Pakistan Looks East: Why Pakistan is Turning from Washington to Beijing for Defense Equipment. By Shane Mason. avascent.com WHITE PAPER JULY 2018

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1 Pakistan Looks East: Why Pakistan is Turning from Washington to Beijing for Defense Equipment By Shane Mason WHITE PAPER JULY 2018 avascent.com DC LONDON PARIS OTTAWA TOKYO

2 Since 9/11, the United States has provided over $22.8 billion in overt security aid to Pakistan, and another $10 billion in economic aid. 1 Pakistani Defense Spending by Account US $ BILLIONS $12 $10 $8 $6 $4 $2 $ Source: Avascent Procurement R&D Personnel O&M The logic for military assistance to Pakistan has been compelling. Pakistan permits the Pentagon to supply American troops in Afghanistan through Karachi, allowing the US to conduct drone strikes in the western part of the country, and its Army remains the most stable institution in a country with over 120 nuclear weapons and countless terrorist groups. 2 In addition, Pakistan has used some of these funds to procure US defense equipment, particularly aircraft. The Air Force, for example, has spent at least $2.6 billion to field an inventory of 86 F-16 fighter aircraft from Lockheed Martin, 45 of which received mid-life upgrades in At the same time, Pakistan gives safe-haven to groups like the Taliban and Haqqani Network that have killed thousands in Afghanistan. 3 Osama bin Laden was hiding in Abbottabad in the years before he was killed by American special forces, while Mullah Omar, the former head of the Taliban, is believed to have died in Karachi. 4 Pakistan is both essential to US efforts in Afghanistan and a reason why those efforts have been unsuccessful. 5 Despite the contradictions in the relationship, the Bush and Obama administrations decided that aid would continue. Ultimately, access to the Pakistan Army was considered more important than its support for the Afghan insurgency. With his first tweet of 2018, President Trump overturned two decades of US policy toward Pakistan. 6 The President announced, The United States has foolishly given Pakistan more than 33 billion dollars in aid over the last 15 years, and they have given us nothing but lies & deceit, thinking of our leaders as fools. They give safe haven to the terrorists we hunt in Afghanistan, with little help. No more! Several days later, the State Department confirmed that the United States was suspending all security aid, totaling over $200 million, to Pakistan. 7 The move accelerated what was already a deteriorating relationship between Washington and Islamabad by the time President Trump took office. Nevertheless, the aid freeze marks a new chapter in bilateral ties, with implications for US regional interests and the position of American firms in Pakistan s defense market. 2

3 Impact of US Aid on Pakistani Defense Procurement Pakistani Procurement Before and After US Aid Freeze $3.5 American military aid has been used by Pakistan to import weapons from US firms. In addition to the Air Force s fleet of F-16s, the Army s main attack helicopter remains the AH-1 Cobra from Textron s Bell Helicopters. Likewise, Pakistan s Navy flies seven Lockheed Martin P-3 Orion patrol aircraft which it purchased in 2005 for an estimated $970 million. American assistance accounted for 20 percent of Pakistani defense spending since 2011, an annual average of $1.2 billion. US $ BILLIONS $3.0 $2.5 $2.0 $1.5 US assistance has also cleared budgetary space for Pakistan $1.0 to import weapons from other countries and fund military operations. Over the past two decades, Islamabad expanded $0.5 Source: Avascent its ballistic missile program, developed a nuclear-capable submarine-launched cruise missile, and procured a second tranche of JF-17 fighter aircraft from China. It also launched a campaign against the Pakistani Taliban beginning in 2014 Pakistan s Procurement Budget US Contribution which significantly reduced terrorism, and last year raised military pay by ten percent. 8 Future Scenarios for US Aid to Pakistan Future Pakistani Defense Procurement Based on Different Aid Levels The future of US aid will have a significant impact on $4.0 Pakistan s ability to invest in its military. The extent of the impact on procurement hinges on the extent to which $3.5 President Trump is involved in Pakistan policy, the level of US commitment to Afghanistan over time, and whether Pakistan continues to view militants as assets rather than liabilities. Whether the current suspension is permanent remains to be seen. Given President Trump s approach to foreign aid and Washington s frustration with Pakistan, an enduring cut-off is a possibility. In terms of Pakistan s US $ BILLIONS $3.0 $2.5 $2.0 ability to import defense equipment, the impact will be most painful in the short term. Without US aid, Islamabad s procurement budget will be ten percent lower in the next five years than originally forecast. Avascent estimates that under this zero-option that Pakistan will allocate $26.7 $1.5 $ Source: Avascent billion to procurement through However, the logistical necessity of supplying US troops Pakistan Changes Course Glide Path Zero Option in Afghanistan may convince the administration to cut off some, but not all, security assistance. This would be a 3

