World Naval Developments: Asian Financial Crisis Affects Defense Modernization

By Norman Friedman

The Middle East, in the past the greatest customer for European arms, is quieter than it has been in decades, with Iran probably the main exception. Moreover, with the fall in oil prices, Middle Eastern countries lack the discretionary income that in the past has fueled arms purchases. The United Arab Emirates, for example, have decided to cancel their much-touted new frigate program, settling for the moment on two ex-Royal Netherlands Navy Kortenaer -class frigates.

The other major potential market is in Latin America. There, too, however, in the absence of a major immediate threat, and also in the absence of money, little is being bought. It seems likely that the U.S.-imposed restrictions of the past will be relaxed (owing in large part to potential Russian competition), but it is not clear that very large orders are to be expected.

The likely slump in East Asian defense orders coincides with a major slump in orders for commercial airliners. That matters, because with defense consolidation, most of the big defense companies also are involved deeply in the civilian aircraft market. They reasonably guessed that involvement in both businesses would tend to provide a hedge against disaster in either. In the special case of East Asia, however, the problem is not government policies favoring trade over defense, but rather a crash in government income. With this crash comes a likely major reduction in the number of profitable business travelers—hence, disaster for the airlines servicing the area. East Asian orders played an important role in pulling the airliner business as a whole out of its recent long-term slump. Big defense companies are major national assets. Even though there may be no immediate threat on the horizon, no government is willing to bet against future problems. Western governments, then, probably will try to cushion their major producers against what is surely a short-term problem. As an example, the U.S. government is helping Malaysia restructure payments for F/A-18s.

Clearly, situations vary. The original Asian "tigers"—South Korea, Taiwan, Singapore, and Hong Kong—all based their prosperity on talented workforces, solid industrial development, and large exports. In effect, they copied the Japanese philosophy: as long as the population was frugal, its savings could be used to boost the export-led economy. To the extent that these countries (and Japan) have encountered trouble, it appears to have come from an absence of the sort of hard-headed business sense that made for prosperity. Korean and Japanese banks, for example, loaned too much to weak companies—out of cronyism—and ignored bad loans for far too long. Korea ran into crisis partly because its big industrial combines, which had access to money from captive banks, all tried to expand into many of the same businesses. That was not sustainable. Banks also tried a variety of questionable practices—in effect, speculating on currency. When the Korean economy weakened, all of its problems worsened dramatically. None, however, could take away the educated and very capable Korean workforce, or the massive industrial base built up over the past few decades.

The situation in Malaysia, Indonesia, and Thailand is quite different. All are trying to industrialize. All attracted Western (and Japanese) money essentially on the theory that, because they were Asian, they could duplicate the performance of the original tigers. The Malaysian government, for example, claimed that it could build up a computer software industry similar to that of Singapore, even though Malaysia lacked the necessary trained manpower, and had absolutely no overall plan.

These three countries were the victims of bubbles, a common financial disease. As many unfortunate investors have learned, the ultimate stage of a bubble is the burst—in which value reverts to (or falls below) a realistic figure. Corruption often is cited as a cause of this disaster, but it probably is fairer to say that the frenzy to invest attracted the problem.

In each case, the local currency crashed. Often, such crashes help by making local products cheaper in foreign currencies. In East Asia, however, many loans were made in terms of dollars rather than local currency, which made the loans much more difficult to service. Much more money had to be sucked out of the local economy to do so, leaving that much less to pay people and to buy vital services. Defense budgets worked out in local currencies suddenly bought many fewer dollars, and thus many fewer foreign-made weapons.

Real defense needs remain. Each country has important natural resources, such as fisheries, which it wants to protect against foreign predators. Each needs OPVs and maritime patrol aircraft. Some form of barter might be more attractive than further disappointing cash transactions. The most likely beneficiary would be the Russian defense industry. On the other hand, the Russians, too, need cash. Indonesia had to cancel a large order, rather than shift terms to barter.

In the Asian case there is an additional twist. The long-running Japanese recession was touched off when two bubbles burst: real estate and the stock market. Banks that depended heavily on bubble earnings turned to an alternative: Asian development, which has become the third bubble to burst in Japan.

The current attempt to bail out the East Asian economies is an attempt to fend off much worse consequences. No matter what is done, however, the formerly prosperous countries of East Asia are suffering serious unemployment and are unlikely to blame themselves and their governments. In the Japan of the 1930s, economic disaster seemed to justify militarism and aggression. In Korea today, the United States is being blamed for the disaster; Japan also is likely to be seen as a villain. Enmity between the two countries dates back to well before World War II, when Korea was a Japanese colony.

