China’s Defense Industry on the Path of Reform
Prepared for
The US-China Economic and Security Review Commission
October 2009
Executive Summary
Key Findings
• With some notable exceptions (missiles and space), the Chinese defense-industrial base through the 1980s and most of the 1990s uniformly suffered from chronic shortages of capital, technology, and production know-how;
• The purchases of Russian military technology in the early to mid 1990s, such as Su-27 FLANKERs, Kilo-class submarines, and Sovremenny-class destroyers, were meant to fill critical mission-related gaps in Chinese military modernization, and should therefore be seen as a scathing indictment of the failures of the PRC defense-industrial base to fulfill its long-standing promises to the People’s
Liberation Army (PLA);
• Since the reforms of 1998, the Chinese defense industries have undergone a dramatic and successful transformation, surpassing the expectations of even the most forward-leaning analyst;
• There is now significant variation across the various sectors (aviation, aerospace, ordnance, shipbuilding, defense electronics) of the Chinese defense-industrial base;
• The relative progress of an individual defense-industrial sector appears to be best explained by its relative integration into the globalized production and R&D chain, which provides access to the latest production and manufacturing technologies and know-how;
• While missiles and aerospace have always been a “pocket of excellence,” the greatest progress appears to have been made in the shipbuilding and defense electronics sectors, both of which have benefited greatly from China’s current position as a leading producer of commercial ships and information technologies;
• Those sectors that have lagged in relative terms (aviation and ordnance) have been hurt by a lack of similar spin-on benefits from partnerships between multinational corporations and domestic industry, though the defense-industrial reforms of 1998 and diffusion of innovation in the system have improved their performance;
• Integration with the global production and R&D chain has facilitated dramatic improvements in Chinese defense-industrial production and PLA modernization since the late 1990s;
• China’s emergence as the world’s IT workshop has played an important role in the PLA’s C4I revolution, particularly the elements of the C4I system that rely on COTS (commercial off-the-shelf). This C4I revolution has significantly improved the Chinese military’s operational and communications security.
CHAPTER ONE: Organizational Infrastructure and Relationships among Major Players at Government and Enterprise Levels
Summary
The structural changes and developments in each sector of China’s defense industry illustrate a broad process of consolidation and reform at both the government ministerial and defense enterprise levels. Through these changes, the leadership in Beijing aims to
build a modern military industrial base capable of competing in the world market for weapons sales and meeting the force requirements of the People’s Liberation Army (PLA) as it assumes a more forward military posture.
Specifically, the reforms and consolidation process represents a new model for success built on the principle of Yujun Yumin and the concept of injecting the “Four Mechanisms” into the military industrial base. At the government level, the most significant change is the creation of the new “super ministry,” with the Ministry of Industry and Informatization (MIIT) and the elevated position of the General Armaments Department (GAD). Developments at the level of enterprises and subsidiaries manifest these strategies in expanded autonomy and competition for the enterprises and their subsidiaries, and increased opportunities for commercial business in the global market.
The following chapter will assess each sector to gauge which ones are benefiting from these structural changes and to evaluate their relative strengths and weaknesses
CHAPTER TWO: Net Assessment of China’s Defense-Industrial Sectors
The Chinese defense industry has undergone a broad-based transformation since the late 1990s. Historically, China’s defense industry has been plagued by a lack of capital, technology, and incentives. Redundant personnel, lack of R&D experts, limited knowhow and communist management practices impeded innovation and attempts to manufacture “leap-frog” technologies. The moribund nature of China’s defense industry resulted in backward weapon systems and an overreliance on foreign technologies.
After reforms began in the late 1990s, China’s defense industry started to shed this historical legacy, resulting in substantial improvement. In fact, then head of the General Armaments Department Li Jinai stated in 2003 that “there has been a marked improvement in national defense scientific research and in building weapons and equipment. The past five years has been the best period of development in the country’s history.” Reforms included shedding thousands of jobs, increasing funding, and bifurcating each defense industrial ministry into two independent enterprises to foster competition. This was followed by a directive to commercialize and reform the business practices of the defense industry to make it competitive in a market economy. Defense industrial executives now had to respond to profit and loss statements and seek new ways to make their companies profitable outside of the defense sector. Moreover, as the civilian economy, especially the electronics sector, began to improve, the defense industry was able to exploit the “spin-on” benefits of civilian technologies. Indeed, the opening of the Chinese economy to foreign investment and technology provided new opportunities, legal and illegal, to transfer technology and know-how to Chinese weapon programs.
The result of these ongoing reforms is that analysts can no longer make blanket claims about China’s defense industry across the board but instead must evaluate each sector individually. Each sector has responded in different ways to these reforms and has faced different challenges. While China’s pockets of excellence continues in the space, missile, and nuclear fields, the relative success of other sectors appears to depend greatly on the extent to which the sector is integrated into the global R&D and production chain. Those sectors that are well-integrated, such as shipbuilding, have made enormous strides. Those sectors that are not well-integrated, such as ordnance and aviation, have lagged world standards. And at least one sector, defense electronics, appears to be a hybrid, exhibiting significant improvement in capability areas that can exploit China’s emergence as the world’s information technology workshop, such as COTS systems like switches and routers, but continuing to lag in other areas, such as radiation-hardened mil-spec electronics with no commercial analog.
