As Russia continues to wage its war of aggression against Ukraine, leaders in Kyiv view security guarantees from the United States and Europe as the only path to an enduring peace. But here, there is no easy solution. Ukraine joining NATO is an unlikely option until the war ends, something President Volodymyr Zelensky has acknowledged. EU membership, which comes with a weaker security guarantee, is still years away. Meanwhile, Russia appears to be preparing for a long war of attrition. Ukraine’s fighting spirit remains high, but its economic and human resources are heavily strained.
For now, Ukraine’s best security strategy is to build up its military capabilities not only to defend against Russia’s ongoing attack but also to deter any future renewed large-scale assault. This requires significant resources, careful long-term planning, and technological advancements to overcome Russia’s advantages in the air, naval, and other domains. Ukraine has come to rely almost entirely on equipment and munitions from its partners worth tens of billions of dollars since 2022. But with growing uncertainty about the West’s political will to sustain such aid in a protracted war, it needs a path to meet a larger share of its security requirements through domestic production.
Ukraine’s once-mighty defense industrial base, now battered by the war, holds significant potential to help achieve this objective, but this is not a near-term solution. Major investment in new physical infrastructure remains unlikely amid the persistent threat of Russian air and missile attacks. Corruption, inadequate professional management, inefficient corporate structures, and technological gaps are just a few of the serious challenges that reformers in Kyiv will have to address before Ukraine can begin producing weapons systems, munitions, and other technologies at the scale needed to address its enormous military needs.
The United States and Europe are trying to devise an interim framework that aims to help Ukraine defend itself until it can formally join Western institutions down the road. On the margins of the NATO summit in Vilnius in July 2023, the leaders of the G7 nations and the EU signed a joint declaration of support for Ukraine. This document, while merely a political statement, launched a process by which the signatories must elaborate concrete long-term commitments, including on equipment transfers, military training, intelligence cooperation, and economic support. The declaration also committed the signatories to providing “support to further develop Ukraine’s industrial base.” And it committed Ukraine to advancing defense-sector reforms, in particular to improve efficiency and transparency.
It remains uncertain how the signatories will operationalize these commitments. There are signs that some European defense firms are interested in partnering with Ukraine’s state-owned defense industry, but it is not clear that these efforts will yield production lines at scale, and certainly not soon, given the significant challenges facing the industry.
Ukraine’s partners should consider allocating a portion of their military aid to a fund that could incentivize Western firms to form joint ventures (JVs) with Ukrainian defense enterprises, based in nearby European countries and under EU law. Such an arrangement would ensure sufficient legal safeguards for intellectual property (IP) and investor rights, allow Ukraine to benefit from U.S. and European innovation and supply chains, and allow NATO countries to incorporate lessons from Ukraine’s battlefield experience to improve their own capabilities and defense industrial base. Once security conditions warrant and Ukraine has enacted sufficient rule-of-law reforms, these joint ventures could be relocated to the country.
Defense Industry Transforming Slowly
When the Soviet Union collapsed in 1991, Ukraine inherited some 30 percent of its defense industry, with over a million employees. Ukrainian factories had played a key role in supply chains and in producing and maintaining Soviet weapons systems, including missiles, tanks, aircraft engines, and components for the space industry. As Soviet-era technology lost its edge, however, they struggled to compete on the global arms market and became ever more dependent on exports to Russia. This trend only began to reverse after Russia’s illegal annexation of Crimea in 2014.
The Soviet legacy also saddled Ukraine with near-total state control over the defense industry. Previous attempts to privatize state-owned enterprises, while successful in other industries, have faltered in the defense sector. Zelensky has said that Ukraine’s state-owned industry will be key to the country’s long-term self-defense strategy, but this requires overcoming long-standing structural challenges. These include a reliance on outdated technology; a lack of incentives for the industry’s development; an inefficient asset structure; neglected human capital, especially at the managerial level; and pervasive corruption and political interference.
New Structure, New Team
Ukraine’s state-owned defense industry is undergoing a transformation after numerous failed reform attempts over the past decade. In 2020, the Cabinet of Ministers established the Ministry of Strategic Industries and tasked it with formulating and implementing policies related to the defense industrial base, defense procurement, and the aircraft and space industries. The ministry’s goal is to fix endemic problems in the defense industry, and in particular to carry out to completion the restructuring of the state-owned defense conglomerate Ukroboronprom (UOP).
But the Zelensky administration has struggled to find capable professional managers with relevant industry experience to take on such a tough mission. The ministry has undergone three leadership changes since it was created. The current minister, Oleksandr Kamyshin, had a successful stint as the head of the state railways and, prior to that, was a manager in the main holding company owned by Ukraine’s biggest oligarch, Rinat Akhmetov. Kamyshin has promised a new cycle of reforms for UOP.
In 2021, Ukraine adopted laws and regulations that lay the groundwork for UOP’s transformation. UOP was initially established in 2010 as a “concern,” an association of financially interdependent enterprises under central management. In June 2023, it was dissolved and transformed into a joint-stock company called Ukrainian Defense Industry (UDI), an important step in transitioning the company to a corporate structure aligned with industry best practices on transparency, compliance, operational efficiency, and combating corruption.
