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.