4 Without US aid, Islamabad s procurement budget will be ten percent lower in the next five years than originally forecast. return to the strategy developed during the Obama administration, in which a glide-path approach to assistance would slowly reduce our financial commitments to Pakistan. Aid could be decreased gradually over time if the US decides to scale back its role in Afghanistan, conditioning a greater share of reimbursements to Pakistan on Islamabad s approach to the Haqqani Network. The House version of the FY2019 National Defense Authorization Act (NDAA), for example, stipulates that half of the $700 million allocated to Pakistan would be withheld if it fails to deny safe-haven to the Haqqanis. 9 The most significant change could occur in the unlikely event Pakistan were to completely reorient its foreign policy, abandon the practice of using terrorist groups as instruments of foreign policy, and pursue the Haqqani Network and Afghan Taliban operating from its soil. Such a shift would likely trigger the release of hundreds of millions of dollars authorized to Pakistan by the US Congress each year. Avascent estimates that Pakistan s procurement spending under these conditions for the next ten years would increase 36 percent from the zero-option, and exceed $36.3 billion. While such a shift is unlikely, it highlights what Pakistan is willing to surrender in exchange for its current policy towards militant safe-havens. Pakistan s Alternatives Amid Economic Uncertainty The aid suspension comes at an inopportune time for Pakistan, which faces its most precarious economic outlook in years. Economic growth is expected to slow for the first time since Moreover, Pakistan s current account deficit stands at $14 billion, over 5 percent of GDP, while its foreign exchange reserves have dwindled to $9.6 billion, enough to cover only two months of imports. 10 In a move seen as paving the way for an IMF loan after national elections on July 25, the country s central bank has devalued the rupee three times since December A weaker currency makes imports more expensive, further constraining Islamabad s ability to buy defense equipment and spare parts in US dollars. Given negative trends in its relationship with the United States, a depreciating rupee, and its untenable foreign exchange position, Pakistan has already begun reaching out to other countries for support, particularly China. Pakistan has received over $5 billion in bilateral and commercial loans from China this fiscal year, including a $1 billion loan in early July. 12 In addition to the China-Pakistan Economic Corridor (CPEC) a package of infrastructure projects in Pakistan funded by Chinese loans worth an estimated $62 billion Pakistan has also turned to Beijing as a source of defense imports. 13 Over the next decade, Beijing will become the single most important arms supplier for the Pakistani military. 4

5 Given negative trends in its relationship with the United States, a depreciating rupee, and its untenable foreign exchange position, Pakistan has already begun reaching out to other countries for support, particularly China. Pakistan may have difficultly financing some of its costly defense imports from China. Along with JF-17 and J-10 fighter aircraft worth over $5.3 billion, Pakistan has also signed deals for eight Type 41 submarines for over $5 billion and four Type 054 frigates worth $1.4 billion. Given fiscal constraints, Islamabad will have few good options. If Pakistan applies for an IMF loan to prevent a currency crisis, as it is expected to do later this summer, it will be subject to conditions on government spending and transparency, including details on how the country funds CPEC. Greater transparency may jeopardize Chinese and Pakistani interests in a $62 billion project with the full, public support of President Xi Jinping. At the very least, Islamabad would be hard-pressed to justify its submarine modernization program, for example, when it is receiving loans from the international community. 14 China is not Pakistan s only alternative to the United States. Turkey and Russia have also emerged as partners. Pakistan has finalized contracts with various Turkish firms such as STM to upgrade the Navy s three Khalid-class (Agosta 90B) submarines and provide four MilGEM corvettes for over $1 billion, and Turkish Aerospace Industries for 30 T129 ATAK attack helicopters. Overcoming decades of distrust dating back to the Soviet invasion of Afghanistan in 1979, Pakistan purchased four Mi-35 helicopters from Russia in 2015 for $153 million. 15 Despite the symbolism of the helicopter sale, Moscow will likely tread carefully before seeking to enter Pakistan s defense market for fear of upsetting India, the most important destination for Russian defense exports. Rupee Depreciating to Record Lows ( ) USD / PKR US $ BILLIONS Source: International Monetary Fund 125 JUL AUG SEP OCT NOV DEC JAN FEB MAR APR MAY JUN Chinese Firms Dominate Pakistani Procurement Programs $2.5 $2.0 $1.5 $1.0 $0.5 Source: Avascent $ All Other Procurement Type 054 Frigates JF-17 Fighter Aircraft J-10 Fighter Aircraft Type 41 Yuan-class Submarines Opportunity Space 5

