AVASCENT WHITE PAPER
By Dr. Dominik Kimla
Ahead of the 26th Annual MSPO taking place in Kielce this week, Dominik Kimla analyses Central and Eastern Europe as one of the fastest growing defence markets in the world presenting sizable market opportunities for Western defence suppliers. However, challenges remain in the region and to be successful on the market, defence suppliers must be prepared to swiftly react to CEE’s constantly changing dynamics and proactively engage and integrate the local industrial base into their supply chains.
Romania as the CEE Defence Modernisation Rising Star is Troubled by Political Turmoil
The 26th International Defence Industry Exhibition ‘MSPO’ will take place in Kielce from the 4th to 7th of September. This year’s trade fair is highly anticipated due to Poland’s celebration of the centenary of regaining independence. The MSPO is the biggest defence-orientated event in Central and Eastern Europe (CEE). It is also a perfect opportunity to take a closer look at the situation in the subregion from a military point of view, specifically that the increase in military spending for CEE states is the largest in NATO and the region presents a number of defence modernisation opportunities across all military domains. For this analysis, the CEE region covers nine countries: the Baltic States (Estonia, Latvia and Lithuania) Bulgaria, the Czech Republic, Hungary, Poland, Romania and Slovakia. All the aforementioned countries are members of NATO and operate predominantly ex-Soviet, rapidly obsolescing military hardware. Although the CEE countries joined NATO a dozen years ago, their defence modernisation efforts have been relatively limited. The situation has changed since Russia’s invasion of Eastern Ukraine and annexation of Crimea in 2014. Moscow’s destabilising activities in Ukraine and continued military build-up, combined with the reinforcement of Russian Anti Access/Area Denial (A2/AD) capabilities in the Kaliningrad enclave and in the Black Sea were a wake-up call for defence decision makers in the CEE. The Russian threat has caused an increase in defence spending and is one of the main drivers of defence modernisation programmes in the region.
Rapid Defence Spending Growth
Under Russia’s military threat, the increase in military spending for CEE states is the largest in all of NATO. The Baltic States, Poland and Romania have already reached spending 2% of gross domestic product (GDP) on defence, and some of them, notably Estonia and Poland, will increase their defence spending even further beyond the 2% mandatory GDP level. However, a few CEE countries including the Czech Republic and Hungary will struggle heavily to reach the 2% threshold in the foreseeable future. Nevertheless, cumulative Central and Eastern European defence spending is expected to reach $165.15 billion by 2023, with a compound annual growth rate (CAGR) of 6.1% during the forecasted period. The CEE defence expenditure will swiftly increase from $23.29 billion in 2018 to $31.37 billion in 2023.
However, rapidly growing defence spending may not directly translate into immediate new procurement opportunities. Despite urgent modernisation needs in all military branches of the CEE armed forces, defence spending will also finance the increase in number of active military personnel in Poland and the Czech Republic, cover additional financial benefits to improve terms of service for military and civilian personnel, renewal of largely neglected military infrastructure across the whole region and, lastly, financially digest already procured military hardware. The biggest cumulative defence spending, driven by the implementation of technical modernisation programmes, will be generated by Poland, Romania and the Czech Republic with $73.31 billion $28.59 billion and $19.16 billion respectively, whereas Estonia and Latvia will allocate cumulatively $3.95 billion and $4.28 billion.
Romania – the Rising Defence Modernisation Star
Surprisingly, Romania, not Poland, appears to be the most appealing market in the region for contractors looking to support modernisation. Poland is the biggest defence market in the region, but despite allocating significant resources it does not fulfil its maximum potential as a regional leader of military modernisation. There are several reasons for this, such as a lack of consensus between the main political parties and even within individual parties over the long-term modernisation priorities and structure of the armed forces. Additionally, the constantly changing modernisation agenda, the overcomplicated and inefficient defence procurement system, limited knowledge of decision-makers about defence matters and a careless approach to defence spending do not help to implement a consistent and long-term defence policy. Consequently, Poland is punching below its weight in terms of implementation of the defence modernisation agenda.
