Russia's Defense Industry Finds Itself in a Tailspin

Russia's defense industry is face to face with a major foe, but it's not a foreign military power. The Kremlin has been striving to modernize all branches of the Russian military, but the country's defense industry is struggling thanks to decreasing volumes of orders, difficulties in attracting high-skilled talent and limits to its technological capabilities. According to recent figures, the performance of Russia's aerospace sector is declining precipitously. In 2018, for instance, Russian aircraft and spacecraft makers produced 13.5 percent less than in 2017. And there's been no letup in 2019 either: In the first two months of the year, aerospace output plummeted 48 percent year on year.

Russian T-14 Armata tanks make their way during the Victory Parade marking the 70th anniversary of the defeat of the Nazis in World War II, in Red Square in Moscow, Russia. Russia's first new tank in decades was released to great fanfare, but production targets for the expensive platform have not been met.  (AP Photo/Alexander Zemlianichenko)

Under pressure from a limited government budget, the Kremlin even started reducing its military spending in 2017 — a strong indicator that, despite the modernization push, Russia's financial challenges are taking a toll on the country ambitions. Economically, the plunge in oil prices at the end of 2014 hurt Russia's bottom line, depriving the country of essential revenue and forcing it to dip into its reserves to bridge the gap. Today, more than four years on, Russian oil revenues are rising, yet the country is continuing to deal with the consequences of the lean years. Beyond that, low revenues from taxes, which have forced Russia to raise taxes and the retirement age, and Western sanctions over Moscow's activities in Ukraine and elsewhere, have shrunk the financial pool available to military planners.

Low oil prices, declining revenues from taxes and Western sanctions have taken a chunk out of the financial pool available to Russia's military and the broader defense industry.

But the Kremlin's problems don't end there. In the past, Russia has benefited from its position as a major global arms exporter to fuel further military development. During the 1990s, for example, such sales were critical to the country as it faced severe economic hardship. While Russia remains the world's second-largest arms exporter (only the United States sells more), the actual value of those exports has been decreasing significantly. Between 2014 and 2018, their total value dropped by as much as 17 percent. Again, budgetary limits are somewhat to blame: In the past, Russia frequently used arms exports as a political tool, offering weapons at a heavy discount, if not entirely free. But with Russia no longer able to offer customers a good deal on its fighter jets and other defense products, the country is losing business.

And Russia's arms industry faces an even greater problem in the years to come: reduced competitiveness. Russia has long dominated some of the market by offering affordable military equipment without attaching any conditions regarding human rights, but the rise of China's military industry, as well as several smaller producers around the world, has made it much more difficult to compete for contracts.

Ultimately, the loss of export opportunities not only complicates Russia's efforts to finance its defense industry, it also reduces the scale at which the defense industry produces, which, in turn, decreases scale-dependent savings that accompany higher levels of production. In effect, this means that the more Russia fails to find foreign customers for specific weapon systems, the more it will become burdened with a higher relative cost per unit as it seeks to meet its own needs. The conundrum, in turn, will further limit Russia's ability to competitively price weapons systems for export, thereby perpetuating the effect.

This is why, for example, India's withdrawal from the joint development and production of the Su-57 fighter aircraft last year has cast doubt on Russia's ability to sustain the program in a meaningful way or at an acceptable cost. As a result, Russia has sought — albeit unsuccessfully so far — to export the Su-57 more widely in an effort to find a partnership that would make the aircraft viable.

Russia, accordingly, has been considering other solutions to safeguard its defense sector and improve its overall industrial performance. One possible remedy centers on what amounts to burden sharing across sectors. In this, the country is looking to harness the defense industry's strengths for civilian production, similar to the way Western enterprises such as Boeing or Airbus operate. By producing non-military products for domestic and foreign civilian markets, Russian defense manufacturers could sustain themselves even if their military goods are earning less revenue.

Russia's arms industry faces an even greater problem in the years to come: reduced competitiveness.

Unfortunately for Russia, the chances that such a gambit will succeed are low — even for domestic consumption. Although Moscow has been pushing an import substitution program amid the West's sanctions, Russian firms continue to privilege foreign, instead of domestic, components. In 2018, 38 percent of Russian industrial enterprises purchased equipment from abroad; two years before, the figure was just 6 percent. Ultimately, if Russian arms producers are failing to find sales for defense customers at home, they're unlikely to find any more of a domestic civilian market for their wares.

As a great power, Russia has lofty ambitions for the modernization of its military. Budget constraints, more competition from elsewhere and other issues, however, mean many of the army's most ostentatious projects never make it past the showroom. And moving forward, the Russian defense industry's plight is unlikely to improve as it faces a vicious circle that is leaving it worse for wear.

This article appeared originally at Stratfor Worldview.