By Avascent Analytics team
A quick look at the biggest stories of the week
Pakistan • Qatar • Philippines • NATO
Avascent Analytics introduced a segment to the Weekly Wire called “Beyond the Headlines.” Each week, we will provide an in-depth look on various defense topics, ranging from country-specific defense news to emerging technologies impacting defense.
Inspector General Report Puts Spare Parts Market in the Spotlight
Hamilton Cook, Research Associate
A recent report by the Department of Defense Inspector General (IG) has placed a spotlight on the potential for “extreme profit margins” in the defense industry after the IG discovered that parts contractor TransDigm had reaped profits up to 4,451% on a variety of mechanical replacement parts used by US military platforms. TransDigm did so by purchasing or licensing the intellectual property for highly bespoke parts from other companies, significantly increasing the price, and then serving as a “one-stop shop” for spare parts acquisition. This was aided by the fact that the company refused to disclose cost data to acquisition officials. However, once whistleblowers leaked such data, it was unsurprising that Congress took notice as even the most pro-industry members would balk at paying $11,988 for a $799 actuator cover or a $6,986 for a coupling half for the F-5 that takes $173 to make.
While such oversight concerns are longstanding considerations for prime contractors, particularly in the wake of sequestration and the peak of lowest cost, this latest round of oversight poses significantly more danger for subcontractors in the DoD supply chain. While prime contractors receive considerable oversight to meet price targets, subcontractors can reap more substantial margins for providing their specialized components via a prime contractor middleman. In these situations, topline price pressure by the prime contractor is expected to control these inflated costs. However, once the platform enters the sustainment phase of its lifecycle and its parts market develops, the subcontractor is removed from these various channels of oversight and can price “at market rate.”
While competitive dynamics, technical requirements, and visibility tend to limit these behaviors in high-end subcomponent markets such as airborne radios (where the government is able to meet its UHF/VHF radio needs by sourcing either the ARC-210 or ARC-231), the mechanical parts market requirement for highly bespoke solutions during platform development means that a subcontractor can lock-in a monopolistic position during platform development and then reap significant profits where it can set market price by default. Or a contractor can seize a position on an aircraft whose production ended decades ago and claim a monopoly simply because they have the only remaining set of engineering drawings.
As a result, Congress will likely be looking into ways to assert oversight over the pricing behaviors of subcontractors, particularly in the spare parts market. However, a potential change in acquisition law would face significant opposition from major subcontractors and industry associations, particularly in the wake of the most recent round of mergers.
On May 12, Pakistan and the International Monetary Fund (IMF) reached an unofficial agreement on a three-year, $6 billion loan. The deal, if formally approved by the Fund’s executive board, would represent the country’s 13th IMF bailout in thirty years. Since taking office last summer, Prime Minister Imran Khan sought to address Pakistan’s economic challenges by reaching out to allies.
Loans from China and Saudi Arabia and a preemptive effort to devalue the rupee weren’t enough to overcome Islamabad’s declining foreign exchange reserves—which fall below the recommended ability to cover three months’ worth of imports—growing current account deficit, and an increasing debt burden that now exceeds 86 percent of GDP.
The IMF deal will impact Pakistan’s defense market in three ways. First, the terms of the agreement will likely result in a short-term reduction in defense investment. Fiscal consolidation requirements included in the deal will put pressure on the government to cut spending, including defense. The last two times that the country received an IMF package—2008 and 2013—Pakistan’s military budget fell by 3.6% and 0.1% respectively the following year. Second, the further devaluation of the rupee will make dollar-based imports more expensive, accelerating trends in Pakistan’s defense market that favor Chinese and non-Western suppliers. The deal, which requires the country to accept a market-determined exchange rate, will likely lead to a weaker rupee. A weaker currency will raise the cost of importing defense equipment in US dollars, making non-dollar alternatives from China and Russia more attractive. Finally, Pakistan may be required to increase transparency with respect to its defense budget. Insight into the country’s defense budgeting process and planning could help Western firms shape future opportunities.
