War Economy: Ukraine, the European Union and the Defence Technological and Industrial Base

CSDS POLICY BRIEF • 11/2024

By Daniel Fiott

23.4.2024

Key issues

• Ukraine’s defence industry has become a central feature of the country’s military strategy against Russia, and the European Union (EU) understood early on the potential of cooperation with Ukraine in this sector.
• Ukraine’s integration into the European Defence Technological and Industrial Base will take time, and there is not yet an EU consensus on what this integration will look like in practice.
• Political challenges will hamper EU-Ukraine defence industrial cooperation as individual EU member states and Ukraine discuss sensitive issues such as technology sharing and control.

Introduction

Speaking at a high-level meeting of Ukrainian defence industrial representatives in December 2023, President Volodymyr Zelenskyy, called for a redoubling of efforts to bolster Ukraine’s defence industrial potential. While recognising that the industrial representatives play a key role in Ukraine’s defence against Russia, the president made clear that ‘anyone who provides Ukraine with equipment, shells, and all the necessary weapons also provides our state with political independence’. For Ukraine, the importance of the defence industry is not only measured in relation to how it boosts domestic production of ammunition and drones, but also how it lays the foundation for Ukraine’s defence in the future. Interestingly, it is not only Ukraine’s domestic defence industry that has understood the potential of the country in terms its productive capacities and the skills and knowledge base of its population. The reality is that many European and American defence firms are taking a greater interest in Ukraine for commercial and political reasons.

Ukraine’s defence industry has emerged as a core feature of, and even inspiration for, the European Union’s (EU) own defence industrial resurrection. Indeed, Ukraine features strongly in the first-ever European Defence Industrial Strategynot just in terms of a partner for the Union to work with, but also as a key reason why the EU seeks to invest in defence readiness. The Strategy is replete with references to high-attrition warfare, the criticality of supply of ammunition and equipment and the need to innovate – concepts that have been directly inspired by Ukraine’s experiences on the battlefield. Yet, politically, the EU is seeking to bolster its defence industrial cooperation with Ukraine in the context of the country’s EU accession process – the underlying logic is, if Ukraine is to be an EU member state, defence industrial cooperation should begin in earnest.

As this CSDS Policy Brief explains, however, there are several challenges to integrating Ukraine’s defence industry into the European Defence Technological and Industrial Base (EDTIB). Not only is the concept of the EDTIB not fixed, but Ukraine is currently at war and the country therefore has its own interests in forging a national defence industry as part of its overall economic reconstruction. While the European Defence Industrial Strategy holds out the potential for Ukraine to be a part of future EU defence industrial financial mechanisms, the politics of integrating Ukraine’s defence sector into the EDTIB needs to be properly assessed and analysed. In this respect, this Policy Brief provides some of the contours of the debate over Ukraine’s defence sector and EU integration that will only increase in importance in the coming months and years.

Ukraine’s defence industry

The potential of Ukraine’s defence industry cannot be underestimated. Centred in industrial locations close to the battlefront such as Kharkiv and Kherson, the Ukrainian defence industry has proven remarkably resilient in the face of Russia’s war. Available data indicates that Ukraine’s defence industrial base employs some 300,000 workers in 2023 and is comprised of roughly 500 different defence companies; it is worth considering here that the European defence sector employs close to 1 million employees. Ukraine also invests approximately 33.5% of its Gross Domestic Product (GDP) on defence. In this respect, a truly modernised Ukrainian defence industry would rank as one of the largest defence markets in Europe. Yet, modernisation during a war is not easy. Traditionally, Ukraine inherited much of its defence industrial capacity from the former Soviet Union (i.e. data indicate that Ukraine inherited 30% of the entire Soviet defence industrial base after the union was dissolved), and for this reason the Ukrainian defence industry is still in need of reform and modernisation. The need for reform was already well-recognised following Russia’s illegal seizure of Crimea in 2014, where some analysts rightly noted the urgent need to modernise Ukraine’s defence industry.