As for military procurement, the picture is complex. To some extent defense programs are public works, and so may be attractive as a way of staving off economic pain. The United States, for example, built the two original Yorktown (CV-2) class carriers as part of a Depression-era economic recovery program. Clearly warship hulls fit this category, at least in a country like Korea, which has a large shipbuilding industry. That suggests that the KDX destroyer program is likely to survive the disaster, but what goes in those hulls may be a different proposition. As long as it is license-built in Korea, it qualifies as disaster alleviation; if it has to be imported, then that is attractive only if the seller is willing to accept an offset.

Malaysia, with the other major ship program in the affected area, is in a different category. The government hoped that whoever won the OPV contest would transfer modern shipbuilding technology That investment has not yet been made, so Malaysia is in no position to spend internally on new ships. It remains to be seen whether the winner, Blohm & Voss, decides that investing in Malaysia is worthwhile, because it can build more cheaply in a new yard there.

Taiwan is still prosperous, and it still needs defense goods badly. The slump, then, ought to provide Taiwan with considerable leverage as it buys weapons on the world market.

Mention of Taiwan raises the issue of the People's Republic of China. Most reports credit that country with an enormous and rapidly growing economy, so vast that it will inevitably become a superpower sometime in the next century. The tacit assumption is that China will be able to convert all that economic power into military power, deploying next-generation weapons far more easily than an aging U.S. defense force.

Recent developments in China, however, raise some interesting questions. For some time, the Chinese government has said that it will move the big state industries onto a more business-like footing. It has acknowledged that they are heavily featherbedded, and that they lose vast amounts of money each year. In fact, the entire Chinese defense industry is the remnant of a Soviet-style economy; it has little incentive to make competitive products. For years, for example, Chinese spoke of an "iron rice bowl," a guarantee of state employment. In return for that guarantee, the state exacted obedience.

In the 1980s, the government decided that its Stalinist industrial base was falling behind the world and decided to build a parallel free-enterprise economy. This free-enterprise sector has been successful, not only in light industry but also in agriculture, historically the bugbear of communist regimes.

The world missed the rub. Once agriculture went onto a free enterprise basis, the government had to pay real money to peasants to feed the workers in state industry, which was not bringing in cash. Chinese exports are created by the free-enterprise sector, which the government finds very difficult to tax (the entrepreneurs do pay taxes, largely protection money to the Chinese Communist Party, but most of it does not go into government coffers). Ultimately, the government had to decide whether to reverse its economic policy and seize food (as the Soviets began to do in the late 1920s, with gruesome results) or to break the "iron rice bowl" and force its strategic industries to operate more competitively. It has chosen the latter, at least for now.

The choice has extremely important military implications. First, the military production companies are now far more desperate for cash, since without it they may be allowed to fail. That strongly suggests that any government agreements to limit exports, e.g., antiship missiles to Iran, are unlikely to stand for long. This leads to the second implication. In January, the Chinese government announced the millions of workers in state companies, including the national railways, are to be laid off. There is already a vast army of the unemployed roaming China looking for casual work. The decision to cut the workforce suggests a third implication. If the government cannot feed all its workers, how can it feed the whole People's Liberation Army? The army already is self-supporting, but surely the government would prefer to control it by controlling its purse.

At the least, if the state industries (such as shipbuilding) come under fiscal discipline, they may be unable to fulfill Chinese government orders unless the government can come up with sufficient cash. This is not an abstract projection. It is happening right now to Russian military industries, as Russia continues to shift from a Stalinist to a cash economy.

In the past, Chinese weaponry has been aggressively promoted at arms shows. However, it seems to have sold mainly to countries facing Western embargoes. In a few cases, such as Thailand, major arms sales were made because the local government wanted to show its friendship, and because prices were very low. What happens now, when sales are far more important than in the past? One possibility would be that depressed governments in East Asia, who still need weapons, would turn to low-priced Chinese imports. However, they need weapons mainly to face China itself. The Chinese government may not consider that a major barrier, particularly if it has no immediate intention to threaten the governments involved. In some cases, such as the Malaysian OPV program, this political issue would seem irrelevant.

 

Norman Friedman is a consultant on global naval strategy, naval trends, and naval warfare. An internationally known military technology analyst and naval historian, he worked for a decade as an advisor to Secretaries of the Navy, and for another 10 years with a leading U.S. think tank. Dr. Friedman travels the world speaking to military and defense industry leaders, and appears frequently appears on television as a guest commentator. He has authored more than 30 books, and has since the 1980s contributed regular columns analyzing world naval developments for Proceedings magazine. His PhD in Physics was earned at Columbia University.

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