Low Oil Prices Force Russian Defense Cuts

MOSCOW—Russian defense procurement will drop by about 10% this year as low oil and gas prices drain income from the state budget, according to the powerful head of the conglomerate that controls the key pieces of Russia's military- industrial complex.
Sergei Chemezov, chief executive of the Russian state industrial holding Rostec—the maker of weapons including Kalashnikov assault rifles and Pantsir antiaircraft systems—said he expected the Russian defense sector to contend with a decrease in government orders.
"Oil and gas prices aren't as high as desired, and they're the main source of income for the budget," said Mr. Chemezov. "So, of course, it's completely understandable that there is a reduction in defense orders."
Added Mr. Chemezov: "It's not to the point of being critical for our industry."
The anticipated reduction underscores that military spending—a strategic priority for President Vladimir Putin—is no longer sacrosanct in an era of low commodity prices.
Russia is in the midst of its biggest military modernization since the Soviet era. In 2011, Mr. Putin launched a decadelong, 23-trillion-ruble ($321 billion) rearmament of Russian forces, with the goal of updating 70% of the country's military equipment. The geopolitical standoff with the West has endowed the task with new urgency.
But a steep drop in commodity prices has pushed Russia into recession and depleted oil-and-gas revenues that bankrolled a more than 1000% increase in the defense budget since 2000. Crude has now fallen to prices well below the $ 50-a-barrel estimate Russia originally used to calculate its 2016 budget. As a result, the government is pressing ahead with an array of cuts to avoid running afoul of strict deficit targets.
Initially, Russian officials said defense would be spared. Earlier this month, however, a Ministry of Defense official confirmed in a Russian radio interview that the overall 3.14- trillion-ruble defense budget would be slashed by 5%. Analysts estimate that defense procurement accounts for well over half that budget.
The cuts herald the end of an era of rapid growth in Russian defense expenditure, even as Mr. Putin engages in the most high-end display of Russian military might since the Soviet era in Syria. Russia hasn't reduced top-line military spending since 1998.
Still, Russia's defense sector has fared better amid the recession than consumer-dependent parts of the Russian economy. Russian defense outlays remain very high, at about 4% of gross domestic product, with a steady flow of arms orders.
The Russian ruble's dramatic slide has also made Rostec's dollar-denominated arms sales abroad more lucrative. Those sales are helping the conglomerate maintain profitability, according to Mr. Chemezov. Sanctions already forced the arms- maker to substitute Western components with domestic alternatives or Asian parts.
Mr. Chemezov's remarks carry particular weight. Originally from Siberia, Mr. Chemezov became friends with Mr. Putin in the 1980s when they both served in the Soviet security services in East Germany.
After Mr. Putin rose to the Kremlin, Mr. Chemezov led the charge in reasserting state control over a slew of strategically important companies, mainly in defense but also in other sectors, eventually consolidating them into the government holding now known as Rostec.
The conglomerate—which today oversees some 700 enterprises selling everything from missile systems to baby incubators—is an example of Mr. Putin's state capitalism. In theory, Rostec functions partly like a state- sponsored private-equity firm, turning around strategically important businesses using government support with a view to selling stakes in them to private investors. Critics of Russia's state-owned behemoths say they risk wasting money because they lack the discipline, focus and strict business rationale of private firms.
Rostec says its stewardship enhances investment and management for important businesses that otherwise might fail. The holding is in talks to sell 20-25% of Russian Helicopters to Abu Dhabi-based Mubadala Development Co., Mr. Chemezov said, and is preparing to sell up to 49% of KRET, the holding's maker of avionics and electronic warfare systems. The KRET stake will be sold in an open auction likely limited to Russian investors as early as this year, he said.
The economic challenges at home have given Rostec an extra impetus to sell weaponry abroad. Last month, a Russian newspaper said Iran is looking to buy $8 billion of weapons from Russia, now that sanctions over the country's nuclear program are being lifted.
"That is their desire, but so far there is no such deal," Mr. Chemezov said. "Discussions are under way on various subjects, but so far there's nothing concrete."
The list of weapons Iran is seeking to buy is "very long," the Russian defense-sector boss said. "First, they still have to find money for all of this." While Russia has extended credit for civilian projects in Iran such as the construction of a thermal power plant, it isn't offering credit for weapons purchases, he added.
Mr. Chemezov confirmed that Russia would supply Iran with an S-300 antiaircraft system by the end of the year, a sale that has drawn criticism from the U.S. and Israel. He said Iran would receive the original weapon it ordered, the S-300 PMU-1, even though Russia now produces more modern versions of the antiaircraft system.
Another foreign customer that has turned to Russia for weapons is China. Rostec struck an agreement late last year to sell China 24 Su-35 jet fighters for about $2 billion.
The deal still requires ratification from both the Russian and Chinese sides, which Mr. Chemezov expects to take place in the coming summer or fall. He said none of the jet fighters would be delivered to China this year.
Russia's economic difficulties come as its military continues to aid Syrian President Bashar al-Assad with an air campaign that began last fall. For the Russian defense sector, the Syrian battlefield has become something of a testing area to deploy equipment that in some cases hasn't been tested in combat before.
"It's no secret that we are using it as a proving ground," Mr. Chemezov said. "We look at how everything is working, whether it's good or bad, and we make corrections or modifications."