DEFENSE DEPARTMENT

In Global Trends, Warnings for U.S. Industry

8/1/2014
By Sandra I. Erwin
American contractors rule the international defense market, propelled by the overwhelming dominance of the United States as a military power and arms developer.

Their lead is safe for now, but there are early signs of slippage. Economic forces that are playing out in the world could tip the scales over the next decade or two, analysts predict, as developing countries step up investments in defense industries while the United States and Western Europe cut back.

These trends portend both good and bad news for the Pentagon, according to new data by Deloitte Consulting LLP. More defense spending by friendly nations helps shoulder the burden of policing the world at a time when the United States faces steep budget cuts and a growing isolationist strain. By the same token, as other countries ramp up their militaries and defense industries, they will slowly catch up with U.S. technologies and eventually chip away at U.S. manufacturers’ massive lead in arms exports.

Of $85 billion in global arms deals in 2011, U.S. firms captured an astonishing $66 billion. Russia came in distant second with $4.8 billion.

Countries like Russia, China and India are positioning themselves to challenge U.S. industrial supremacy over the next 20 to 30 years, says Jack Midgley, a Deloitte consultant. More nations see defense spending as an economic development engine as well as a security policy, he says. “We can expect that to continue.”

At 4.2 percent of U.S. gross domestic product, military spending is a key component of the economy. But projected cuts to discretionary federal budgets will continue to squeeze defense. The Congressional Budget Office estimates that by 2023, discretionary spending will reach its lowest percentage of GDP in decades.

The U.S. share of the world’s $1.7 trillion in defense spending has dropped from 40 percent in 2012 to 35 percent in 2013. China, Russia and Saudi Arabia have posted the largest increases.

If one looked at these trends through a political lens, they could be seen as evidence of U.S. weakness, says Midgley. “But another way to see it is that the rest of the world is converging on U.S. levels of defense capability.”

Technological convergence, he adds, “does not necessarily mean hostility.” From a macroeconomic standpoint, higher defense spending does not indicate bad intent, he says. “It shows that low-debt countries are moving to the technology frontier in defense.”

In the developing world, a combination of above average growth and below average debt is prompting governments to invest in indigenous industries that will compete with U.S. manufacturers, says Midgley. “That’s as much about economic development as it is about military capability.”

The concerns for U.S. companies are twofold. One is simply that they will be facing tougher competition in the export markets as they become more dependent on international sales for growth. The other is the changing makeup of the defense market. The demand for the products that the United States does best — big-ticket weapon systems — will fall at the expense of less complex, lower cost weaponry. Only a handful of countries will be buying the F-35 joint strike fighter, but many more will buy propeller driven patrol aircraft equipped with commercial sensors, Midgley says. “Growth areas in export markets are lower tech. And we are less well positioned to compete there than emerging industries.”

Russia is making a big push in military aircraft manufacturing and exports. The helicopter business appears to be the model, a Deloitte study notes, as Russian made helicopters now operate in more than 100 countries.

The best defense technology in the world today is American, and both China and Russia are still decades behind. “The vulnerability that U.S. firms have is not at the high end but at the low end, where we tend to not pay as much attention,” says Midgley. “Lower tech systems are not as interesting to the Defense Department, but they are appealing to foreign ministries of defense.”

On China’s military buildup, it is too early to ring alarm bells. Its technology lags significantly behind the United States, he says. But if China continues to invest in its military weaponry, eventually it will catch up with the United States. “Some of that is inevitable,” Midgley says. “The pace and the direction of economic development in the world are going to continue to eat away at the U.S. edge in defense technology just as they have eaten away our edge in information technology, wireless services and other areas.”

The United States in 20 or 30 years will have to live in a world where the Chinese will have stealth, unmanned strike aircraft, smart weapons and “most of the things we have traditionally associated with U.S. technological edge,” he says. “Other countries will get them.”

The United States cannot escape the reality that developing countries are acquiring the same technologies that we have. “That’s not because we are getting slower but because they are getting faster,” Midgley says.

The upside for Western powers is that there might be an opportunity to establish new alliances with emerging countries that invest in high-tech weapons. “As Asian nations grow more prosperous, their economic power is being translated into hard military power,” says an Atlantic Council study. In 2013, Asia spent more on defense than Europe for the first time in centuries.

Former NATO commander and retired Navy Adm. James Stavridis suggests that it might be time for the United States to capitalize on the defense innovation that is taking place elsewhere. “Other nations like Israel are doing amazing things,” Stavridis says. “It’s very difficult for us to hook up the transmission belt to a non-U.S. entity.”

The future role of the United States on the world stage is uncertain, but not necessarily bleak. For the defense industry, the key will be to find a way to hold on to its market lead and defy the economic headwinds. The notion that the United States can continue to vastly outspend everyone else may be at odds with the nation’s economic capability and with the economic development that is taking place in the rest of the world.

Topics: Defense Contracting, Defense Department, Defense Watch, DOD Budget, International

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