Privatization in the Russian Defense Industry: Situation in 2001

Ruslan PUKHOV

Privatization in Russia: stages and pro­cedures

Industrial facilities and institutions of the Rus­sian defense industry were privatized according to the same patterns that were applied in the Russian economy as a whole. However, the stages and dynamics of privatization in the de­fense industry differed greatly from the general trends in Russia. The privatization of the Rus­sian economy can be divided into five stages.

·   At the first stage in 1992 companies were sold for money according to three patterns to be de­scribed below.

·   At the second stage initiated by Anatoly Chu­bais in 1993-1994, privatization took a mass scale and was conducted for privatization vouchers.

·   The third stage of denationalization in 1995 had the form of shares-for-loans auctions. In fact, before of the December 1995 parliamentary elec­tions, major banking empires started credit­ing the Russian government, which in return placed banks in trust management of major companies in oil extracting, iron and steel pro­duction, and nonfer­rous metallurgy. The offi­cially announced objec­tive of the auctions was to raise money to cover the budget deficit and stabilize the political re­gime. The formal as­sumption was that by 1997-1998 the government would pay back its debts and regain its rights to the transferred compa­nies. However, in actual fact both sides - the government and banks - implicitly realized that the property acquired at the auctions would remain at the disposal of the banks. Though the process had the form of auc­tions, it is the general belief in Russia that the winners were handpicked for their proximity to the authorities, not for economic reasons. It was in the process of loans-for-shares auctions that the banking-industrial empires of Russian oli­garchs were created, that later collapsed in the wake of the 1998 crisis.

·   The fourth stage of privatization in 1996-1998 had the form of contests with investment condi­tions. Bidders for controlling or blocking stakes (the very same banking-industrial empires of the oligarchs) in addition to paying for the stakes had to assume commitments to cover wage ar­rears to the personnel and propose investment programs for the companies they acquired.

·   Finally after the 1998 financial crisis ordinary auctions for money became the main form of privatization because the fulfillment of invest­ment conditions had proved impossible.

As mentioned above, the auctions in 1992 and pri­vatization for vouchers in 1993-1994 followed three patterns. Under the first pattern a control­ling stake of 50%+1 shares was placed in the hands of the personnel and the other shares were sold. Under the second pattern the person­nel got only 25% of the shares, non-voting pre­ferred stock at that while the rest were sold for money or privatization vouchers. This pattern was most wide spread during mass-scale privatization of 1993-1994. Under the third pat­tern a 25% stake was reserved for sale to the company management only with the rest being traded on the free market. It was the second most popular privatization pattern. The second and third patterns offered the most favorable conditions for managers to become company owners, and the first pattern - to outside inves­tors. That is the reason why in most cases com­panies were privatized according to the second and third patterns.

Privatization in the defense industry: stages and dynamics

Unlike the Russian economy in general privati­za­tion in the defense industry had two stages and the entire process was relatively short. Af­ter 1995 the privatization of defense plants was frozen, and later, property was only re­distributed in the process of competition be­tween financial and industrial groups. The first stage of privat­izing the defense industry began in 1992 under the govern­ment of the liberal Yegor Gaidar. Most sales took place in July-De­cember 1992 in keeping with government ordi­nances. The enter­prises that went through the process of incorpo­ration and partial privatiza­tion included Sukhoi Design Bureau, however, the state kept a con­trolling stake. After Viktor Chernomyrdin was appointed prime minister in December 1992, large-scale privatiza­tion in the defense industry stopped. The high­light of privatization in 1993 was the auctioning of shares in the Irkutsk Aviation Industrial Associa­tion (IAIA) in December, as a result of which the state retained control over only 14.7%.

The beginning of large-scale privatization for vouchers initiated by Anatoly Chubais, at that time - Chairman of the State Property Commit­tee, in 1993 gave an impetus to the second stage of denationalization in the defense industry. Evidently, it was then that the bulk of defense industry facilities were privatized. However, al­ready in 1995, when shares-for-loans auctions were widely held, privatization in the defense industry came to a halt. The interests of bank­ing groups that had become key players in pri­vatization were concentrated in the oil and metal sectors. Company managers who were the most active figures in defense industry privatiza­tion in the first three years of post-Soviet his­tory had mainly reached their objectives.

In theory, banking-industrial empires remained in­terested in export-oriented defense industry fa­cilities. After plummeting to a record low level in 1994, arms exports started soaring in 1995. However, the attempts of further incorpo­ration and privatization of the most attractive defense facilities were effectively blocked through the joint efforts of local and regional authorities in­terested in keeping tax returns and managers who in most cases ran the companies as their own, even if they formally remained state-owned. In this respect, attempts to incorpo­rate the Komso­molsk-on-Amur Aviation Indus­trial Association (KnAAPO) fulfilling major contracts for the de­livery of Su-27 fighters to China are quite indica­tive. Despite the support of the federal authori­ties and the might of the ONEXIMbank empire, all efforts to incorporate the plant or establish effec­tive control by AVPK Sukhoi core company were successfully neutral­ized by the Khabarovsk terri­tory administration and the plant management until the end of 2001.