The New Defense-Industrial Spectrum
Traditional “Pockets of Excellence”
Nuclear weapons and missiles, including the derivative capabilities in space launch, have long been so-called “pockets of excellence” in the Chinese system, enjoying a string of programmatic successes even during the chaos and irrationality of the Mao era.
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Globalized Defense-Industrial Sectors (“Leaders of the Pack”)
Shipbuilding
China’s shipbuilding industry is the exemplar of the globalized defense-industrial sectors, reflecting the progress possible when a sector is fully integrated into the global R&D and production chain and can take advantage of the full range of foreign technology and know-how.
Unglobalized Defense-Industrial Sectors (“Laggards”)
Aviation
Bifurcated Sectors (“The Hybrids”)
Defense Electronics and Information Technologies
The Chinese defense electronics and IT sector has always been a special case, reflecting both the successes of the shipbuilding sector and the problems plaguing other sectors. On the one hand, the sector has benefited greatly from China’s status as the world’s IT workshop, reaping the best of the state-of-the-art commercial technologies, such as switches and routers, to support the COTS elements of the PLA’s C4ISR modernization.
On the other hand, the lack of a commercial analogue for high-end military defense electronics, such as radiation-hardened electronics components with wide temperature ranges, has driven the Chinese to aggressively pursue illegal technology acquisition around the world.
...the Chinese military is in the midst of a C4I revolution, characterized by the wholesale shift to digital, secure communications via fiber optic cable, satellite, microwave, and encrypted high-frequency radio. The pace and depth of these advances cannot be explained by traditional Chinese defense-industrial dynamics, but instead spring from a paradigm shift known as the “digital triangle,” which resembles a classic techno-nationalist strategy, with high-level bureaucratic coordination and significant state funding. The three vertices of the “digital triangle” are (1) China’s booming commercial information technology companies, (2) the state R&D institute and funding infrastructure, and (3) the military.
CHAPTER THREE: Role of Western and U.S. Companies in Contributing to Improvements in the Capabilities of the PRC Defense Industry
Summary
The examples of partnerships and exchanges that can facilitate transfers of technology, know-how, and capital from Western and U.S. companies to China’s defense industry are meant to be representative rather than exhaustive lists. They indicate the complexity of the challenges U.S. policy makers face in regulating and monitoring U.S. commercial involvement with Chinese firms. Western and U.S. companies have tremendous incentives to invest and collaborate with their Chinese partners. This is particularly evident in aviation, where safety standards must be a priority. Capital incentives also exert a strong pull, as exhibited by the U.S. software companies that agreed to transfer technology in exchange for market position. But the structure of the Chinese defense industry makes it difficult to restrict transfers of technology, know-how, and capital to Chinese military entities without crippling U.S. business with commercial firms. Under the Yujun Yumin system, and the often gray line separating civilian and military entities, it is exceedingly difficult to distinguish between commercial partnerships that are benign and those that may contribute to strengthening PRC military capabilities.
CHAPTER FOUR: Access to International Capital Markets
Summary
After a slow start, Chinese defense-industrial companies are gaining more funding from international capital markets. An emerging trend reveals that more companies are offering H shares on the Hong Kong market, which are favorable to foreign investors. While most companies still have A shares on Chinese domestic markets, a 2002 regulation enables foreign investment in A shares through QFIIs.
In the aviation sector, AVIC is expanding its access to international capital markets and foreign investment relative to the other sectors. It is in the sectoral leader in H-share offerings (3) and total listed subsidiaries (22). This additional capital is primarily used to support development of the indigenous commercial jet project. China’s shipbuilding industry also is a major player in the international capital markets through mammoth holding companies and at least one subsidiary offering H shares.
CHAPTER FIVE: China’s Defense-Industrial Reforms As a Path to True Independence? Entering the “Critical Stage” of Defense-Industrial Reforms
The Chinese defense industry since the late 1970s has undergone a profound transformation, evolving from a relatively inefficient and backward set of legacy organizations from the Mao period to a relatively dynamic and capable network of R&D and production units increasingly integrated into the global economy. Looking to the future, however, China’s senior political, industrial, and military leaders have called the next 20 years the “critical stage” (关键阶段) in China’s modernization of its defenseindustrial base.
A key feature of this “critical stage” involves increasing the relative independence of defense industry. Though domestic innovation is playing a larger role in the industry’s successes, major policy documents and speeches by senior S&T and industry sector leaders make clear that China’s level of dependence on foreign technology and know-how is still too high. To achieve this independence and to progress to a higher level of production sophistication, Beijing is pursuing a multi-pronged reform and modernization strategy.
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• Significant contract awards to nontraditional suppliers, including non-state enterprises
• Divestures and acquisitions driven by decisions taken by enterprise management, not ministries
• Privatization of defense manufacturers
• Substitution of domestic production for imports
...analysis of procurement patterns suggests that the competitive bid process has become the norm. This revolutionary change will likely be aided by the March 1998 subordination of COSTIND under the Ministry of Industry and Informatization and the corresponding empowerment of the General Armaments Department, which is responsible for running the competitive bid process.
...In terms of significant contract awards to nontraditional suppliers, including non-state enterprises, the biannual China Defense Logistics Exhibition was notable for the number of non-state enterprises in attendance, strongly suggesting the proliferation of a network of new private sector enterprises supporting the defense establishment. Divestitures and acquisitions driven by decisions taken by enterprise management, not ministries are a major focus of SASAC’s reform efforts within the defense-industrial base, particularly as it prepares individual defense-industrial corporations for possible foreign market listings and international capital investment.
