Pakistan’s Defence Industry: Constructing a Domestic Marketplace & Examining Offsets

Constructing a Domestic Marketplace of Products

One of the drawbacks of nascent private sector activity in the defence industry, especially in new product development, is that Pakistan lacks a domestic marketplace to consult for its requirements. Thus, each of the service arms routinely approach overseas suppliers for solutions, causing the domestic industry – both publicly-owned and the private sector – to miss on valuable workshare and capital (which could later be invested in Pakistan through expansion and development projects).

Financial assistance notwithstanding, the Pakistan Navy’s decision to procure two 75 m corvettes (with an option for an additional two) from U.S-based Swiftships and two offshore patrol vessels (OPV) from the Netherlands’ Damen Shipyards are examples of this shortfall. Pakistan’s domestic industry was unlikely to have been a factor in either project (outside of locally constructing one of the Damen OPVs) because Pakistan lacks mature ship design firms. Maritime Technologies Complex (MTC) has been modifying the Azmat-class fast attack craft (FAC), which was procured from China, but it has not undertaken original design work. Besides corvettes, local entities are also non-factors in domestic and overseas competitions for small patrol boats, mine countermeasure vessels (MCV), cutters, survey ships and training ships. While valued a fraction of multi-mission frigates or anti-submarine warfare (ASW) corvettes, low-cost ships can amount to sizable business domestically and abroad. For example, in 2014 Pakistan had sought eight GRC 43M cutters for the Maritime Security Agency in a proposed deal worth $350 million U.S.[1]

Pakistan’s domestic marketplace paucity extends beyond ships, it includes wheeled and tracked armoured vehicles, small arms and electronics. Granted, it is infeasible for Pakistan to immediately produce – be it through public or private sector means – in all areas, especially complex fields that involve decades of maturation and evolution (e.g. propulsion technologies). However, there are numerous other programs that can be pursued sooner than later, and though they do not constitute the majority of armed forces spending, they can cumulatively amount to large procurement, especially through small-batch orders over a prolonged duration. These include small corvettes, small patrol boats, OPVs, cutters, MCVs, MRAP vehicles, lightweight utility helicopters and others. By virtue of being comparatively low-cost, these goods could be of interest to many countries. If the private sector could engage in these fields, it could fulfil both domestic procurement as well as compete internationally. By not being linked to the armed forces for the product development process, the private sector can also proceed to design and market goods for foreign markets in periods when the armed forces are not engaged in procurement.

However, as discussed earlier, engaging in the production of the aforementioned systems requires large capital investment. In the near-term, it is unlikely that the private sector will be a factor for supporting big-ticket programs. Moreover, able stakeholders will require substantive incentives from the government and armed forces, be it through assured order prospects (e.g. a policy commitment to only procure locally or mandating majority local workshare in a bid), direct public funding for program development and/or infrastructure construction and linking private sector suppliers to big-ticket programs, such as Project Azm. Despite the call for defence exports, the sustainability of these ventures will need to be built on a strong and consistent domestic orderbook. In fact, the cost of the private sector enduring reduced orders will be reducing the production output, which would see loss of employment.

Examining Offsets

Pakistan’s private sector is not in a position to showcase a domestic marketplace equivalent to those of Turkey and South Africa in the near-term, though there are emerging portfolios in Shibli Electronics and Cavalier Group in thermal sights and wheeled armoured vehicle proposals, respectively. For these and other companies to bring new proposals to fruition and sustain production, they will require capital and healthy domestic orderbooks. Besides encouraging Pakistani investment in these areas, the Pakistani government or armed forces can consider leveraging big-ticket defence procurements with foreign vendors. This could occur by tying procurement to offsets, which can involve deferring production and services workshare to Pakistani companies or foreign companies operating within Pakistan. Besides channelling some of the expenditure to local suppliers, offsets could potentially result in jointly owned subsidiaries to support contracts.