6 Outlook for American Firms Along with a devalued rupee which will make imports more expensive, the Trump administration s decision to freeze military aid will make US firms less competitive in Pakistan s defense market. American defense platforms will become harder to purchase without the billions of dollars in aid from Washington. During the Obama administration, for example, Congressional objections prohibited Pakistan from using US funds to purchase eight F-16 Block 52 aircraft worth almost $700 million. 16 Required to finance the procurement on its own, Pakistan looked to buy cheaper F-16 Block 30s from Jordan, although that transfer was reportedly blocked by the United States. 17 Absent security assistance, it will be difficult for American firms to maintain their predominant position in Pakistan s military aircraft market. Over two-thirds of Pakistan s mobility aircraft are American. Last year, Rockwell Collins Along with a devalued rupee which will make imports more expensive, the Trump administration s decision to freeze military aid will make US firms less competitive in Pakistan s defense market. was awarded a $30 million contract to upgrade the avionics on 11 C-130Es and five C-130Bs. 18 This will likely be the last major platform upgrade by an American firm for the foreseeable future. Pakistan s fleet of almost 80 F-16s, along with 85 JF-17s from China, represent the mainstay of the country s fighter aircraft fleet. The F-16s saw action during Operation Zarb-e-Azb, a military campaign against the Pakistani Taliban credited with reducing terrorist attacks in Pakistan. 19 While the country s F-16s will remain operational until at least 2030, the Air Force will add another 50 JF-17s during the same time period and will eventually overtake the F-16 as its premiere attack aircraft. Unlike in Pakistan, prospects for US firms in India s defense market are growing. The case for continuing to withhold aid to Pakistan is strengthened by Washington s growing defense partnership with New Delhi, which historically has viewed arms sales to Pakistan as an affront. India s defense market is over five times that of Pakistan, and American firms have sold over $15 billion worth of defense equipment to India in the last decade. 20 The United States now accounts for 12 percent of India s total defense investment, and American firms are active participants in competitions worth an additional $24 billion. 6