In contrast, Romania has signed contracts for Patriot mid-range air and missile defence system, HIMARS rocket artillery programme and Piranha V armoured vehicles. It is also expected that the country will finalise contracts for attack helicopters and four corvettes just this year. All of this activity highlights how Romania is growing as a leader of defence modernisation in Central and Eastern Europe. Although looking back, Romania was far behind Poland when the country announced its technical modernisation programme for 2013-2022 (TMP) in December 2012. Romania’s fast contracting approach is fully justified by an obsolete armed forces inventory and changing security environment, but this may cause challenges in the implementation and funding phase of already signed contracts. Limited administrative capacity and management skills may cause delays and create obstacles for future procurements.
Beyond this, political volatility is the single biggest threat for the smooth implementation of defence modernisation programs both in Romania and in Poland. Recent massive anti-corruption demonstrations in Romania may cause further political turmoil, which in turn may lead to the restructure or even a change of the government. A potential new government may less intensively procure weapons systems, focusing more on social aspects of Romanians’ day-to-day life. As to Poland, Poles will have to go to ballot-boxes four times within the next two years, to choose their local, national, European representatives and President of Poland. Any change at the national level as a result of the elections marathon will translate into another review of defence modernisation priorities and even further stretch out the already long-delayed process.
Short-term Market Opportunities
In terms of expected near-term market opportunities, the region presents relatively balanced opportunities across all military domains. After signing contracts for mid-range air and missile defence systems by Romania and Poland in 2017 and early 2018 respectively, both fixed-wing and rotary-wing platforms are on top of the defence procurement lists
in the region. After Slovakia’s recent decision to select F-16 Block 70/72 combat aircraft for its air force, Bulgaria is the last country in the region with an outstanding combat aircraft requirement. The country is going to make its choice regarding the selection of modern combat aircraft either by the end of 2018 or at the beginning of 2019, but a limited budget may narrow the competition to the second-hand platforms. Poland and the Czech Republic want to buy attack/reconnaissance helicopters, but both competitions may be delayed due to the aforementioned revision of procurement priorities in Poland and a corruption investigation in the Czech Republic. In terms of land platforms, competition for a tracked infantry fighting vehicle (IFV) in the Czech Rep. and for 4×4 armoured vehicle in Slovakia are ongoing and the final decisions should be announced soon. On the other hand, due to the ambiguous future of the Polish Navy’s modernisation programme, the Romanian Navy’s intention to procure 4 corvettes may present the biggest market opportunities for the naval sector in the region.
In this context, although the Baltic countries have at their disposal considerably smaller procurements funds and represent much smaller markets they still have some significant opportunities, specifically for suppliers of land vehicles, helicopters and even advanced mid-range air defence systems. Latvia is finalising the procurement of 4×4 tactical vehicles, whereas Lithuania is considering the procurement of armed helicopters, and Estonia, either unilaterally or more probably jointly with other Baltic states, will procure two mid-range air defence system batteries. The three countries are building their military capabilities wisely, linking the procurement of modern military hardware with the acquisition of selected, second-hand weapon systems.
Between Offset Requirements and the America First Approach
From the industrial point of view, it is worth noting that most countries in the region are procuring weapon systems off-the-shelf with marginal offset and industrial participation requirements. A different approach was taken by the two biggest countries in the region. Although Romania also procured off-the-shelf Patriot and HIMRAS systems, it has focused its offset requirements on rotorcraft, land-based and naval platforms, due to local industrial capabilities in the mentioned segments. Consequently, 191 out of 227 PIRANHA V armoured fighting vehicles will be produced in the country at the Bucharest Mechanical Factory. A similar industrial approach will be implemented in the expected procurement of at least three hundred Agilis 8×8 armoured personnel carriers. Furthermore, Romania’s Ministry of National Defence (MND) expects that future attack and utility helicopters, whose contracts are under negotiation, will at least be assembled locally. Local production is also a precondition in an ongoing competition for the acquisition of four corvettes, which will have to be built in local shipyards.
