PRIVATIZATION IN NACC COUNTRIES Defence Industry Experiences and Policies and Related Experiences in Other Fields COLLOQUIUM 1994 ********* COLLOQUE 1994 PRIVATISATION DANS LES PAYS DU CCNA Experiences et politiques des industries de defense et experiences comparables dans d'autres secteurs Colloquium 29-30 June, 1 July 1994 Brussels -------------------------------------------------------- POST-COMMUNIST DEFENCE INDUSTRY RESTRUCTURING: THE ROLE OF FOREIGN DIRECT INVESTMENT Daniel Daianu Privatization won't convert the defence industries by itself, says Daniel Daianu. The slump is what is really cutting them down to size. Meanwhile the world is becoming more unstable, and Eastern European countries feel they're living in a security vacuum. They know they have a saleable commodity of proven value - arms. They also know that Western protectionism is keeping their consumer goods out. The real question is how to get the West to face up to this, and invest politically in Eastern Europe. Countries with the most foreign direct investment do better economically. Why not go for foreign political investment as well? Dr. Daniel Daianu is the Chief Economic Advisor of the National Bank of Romania. The Magnitude of Change ----------------------- What is unique about post-communist transformation in Europe is that it implies several simultaneously evolving processes: large-scale institutional change, economic (industrial) restructuring, structural adjustment and macro-stabilization. When comparisons are made with other countries one should not underestimate the lack of institutional ingredients of a market environment (in post-communist societies) and the enormous inherited distortions in the allocation of resources. Not infrequently, people - both in the west and the east - do not realize the magnitude of this transformation. This is, perhaps, the main reason for the emergence and persistence of too many false expectations among people, at large, and policy-makers, regarding the feasible speed of real change. These expectations lie behind the development of social tensions and the genesis of wrong macro-policy decisions. The most telling indicator of the magnitude of post-communist transformation is the extent of required reallocation of resources as compared to the ability of the system to undergo wide range and quick change. In eastern Europe (and in Russia even more), the structure of the economy and the size of resource misallocation have put the system under exceptional strain once the combination of internal and external shocks occurred. What are major implications of the existence of such strain? One is that these economies can very easily become unstable and that their capacity to absorb shocks is pretty low. Policy-makers face extremely painful trade-offs and that, in most of the cases, unless sufficient external support is available, the room for manoeuvre is dangerously small. Policy-makers have to sail between the Scylla of high inflation and the Charybdis of high (huge) unemployment. Resource reallocation and industrial restructuring involve privatization. Moreover, foreign direct investment (FDI) - which can speed up considerably privatization - is essential for fostering restructuring. If one considers the economic slump in the region, as well as the anaemia of domestic savings and investments, the significance of FDI becomes obvious. The International Environment: Restructuring (Privatization) and National Security -------------------------------------------- Industrial restructuring - via privatization - with its focus on meeting consumer demands, implies a reallocation of resources from military toward civilian use as well. The zeitgeist of the post-Cold War world would make such a process more than natural - the so-called " peace dividend " would be at work. This is the rationale which led to the conclusion of the Paris Treaty concerning the reduction of arsenals. However, one can easily detect worrying trends on the European continent and in the world at large, which increase instability in the emerging democracies and raise serious questions as to how to define national security. Military conflicts (the war in Bosnia-Hertzegovina, and ongoing (latent ), or looming conflicts in other parts of Europe), inter-ethnic tensions, borders which are questioned explicitly, or implicitly, the lack of "perceived", or real adequate security guarantees, rising nationalism and protectionism - all these portray a dynamic reality which is still very confusing to policy-makers. From a certain perspective, ironically, the post-Cold War world looks less stable. To the above mentioned trends one can add the widespread global economic recession, the rise of Islamic fundamentalism and right-wing extremism. There are three concentric circles of transition in the world: one that comprises the former communist states; a larger one that regards the whole of Europe; and a third one that refers to processes in the world beyond. Under such circumstances, one could argue that states (including the East European states, which still feel they are in a security vacuum) develop a propensity to get more cautious in downsizing and privatizing their defence apparatus, lest they harm their defence capabilities. There are several additional factors which, in my view, increase this propensity: the existence of highly saleable military goods as against the range of tradeables in the economy, an intensifying western trade protectionism combined with the foreign exchange constraint syndrome afflicting the transforming economies, and a very brisk and tempting world trade in weaponry which is stimulated by world instability. On the other hand, the economic slump engulfing the post-communist economies can force a substantial - be it temporary - ad hoc curtailment of activity in the defence industry. In the case of Romania, for example, the capacity utilization of many facilities in the defence industry was below 20% in 1993. There is no doubt that defence industry is a special area, and that irrespective of the size of the private sector (or, of the intensity of privatization), governments have a special relationship with this industry. Basically, national governments strive to make sure that national security needs are safely protected, which means that