The global economic crisis is making for radical change in the global defence market. What does this mean for the make-up of the defence sector?
The defence industries of the Western world are facing greater challenges than at any time since the end of the Cold War.
Military equipment spending across the old markets of Europe and the US are now set on the downward trajectory triggered by the worldwide financial crisis, with predictable consequences for armed forces and the corporations that support them.
While the defence industries are used to cyclical spending – recurring years of feasts followed by famine – the current dynamics facing the global markets are without precedent. Plunging military spending in the West is being more than matched by the rapid growth of the world's emerging economic powerhouses; countries such as Brazil, Russia, India, and China (the so-called BRIC countries) plus other pockets of prosperity in the Middle-East, Asia-Pacific region, and Latin America.
For companies headquartered in Europe and the US there have been three principal approaches to coping with the new market realities. Payrolls at home have been slashed to match available opportunities; an attitude of export or die has taken hold at board level; and corporate strategies have been redirected to take advantage of opportunities in adjacent commercial markets such as civil aerospace, and the few remaining pockets of growing military investment such as the ill-defined realm of cyber-security.
Western governments, meanwhile, have been forced to accept the consequences of their lower investment. Ambitious procurement plans of new systems have been scaled back, delayed, or cancelled altogether, leading their armed forces to battle on with aging equipment or even reduced inventories as the support of existing systems becomes unaffordable. Such austerity has also had a negative effect on international operations, with a series of European countries having been forced to scale back troop contributions to efforts in the world's conflict zones or to withdraw end contributions ahead of plan.
There have been moves to mitigate the worst effects of the downturn on national industries, of course. Efforts have ranged from relatively empty gestures – such as the introduction of a UK taskforce to direct redundant defence industrial professionals towards largely theoretical opportunities elsewhere – to the pragmatic. There has been an acceptance that the range of sovereign industrial capabilities that can be defended onshore will be more limited; that international collaboration – along the lines of the Anglo-French cooperation agreement of 2010 – is unavoidable; and that government support for national defence industries in export markets must be accelerated.
It was clear from 2007 onwards that the defence industries of Europe and the US – historically insulated from the worst of the ebbs and flows of economic cycles – would not escape their share of fiscal pain. It wasn't until 2010, however, that uncertainty turned to bleak clarity.
The UK, with Europe's largest and arguably most advanced defence industry, had its worst fears confirmed in October last year with the publication of the Strategic Defence and Security Review (SDSR).
The details of the review were devastating. It emerged that: the £3.65bn Nimrod MRA.4 maritime patrol aircraft would head straight from the production line to the breaker's yards; two planned Queen Elizabeth-class aircraft carriers would be built, but one would be immediately mothballed and perhaps sold to a foreign country; the Challenger 2 main battle tank fleet would be slashed by 40 per cent and the heavy artillery inventory by 35 per cent; and the iconic Harrier GR.9 carrier-capable attack aircraft would be retired from service earlier than previosuly planned while the Tornado GR.4 strike aircraft fleet would be cut.
The potential impact on the UK's military capabilities was predictable, and has been well documented. The perennial question of whether the Falkland Islands could be satisfactorily defended was debated endlessly in the mainstream press. The answer, according to the former chief of the general staff of the British Army, retired General Sir Richard Dannatt, was that 'if Argentina invaded and recaptured the Falklands, we do not deserve to keep them'. The Libya campaign also raised the question as to whether the defence review had been too rash, and whether investment should be re-examined, an option apparently dismissed by the government.
For British industry, the consequences of the SDSR were dire. The psychological impact on engineers who saw programmes that spanned entire careers heading straight for scrapyards was profound.
One particularly harsh blow to the sector was the decision to retire existing platforms rather than the dearth of new opportunities outlined. Revenue streams derived from maintenance and support operations spanning 20 years or more vanished at a stroke, and the industry will be decimated. Around 10,000 jobs were lost during 2010, and trade group ADS estimated during 2011 that a further 30,000 to 40,000 will go: 10 per cent of the UK defence industrial payroll.
In Europe, the picture was broadly the same. Spain revealed cuts to material spending of 8 per cent, swelling already bloated unemployment lines, and the German armed forces outlined potential equipment cuts totalling £9.3bn.
Cuts were, of course, relative to the scale of the market. The spending reductions that have been announced by the US have been staggering. Equipment spending stood at $170bn in 2008 – more than ten times the size of the world's second biggest market, the UK – yet is forecast to dwindle to $125bn by 2015.
President Barack Obama has made little secret of his wish to scale back the Pentagon's spending, given that it is the single biggest drain on federal outgoings. The White House said that in 2011 they wish to see savings of around $400bn over the next 12 years while identifying areas in which it can scale back military commitments, keeping an eye on reducing the US public debt.
Salvation through exports?
Against the backdrop of plunging military equipment spending in home markets, export aspirations are understandable.
The UK's SDSR included a rather nebulous commitment to back legitimate exports by UK companies, and defence secretary Dr Liam Fox has since taken the role of senior salesman with a number of visits to priority countries such as India.
Superficially, the strategy has merit. Markets such as India, Saudi Arabia and the UAE have significant sums to invest in military material, plus relations with European suppliers (the UK in particular) are cordial and deeply entrenched.
The UK defence industry has frequently punched above its weight, having been the global number two exporter since 2004 with a market share of around 20 per cent.
Indeed, there is reason for cautious optimism from the UK perspective, given that it has recently emerged that the Eurofighter Typhoon, in which British industry is a major stakeholder, has been down selected alongside France's Dassault Rafale in the Indian Medium Multirole Combat Aircraft competition – at $10bn, it is one of the biggest open competitions in the world.