In contrast to Romania, Poland took a more ambitious industry strategy aiming to use defence expenditure to completely transform its defence industry and build new capabilities with an aspiration to join the top tier of defence suppliers. Initially, the Ministry of National Defence, which controls the state-owned defence companies (primarily the Polish Armaments Group (PGZ)), wanted to locally produce as much as possible; the original goal was not less than 50% of procured weapon systems. However, after receiving a preliminary bill for the first phase of the ‘Wisla’ mid-range air defence programme the MND substantially narrowed down the offset requirements at the expense of the local defence sector. Furthermore, the bill for the first phase of ‘Wisla’, although reduced,is so significant in the MND’s budget that no other major defence contract, with an exception for the ‘Homar’ rocket artillery programme, will be signed by Poland without at least initial knowledge about all costs related to the implementation of the second phase of the ‘Wisla’ programme. Therefore, it is expected that the MND will again review its expectation regarding the local production and industrial participation in exchange for lower procurement costs and quicker timeline delivery. Such a change may negatively impact the further development of PGZ, which had revenue of about $1.32 billion in 2017 but posted a cumulative loss of $30 million.
Regarding the weapon suppliers base, both Poland and Romania are implementing in practice the ‘America first’ slogan and procuring military hardware mainly from their key ally, whereas other CEE countries such as Estonia, Hungary or Lithuania present a more balanced approach in terms of their suppliers’ base. The Polish and Romanian US-centrism causes murmurs of dissatisfaction in some European countries, which are also top producers of weapon systems. Such an approach may contribute to the marginalisation of the Polish and Romanian defence sectors in the European Union within a long-term perspective. Consequently, the voice from both countries’ defence industrial base may not be heard in Brussels. This is a sinister scenario specifically in light of the inauguration of the European Defence Fund (EDF) and a number of European next-generation weapon system programmes, which will form the future defence industry base on the continent.
Clearly, Central and Eastern Europe is one of the fastest growing defence markets in the world, with countries increasing defence spending to get in line with NATO’s 2% goal and the commitment of local decision-makers to procure new military hardware. However, the implementation of the defence modernisation agenda is a challenging issue because end-users have to navigate between balanced programme costs, delivery timelines, offset/industrial participation requirements, limited administrative capacity and overcomplicated procurement regulations.
From the European point of view, the EDF and other industry initiatives have game-changer potential and, if their implementation goes smoothly, will boost joint development and procurement programmes across the continent, permanently changing the defence industry landscape in Europe. However, it seems that CEE countries, focused on the acquisition of critically needed capabilities, are not fully prepared to take a seat in this venture.
Despite all the challenges, the CEE region presents sizable market opportunities for Western defence suppliers. In addition, the acquisition of advanced weapon systems by the region allows addressing both the threat issues and growing modernisation needs to replace rapidly obsolescing ex-Soviet era military hardware. To be successful on the market, the defence suppliers have to be prepared to swiftly react to CEE’s constantly changing dynamics and proactively engage and integrate the local industrial base into their supply chains.
 Cost of the first phase of ‘Wisla’ is estimated at $4.75 billion, although the Defence and Security Cooperation Agency’s notification estimated it at $10.5 billion.
 Milosz M., 2018. PGZ miala ponad 100 mln straty. Teraz wazy sie jej los. Gazeta Prawna, 14th of August.
ABOUT THE AUTHOR
Dr. Dominik Kimla is a Warsaw-based consulting associate at Avascent, supporting the firm’s operations in Poland and broader Europe. He specialises in Central and Eastern European defence markets, military offsets, and customer and competitor analyses. For more information, contact: firstname.lastname@example.org.
The author would like to thank Benjamin Goodlad, Matt Vallone and Brianna Nord for their time and contribution to this analysis.
Avascent is the leading strategy and management consulting firm serving clients operating in government-driven markets. Working with corporate leaders and financial investors, Avascent delivers sophisticated, fact-based solutions in the areas of strategic growth, value capture, and mergers and acquisition support. With deep sector expertise, analytically rigorous consulting methodologies, and a uniquely flexible service model, Avascent provides clients with the insights and advice they need to succeed in dynamic customer environments.