In defence procurement, “offsets” typically describe the process in which an arms importer can receive a “return” or “flow-back” of national expenditure on weapons. Consider the following example: a country might negotiate a purchase of fighter aircraft priced at $2 billion from an overseas supplier. As an import, the purchase would result in an outflow of foreign or hard currency from the client state. However, the client may require the supplier to spend a portion of that $2 billion in the client’s economy. If the supplier agrees to spend $500 million of that deal in the client state, that would be an offset (of 25% of the deal). In its deal with India, France agreed to invest 30% of the Rafale program’s price in India through domestic work and supporting various Indian defence programs. The appeal of offsets, especially for governments required to justify big-ticket arms procurement, is that it suggests that the receiving country will save on some on its foreign/hard currency and, indirectly, reduce the fiscal tradeoff (with some of the money returning to the client state as an apparent economic stimulus).

While offsets have not figured much, if at all, in big-ticket Pakistani procurements, Pakistan’s Directorate General Defence Purchase (DGDP) does maintain an official offset policy.[2] The DGDP states, “all foreign suppliers … entering into a contract with Ministry of Defence Production for supply of defence goods [and] services for the Armed Forces of Pakistan shall be mandated/obliged to sign … an ‘Offset Contract’” for all programs valued higher than $15 million. The policy requires contracts to ramp to 30% expenditure in Pakistan in three years of signing the contract. Instituted in October 2014, it does not appear that the Pakistani government and armed forces leaderships have applied the policy, at least not consistently.

It is unlikely that there is a 30% offset component to the Pakistan Army’s purchase of 12 Bell Helicopter AH-1Z Viper attack helicopters or the Pakistan Navy’s Swift Corvette order. The Damen OPV and Hangor (II) air-independent propulsion (AIP) submarine order from the Netherlands and China, respectively, could theoretically possess offsets since KSEW is involved in both production processes (to what extent beyond final assembly is unknown). Specific contractual details for these programs are not available, so one cannot confirm if the suppliers will re-invest up to 30% of the program contract in Pakistan or if Pakistan is buying the local workshare. In offsets, a portion of the monetary amount spent on a deal needs to return to the client state. This can also occur through countertrade where the original equipment manufacturer (OEM) buys from the client’s market, or with the OEM investing in the client’s economy.

For example, in Indonesia’s recent $1.14 billion order for 11 Sukhoi Su-35 Flanker-E multi-role fighters from Russia, the Russians agreed to both countertrade and offsets. Rostec will spend $570 million on Indonesian goods in addition to investing $400 million on Indonesia’s maintenance, repair and overhaul (MRO) industry. Approximately 85% of the immediate monetary value of the Su-35 deal will return to the Indonesian economy, thus limiting the country’s near-term foreign currency outflow.[3]

Prospective acquisitions currently on the table include 30 Turkish Aerospace Industries (TAI) T129 attack helicopters and four MILGEM Ada corvettes. The Pakistan MoDP confirmed both matters are in advanced stages of negotiation, with Pakistan examining financing proposals. In its marketing for the Anka UAV and T129, TAI had offered offsets to Pakistan in the form of co-production. In fact, TAI General Manager Temel Kotil offered PAC component production work, which would see PAC supply TAI. Pakistan could examine ways to entice the Turks to commit to offsets, perhaps by convincing Aselsan, Havelsan and Roketsan to partner with Pakistani companies to raise shared-equity subsidiaries to undertake product development and production in Pakistan (starting with sub-system and munitions sourcing for the T129). For Turkish companies, it would mean having a native footprint through which they can pitch electronic subsystems and munitions for marquee programs such as the JF-17 and al-Khalid, among others.

Within Turkey, there has been some success in executing a similar model. For example, the Turkish Utility Helicopter Program (TUHP), which will involve the licensed production of 109 S-70i Black Hawk helicopters in Turkey, will also involve Turkish private sector companies in the production process. Alp Aviation will invest $90 million in raising a manufacturing facility to supply the TUHP with its main dynamic components – e.g. main rotor, tail rotor, tail rotor drive system, main transmission system, etc.[4] Under the Turkey’s required co-production and offset requirements, Lockheed Martin will also link Alp Aviation to its global supply chain for the Black Hawk, providing Alp Aviation business activities worth $500 million.[5]