However, for the UK industrial base itself – and, more specifically, the professionals within it – there are three major reasons for a degree of realism.
First, the strategy of using exports to offset falling domestic spending is not unique to the UK: every single advanced military equipment producing nation, from France to the US, is pursuing a near identical strategy with the inevitable consequence being fratricide in world markets.
The outlook worsens when one considers that emerging competitors such as Russia, China and Korea are also seeking to export, and that equipment cuts in major markets mean that there will be a dearth of surplus material rattling around the world.
Secondly, there is the issue of offset and industrial participation: increasingly the elephant in the room when military exports are discussed.
Countries buying military equipment have long demanded a degree of quid pro quo, usually in the form of investment to offset the cost of the materiel bought; the transfer of technology to kick-start local industrialisation efforts; or a demand that a portion of the work on a programme takes place in their territory.
The scale of industrial participation demands have ballooned in parallel with the defence spending and wider economic growth of new markets. The reality is that traditional buyer countries seldom buy complete military equipment off the shelf, but rather blueprints, expertise and local production rights. An example, given the UK's emphasis on India, is BAE Systems' Hawk MK 132 advanced jet trainer contract. India's Hawks are built largely under licence by Hindustan Aeronautics in Bangalore.
The final issue facing exporters is the fragmented, stop-start nature of major procurement programmes in emerging markets and the effects that the political climate can have on commercial prospects. India is a case in point: top-line equipment spending figures are buoyant and growing, although they mask enormous inefficiencies in procurement processes that have led to millions of dollars for procurement being returned to India's treasury each year. Indeed, 2010 was the first year on record that India's defence ministry managed to spend its entire year's equipment allocation.
The UK had high hopes of selling warships and naval systems to Brazil and, in 2010, signed a high-profile defence cooperation agreement. BAE Systems wanted to meet the country's requirement for offshore patrol vessels, and also to entice Brasilia into joining its efforts to design and develop a new frigate-sized escort, the Global Combat Ship. Such ambitions appeared to have been thwarted in January when the Falklands Islands patrol ship HMS Clyde was denied entry to Rio de Janeiro: an indication of warming relations between Brazil and Argentina that are not to the UK's advantage.
The need to maintain relevant capabilities in the face of limited spending at home and to achieve meaningful penetration of export markets point to clear procurement trends that will be apparent over the coming years.
First, defence industries of the Western world will increasingly factor exportability into procurement plans, given the twin advantages of improving balance of trade while sharing burdensome development costs. The UK has historically taken a 'gold-standard' approach to procurement, with entirely bespoke systems selected that proved too expensive for world markets.
The classic example is the world-class Type 45 destroyer; a UK-specific solution produced in tiny numbers that never found an export customer – in contrast with the Franco-Italian FREMM programme from which Type 45 spun off. Lessons have been learned, and the BAE Systems-led Global Combat Ship project has been conceived with foreign collaboration in mind.
Secondly, collaborative projects are likely to increase in number: particularly in Europe where equipment and research funding is particularly tight. Multi-national grand projects in the mould of Eurofighter and the A400m transport aircraft are unlikely to be on the agenda for two reasons: the toxic legacy of recently-experienced cost overruns and delays, and the dearth of funding to justify such projects. Instead, activity will be bilateral in nature.
A third theme trend will accelerate efforts in Europe to gain ground in strategically vital areas, such as unmanned aerial vehicles and cyber-security. It is to Europe's shame that Israel and the US have been allowed to dominate the global UAV market, and that so far only one European-developed UAV has achieved an international sale.
Finally, the era of government-funded development activity may be over. Instead, companies will turn to their own resources to fund development activities in the hope of recouping costs down the line.
Unmanned aerial vehicles
Current European market trends are exemplified by the unmanned aerial vehicles domain. The strategic importance of such systems in modern conflicts – ranging from signals relay to reconnaissance and strike roles – cannot be underestimated. So-called drones have been used to great advantage by UK and US forces in Afghanistan, and Russia's dearth of UAV technologies has been blamed for hampering its efforts during the 2008 Russo-Georgian conflict.
Europeans have been slow to react to the growing role of UAVs, and have often been forced to look beyond the EU to meet requirements, an example being the UK's Watchkeeper programme, which is based on the Israeli Elbit Hermes 450 platform.
Whilst such a strategic gap cannot be allowed to remain, the development of indigenous solutions is unaffordable. This explains why UAV collaboration is at the core of the Anglo-French defence cooperation accord, with Prime Minister David Cameron and President Nicholas Sarkozy announcing in November 2010 that they would seek a joint solution to mutual medium altitude long endurance (MALE) UAV requirements. Dassault of France and BAE Systems are likely to compete against EADS.
The UK's own programme to develop a MALE UAV stalled due to funding. The MoD's 2009 spending did not include continued funding for the UK Operational Unmanned Air Systems project, stopping at the first phase of the BAE Systems-led Mantis OUAS demonstrator. It is also notable that OUAS only received partial government funding.
The outlook for European industry – given the demands of exportability, bilateral collaboration and reliance on corporate funds – is unclear. Anglo French co-operation has great political support at a government level, but such collaboration can flounder with questions such as workshare on the sharing of intellectual property. It remains to be seen whether the need to develop indigenous solutions to pressing operational needs outweighs pure cost concerns, which could lead countries such as the UK towards relatively low-cost 'off the shelf' systems from the US. The impact of such a scenario would be devastating; both for the industrial base and the retention of capabilities. *