Even before the war in 2022, Ukraine had decided to reorganise its domestic defence industry around a central state-owned company called Ukroboronprom (UDI). UDI, which was formed in 2020, represents some 140 plus companies and employs approximately 67,000 skilled individuals that work to firearms, missiles, demining technologies, drones, etc. Since Russia’s full-scale invasion, however, Ukraine has had an obvious incentive to further boost its domestic industry. In this regard, three structural challenges have persisted within Ukraine’s defence industry: 1) the lack of investment and financial sources; 2) a shortage of skilled managers and modern techniques; and 3) corruption, which has been a key focus for President Zelenskyy as Ukraine attempts to ensure its large-scale investments are not wasted. In fact, since 2020 the creation of a Ministry of Strategic Industries for Ukraine has sought to bring further coherence and management to the defence sector. The Ministry is charged with clamping down on corruption and ensuring that state investments produce military equipment on time and to standard.

Beyond the facts and figures, however, Ukraine has an added advantage today as it is developing defence innovation in a more raw and tangible fashion than many EU or NATO member states. Whereas defence innovation is usually conceived of as scientific work in a laboratory, Ukraine is innovating in the battlefield itself by rapidly adapting technologies to tactical military needs. So, when the EU and NATO seek to increase its cooperation with Ukraine’s defence sector, they will also have the potential to learn new military and technological techniques forged in war. This is certainly one of the key messages being promoted by the Ukrainian government, as there is still a substantially high degree of risk associated with developing defence manufacturing capacities in a country at war. On the one hand, Russia has taken it upon itself to militarily target defence production sites in Ukraine (e.g. Russia has targeted the Malyshev Plant in Kharkiv where Ukraine produces engines and tracked vehicles), which may dissuade European investment in the country. On the other hand, the Ukrainian defence ministry has made clear that Western defence companies have a unique opportunity to test equipment directly in a warzone, which provides for an unparalleled chance to improve Western weapons technologies.

An industry at war

The risks associated with European cooperation in Ukraine’s defence sector should not be overlooked, yet this has not stopped European and global industries from cooperating with Ukraine while it is at war. Ukraine has already struck up direct industrial partnerships with Colt CZ Group SE (Czechia), MBD Deutschland (Germany), Rheinmetall (Germany), Polska Grupa Zbrojeniowa (Poland), Honeywell (United States (US)) and more for the joint development or licensing of drone technologies and 125mm and 155mm ammunition shell production, among other types of military equipment. In fact, Ukraine has adopted a strategy of international outreach where it strikes both bilateral and multilateral cooperative deals with firms and governments. A key question for Ukraine’s defence industrial base in the coming years is how should it be structured to meet the longer-term threat from Russia. There is no set formula for how defence industrial bases evolve in post-war environments. In Japan, the post-Second World War experience saw the continuation of its formidable technological experience in the aeronautics and naval domains, but post-war demilitarisation saw a growing dependence on the US for defence. This had the effect of increasing defence technology imports from the US, which in turn led Japan to focus its indigenous technological skills and labour into dual-use domains.

In the case of Ukraine, perhaps the experience of South Korea is more instructive, as this was a country that effectively managed to build-up defence production after the Second World War despite intense overall economic hardship and harsh political conditions. South Korea is an interesting case because it is a country that effectively fused three factors to stimulate its domestic defence production: 1) it remained locked in a frozen conflict with North Korea and therefore had a continuous need to develop its defences, while maintaining large-scale investments in defence (6.8% of GDP for three decades beginning in the 1960s); 2) it sought out international partnerships, especially with the US; and 3) it maintained a domestic political consensus among the major parties to develop the defence industry. Today, South Korea has earned the ability to export high-quality defence equipment based on a reputation of technological excellence, cost effectiveness and timely deliveries. The comparison between what South Korea is today and what Ukraine could become in the future has not been lost on several commentators.

