Pakistan’s Defence Industry: High Risk and High Reward Partnerships Plus

Prologue:

This is a continuation of the Quwa Premium articles discussing the Pakistani defence industry, specifically its inability to produce a domestic marketplace to which the Pakistani armed forces and foreign customers can consult, its nascent private sector activity and the steps Pakistan can consider for infusing the private sector with capital investment and capacity building. Based on the discussion, it appears that the challenge is circular: in order to undertake high-value work and offer compelling products, one needs capital, but to justify the influx of capital by private investors, one needs to have a high-value orderbook, which in turn requires products. In effect, one party (e.g. government or private industry) will need to pay for the cost of developing new products and generating an orderbook.

Previously, we had looked at how governments might place that burden on an overseas actor – e.g. a major defence industry firm – by requiring offsets, foreign direct investment (FDI) and/or countertrade. However, there are risks to such measures, such as artificial price mark-ups, equity-sharing with foreign firms causing hard currency outflow or foul-play. In this article, we look at an alternative, i.e. having Pakistan’s state-owned defence industry firms – i.e. Heavy Industries Taxila (HIT), Pakistan Ordnance Factories (POF), Pakistan Aeronautical Complex (PAC), Karachi Shipyard & Engineering Works (KSEW) and others – enter foreign development programs as partners.

On the surface, this might appear like opening the industry to FDI and foreign equity ownership of the country’s domestic firms. However, it is fundamentally the opposite. Where receiving FDI involves foreign companies buying into Pakistani companies to profit from work for the domestic and export customers, the Pakistani state joining overseas programs would be akin to Pakistan serving as the FDI source. Pakistan can identify big-ticket defence programs undergoing development overseas and, in turn, co-invest in them with the condition that a percentage of all workshare (i.e. for first, second and third-party customers) be done from Pakistan. Through investment, Pakistan will also own equity in these ventures, hence receiving a portion of the profit as well. The earlier the project is in its development, the higher its risk of failure. At the same time, the higher its risk, the more Pakistan can leverage with its funding in terms of receiving its share of production workshare and equity in the program. While this approach will not provide complete ownership, it enables Pakistan to share the funding burden and the risk with its partner (and vice-versa).

In effect, partnering means that the Pakistani state (through its state-owned defence producers) will have to be the source of funding and securing workshare. Pakistan will have to pay for development. However, by securing a healthy percentage of program workshare, Pakistan can offer to subcontract its workshare to its own private sector. In other words, Pakistan will have built an orderbook to which private investors can now spend towards fulfilling by raising their own production infrastructure and human capital. This way, a portion of the funding necessary to undertake production within Pakistan need not be the burden of the state, if there is genuine opportunity for long-term work, the private sector can absorb that part of the burden. In turn, these companies can profit and grow from the work contracted to them by the state-owned firms, which could come from domestic and foreign orders. The latter would help Pakistan recoup some of its investment through the profit-sharing with its partner (but this is conditional on having a partner which is well-positioned to secure many exports). Granted, a portion of the procurement funding spent on partnership goods will be spent in the partner’s economy, but by virtue of workshare, the partner will also source from Pakistan for its own orders (e.g. for an aircraft, Pakistan can require that all wings be built in Pakistan, regardless if it is for Pakistani, the partner’s or third-party export orders). Workshare will enable the private sector to recoup its own investment and, in turn, allow it to have infrastructure that it can offer to foreign firms, thus connecting themselves to foreign supply chains and becoming exporters.

However, sustaining this approach – be it from justifying the expense of partnering and to guarantee long-term orders for the domestic industry – requires a strict and non-negotiable refrain from imports (unless the development route is infeasible). In the near-term, partnerships will be a heavy fiscal strain (albeit to a lesser degree than a wholly indigenous development effort), though it can be offset over the long-term through exporting production input and services to the partner and third-parties. Nonetheless, imports – especially in a fiscally-strained country such as Pakistan – can be zero-sum trade wherein buying from the U.S. or Europe can mean shelving the development and partnership route. Moreover, where imports are a permanent hard-currency loss, partnerships can be structured as investment for equity – exports and to an extent even sales to the partner will result in proceeds for the investor (i.e. a hard-currency return). Pakistan currently aspires and broadly commits to prioritizing domestic sourcing over imports, but it is unclear whether there is a firm and non-negotiable policy driving long-term procurement strategies.

For example, why did the Pakistan Navy order offshore patrol vessels (OPV) from Damen Shipyards and corvettes from Swiftships? Neither one of these ship designs was particularly complex wherein Pakistan was prevented from investing in an original design – be it domestically or via partnership – for the purpose of having them built in Pakistan. The Damen OPV[1] and Swift Corvette, while exhibiting hulls with low radar cross-section (RCS) design principles, are built from steel (as are their superstructures)[2]. In other words, these are not inherently high-complexity or high-cost designs, the delta or gulf for Pakistan to reach in order to build its own analogous solutions (especially with the support of an experienced contractor and/or partner) is not as significant as a composite superstructure-based design, such as the MILGEM or Gowind. However, even inherent complexity of a necessary system is not a de-facto excuse to eschew development, as seen in the Pakistan Air Force’s (PAF) Project Azm, which aims to have a fifth-generation fighter designed, developed and produced in Pakistan to a higher degree (at least based on the PAF’s messaging) than the JF-17 and to ‘free’ Pakistan from relying on overseas suppliers.

When approaching procurement, imports ought to be levelled with the following question, “what stops us (Pakistan) from sourcing this locally?” In some cases, the gap between not having capacity and having it in a sufficiently reliable and cost-effective fashion could be untenable in the near-term, such as turbofan engines. In others, such as steel-hull and superstructure ships, it is the next progressive – yet oft-ignored – step for KSEW and Pakistan’s maritime industry at large (as it has experience cutting and constructing such ships provided it has the documentation and training with the design). In the case of KSEW producing its own take on the Swift Corvette or Damen OPV, it would be developing a design (perhaps in partnership or with support from an experienced ship designer) and its technical documentation, which in turn KSEW can execute the way it would with its other programs by sourcing the necessary materials and subsystems for construction at its shipyard. By owning the design, KSEW can market the corvette or OPV to foreign customers (i.e. competing with Swiftships and Damen). Once mastering this step, Pakistan could consider proceeding to sourcing materials – such as ship-grade steel and composite materials – domestically.

Prospective Partnership Programs

Potential partnership programs can include complete weapon systems, such as combat aircraft, transport and utility helicopters, transport aircraft, naval surface combatants, armoured vehicles and air defence systems. In addition, partnerships can be forged to develop and supply subsystems, munitions, materials and other inputs for those complete systems. Basically, any defence program the Pakistani armed forces intend to procure in the near and/or long-term is a viable candidate for co-development.

For example, to supplant its aging Sea King and Puma helicopters, Pakistan can consider partnering with TAI on its 10-ton helicopter project instead of importing a helicopter off-the-shelf. As per TAI, the 10-ton helicopter will have the capacity to carry at least 20 personnel. It will have a top speed of 315 km/h and range of 1,000 km.[3] The program is in its infant stages of development, and with Turkey gearing-up to license manufacture the S-70i Black Hawk, the TAI program is a distant factor. If willing to part with funds, Pakistan can leverage the program’s infancy and long-term process to exact relatively significant workshare, technology transfer and commercial rights (for marketing and exporting the platform exclusively to certain third-party markets). Likewise, Pakistan can consider co-developing and co-producing electronics, sensors and munitions for Project Azm.