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April 2, 2020 | International, Aerospace, Naval, Land, C4ISR, Security

Opinion: Six Ways COVID-19 Could Change Defense Sector

Byron Callan

The coronavirus pandemic is going to be as consequential for defense and security as were the Sept. 11, 2001, attacks in the U.S. For the defense sector, there are multiple implications to ponder and possibly to begin to position for as these play out in 2021 and beyond.

Large contractors should fare relatively well in 2020, compared to other sectors. They will not see the demand destruction that is ripping through commercial aerospace and therefore are unlikely to experience financial duress. That alone may enable them to act strategically and aggressively in 2020 and beyond, although there are risks to weigh as well. Here are six changes to ponder:

First, a crisis the size of the COVID-19 pandemic is bound to spawn new government investment and organization to address future outbreaks. The Sept. 11, 2001, attacks led to the formation of the U.S. Department of Homeland Security and creation of the position of director of national intelligence. It's fair to assume there will be changes in the wake of the current pandemic. Some contractors already have federal services segments that address U.S. health care. Core skills they can bring are dealing with bureaucracies, technology and regulations. There should be new opportunities in 2021 and beyond from whatever changes are made to improve the national resilience and response to future pandemics.

Second, small and medium-size businesses are being stressed. The CARES Act in the U.S. may help somewhat, and changes in Defense Department progress payment rates could be another short-term relief. Large contractors might choose to vertically integrate to improve their fortitude against future shocks. Or there could be further consolidation, particularly of distressed suppliers.

A reintegration of defense and commercial aerospace is a third change that might emerge. The Raytheon-United Technologies merger may be a harbinger of this shift. The ramifications of the coronavirus crisis on the air transport and commercial aerospace sectors could lead to structural changes and a need for capital, particularly in commercial aerospace. If valuations remain depressed in 2020-21 in commercial aerospace, there could be more opportunity for defense contractors to reintegrate.

A fourth change could be to expectations for contractors. The model for U.S. defense since 1945 has largely been that the Pentagon pays for the bulk of research and development, and contractors can reclaim most of their own research and development as an allowable cost for which they are reimbursed. Operating margins have generally risen, compared to levels evidenced in the 1980s and before, and large contractors have in the last 15-20 years allocated most free cash flow to shareholders.

It is conceivable that this model will change in the 2020s. Operating margins may appear to be ho-hum compared to other sectors, but returns on invested capital are attractive.

If there is a greater squeeze on the Pentagon budget and demand for security remains steady or increases, this could compel the Pentagon to change expectations for contractor behavior. Could they be expected to take on more contract risk? Will they need to step up their own independent research and development funding or find more creative ways to access and apply technology to national security needs? On the flip side, could there be more emphasis on dual-use technology investment, as occurred in the 1990s, where research and development for defense should have commercial/civil benefits as well?

A fifth potential change is in security threats and national defense strategies. Some governments and regimes might come through this crisis with their positions enhanced, having overseen relatively mild disruptions and having been able to achieve quick economic bounce-backs. Others, however, will have failed this test, and they could see new political challengers (in democracies) or be overthrown or consumed by internal unrest from competing forces or mass movements that are emboldened by recent failures. The Middle East remains a likely place for these sorts of changes; Venezuela is another. The civil war in Syria and the fighting in Libya are current examples of how state collapse and regime challenge can drag in outside interests.

The U.S. National Defense Strategy that reoriented the Pentagon and contractors toward “great power” competition could be pulled in different directions depending on where fragilities emerge. Some allies may be significantly weakened, and that could bear on U.S. defense planning and export sales. It is not just the coronavirus that matters in this regard; the crash in oil prices is also a factor to weigh.

Finally, the coronavirus has turbocharged federal deficits and is sending federal debt to record levels. It may take weeks or months to assess just how much is going to be added, but there will be a fourth and possibly a fifth stimulus package in the U.S. Ultralow interest rates and the urgency of limiting social and economic damage and keeping the health care system functioning make this tolerable. But higher debt raises the risk in the 2020s that if rates increase, interest outlays could weigh on defense.

https://aviationweek.com/defense-space/opinion-six-ways-covid-19-could-change-defense-sector