On May 9, the US Department of State approved a potential sale of AH-64E Apache rotorcraft to Qatar. While the exact details of the sale may change later due to acts of Congress and contract negotiations, the current terms of the sale include 24 AH-64E rotorcraft, as well as 2,500 AGM-114R Hellfire missiles and several other support systems and munitions. The total estimated value of the sale is $3 billion. The new rotorcraft would supplement Qatar’s existing fleet of 24 AH-64Es, bringing the total fleet to 48. Qatar uses their AH-64s to perform close-air support, armed reconnaissance, and anti-tank missions, so these will most likely help to deter any potential aggression against Qatar from other hostile regimes in the region. They will also help to protect oil and gas infrastructure.
The Armed Forces of the Philippines embarked on a broad modernization program in 2012 that aimed to bring new equipment into the force over three five-year periods. A series of acquisitions made in the first period that lasted from 2013-17, also called the First Horizon, is beginning to bear fruit with a string of significant deliveries and milestones this May.
- On May 7, two AW159 anti-submarine warfare helicopters arrived in the Philippines. They are expected to be inducted into service later this month. These aircraft will be deployed on the Philippine Navy’s new Rizal-class frigates being built by Hyundai Heavy Industries.
- On May 9, the initial batch of four KAAV-7 amphibious assault vehicles arrived in country. The KAAV-7 is a Korean-built version of the American AAV-7. The Philippines ordered eight vehicles in 2016 for the Marine Corps.
- On May 13, the Philippine Army received the first batch of upgraded M113A2 armored personnel carriers (APC). The APCs were upgraded by Elbit by installing new remote-controlled weapon stations on 41 APCs and converting another five to mortar carriers. The upgraded APCs will also have networking equipment installed so that they can be integrated into the Army’s C4ISTAR system.
- The Philippine Navy’s future BRP Jose Rizal, first of two Rizal-class frigates being built by Hyundai Heavy Industries, is expected to be launched later this month. This represents the Philippines’ first modern surface combatant outside of small fast attack craft. The Philippine Navy has long relied older surface combatants, none of which were missile equipped.
NATO has been busy reassuring its allied members that it remains committed to them and is grateful for their contributions. On May 6, NATO Secretary General Jens Stoltenberg stood in solidarity with Turkish officials, relaying to the media that “Turkey is an important and highly valued NATO ally,” and that the alliance will “stand with Turkey as it faces serious security challenges.” The security challenges Secretary General Stoltenberg is referring to are the ongoing turmoil emanating from Syria and Iraq. However, the Secretary General’s comments come at a time when the US is threatening to pull its sale of the F-35 to Turkey, which is a partner nation in the F-35 program, if they move forward with the purchase of the Russian-made S-400 air-and-missile defense system. The acquisition of the S-400 has soured the relationship between Turkey and its NATO allies over recent months, with the US and other NATO allies voicing their concern over Russian-made military equipment being integrated into the NATO military architecture. As the relationship between the US and Turkey continues to deteriorate, Russia is now seizing on the opportunity to offer its Su-57 fighter aircraft as an option if the US decides to ban the sale of the F-35, further pushing Turkey into a closer relationship with Russia.
Following the meeting with Turkish officials, Secretary General Stoltenberg met with UK Prime Minister Theresa May on May 14 to discuss a future meeting with NATO leaders slated for the end of the year and ongoing security threats the alliance faces. Secretary General Stoltenberg during an interview acknowledged the UK’s “essential contributions to our shared security.” As the UK struggles with Brexit and its potential side effects, including how it will affect current and future defense cooperation, Secretary General Stoltenberg highlighted the contributions the UK has made towards the alliance including allocating 2 percent of its GDP towards defense and its role in NATO missions in the Baltic region, Iraq, Afghanistan, and Kosovo. But the decision for the UK to eventually leave the European Union has caused tension with its neighbors which could spill over into NATO, with some expressing concern that this could further weaken the alliance.
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