In the process of this transformation, Yuriy Husiev was removed as UOP’s chief executive officer in June 2023 and was replaced by Herman Smetanin, a young engineer who rose through the ranks of the defense industry. Husiev was faulted for UOP’s underwhelming performance, especially its failure to deliver on a promised missile program. Kamyshin has charged Smetanin with increasing the production of ammunition and equipment, fighting corruption, and completing the corporate restructuring process.
A Burdensome Legacy
UDI’s new leadership team faces several legacy challenges as it seeks to transform the company into a profitable enterprise that can contribute meaningfully to Ukraine’s urgent and long-term defense needs.
First, many defense enterprises rely on outdated technology and struggle to compete on global markets. This lack of competitiveness is evident in Ukraine’s declining export of military equipment. In 2020, defense exports amounted to $514 million, a two-fold decrease from 2013.1 Ukrainian firms primarily produce simple, low-technology products, and they cater to countries still utilizing Soviet-era systems. Due to the war, the Ministry of Defense now buys all of UDI’s output, but frontline soldiers sometimes reject these products because of their poor quality in comparison to Western weapons.
Second, the state has failed over the years to incentivize production. Although the conflict has been ongoing since 2014, state orders accounted for only 30 to 40 percent of UOP’s income in the years preceding the full-scale invasion in 2022. The state also regulates the profits companies can earn on production tied to state orders, thereby undercutting enterprises’ financial health and ability to invest in new technologies. Indicative prices, subject to subsequent adjustments, reduce the motivation to save costs. Government investments into new technologies have been notably low and inefficient, and plagued by corruption issues and a lack of long-term vision. Defense production expenditures for 2024 are set at UAH (Ukrainian hryvnia) 51 billion ($1.4 billion), which is a relatively small sum considering Ukraine’s needs.
Third, Ukraine’s state-owned defense assets are not organized for success. Over the past ten to fifteen years, debts have accumulated due to a suboptimal asset structure and the lack of state orders. In 2020, UOP comprised 137 enterprises, with twenty-one located in the occupied territories and Crimea, eighty-three facing financial instability, and fifteen already bankrupt. Twenty-eight enterprises generated 98 percent of UOP’s revenues in 2021. Such an inefficient corporate structure—combined with a surplus of staff, property, and real estate—creates additional expenses, elevates the tax burden, and diminishes efficiency.
Fourth, Ukraine has neglected its human capital in the defense industry. The workforce—around 68,000 in UDI’s combined enterprises—is generally older and wages in 2020 were nearly twenty times lower than the global industry average. The recruiting and training pipeline for young talent is broken. Highly qualified engineers often move abroad to work for foreign companies, resulting in a significant brain drain and a loss of human capital. Those who remain in Ukraine often change jobs or re-skill to join the private sector, where salaries are higher. This problem extends to management. From UDI itself to the smallest company within its portfolio, there is a dearth of professional, apolitical managers with relevant industry experience who have a long-term vision.
Still a Black Box
The final challenges for UDI’s success are corruption and political interference. Ukraine’s state-owned defense industry has historically been one of the least transparent sectors of the economy. Although the need for secrecy is understandable, especially during wartime, the industry’s opaque practices have hindered its efficiency and ability to cooperate with foreign partners.
UDI has unveiled a one-year plan to fight corruption, although this appears to be merely a bridging document until a longer-term strategy is produced. The company also has introduced selection commissions for choosing candidates for director positions at high-priority enterprises that will handle large state orders. However, past practice suggests these commissions will select candidates based on their personal connections rather than on their professional qualifications.
International donors and Ukraine’s civil society are pushing the government to form an independent supervisory board for UDI, in line with OECD standards. The goal of creating such a board is to insulate UDI from political interference. The United States reportedly views this as a key priority to be completed by early 2025. U.S. officials want UDI to better align its work with the requirements of the Ministry of Defense and the General Staff of the Armed Forces, and also to meet NATO standards for transparency and accountability. Wartime secrecy cannot be an excuse to avoid reforms, the United States argues.
Author interviews with Ukrainian officials in various ministries and agencies reveal another emerging concern. These officials report their impressions that their U.S. government counterparts privately worry about the concentration of power in the Office of the President of Ukraine, particularly in the hands of a few top officials. Decisions made at the top often conflict with each other and with prior commitments to international partners.
The weapons procurement process is of particular concern. At the start of the full-scale invasion, state-owned arms-trading companies were re-subordinated from UOP to the Ministry of Defense and were given the function of arms importers. But despite receiving substantial advance payments from the government in the spring of 2022, these companies did not deliver on these contracts, leading the ministry to take legal action against several of them.
