24 July 2008  New Challenges for Russian Defense Industry

Russia & CIS Observer, #3 (22) July 2008

Konstantin Makienko

The first half of 2008 saw several developments that indicate the Russian aerospace and defense industries may have entered a new phase, which some commentators refer to as a crisis situation.

The most noticeable event was the cancellation of a $1.3 billion contract to supply 34 MiG Corp. MiG-29SMT/UВТ fighter jets to Algeria. In addition, India's navy is unhappy with the performance of the Russian-made Sea Dragon targeting and tracking system, which is being offered as part of the upgrade program for India's Ilyushin Il-38SD maritime patrol aircraft. Separately, the Indian navy refused to take delivery of the refitted Project 877EKM diesel submarine Sindhuvijay after pre-delivery test firings last year revealed serious flaws in the Russian Novator Club-S missile system. These misfortunes come on top of the cancellation two years ago of a contract to deliver 38 Ilyushin Il-76MD military transports and Il-78MK airborne tankers to China.

All these problems stem from three causes: substandard quality of products, the financial difficulties Russian contractors encounter in executing contracts, and the inability of separate companies to observe contractual time limits. There are at least three reasons for the current situation: the problem of organizing full-cycle production after 15 years of extensively depleting the industrial legacy left after the Soviet Union; the growing backlog of contracts, which is taking its toll on the worn infrastructure; and the worsening economic environment due to the dollar's weakness and the high inflation rate.

The industry's transition to full-cycle production is complicated by the virtual exhaustion of various Soviet-era reserves – from airframes to metal stocks and, ultimately, production capacities and qualified labor. Today, almost all Russian military and civilian aerospace enterprises are being forced to organize production "from scratch." However, the successful setting-up of full-scale production of Sukhoi Su-30MKI fighter jets in Irkutsk for the Indian Air Force demonstrates that such a transition is possible, despite all the delays and technical problems.

Another challenge is the recent production growth in several industrial sectors caused by the increasing number of contracts. Throughout the 1990s, the combined backlog of Russia's export defense contracts stood at $6-7 billion. By late 2007, it amounted to $32 billion. Against this backdrop, the industry's production capacities have been shrinking – both due to the wearing out of equipment, and an intensifying shortage of qualified labor.

The second half of the 2000s brought about a peculiar change within the industry: back in the 1990s, the greatest problem was landing a contract, whereas now the main risks lie in the proper execution of numerous foreign orders and the growing number of domestic contracts. The reality is that sustained production runs can be organized today only at the Irkutsk and Komsomolsk-na-Amure production sites, at Kazan Helicopters and the Ulan-Ude Aviation Plant. The production capacities of the Novosibirsk NAPO plant will also be enhanced shortly. The greatest problems are to be expected in restoring large-series production of MiG-29 fighters.

Finally, the economic situation has changed. In the 1990s and during the first half of the 2000s, the aerospace and defense industries relied on a weak ruble for high profitability of export operations. But beginning in 2005, the real dollar exchange rate started falling, and the ruble began to strengthen. Here is a plausible explanation of why a significant portion of Russia's current defense export contracts are forecast to either just about break even or make an outright loss. This assumption is supported by Russia's demands to review the financial terms of its contract to supply the Admiral Gorshkov aircraft carrier to the Indian Navy, and by the recent adjustment for price deflation in the long-term Su-30MK1 production agreement with India.