However Ukraine’s defence industry evolves after the war, the EU has already positioned itself to support the modernisation of Ukraine’s defence industrial base. Seen in the wider context of Ukraine’s EU accession process, the European Commission and High Representative / Vice-President (HR/VP) were quick to use the first-ever European Defence Industrial Strategy to signal the Union’s intention to integrate Ukraine into the EDTIB. For example, the Strategy posits the idea that windfall profits from frozen Russian assets could be utilised to jointly purchase military equipment for Ukraine. In fact, the Strategy specifically states that ‘as and when the immediate defence needs of Ukraine permit, certain amounts could also be drawn from such extraordinary cash balances for the purposes of the medium- and long-term development of the Ukrainian DTIB’. In essence, the Commission and HR/VP are making the case that the EU needs not only to supply Ukraine with military equipment, but to also ensure the long-term health of Ukraine’s DTIB. Obviously, the Ukrainian government has been extremely positive about such ideas, even if some EU member states may have reservations about using Russian frozen assets in this way.

Yet, the European Defence Industrial Strategy goes further than simply calling for the use of Russian frozen assets to support Ukraine’s defence industrial base. Indeed, the Commission and HR/VP call for ever closer ties with Ukraine to ensure that the defence sector can help Ukraine recovery economically after the war. While the Strategy calls for closer cooperation with Ukraine via the European Defence Agency’s (EDA) existing Administrative Arrangement, and the Union will organise an EU-Ukraine Defence Industry Forum in May 2024, the really interesting dimension of the Strategy rests on the potential for Ukraine to join EU defence funding programmes. In this regard, the Strategy not only calls on the European External Action Service to explore ways of boosting EU-Ukraine defence industrial cooperation via the European Peace Facility (EPF), but it directly raises the ‘possibility for Ukraine to participate in joint procurement’ through future tools such as the European Defence Industry Programme (EDIP). Although the EDIP is not a reality today, it is a tool designed to stimulate joint development and procurement between EU member states. However, as bold and significant as including Ukraine in the early designs for an EDIP are, there are major challenges that need to be tackled in the coming months and years.

The challenge of geography: locating defence production

Ukraine’s full membership into the EU is likely to take some time, even with the ambition to integrate Ukraine’s defence industry into the broader EDTIB. The country is at war, and so this imposes a range of risks. For example, as Ukraine is at war the EU must expect all defence production sites in Ukraine to be potential targets for the Russian military. In fact, there is already evidence to suggest that Russia is striking Ukraine’s defence production sites and attendant energy infrastructure in order to cripple Ukraine’s ability to produce military equipment. Ukraine has played a remarkable hand in producing equipment indigenously, with which it has been able to strike Russia’s strategic capabilities such as naval vessels (e.g. Magura V5 multipurpose drones in the Black Sea). While Ukraine will want to continue to produce as much military equipment as possible on its territory, not least to fasten supply chains and reduce production delays, it would be wise to consider developing co-production sites within the EU and NATO territory. The co-production of equipment in EU/NATO territory would give an added protection to production centres and Russia would not realistically strike production sites. Such co-production could also go hand-in-hand with skills transfers and training between Ukrainian military technicians and their EU/NATO counterparts.

The challenge of partnerships: when is a state a third state?

Until Ukraine becomes a full member state of the EU it will be seen as a candidate country. This poses a challenge for the EU, as Ukraine’s potentially planned involvement in the EDIP raises general questions about access to EU defence financing tools. There has already been an intense reflection on how far third states should be associated with EU defence cooperative frameworks. While countries such as the US, Canada, Norway and the United Kingdom (UK) are involved in the military mobility project under Permanent Structured Cooperation (PESCO), the reality is that third states are generally excluded from EU efforts, not least to protect the Union’s security interests with regard to technology control and proliferation. Potentially bringing Ukraine within the EDIP certainly displays creativity and flexibility, but third states may ask why such flexibility is not afforded to them too, especially as many are in possession of even larger DTIBs than Ukraine. Of course, this implies that third states will be looking at how the Union approaches Ukraine for potential in-roads into EU defence industrial frameworks for their own national industries and interests.

