleagues, who manufacture equipment for us, to take on the function of tracking equipment over the course of its entire life cycle. We transferred resources to them for various types of repairs. Of course, repair factories need to modernize their basic assets and to have new personnel policies. But you'd admit that production issues – these are not functions of the Ministry of Defense. We should deal with issues of combat proficiency and how to use this hardware. This is the world trend.

— So, absolutely all functions related to the maintenance and repair of military equipment have been transferred to the defense-industrial complex?

— The situation does not need to be carried to the point of absurdity. We aren't going to send our equipment off for the oil and tires to be changed. For routine repairs and preventive maintenance, repair elements have been established within military units; consumables and repair parts are purchased for them. Repair companies’ economic situations vary. To transfer companies on the verge of bankruptcy to our industry colleagues would do more harm than good. They will start bankrupting them, and then the entire chain linked to fulfillment of the SAP will suffer. Here, as I have already said, sensible cooperation between agencies and companies is important, and "manual control" by integrated structures of the defense-industrial complex can help organize this.

— In October the Russian government's Military-Industrial Committee received presidential status. How have the committee's tasks changed as a result of this?

— Issues of implementing a state policy with regards to the defense-industrial complex, military-technical support and security of the state were raised to the presidential level. First and foremost, the Military-Industrial Committee is analyzing new threats which arise with the development of technology. For example, America is implementing its "Prompt Global Strike" program — using hypersonic delivery platforms, weapons can be delivered within one hour to any point on the globe. Threats of this type emerge in the process of scientific-technical progress. Adequate responses to such threats must be sought out not only by security agencies, but also, first and foremost, in the industrial sector, which develops new technologies.

Additionally, import substitution is one of the most important examples of strategic tasks solved by the military-industrial complex. If we do not consider the risks of non-deliveries of components for producing military hardware based on existing cooperation, then planning will go into disarray, and the goal may not be reached — everything will collapse, like a house of cards. Therefore, this issue demands serious coordination, and the president has taken it under his personal control.