In the final account, oligarchic empires were forced to adopt the tactics of forming personal alliances with the management of state-owned enterprises in the defense industry. At best, such alliances allowed them to win the right to ser­vice the accounts of such enterprises and pay for po­litical lobbying and management optimiza­tion.

As a result of tough competition between oligar­chic groups to redistribute privatized property in the defense industry and due to the 1998 fi­nan­cial crisis that disrupted financial-industrial em­pires, the following arrangement of key non­gov­ernment players has evolved in the Russian de­fense industry sector.

In shipbuilding, the biggest outside owners of the two most attractive shipyards are the New Pro­grams and Concepts (NPC) industrial holding company that inherited the defense indus­try as­sets of ONEXIMbank, and IST group, the origin and business of which are quite vague. NPC con­trols JSC Shipbuilding Plant Severnaya Verf (Northern Shipyard) that in 1999-2000 car­ried out a major contract for the delivery of de­stroy­ers to China, while IST group has a con­trolling stake in Baltiysky Zavod shipyard which is build­ing three frigates for India. Besides, the Inter-Regional Investment Bank (MIB) owns stakes in a number of small shipyards. However, the companies it fully or partly controls are not working on any major export contracts or Russian Navy orders at the moment.

In aircraft-making the biggest private player is the KASKOL Group, having a controlling stake in Gidromash plant (the Russian sole designer and manufacturer of aircraft undercarriages) and a 38% stake in Aircraft-Building Plant Sokol in Nizhny Novgorod manufacturing the MiG-31 all-weather interceptor and MiG-29 air superiority fighter.

However, managers who in the process of priva­tization became owners of their facilities consti­tute the biggest, increasingly active and suc­cessful group of players in the non-government sector of the defense industry. The Irkutsk Avia­tion Industrial Association or the Rybinsk Motors plant are the best examples of the kind. IAIA owner Alexei Fyodorov and Rybinsk Mo­tors pos­sessor Yuri Lastochkin initiated the process of forming corporate structures (until then pro­moted mainly by the government) when in 2001, in addition to the production facilities they con­trolled, they bought Rus­sian Avionics and Lyulka-Saturn design bureaus, respectively.

Specifics of economic behavior of privat­ized companies

Private companies demonstrate distinct differ­ences in their economic behavior from defense in­dustry facilities controlled by the government. Firstly, the owners of private companies are taking steps to reduce the share of military pro­duction and diversify the civilian sector. The ex­treme example is Uralmash-Izhora holding com­pany, which consistently converts its muni­tions' plants, stopping the production of defense goods at some of them altogether.

Secondly, private companies display a much higher degree of openness of their financial in­formation. Such transparency is a necessary con­dition for entering the market of external fi­nan­cial resources (promissory notes, bonds, ADRs). By the way, only private companies use or plan to use such resources. They enjoy a much greater degree of freedom in restructuring and stream­lining of personnel. Evidently, the attempts of managers at state-owned companies to reduce re­dundant staff are blocked by the government, interested in maintaining employment and related social stability.

Thirdly, in 2001 private companies proved suc­cessful in corporate development and the forma­tion of international industrial alliances, i.e., in a sphere where the attempts of govern­ment bodies and management of state-owned en­terprises have been quite feeble.

Table 1. Ownership forms in the Russian defense industry

Ownership form	Number of companies
State-owned enterprises	701
	Privatization allowed	266
Privatization prohibited	435
Joint-stock companies	930
	No government stake	460
Partly state-owned	470
	Golden share	265
Controlling stake	99
Blocking stake	89
Stake smaller than 25%	17
Total number of defense enterprises	1631

Source: TS-VPK news agency

Latest trend: the threat of renationaliza­tion

The latest trend that appeared in a latent form in 2001 is the determination of government elite to renationalize privately-owned defense indus­try companies. The Federal Program of Restruc­turing the Defense Industry Complex approved by the federal government in October 2001 im­plies as a concept the introduction of advan­tages for state-owned companies that should have preference in getting Russian Defense Ministry orders, and, most importantly, export orders. At the moment, this provision is unlikely to be implemented, because, at least in several sectors such as shipbuilding, state-owned facili­ties are simply unable to fulfill certain export contracts. For instance, the contract for the de­livery of the second group of destroyers of the Sovremenny class to China can be carried out only at private shipyards in St. Petersburg or Kaliningrad.

This only adds to the reasons for suspecting that there are intentions to nationalize private companies on a large scale. The most likely instrument of such renationalization will be the claim that private owners have benefited from the results of R&D financed by taxpayers back in the days of the Soviet Union. The government may offer to swap rights to intellectual property for con­trolling shares. The other possible way in which the government may increase its defense indus­try assets is Rosoboronexport arms trader buy­ing up shares earlier owned by Inkombank.

So far these scenarios have not materialized, but there are no doubts about their existence and they have been confirmed in the public statements of officials and recorded in of­ficial documents. Such plans are initiated mainly by agencies in charge of defense industry sectors. In our opinion, the true motive force of these attempts is not so much the strive to na­tionalization as the eagerness of the new post-Yeltsin elite and bureaucrats who failed to es­tablish control over attractive pieces of property to redistribute, not renationalize property.