There is precedence of Turkish offsets in other states. In Kazakhstan, Aselsan partnered with Kazakhstan Engineering to raise Kazakhstan Aselsan Engineering (KAE) in 2013. When founded, KAE was worth $44 million. Ownership is split between Kazakhstan Engineering (50%), Aselsan (49%) and the Turkish Undersecretariat for Defence Industries (1%).[6] KAE produces Aselsan’s Boa and Python line of thermal sights for the Kazakh and Central Asian market, with Aselsan aiming to export $1 billion in goods from KAE. In November, KAE had announced that it was aiming to re-export $96 million in goods to Turkey.[7] Considering the vastness of Pakistan’s infantry, armour, maritime, aviation and law enforcement markets, there could be a case for Aselsan et. al to also invest in Pakistan in such a manner. This could provide Pakistani firms with foreign direct investment (FDI) to assist with establishing production infrastructure.

However, FDI comes with its drawbacks. First, while providing domestic employment from first, second and/or third-party export orders, equity sharing in these subsidiaries would mean a portion (potentially half or even a majority) of profits would return to the FDI source. Pakistan wants to reduce foreign currency outflow, but profit to FDI sources could mitigate – or damage – that effort. Second, the foreign partners will have a significant say in determining the product catalogues of their subsidiaries in Pakistan. Foreign companies might be directed by their native governments to keep the competitive edge – i.e. the latest products and technology development – at home. This can prevent Pakistan from constructing a competitive domestic marketplace. Finally, when facing austerity pressures and an uncertain economic outlook, Pakistani decisionmakers may be enticed with offsets in the form of selling shares in public-sector firms as a means to finance defence imports. This would be a fatal and categorically counterproductive route as it would render core Pakistani assets to foreign ownership.

Regarding offsets specifically, there is also the risk of them being used as little more than marketing ploys to help governments placate domestic concerns over expensive procurement. For example, when asking for said offsets, Pakistan could incur inflated pricing in the armaments it is seeking, which would mitigate the impact of those offsets. In addition, Pakistan’s lack of human capital and infrastructure conducive for high-tech manufacturing may relegate those offsets to low-value work that does not add to local capacity. Alternatively, offset workshare may force local companies to aggressively specialize, thus preventing them from undertaking other work that might have been more beneficial, especially over the long-term. Finally, if it is a question of providing the domestic industry with capital, then the simple alternative would be for the state to directly provide that capital as domestic development funding as loans or investment.

Likewise, countertrade is also laden with various risks. Notwithstanding the risk of the OEM inflating the price, countertrade is at risk of being offset by price inflation. For example, if the client’s economy has a production that is already in-demand, then the OEM’s entry into the market may cause prices to climb. The OEM may spend its countertrade commitment on a relatively limited set of goods, thus reducing the added benefit of employment and work (i.e. stimulus) in the client’s economy. Worse, those goods could have been sold by businesses tied to the client state’s government, i.e. foul-play and corruption.

[1] Pakistan – GRC43M Cutters. Defense Security Cooperation Agency. 30 October 2014. Accessed 03 December 2017. URL: http://www.dsca.mil/major-arms-sales/pakistan-grc43m-cutters

[2] “Defence Offset Policy.” Directorate General Defence Purchase (DGDP) Pakistan. Accessed: 03 December 2017. URL: http://www.dgdp.gov.pk/documents/defoffsetpolicy.pdf

[3] Bradley Wood. “Indonesia’s Su-35 countertrade deal: Worth its weight in jet fighters?” The Jakarta Post. 27 September 2017. Accessed: 04 December 2017. URL: http://www.thejakartapost.com/academia/2017/09/27/indonesias-su-35-countertrade-deal-worth-its-weight-in-jet-fighters.html

[4] “New 90 Million Dollar Helicopter Investment in Eskişehir by Alp Aviation.” MSI Turkish Defence Review. November 2017

[5] Ibid.

[6] “Professional Radio Stations Transfer of Technology for Kazakhstan.” Aselsan. 25 November 2016. Accessed: 04 December 2017. URL: http://www.aselsan.com.tr/en-us/press-room/news/Pages/kaeimza_20161125.aspx

[7] Aliia Raimbekova. “Kazakhstan Aselsan seeks to expand exports.” Anadolu Agency. 09 November 2017. Accessed: 03 December 2017. URL: http://aa.com.tr/en/economy/kazakhstan-aselsan-seeks-to-expand-exports/960861