In particular, third states will be waiting to see whether Ukraine’s potential participation in the EDIP before it even becomes an EU member state will help alter the Union’s overall approach to third state access. Today, the European Defence Fund (EDF) Regulation is water-tight in blocking access to third states on security grounds, and the proposedEDIP Regulation also underlines that any Ukrainian involvement in the EDIP should ‘not be subject to control by non-associated third countries’. However, the EDIP Regulation is yet to be formally agreed by the European Parliament and Council of the EU, and so there is still the potential that some degree of flexibility for third state access emerges to accommodate Ukraine. Should any general flexibility occur, third states could argue that the EDF should also be subsequently revised to allow for third state access to EU funding tools or that, should the EDF and EDIP be merged at some point, the more flexible legal arrangements should prevail. Either way, the EU will certainly stress the unique nature of Ukraine as a partner, not least because it is a candidate country, whereas the majority of the third states seeking closer defence industrial access with the EU are not aspiring members.

The challenge of politics: how to structure EU-Ukraine cooperation?

As Ukraine is a unique country, there are considerable arguments in favour of offering Kyiv a tailored defence industrial partnership with the EU. However, the truth of the matter is that we will still have to wait for the EU member states to agree on the fine print of the EDIP Regulation, which is not going to be a simple or rapid affair. EU member states may not uniformly view the European Commission’s role in stimulating defence industrial cooperation with Ukraine as entirely positive. Indeed, certain EU member states seek to maintain bilateral ties with Ukraine without the interference of the EU via the European Commission. The firms of countries such as Germany are already engaged in sizeable bilateral defence industrial trade with Ukraine, so why, the logic may go, should this be supplanted by an EU-wide approach? In this sense, a preferred form of cooperation between the EU and Ukraine could be found via the EPF, which puts the Council of the EU in the driving seat rather than the European Commission. There may also be resistance from EU member states because of a perceived fear that Ukrainian defence firms may outperform existing EU-based firms under the EDIP.

Conclusion: what does the EU want from cooperation with Ukraine?

To conclude, the politics between EU member states, and between capitals and Brussels, has a bearing upon the type of relations the EU and its member states ultimately strike up with Kyiv over the long-term. Defence industrial cooperation will be easier to handle when Ukraine becomes an EU member state, but until then the politics of competition and national interests are likely to be much more pronounced (i.e. see how some elements of the EU’s agricultural sector reacted to the import of Ukrainian grain). It is no secret that a large European defence industrial footprint in Ukraine is likely to be commercially lucrative for the foreseeable future, with a relatively large and stable demand for defence equipment existing. Yet it is not only the business case that makes sense, as a large stake in Ukraine’s defence industry comes with political influence over Kyiv’s defence policy and it creates a dependence for Ukraine on those countries that create the largest defence industrial footprint in the country. In this respect, despite the unique nature of Ukraine’s predicament, we should expect defence industrial interests to reduce any degree of altruism vis-à-vis Ukraine’s defence sector.

Overall, however, the continued relevance of national defence industrial interests in the EU points to the larger issue that EU member states do not yet have an agreed position on how they should engage with Ukraine’s defence industry: 1) should defence firms in the EU simply sell or provide equipment to Ukraine?; 2) should these firms engage in co-production and technology sharing to help create a genuine EDTIB?; or 3) should these firms actively transfer technology and production know-how and capacity to help Ukraine build its own autonomous industry? So far, the first approach has largely won the day. The hope within the EU is that continued Union financial support to Ukraine will eventually find its way back to defence industries in the EU, especially as Kyiv places more orders for equipment that it does not or cannot produce. This form of subsidisation may work for all sides for a time, but it is unlikely to be a lasting strategy, not least as, based on the haphazard support of the West for its defence needs thus far, Ukraine will have every incentive to achieve the highest degree of national defence autonomy as possible.