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

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.

There are many potential areas, but only time will reveal if Pakistan will embark upon wholly domestic or partnership development efforts. However, PAC might have an opportunity to pilot a partnership program involving the private sector (as described earlier in the article) – i.e. the potential 10-30-seat commuter aircraft. During the 2017 Dubai Air Show, a PAC official told Khaleej Times that PAC was looking to develop and produce a commuter airliner for domestic and overseas markets.[4]

Pakistan can partner with South Africa’s Denel Aeronautics, PT Dirgantara Indonesia (PTDI) or the Czech Republic’s Evektor (and possibly others). In addition, it can guarantee firm government orders (from the Ministries of Defence, Interior, Pakistan International Airlines and others) and majority workshare (of Pakistan’s share) to the Pakistani private sector to instigate private investment in the requisite production, maintenance and training services in Pakistan. With PAC being a primarily a defence supplier, contracting the majority of the production and support work to the private sector could free PAC from having to spend on raising the requisite infrastructure, which – in civilian aviation – will necessitate a parallel production line as well as adhering to different standards, especially for flight safety and certifications.

For PAC, the risk in pursuing the commuter aircraft is that the cost of also certifying it for other markets and ensuring that production adheres to acceptance standards may be too high for the private sector. The private sector is risk-sensitive; hence, PAC might need to take on some of the costlier or more complicated areas of production and/or ensure that the orderbook is healthy enough to incentivize private investors. Partnering with another major vendor, such as TAI, PTDI or Evektor, would enable PAC to share these risks with another party. In fact, as the outside party – ideally an experienced vendor – has a vested stake in the joint-program succeeding, it might be available to the Pakistani private sector as a source of guidance and support for ensuring that Pakistani suppliers raise their infrastructure in line with the right standards.

Finding the Right Partners

In terms of pursuing partnerships, it is imperative for Pakistan to select the right partners. Ultimately, the partner must be a country and/or original equipment manufacturer (OEM) with a vested interest in seeing its program succeed both for its own sake and its long-term commercial success. If only confined to the former, then the OEM will simply invest to the extent where the program is brought to fruition, but it may continue investing in potential competitors or leave Pakistan on its own to export the system. In scenarios where the primary need was to fulfill domestic requirements foremost – such as the JF-17 Thunder – this was an appropriate partnership. However, where long-term commercial success is integral, which will be the case in programs that intend to spur private sector activity and pull foreign-exchange inflows and hard currency to Pakistan, the partner must be fully committed to the program from its development through serial production and after-sale support.

It is unlikely that there would be one partner with whom all projects can be undertaken. For example, the immense complexity and cost of engine technology requires a partner with complete turnkey industrial and research and development (R&D) capacity. In this case, China is the ideal partner and it is generally unlikely that it would maintain parallel engine programs of similar performance and complexity (which is costly), ensuring that it will also adopt and push the engine for export (thus guaranteeing Pakistan of its workshare and its profit equity). On the other hand, in armoured vehicles, ships, small arms and aircraft, the Chinese have parallel designs for export and domestic use, and in some cases, parallel export products with overlapping capabilities and markets (e.g. the Hongdu L-15 was marketed and sold to countries that could have also been viable JF-17 customers).[5] In these cases, it would be advisable to partner with smaller countries or OEMs – with fewer resources and programs at their disposal, they will have a vested interest in seeing their co-development programs with Pakistan come to fruition and succeed on the market.

In terms of less complex/lower-cost products, smaller entrants or those with limited product catalogues – such as South Africa (e.g. Denel Group and Paramount Group), Turkey (e.g. TAI, Aselsan, Roketsan, etc), Poland, the Czech Republic and Ukraine could make for fruitful co-development and commercial partners. Consider the Denel Dynamics A-Darter high off-boresight (HOBS) air-to-air missile (AAM). Since the late 1990s, Denel Dynamics had approached several countries with the A-Darter as a possible co-development and co-production program. In 2007, Denel and Brazil signed a $130 million US deal to undertake joint development of the A-Darter.[6] Brazil’s Avibrás, Mectron and Opto Eletrônica are responsible for the Brazilian side of the A-Darter, including production for the Brazilian Air Force and work-sharing with South Africa for third-party exports. While Brazil’s orders are currently unclear due to its fiscal constraints and other funding commitments, the South African Air Force (SAAF) is proceeding ahead with its A-Darter induction plans. In March 2015, the SAAF placed a $74 million US order for its missiles[7] – a portion of the work will flow to Brazilian companies, even though the Brazilian Air Force itself has yet to issue orders.

Sadly, South Africa’s pivot to India in the mid-2000s had frozen contact between Pakistan and Denel Group, which might have seen Pakistan as the partner of the A-Darter instead of Brazil. However, since 2017 the South African government pivoted again, this making Pakistan one of its 10 target markets (and excluding India).[8] Project Azm will necessitate air-to-air and air-to-surface munitions analogous to those slotted for deployment in 4.5 and 5^th-generation fighters, such as the MBDA Meteor, Roketsan Stand-off Missile (SOM), Raytheon AGM-154 Joint Standoff Weapon (JSOW) and others. With Denel Group in need of funding to continue its development and production work, Pakistan can leverage its funds to exact very favourable workshare and technology transfer terms.

