As uncertainty rises over US defence spending and as the possibility of further deep defence cuts tied to sequestration raises questions over the future of the US force structure, both China and Russia are moving forward, significantly increasing their investments in defense procurement and force modernisation over the next decade.
Recent analysis by IHS Aerospace, Defence & Security highlights the challenges and opportunities this overall shift in worldwide defence spending presents for US defence contractors and the need for greater agility in responding to an ever-more competitive marketplace.
The statistics on trends in US, Chinese and Russian spending are stark. According to IHS Jane’s Defence Budgets, in 2011 the US defense budget was more than three-and-a-half times the size of Chinese and Russian military spending combined. However, by 2020, this US multiple will shrink to less than twice of that of the combined Chinese and Russian budgets.
This shrinking gap is the result of a continuing steep rise in Chinese and Russian defense spending and a corresponding projection of a 25 per cent reduction in real US expenditures during the same period.
By 2020, the actual—as opposed to announced–Chinese defense budget is estimated to rise to USD259 billion, up from USD143 billion in 2011. Russian spending will increase to USD108.3 billion in 2020, up from USD57.2 billion in 2011.
US spending is likely to decline to USD540 billion at the end of the decade, down from USD720 billion in 2011.
Yet the more pertinent factor weighing on the defence industry is the sheer uncertainty surrounding US spending plans.
Neither the Obama administration nor Congress has provided sufficient clarity on whether sequestration will take full effect in 2016 as currently planned, or whether fixes will be made to avoid precipitous drops in spending. This uncertainty complicates efforts to project the size and composition of the US force structure and which programs will be funded at what levels, further undermining the internal planning of defense contractors.
Furthermore, senior US military officers have expressed concern that sequestration in 2016 could endanger the American shipbuilding industrial base.
“The biggest threat, the one that worries me the most, is the industrial base,” said Admiral Jonathan Greenert, chief of naval operations, speaking in May. “If it’s time to recapitalise and we don’t have the shipbuilding industrial base, we’re in a hurt locker. We’re in deep trouble.”
Money isn’t everything
The shrinking gap in defense spending between the United States on the one hand and Russia and China on the other should not be over emphasised.
Defence spending is not an exact proxy for military capability, and the United States continues to enjoy key advantages in its operational experience and capabilities; current technologies; and existing industrial base. China’s military faces a range of technical, operational and organisational challenges.
China’s military, and especially its blue-water navy, is relatively inexperienced. The country also faces obstacles in developing expertise in operating more sophisticated armaments.
Meanwhile, Russia must confront hard questions over the technical capability of its armaments industry to produce advanced systems in coming years.
Nevertheless, tentative signs of a growing Sino-Russian rapprochement, including greater economic as well as energy cooperation and joint military training, underscore the potential threats to U.S. strategic dominance if left unchecked.
Contractors face challenges
With these shifts in the defense landscape, the overriding question for US defence contractors involves the future of their capability to develop and maintain exports in an increasingly competitive market. Without question, the US military will remain their dominant customer. However, with decreased domestic sales and increasingly thin margins, IHS Jane’s Defence Industry & Markets Intelligence Centre analysts see US firms having increasingly to address emerging markets and commercial adjacencies to maintain productive revenue growth and pursue needed market diversification.
In doing so, it is likely they will confront greater direct competition with Russian and Chinese arms makers that already enjoy unique advantages. Most notably, these state-owned entities receive a regular stream of governmental subsidies and support—as do some aerospace and defence companies in Europe and other Asian states—and can thus afford to look past immediate profits or concerns over technology transfer to focus instead on long-term relationships.
For US companies, it can sometimes feel as if they are locked in competition with sovereign governments—with all of the resources and benefits that accrue. For example, Russian Prime Minister Dmitry Medvedev announced in June that 100 state guarantees totaling USD11 billion will be granted to 60 state defense enterprises in 2014.
Most of this funding is designed to ensure the successful ramping up of Russia’s decade-long rearmament effort—the CEO of Russia’s state arms import/export agency Rosoboronexport announced in August that his company anticipates holding exports constant at around USD13 billion until 2017 in order to meet domestic demand. However, the degree and escalation of support does provide Russian firms with some advantages in an increasingly competitive global market, especially the “good enough” market that stresses value, technology transfer and favorable contracting terms.
Thus, it should be no surprise that Russia and China already both rank among the top 10 nations in terms of gross defence exports, or that China scored a major breakthrough by concluding an initial agreement to supply an integrated air defense system to Turkey last fall. The capability of the state-owned enterprise China Precision Machinery Import-Export Corp. (CPMIEC) to offer extensive technology transfer and a system that was approximately USD1 billion cheaper than the European and US offerings was cited as critical to Turkey’s decision.
True, final closure of the deal has been delayed, and the agreement looks as if it might fall through due to persistent NATO concerns about a Chinese state-owned enterprise having access to a NATO integrated air defence system. Nonetheless, the initial award validated the growing perception that China can be a viable competitor against leading Western providers in the global defense export market.
US on the defensive
The US has much to lose in the global realignment of defence spending. America leads in global defense exports, at USD25.3 billion in 2013. This represents more than two-and-a-half times the total of the No 2 exporter, Russia, at USD9.5 billion. U.S. defense exports are about equivalent to the total for the next five largest countries combined. China ranks seventh, with USD1.9 billion in exports.
Adjusting to the new world order
IHS assesses that US defence firms should prepare to adapt their traditional lines and models of business. This worldwide shift in defence spending—from North and West to South and East—and the savage competitive dynamics it has unleashed will compel US firms to rethink their traditional markets and how to most effectively promote their competitive advantages.
IHS will continue to study the shifting terrain for US defence contractors in what may be the most seismic set of shocks to the global defence business since the end of the Cold War.
Tate Nurkin is the Managing Director for Consulting and Thought Leadership at IHS Aerospace, Defense & Security, and contributes regular insight into international defense and security issues for IHS Quarterly.