Saturday, January 23, 2016

States and Defense Contractors over Rolls Royce Nationalization

Britain announced that it was considering nationalization of Rolls Royce to save the company from a foreign takeover. The government sources said that they would either nationalize Rolls Royce, or lead some or all of this company to merge with BAE systems. Rolls Royce suffers from plunging share price since 2014 due to sluggish performance in the maritime and aero engine sectors. It is rumored that Pratt & Whitney of the United States and Siemens of Germany are buying Rolls Royce’s aero engine division (“Britain would consider nationalizing Rolls Royce's submarine business – FT”; Reuters; December 14, 2015). The Cameron administration has posed a critical question to national security policymakers about the relationship between the state and the defense industry, as corporate nationalization is quite un-Conservative, and furthermore, it is a failed policy of Old Labour. Margaret Thatcher would have been startled to hear this, because it is she who privatized this company in 1987.

This news has drawn my attention, in view of a recent commentary by Japanese Member of the House of Councillors Masahisa Sato, that raises some questions about the Japanese defense business. Sato argues that Japan needs the will and specific efforts to help Japanese defense contractors make profits in a small domestic market as it is unrealistic to nationalize them. He is concerned that Japanese defense procurement is squeezed by rising costs of imported weapons such as F-35 and V-22 (“Save the Foundation of Japanese Defense Industries and Indigenous Technology”; Giron Hyakushutu; December 2, 2015). Defense contractors are of high strategic values, and unlike civilian industries, some sort of mercantilist policies are inevitable.

I am talking about Rolls Royce, because this company has a lot in common with Japanese defense contractors, and I believe that careful observation of it would be of much help to defense planners in Japan and the rest of the world. Like Japanese defense companies, Rolls Royce is not so big, but technologically advanced among renowned defense contractors. According to the defense industry ranking for 2015, Rolls Royce is the 15th, and its revenue from defense accounts for 22.60%. Meanwhile, Japanese contractors like Mitsubishi Heavy Industries ranks the 36th with 5.60% defense dependence, and IHI ranks the 91st with 4.30% dependence on defense. Such low dependence on arms is in sharp contrast with those of big contractors heavily relying on defense, like Lockheed Martin that ranks the 1st and 88.00%, BAE Systems raking the 3rd with 92.80%, Raytheon ranking the 4th with 97.40%, General Dynamics raking 5th with 60.20%, and Northrop Grumman raking 6th with 76.70% (“Top 100 for 2015”; Defense News).

However, both Rolls Royce and the above Japanese contractors win high reputation with venerable achievements. In case of Rolls Royce, their brand and advanced technology make a substantial contribution to their maritime and aerospace engine sectors, and even to the nuclear reactor area. Without mentioning British-made weapons, some brand new foreign arsenals use also Rolls Royce engines, for example, gas turbines for the Zumwalt class destroyers of the US Navy. Also, some of South Korea’s indigenous stealth fighter KF-X will use the same Rolls Royce engines as those for the Eurofighter Typhoon. Meanwhile, Mitsubishi’s stealth fighter ATD-X draws worldwide attention. Quite remarkably, IHI that provides engines for this Mitsubishi fighter, has succeeded in developing the HSE (High-power Stream Engine) which outperforms the same sized engines made by American and European manufacturers, in terms of thrust-to-weight ratio and fuel efficiency, and that ultimately helps Japan’s quest for indigenous fighter F-3 (“Japan’s Next Generation Fighter Engine is Superior to American One”; Sankei Biz; March 17, 2015).

On the other hand, small companies are vulnerable to the turbulence of the increasingly globalized world market. Also, their high quality brains are good targets for the hands of foreign and even hostile takeovers. Occasionally, the market mechanism is so ruthless that it does not give any consideration to national and public interests. However, should the state nationalize strategic industries? In the Westland affair from 1985 to 1986, Prime Minister-then Margaret Thatcher admitted Sikorsky of the United States to merge Westland Helicopter in accordance with the market principle, while Defence Secretary-then Michael Heseltine insisted on maintaining the company’s ownership within a European framework. As widely known, Thatcher won the dispute in her cabinet, and Heseltine stepped down.

During the Cold War era, the borderless economy was almost within the Western alliance. Today, businesses act beyond such political boundaries. For example, Haier Group of China has acquired the laundry sector of Western companies such as Sanyo and General Electric. However, the defense industry is not the home electric appliance industry. Once home country loses control a defense contractor to a foreign hand, even if it is a company of an ally or a friendly nation, the sold company could be resold to the enemy. From this point of view, it is understandable that the Cameron administration is dedicated to defending Rolls Royce from foreign acquisition. Particularly, their nuclear sector is sensitive for British national security for its deep involvement with Trident missile submarines.

Reuters columnist Robert Cole argues that the problem can be resolved through the market system, as their business recovery is expected though it is weak. If it does not work, BAE Systems can acquire some or the whole sector, which is more preferable to nationalization. BAE can diversify their business into civilian sectors to lessen their dependence on defense contracts of Britain, the United States, and Saudi Arabia (“BAE deal beats Rolls-Royce nationalization”; Reuters; December 14, 2015). This idea is better than nationalization, but still, it is not a good idea to split Rolls Royce, if BAE were to merge this company, since its technology in motor cars, aero and maritime engines, and nuclear reactors is intertwined. Furthermore, Jeremy Warner of the Daily Telegraph, argues that Rolls Royce can satisfy various requests from their customers as an independent and specialized manufacturer of engines. Once blended into a big company, Rolls Royce will lose advantages in specialty to meet tailor-made demands. That would appear unattractive to its best customers like Pentagon (“BAE in Rolls Royce merger? Let’ not go there”; Daily Telegraph; 16 January, 2015).

In an increasingly globalizing economy, it is a tough question to keep innovative instinct and high morale of a small but strategically important company, while saving it from savage competition, and even from hostile investors. The Westland affairs may help us learn some lessons, but the past is in the past. In case of Japan, if corporate performance of Mitsubishi Heavy Industries or IHI deteriorates, there is no gigantic defense contractor like BAE Systems to act as a white knight against adversarial investors. Should the Japanese government take administrative guidance to have them merged with Kawasaki Heavy Industries, NEC, etc, ranking 46th and 66th respectively, when they face the threat of foreign takeover? But Japanese companies are heavily civilian oriented, as Kawasaki depends 11.20%, and NEC does 3.50% of their revenues on defense. In view of this, most of the Japanese businesses are not likely to have much incentive to follow the Ministry of Defense.

The defense industry is too strategic to apply text book market economy principles. In order to help their business and save the national interest, I would suggest that the government give special preferences to defense contractors even in civilian public projects. Typically speaking, I wonder why the Cameron administration accepted the bid of CGN (China General Nuclear) to rebuild Hinkley Point and Bradwell nuclear plants, despite this company’s notorious tie with the PLA (People’s Liberation Army), if they are so serious to defend Rolls Royce even by resorting to nationalization. They should have given a special preference to Britain’s iconic company, instead. Currently ongoing Rolls Royce affair deserves attention from defense planners all over the world, because this company is far beyond a manufacturer of luxury toys for the rich.