they need to be able to exert control on domestic military production. The Case of Romania ------------------- The military doctrine of Romania emphasizes self-reliance and the modernization of national defence capabilities, within the context of developing closer links with NATO. Currently, almost 70% of defence equipment needs of the country are covered by domestic industry. The production of most defence-related factories has a dual character (military and civilian). Following the passing of Law 15 in 1990 regarding the corporatization of state enterprises, the defence-related units were turned into three "regies autonomes ", one holding company (for aircraft manufacturing), and 40 commercial companies. Approximately, 100,000 people work in these companies. The defence industry has not been unaffected by the brutal decline of economic activity and the requirements of fiscal austerity. In 1993, the defence budget represented almost 10% of the state budget; of the defence budget, less than 24% was made up of capital expenditure. This meant that many development and modernization projects were put on hold. Nonetheless, modernization remains a major focus of the defence strategy. The latter has two main purposes: to make the national defence arsenal compatible with NATO structures; and to compensate the deliberate (as envisaged by the provisions of the Paris Treaty) and the forced (due to the decline of overall economic activity) down-sizing of certain military activities. As far as the defence industry is concerned, privatization is not a major issue for the time being, and, very likely, it will not be for the foreseeable future. Even if privatization were much more intense than it is now, the situation of the defence industry would not change significantly in this respect. At the same time, it should be stressed that improving the management of enterprises in the defence industry should get a very high profile. The role of foreign direct investment should be judged from a similar perspective. Bucharest is very keen on military cooperation managed at governmental level, and on entering cooperation deals in production with foreign companies in certain key defence sectors where modernization is critical. The best known example of such cooperation is between the Romanian company, Aerostar of Bacau, and the Israelian firm, ELBIT. This cooperation in production involves upgrading the fighter MIG-21, with the foreign partner providing highly sophisticated avionics. At a closer look, this cooperation has the allure of an actual joint venture; the inference would be that the FDI element exists in this case. Other deals in the making include microwave telecommunications and frequency-hopping radio stations. Foreign Direct Investment ------------------------- There are two main channels through which resources for productive use can flow into the emerging democracies. One is the private channel. Its utilisation depends, essentially, on the degree of fuzziness, volatility and uncertainty of the area in the eyes of private investors. The countries which evince better economic performances show, also, a relatively substantial inflow of direct investment. The second channel is public; it refers to the strategic and political involvement of the West, as a stakeholder, in the future of the post-communist societies. In a broad political, social, economic and cultural sense, integration into Europe (into pan-European political, economic and defence structures) is an ultimate goal for the post-communist countries. In an operational sense, the public channel regards concrete steps - undertaken by western governments - that can enhance reforms, the stability and security of the emerging democracies. In this respect, there is much discrepancy between rhetoric and reality. The need to "strategize" together! The policy towards eastern Europe has most of the time been reactive. The fact is that the western countries perceive the eastern countries as a highly unstable and contaminating zone. This policy has been shaped more by the desire to contain undesirable events, or by an attempt to set up a sort of a buffer area (with a hard core represented by the Visegrad Group), than by an understanding that western involvement needs to be active and visionary relying on a genuine philosophy of integration. The Copenhagen statement of June, 1993, signalled a major conceptual breakthrough in this respect. However, actual support is still much below what is needed in order to keep alive the momentum of reforms in the East and secure the stability of the continent. For example, there are plans entertained in Brussels (as EU initiative) of undertaking major public work projects in order to deal with the rising unemployment in the west. At the same time, the similar and more perturbing phenomenon of unemployment can derail reforms in the east. If one considers also the very low investment ratios and the badly needed improvement in infrastructure in the post-communist countries, a logical question comes up: why is there no common strategy to deal with this issue? For, if the vision of a future, stable and prosperous Europe - this would include post-communist states - exists, why should not projected trans-European networks (road, rail, energy and telecommunications) cover the area of an expanded European Union? Such infrastructure investments would help homogenize the European space, they would mitigate the costs of transformation, they would forge organic links between the West and the East - and, ultimately, they would help the restructuring and conversion of military facilities to civilian use. The West should "strategize" (which means more than consult) with the East! References - Polanyi, K., (1944), " The Great Transformation ", New York, Farrar and Reinhart; - Sachs, J., (1994), " Russia'struggle with stabilization. Conceptual issues and evidence ", paper presented at the World Bank annual Conference on Development Economics, 28-29 April. -------------------------------------------------------- Copyright 1994 NATO All rights reserved. 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The articles contained in this volume represent the views of the authors and do not necessarily reflect the official opinion or policy of member governments or NATO.