Russia ready to protect its defense sector

MiG-35 produced by United Aircraft Corporation (Dmitriy Pichugin, GFDL 1.2)

Following the annexation of Crimea by the Russian Federation, multiple governments and international organizations, led by the United States, imposed sanctions on Russian individuals and businesses.

Since then, the list of sanctioned Russian entities has been piling up. The current debate on the subject has been revolving around Russia’s defense companies and the possibility of imposing sanctions by the United States government against entities that are engaged in business activities with them. Recent developments in Russia’s defense sector seem to suggest that the US sanctions, or a mere threat of imposing them, has deeply affected not only the defense companies themselves, but also their financial backer – Russia’s banking sector.

America’s adversary

The Russian defense sector, along with many others, was originally targeted by the United States’ administration through the so called “Countering America’s Adversaries Through Sanctions Act” passed by the US Congress in July 2017, and signed by the US President Donald Trump in August of the same year. The document stipulates separate sanctions on entities that have “significant transactions” with sanctioned Russian companies or individuals. Additionally, a new list of Russian companies under US sanctions, which include a large number of defense enterprises, was released in October last year, with new regulations that took effect on January 29, 2018.

Among the Russian defense companies affected by the US sanctions are industry giants such as the Russian Technologies State Corporation (Rostex), Sukhoi Aviation JSC, Tupolev JSC, Almaz-Antey Air and Space Defence Corporation JSC or the legendary Kalashnikov Concern JSC.

A key driver of Russia’s growth 

Along with energy and construction, Russia’s defense sector has traditionally been one of the main drivers of the Russian economy and one of the largest employers in the country, as it employs around 2 million people. Thus, state expenditures on defense concern not only company executives and senior officials, but also many of the authorities in those regions and cities where military production facilities are located.

Recently, the Russian government concluded its next ten-year State Armament Program (GPV). The new program earmarks over USD330bn for defense procurement and equipment support over the ten-year period.

The traditionally strong state involvement in Russia’s defense sector has made domestic defense companies almost completely dependent on state financing. Relying on these subsidies, many of Russia’s defense companies have been accruing financial losses and large debts.

However, the new program intends to reverse that by setting an ambitious goal: increase the share of civilian products in the proceeds of military factories to 30 per cent by 2025 and to 50 per cent by 2030. These products would then be sold on both domestic and international markets. It is an attempt to both modernize Russia’s defense sector and compete with some major western companies. 

The state-owned United Aircraft Corporation (OAK) is an example of a company that has already been heading in this direction. According to the Russian daily Vedomosti, the company is preparing to launch a serial production of a new passenger aircraft MS-21 and IL114. The company is also taking part in the Russian-Chinese project to develop a wide-body cruiser CR929 and plans to resume production of the passenger aircraft IL-96-400.

The Russian Ministry of Industry and Trade recently informed about Russia’s readiness to compete with companies like Boeing and Airbus. To further develop its civilian defense sector and become more competitive internationally, Russia might soon introduce more stringent restrictions on foreign manufacturers. According to Vedomosti, the Kremlin is considering an option to oblige state companies to prioritize purchases of civilian products made by Russian defense companies over those made by their foreign counterparts.

Similar trend has already been noticed in the high tech civilian products. A few months ago, the Economic Development Ministry has concluded six public tenders “for the research and development of several projects within the framework of the Federal Target Program No.1”. The aim of the program is to realize the state economic and social policy when solving long-term tasks and large infrastructure projects, according to the Ministry’s website.

The six tenders were awarded to companies whose task is to replace technology imported from America and Europe. This primarily concerns technology needed for the development of the Russian military-industrial complex.

In December 2017, after his annual press conference, Russian President Vladimir Putin met with the representatives of the Russian military-industrial complex in the State Kremlin Palace. During the meeting, Putin said that the Russian government “invested in the military sector a lot of money – RUB3 trillion.” This money “should not only help maintain Russia’s defense capability but also to enable Russian companies conquer both Russian and foreign markets with high-tech civilian products,” he added.

Financial component

In the framework of the aforementioned State Armament Program, the defense sector has been relying on Russia’s two majority state-owned, undisputable financial champions, Sberbank and VTB, for loans backed by the state. According to Kommersant, these two banks alone have financed around 90 per cent of all state procurements in Russia’s military sector since 2011.  However, both of these financial institutions, especially Sberbank, have large presence in the Central and Southeast Europe (CSE) and other markets around the world and could be seriously affected by any new round of the US sanctions against entities having transactions with the sanctioned Russian companies.

To shield Russia’s multi-trillion armament program from sanctions, Moscow decided to turn Promsvyazbank, one of Russia’s top 10 banks nationalized by the Central Bank of Russia in December last year, into the “defense bank” that will be servicing the military-industrial sector and large state procurements.

To that end, Russia’s Finance Ministry has drafted an amendment to legislation on military procurement that would force other banks to hand Promsvyazbank some of their own capital along with their defense loans. According to some experts, the sum could be as high as RUB80bn (USD1.41bn). The mechanism used for the money transfer hasn’t been determined yet. The current Promsvyazbank owner, the Central Bank of Russia (CBR), has estimated that the new defense bank requires a recapitalization of around RUB100-200bn.

According to Kommersant, one of the key backers of creating the defense bank has been Sberbank head German Gref. In his words, capital transfers might be problematic, as 49 per cent of Sberbank shares are in a free float. This means that the bank would need an approval of its shareholders before it makes any changes in the structure of its capital. The head of VTB, Andrey Kostin said that his bank already has plans to hand the defense bank a part of its credit portfolio exposed to Russia’s military industrial complex. However, he also expressed his concerns about the capital transfers.

Earlier this month, Alfa-bank, Russia’s 7th largest bank by asset value, informed about its decision to phase out business contacts with internal defense companies to avoid being a target of the latest US sanctions. The bank’s founder, Mikhail Fridman said that Alfa-Bank was cutting ties with the Russia’s defense industry. After the recent wave of nationalization of Russia’s banking sector, Alfa-Bank is Russia’s largest privately held financial institutions.

A wave of nationalization

Alfa-Bank became the 7th largest bank in Russia after the bailout of Financial Corporation Otkritie and Binbank by the CBR. The two banks were affected by a sector clean-up that the CBR has been engaged in since 2013. As a result, the share of the state in the Russian banking system rose from 61 per cent in the beginning of 2016 to 70 per cent in 2017, according to the estimates of Russia’s ACRA ratings agency. Currently, all five Russian largest banks are owned by the state, with only 3 private banks making it to the top ten largest credit institutions in the country.

According to Standard & Poor’s credit ratings on the Russian Federation report from September last year, “The state now controls over 55 per cent of total bank assets, which distorts competition, increases the pricing power of a limited number of financial institutions, and potentially might raise questions about the CBR’s credibility, as it now owns two large commercial banks (Sberbank and Bank Otkritie) while at the same time performing the functions of a banking regulator.”

It would be an exaggeration to claim that the rising share of the state in the Russian banking system is a result of the United States’ sanctions targeting Russia’s key military enterprises. Some of these above-mentioned banks have simply grown too quickly – largely through acquisitions of other companies in completely unrelated sectors – to be managed effectively. However, the decision to turn one of those recently nationalized private banks (Promsvyazbank) into Russia’s prime “defense bank” suggest that Moscow is prepared to further undermine some of Russia’s last remaining vestiges of market economy to protect its defense sector, which itself, as a result of western sanctions, has been undergoing a profound transformation.

Filip Brokeš is an analyst and a journalist specializing in international relations.

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