There is also greater parity between the South African Rand (ZAR) and the Pakistani Rupee (PKR) than the PKR and the US Dollar, Euro or British Pound Sterling,[9] which is critical considering that the bulk of Denel’s R&D is done in South Africa. However, with the PKR being a cheaper currency, Denel will find that assigning workshare to Pakistan could reduce the cost of its products, thus enabling it (and its Pakistani partners) to offer contemporary goods at markedly competitive pricing. Potential synergy of this nature makes for mutually beneficial partnerships, especially in markets with a relative dearth of competitors. These areas include new-generation munitions, helmet mounted display and sight systems, active hard-kill vehicle protection suites and other areas that are concentrated among a few providers in the US, UK and Europe. Partnering to develop these systems would enable Pakistan to mitigate its persistent need to import them, provide valuable work – anchored by long-term domestic needs – to the private sector, and provide the private sector with the necessary work (by sub-contracting) to recoup costs and invest in further product development. The latter would be easier if concrete steps are taken – by Pakistan and its overseas partners – to secure sales to third-parties, which would help Pakistan recoup some of its costs (from investing) and enable the private sector to benefit (through more subcontracting work) from those exports.

Conclusion

In economics, there is the saying, “there is no such thing as a free lunch.” Ultimately, whether it be one’s host, the restaurant, guests, a friend or a gift card, someone is paying for the meal. This is true in defence and Pakistan’s pursuit of forming a defence industry to which it can consult its needs and use as a means to propel growth in exports and hard-currency inflows. It cannot happen without a party paying for it.

One might be tempted to have outsiders – using mechanisms such as FDI – provide the capital for the private sector to grow, but the foreign ownership of equity will see precious hard-currency (i.e. profit) leave Pakistan. One might try reducing currency outflow by tying defence deals to offsets, but unless executed in a way to avoid price mark-ups, low-value work and aggressive equity loss in domestic companies, it is unlikely to be beneficial for macroeconomic aims such as hard-currency inflows.

Countertrade is also a risky proposition; if goods in the customer-state being bought by a foreign OEM are already in-demand on the export market, then countertrade may not add much to trade gains. It may also force a spike in demand, which could raise the price of those goods, enabling the OEM to “fulfill” its buy-back obligations with less volume. It may also serve as a means to facilitate corruption with countertrade purchases occurring from companies connected to state officials.

Ultimately, the partnership route requires that Pakistan pay for the cost of raising its industry, though it may do so in collaboration with another state and/or company with identical end-product and commercial objectives so that the cost of doing so is shared or lessened. While the cost and risk are absorbed first and foremost by the state, the payoff would be the ability to guarantee high-value work to the local industry, a return-on-investment for the state through equity sharing (in another’s program) and, if local investors are comfortable with the opportunities on the table, domestically driven growth in manufacturing. These private sector actors would have the capacity to continue fulfilling domestic orders (freeing the state from spending on raising its own infrastructure for the task) and, in time, compete for exports.

For this to work Pakistan must formulate a fully detailed, publicly available and rigorously enforced policy for partnerships and collaborative consortiums being the way for fulfilling its defence needs and backing its public and privately-owned high-tech industry actors. The expectations for Pakistan’s workshare – and how that is to be divided between the public and private sector – along with its profit-sharing, the licensing rights (for third-party users) and technology transfer goals must be laid out and enforced. This will reduce ambiguity – and in turn, risk – for private actors. It would not be correct to say that every sort of high-tech big-ticket program will be implemented immediately through this policy, but with a $10 to 11 billion US annual defence expenditure outlay[10], modest starts can be made (e.g. in munitions and electronics) which can then be gradually compounded with additional programs (i.e. snowballing). Clarity in policy aims, consistency in adherence and continuity in policy execution are integral, but they will lead to success.

[1] The previous Pakistan Navy Chief of Naval Staff (CNS) Adm. Zakaullah Muhammad announced the order during his retirement speech. One of the two Damen OPVs will be constructed at KSEW.

[2] 75 Meter Swift Corvette. Swiftships. URL: http://swiftships.com/vessels/75-meter-swift-corvette/ Accessed: 17 December 2017. (Note: Marine News quoted Swiftships’ CEO Shehraze Shah stating that Pakistan ordered two Swift Corvettes with an option for two more in 2020. The Pakistani variant will have a displacement of 1,500 to 2,000 tons, i.e. the displacement of the steel-hull variant).

[3] 10 Ton Utility Helicopter. Turkish Aerospace Industries. URL: https://www.tai.com.tr/en/product/10-ton-utility-helicopter Accessed: 15 December 2017.

[4] Waheed Abbas. “Pakistan to soon start producing commercial aircraft.” Khaleej Times. 14 November 2017. URL: https://www.khaleejtimes.com/business/aviation/pakistan-to-soon-start-producing-commercial-aircraft-in-kamra-official Accessed: 11 December 2017

[5] AVIC sold the Hongdu L-15 to the Zambian Air Force. AVIC is marketing the L-15 as a lightweight multi-role fighter with the same armament set (e.g. SD-10, LS-6, etc) as the JF-17.

[6] Keith Campbell. “$130m A-Darter missile to be produced in both South Africa and Brazil.” Engineering News. 09 July 2010. URL: http://www.engineeringnews.co.za/print-version/missile-to-be-produced-in-both-south-africa-and-brazil-2010-07-09 Accessed: 16 December 2017.

[7] 2016-2017 Financial Report. Denel Group. URL: http://admin.denel.co.za/uploads/35ae607a5a1262a29df6c
671801de828.pdf Accessed: 17 December 2017.

[8] Ibid.

[9] 1 ZAR = 8.66 PKR. 1 USD = 110 PKR.

[10] “Global Defence Spending to Hit Post-Cold War High in 2018, Jane’s by IHS Markit Says.” Industry Press Release. IHS Jane’s. 18 December 2017. URL: http://www.janes.com/article/76463/global-defence-spending-to-hit-post-cold-war-high-in-2018-jane-s-by-ihs-markit-says Accessed: 19 December 2017.