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    MINOT AIR FORCE BASE, N.D. — With a major arms control agreement between the U.S. and Russia set to expire next February, members of the nonproliferation community have been watching for signs that negotiations may begin in earnest. For those observers, some welcome news: Movement on the Trump administration's arms control plan is “imminent,” according to a senior defense official familiar with internal administration discussions. However, what that looks like appears to be up in the air: a short-term extension of the New START agreement with Russia; something that involves nuclear-armed China; a combination of those two; or all parties walking away entirely. “All the options are literally on the interagency table,” the official told Defense News on condition of anonymity. The New START agreement, signed in 2010, is an arms control pact between Russia and the U.S. that restricts each country to a total of 1,550 warheads deployed on bombers, submarines and in underground silos. Following the dissolution of the Intermediate-Range Nuclear Forces Treaty, New START is the only major nuclear arms control agreement left between the two nuclear powers. China has traditionally refused to sign onto arms control agreements. But Beijing has become a focus for those in Washington convinced that any new arms control agreement must include the Asian nation. China is estimated by the Federation of American Scientists to have 290 nuclear warheads, compared to more than 6,000 for Russia and the U.S. each, and the country is investing in nuclear modernization efforts. Though top Chinese officials made clear that Beijing will not participate in trilateral talks, U.S. President Donald Trump in December expressed optimism that a deal could happen, saying Chinese officials “were extremely excited about getting involved. ... So some very good things can happen with respect to that.” While traveling last week to tour the intercontinental ballistic missile fields at Minot Air Force Base, North Dakota, Defense Secretary Mark Esper declined to speculate on the state of negotiations and what he would recommend Trump do. But he did indicate there would be a meeting at his level “soon” on the issue. “If we proceed forward [with New START], we have to include Russia's new strategic weapons. They have to be included in the treaty. Number two, we should include Russia's nonstrategic nuclear weapons. They have nearly 2,000 of them,” Esper said. “Then I think we should put on the table: Can we bring China into the fold? We're trying to create strategic stability. It's hard to do that if you have a country of China's capacity and capability outside of that treaty.” Speaking at Minot later, Esper added: “If we want to preserve strategic stability using arms control as a counterpart of that, as a tool in that toolkit, then China should be in as well.” State of discussion While some have theorized that the Trump administration is trying to run out the clock on negotiations, the official ascribed the slow public movement to myriad “distractions” around Washington that has sucked attention from Trump, Esper and Secretary of State Mike Pompeo. The official added that the outbreak of the coronavirus known as COVID-19, which originated in China, has made discussions with Chinese counterparts difficult. There have been ongoing meetings on the issue at the assistant secretary level across the Defense Department, the National Security Council, the State Department and the National Nuclear Security Administration. “Ultimate decisions haven't been taken yet, but [a proposal] should be imminent,” the official said. The first challenge, timewise, is the Feb. 5, 2021, expiration date for New START. Getting something done before then may be a challenge, especially if the goal is an expanded arms control agreement that loops in China, but “physically, you could do it because it doesn't require senate ratification, just a couple of notes signed by just getting everyone — the three sides — to agree to something,” the official said. The question of New START's fate is complicated by the desire to loop in China on a new agreement. Administration officials have been working to develop a compelling case for how to convince Beijing to join a trilateral nuclear deal. The argument largely comes in two forms. First, that if China does not sign onto a nuclear arrangement of some sort, it could lead Russia or the U.S. to consider growing their own arsenals — ensuring China's nuclear inferiority at a time when the Pacific power is racing to grow its stockpile. The second argument is that great powers work on nuclear agreements together — and so joining one as equals with Washington and Moscow should appeal to Beijing's desire for recognition on the global stage. Meia Nouwens, an expert on Chinese military affairs with the International Institute for Strategic Studies, says those two arguments are the most sensible ones to put forth to Beijing, particularly the appeal to China as a great power. She also speculated that if China's economy takes a downturn, it may find cooperating with the rules-based international system to be a “greater priority” than a China-first agenda. But, Nouwens predicts, “it will require the U.S. and Russia to make the first steps though before China decides to agree to reducing what it views as an already significantly smaller Chinese nuclear arsenal. The trust isn't there.” Rose Gottemoeller, who served as undersecretary of state for arms control and international security at the U.S. State Department during the Obama administration, before becoming deputy secretary general of NATO from 2016-2019, believes a careful calibration of what, exactly, is being negotiated will be key to any negotiation involving the Chinese. “I think you can make a case for the Chinese to come to the table early on intermediate-range constraints of ground-launched missiles because they are staring at the possibility of a deployment of very capable U.S. missiles of this kind,” she said at a January event hosted by the Defense Writers Group. “But I am concerned, they have so few warheads that if you put an emphasis on controlling their warheads, the incentive is for them to run the other direction rather than come to the table,” she added. Gottemoeller also indicated that the question of extending New START is a separate one from trying to bring China into the arms control fold. “The way the expansion program of New START is written, it's written so that it remains in place four to five years, so from '21 to '26, or until superseded by a new treaty. So it's not as if the administration is stuck with New START for another five years,” she said. “Go for it. Work on the new treaty. Get it done. And then New START would be superseded by the new treaty entering into force,” if ratified. “Let's just get on with what we need to do in negotiating new treaties. I am concerned that there will be a lot of gamesmanship going on, and as I said, the Russians are excellent in that kind of game as well,” she added. “Let us not play around with leverage in this case, but simply extend the thing for five years and then get done what we need to get done, which is to negotiate these new treaties." https://www.defensenews.com/pentagon/2020/02/26/arms-control-decisions-by-trump-administration-could-be-imminent-will-china-be-involved/

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