Despite Growing Defence Budget Russian Enterprises are Heading towards Bankruptcy, Irregular Allocation of Funds One of the Main Reasons

Foreign Affairs

Moscow: Russia’s economy has not shrunk to the point some Western governments and experts predicted following the country’s invasion of Ukraine. Indeed, since February 24, 2022, the more than 11,000 added restrictions aimed at pressuring the Russian government have “not delivered as much hell as originally expected,” according to a report released a year later by the Centre for Strategic and International Studies.

But despite the Kremlin’s ability to defy “apocalyptical forecasts,” as the think tank put it, and the government’s growing defence budget, dozens of Russian defence plants are undergoing bankruptcy proceedings or have claims for bankruptcy recognition. Some have received contracts to support Russia’s invasion of Ukraine and are still operating, while others have turned to selling their property.

“One of the main reasons for bankruptcies is the [inconsistency of] state defence orders,” according to Sergey Tolkachev, an economist at the Moscow-based Financial University. “Further, [there] is an irregular allocation of funds for the fulfilled state order.”

According to government regulations, the state would cover a bit less than half of that additional cost, while the company would have to use its own capital to pay for the remaining amount. Even worse for the business, the Russian state might delay the delivery of funds, forcing the company to seek a loan to cover costs in real time. The bank providing the loan reviews the company’s application, assesses its financial situation and, finding it risky, sets a high interest rate.

Russia’s national register of bankruptcy information lists data on dozens of domestic organisations and their debt. Several bankruptcy procedures are also taking place, according to Russia’s national register of bankruptcy information.

Sergey Gebel, the chief executive of the Russia-based Gebel and Partners law firm, said some defence industry enterprises, following years of downtime and debt, are unable to build weapons. For those organisations, “there is simply nothing here to save,” he said.

Meanwhile, some enterprises are trying to solve their financial problems by selling all or part of their ownership shares. Now the government is creating two new armoured car factories in the Moscow and Rostov regions.

Siemon Wezeman, a senior researcher with the Stockholm International Peace Research Institute think tank, said these investments can work out well for the state. “New plants are a high investment, but in the end they are more effective producers and immediately able to outcompete the companies” that produce older equipment and are in debt, he said.

Years of sanctions that precede Russia’s full-scale attack on Ukraine in February 2022 may have contributed to the current state of Russia’s defence-industrial base.

“Sanctions — also those from before 2022 — may have made the situation worse, especially as they can lead to delays in delivery or the need to find more costly substitutes for the sanctioned parts. This increases costs for contracts where a fixed price was already agreed, or delays payment for contracted goods. Both cost increases need to be covered by the companies from their own pocket,” Wezeman said.

Tom Waldwyn, a research associate for defence procurement with the London-based International Institute for Strategic Studies, said any additional sanctions on Russian companies will negatively impact both defence and civilian sales in terms of product exports and the import of key subcomponents.

“As Russia also experiences high inflation and a brain drain, the Russian defence industry faces a difficult future despite massive increases in defence spending in 2022 and 2023,” he said.

From 2013 (the year before Russia annexed Crimea from Ukraine) to 2022, Russia increased its defence budget by 15%, according to the Stockholm International Peace Research Institute. And from 2021 to 2022, its military spending grew by 9.2% to $86.4 billion — the equivalent of 4.1% of Russia’s gross domestic product, the Swedish think tank reported.

In realising the need to bolster the production and repair of equipment during the ongoing war, the Russian government has tried to simplify contractual procedures. It has shortened the terms of state orders and improved the process of agreeing to costs and contractual requirements. The state has also taken steps to provide advance payments to defence enterprises. In addition, banks have started lowering interest rates and increasing the amount of a possible loan for defence companies. In July 2022, the preferential rate was reduced to 3%, and the maximum loan amount was increased to 3 billion roubles.

And on April 1, 2022, a moratorium on bankruptcy was introduced for six months to give businesses additional time to negotiate with creditors and adapt to new circumstances, such as sanctions and the disruption of supply chains. The moratorium was lifted six months later. Since then, 10 more Russian shipbuilding and naval repair enterprises have received bankruptcy claims from creditors or filed for insolvency themselves.

In September 2022, Russian President Vladimir Putin amended the criminal code so that the failure to fulfil obligations in defence contracts for the state would result in fines of 1 million roubles to 3 million roubles and/or imprisonment for up to 10 years.

“Under these conditions, declaring bankruptcy can be a way to reduce the risks of prosecution and punishment for [those managing] plants,” according to Pavel Luzin, a senior fellow at the Centre for European Policy Analysis think tank. “In addition, this is a signal to the government about the need for cash injections,” he said.

Indeed, government support and increased spending on the Army during the 2022-2023 time frame helped some bankrupt enterprises continue operating. If a company does not participate in the development of a product, but only produces it, the business typically won’t receive the majority of funds allocated for the technology, according to Sergey Smyslov, an independent defence industry expert and an engineer by trade.

“This became possible due to the fact that, since the Soviet era, many enterprises have [duplicative] capacities. And when [the state had an option] to produce a product at a functioning plant, ‘A,’ or a half-empty plant, ‘B,’ a fully equipped plant was chosen,” Smyslov said.

After the bankruptcy moratorium ended in October 2022, State Duma Deputy Sergei Mironov petitioned Prime Minister Mikhail Mishustin and chief military prosecutor Valeri Petrov to help stop insolvency among defence enterprises. As a result of the petition, Mironov said  “some of them [defence enterprises] were reorganised — restructured to prevent the closure and termination of production.”

Other deputies of the State Duma — the lower chamber of Russia’s legislature — proposed the assets of bankrupt companies be transferred to enterprises that successfully fulfil state defence orders during military mobilisation and wartime.

“In the execution of [a] defence order, there is a large pyramid of cooperation. Even if small enterprises — or enterprises that are [in the third or fourth tier] of suppliers and only indirectly relate to the state defence order — fall under the bankruptcy procedure, then a huge risk is created for the disruption of the state budget,” Vladimir Gutenev, who leads the Duma Committee on Industry and Trade, warned in October 2022.

The Russian government created a plan to return state-owned enterprises to the private sector during the 2022-2024 time frame. None of the companies under consideration are undergoing bankruptcy proceedings, but most either had claims from creditors for bankruptcy or are financially unstable. The effort includes more than a dozen defence plants.

Some have already tried selling themselves in whole or in part, but haven’t found buyers. That’s likely because only Russian organisations without foreign shareholders, that have permits to work with classified information and that have licenses to make weapons can purchase the property of defence enterprises. Often buyers need to commit to maintaining production and fulfilling existing state defence contracts.

The government’s plan may backfire, according to Wezeman, who warned any temporary support state-owned enterprises received from the government could help them outperform companies that have had to survive on their own.

“Those companies may in their turn fail,” he said. “However, a level of corruption may also play a role: Orders may go to companies that have ‘friends,’ and those without will have to solve their problems without much support.”