7 US market share can no longer be taken for granted in these key countries, with implications for American strategic and commercial interests. What Pakistan May Foreshadow American firms will be less competitive in Pakistan s defense market due to the freeze in US aid, Pakistan s precarious foreign exchange position and reliance on Chinese capital, and Washington s growing strategic and commercial ties with India. The suspension of security aid marks a new low in ties with Pakistan. Despite Islamabad s support for the Afghan insurgency, previous administrations reasoned that engagement would better protect US interests than estrangement. Pakistan was too close to Afghanistan, too big, and had too many terrorist groups and nuclear weapons to risk a public confrontation. The recent decision on military aid was a clear signal that the current White House has reached a different conclusion. 21 President Trump has gone further than his predecessors in openly trying to coerce Pakistan into acting against militant groups based in its country. In turn, Pakistan has accelerated its embrace of China, positioning itself as Beijing s most loyal friend in Asia and the primary market for Chinese defense firms. Pakistan s embrace may come at the expense of its financial independence. 22 In the face of a currency crisis, Pakistan has accepted over $5 billion in loans from Beijing during this fiscal year alone to shore up its foreign exchange position. 23 Pakistan s dwindling currency reserves threatened economic stability and the future of the $62 billion China-Pakistan Economic Corridor (CPEC), the key project in China s Belt and Road Initiative. 24 Pakistan s increased dependence on Chinese lending leave some worried whether Pakistan will be able to service its debt obligations if CPEC investments yield lower-than-expected returns. 25 As Chinese influence increases in Islamabad, American companies are bound to lose out in the process. Pakistan s pivot from Washington may foreshadow developments elsewhere. Like Pakistan, the arsenals of Turkey, Egypt, and Saudi Arabia have long been dominated by US defense platforms. Amidst regional instability, an increasingly multipolar international system, and growing Chinese influence, each of these countries can now choose between Chinese, Russian, and Western alternatives. US market share can no longer be taken for granted in these key countries, with implications for American strategic and commercial interests. Despite current ties with the Trump administration, it is up to Pakistan whether security assistance will resume. Pakistan, however, is unlikely to change course. The country has long considered maintaining influence in Afghanistan a vital interest and views the Taliban and Haqqani Network its primary conduits in doing so. An about-face would, however, satisfy the conditions Washington has placed on its military aid. This would release billions of dollars in assistance to Pakistan and boost its procurement budget by an estimated 36 percent through After the dramatic move by the Trump administration to freeze security assistance, it will take a dramatic response from Pakistan to change Washington s approach. 7

8 Key Takeaways American defense firms will continue to lose market share in Pakistan to Chinese, Turkish, and Russian counterparts amidst a suspension of US military aid, deteriorating ties with Washington, and declining rupee Pakistan s ability to import defense equipment from Western firms will grow more difficult over the long-term, as the country relies more heavily on Chinese capital to shore up its precarious foreign exchange position and service debt on loans associated with the $62 billion China-Pakistan Economic Corridor At the same time, prospects in India a democracy with a vibrant economy and a defense market that exceeds $53 billion are growing, with American firms already active participants in competitions worth $24 billion Absent more focused corporate strategies, the declining fortunes of U.S. firms in Pakistan s defense market could foreshadow developments in Egypt, Saudi Arabia, and Turkey countries once dominated by American companies that can now realistically choose from non-western alternatives Endnotes pdf/ / ?needaccess=true 3 pubs/1225-report-dec-2017.pdf /1/1225-REPORT-DEC-2017-FINAL-UNCLASS-BASE.PDF 6 status/ ?lang=en Salaries-of-govt-employees-raised-by-10pc-in-Budge update-3-pakistans-new-rupee-devaluation-showseconomic-risk-before-election-idusl4n1td2o pakistan-refutes-imf-report-as-its-eyes-bonds-china-funding Cal-Yr/GS/FY17GSNR33-Pakistan-C130.aspx pakistans-currency-crisis-china-problem-and-solution Ibid 25 pakistan-faces-a-currency-crisis.-who-will-help 8

9 About the Author Shane Mason is a Senior Market Analyst with Avascent Analytics in Washington, DC. Shane was previously a Research Associate at the Stimson Center s South Asia Program, and a Scoville Fellow at the Carnegie Endowment for International Peace. He graduated with an MA from the Middlebury Institute of International Studies at Monterey, and received his BA from Pepperdine University. For more information, contact: smason@avascent.com. About Avascent Avascent is the leading strategy and management consulting firm serving clients operating in government-driven markets. Working with corporate leaders and financial investors, Avascent delivers sophisticated, fact-based solutions in the areas of strategic growth, value capture, and mergers and acquisition support. With deep sector expertise, analytically rigorous consulting methodologies, and a uniquely flexible service model, Avascent provides clients with the insights and advice they need to succeed in dynamic customer environments. AVASCENT WASHINGTON DC 1615 L Street NW, Suite 1200 Washington, DC Tel: +1 (202) LONDON 132 Buckingham Palace Road London SW1W 9SA Tel: +44 (0) PARIS Rue des Archives Paris Tel: +33 (0) OTTAWA Unit 200, 440 Laurier Avenue West Ottawa, ON K1R 7X6 Tel: +1 (613) TOKYO 4F Yaesu Dori Building, 4-15, Nihonbashi 3-chome, Chuo-ku, Tel: +81 (03) avascent.com europe.avascent.com Copyright AVASCENT 2018