Around the same time, the ministry formed a Defense Procurement Agency to centralize the procurement process. Centralizing weapons procurement on the state’s behalf may seem like a logical step and is generally consistent with the practices of NATO countries. But it raises unique concerns in Ukraine. Until recently, the agency was overseen by deputy defense minister Denys Sharapov, an old business partner of Andriy Yermak, the head of the Office of the President. Anti-corruption activists had raised the alarm about Sharapov’s reputation in the arms-trade industry dating back to the era of ousted president Viktor Yanukovych. Sharapov was removed in September 2023 as part of a broader leadership shakeup in the ministry, and the ministry’s procurement functions have been transferred to the newly established agency, headed by Arsen Zhumadilov. But it remains to be seen whether Zhumadilov can clean up the procurement process.
Private Sector Still in its Infancy
Since the start of Russia’s invasion, private citizens have used their entrepreneurial and creative spirit to develop essential tools and devices for the armed forces. These initiatives spearheaded by small volunteer groups, startups, or small companies have the potential to evolve into the foundation of a new defense industrial base.
Army of Drones
There have been positive developments in the private sector of Ukraine’s defense industry, particularly in the production of drones. The military has a significant demand for drones, especially those that are affordable, swift, and lightweight, with a focus on first-person-view (FPV) drones. Addressing this demand, the Ministry of Digital Transformation launched Army of Drones, a collaborative project involving the General Staff of the Armed Forces, the State Special Communications Service, and the fundraising platform UNITED24.
Army of Drones involves the procurement of mostly FPV drones as requested by the military and includes a training course for operators. At the time of writing, under this framework, operators were undergoing training in thirty-one schools, and 10,000 had been trained during the first stage. There are plans to train 10,000 more operators in the second stage.
The project aims to provide the army with 200,000 drones. To achieve this objective, Ukraine is actively promoting domestic production by offering incentives and seeking to nurture the unmanned aviation sector. Army of Drones has entered into approximately eighty contracts with Ukrainian manufacturers. The significant increase from thirty manufacturers engaged in drone production at the onset of the full-scale invasion to now about 200 can be attributed in part to the enthusiasm and creativity of Ukrainians and partly to government support.
The government has implemented policy changes to spur domestic drone production by increasing profit margins and streamlining regulations. In March 2023, the Cabinet of Ministers launched a test project for the procurement of domestically produced unmanned systems. Previously, the government limited manufacturers’ profit margins, allowing them only to add a 1 percent surcharge for foreign components and 30 percent on top of the cost of services. It has now authorized manufacturers to add 25 percent to overall production costs, but even this increased profit margin is not sufficient to scale up production or to invest substantially in research and development. The Cabinet of Ministers has also streamlined the processes for contract negotiation, goods acceptance, operational clearance, and delivery to the front.
Ukrainian production is evolving and advancing beyond basic FPV drones to include new naval drones, AI-based reconnaissance drones, loitering munitions, and more. The government has underscored its commitment to the development of an indigenous drone sector by earmarking approximately UAH 43 billion (around $1.2 billion) for the expansion and enhancement of Army of Drones. While this funding is significant in the context of the state budget, it is relatively modest considering the demands of the ongoing war and the imperative for defense industry development.
The government has also established Brave1, a coordination platform designed to facilitate collaboration among defense industry stakeholders and to provide organizational, informational, and financial support for private defense tech projects. The Minister of Digital Transformation announced that Ukrainian developers have secured grants exceeding $1,000,000 on the platform. A total of 583 projects were submitted to Brave1, and 305 have already passed the defense examination. Additionally, at the time of writing, nineteen projects were in the process of finalizing contracts amounting to $315,000. The ongoing projects, prioritized by the military leadership, span areas such as drones, robotic systems, electronic warfare, AI tools, cybersecurity, communications, and information security management systems. However, the maximum grant available on the platform is $25,000, which is insufficient for substantial defense research and development or for the establishment of production facilities.
Facing Headwinds
Private Ukrainian defense firms and startups are numerous, but they are small, replicate existing technology rather than produce cutting-edge systems, and are limited to prototypes instead of full production lines. A particular challenge for private drone manufacturers is the security of the commercial supply chain. Ukrainian drone startups rely heavily on imported components from China, which since July 2023 has imposed controls over the export of key ones. Other challenges include labor shortages and inadequate state support to address the high costs associated with research and development.
Moreover, there are no publicly known instances of foreign venture capital funds or investors making substantial investments into Ukrainian projects. This reflects the early stage of these startups, with most not being particularly innovative but rather focused on low-cost production. Transforming them into profitable and competitive businesses with Western partnerships will be key to sustaining Ukraine’s long-term military needs.
A significant concern for private industry is the safeguarding of IP rights and innovations in Ukraine. There are reports of Ukrainian law-enforcement agencies conducting searches and seizures in the offices of private defense technology companies. These cases typically lack merit and the goal instead appears to be the confiscation of private innovations for use by the state or by corrupt government actors. An example is the recent case of Archer, the sole Ukrainian manufacturer of cooled thermal imaging sights. In this case, law-enforcement officers copied proprietary design drawings, documentation, and software products, leading to a halt in the company’s operations. If Ukraine is to develop a robust private defense industry, the authorities must tackle these rule-of-law and IP protection challenges head on.
Foreign Collaboration Essential but Lagging
For Ukraine to establish a productive, sustainable defense industrial base that can compete with Russia’s, it must collaborate with Western companies and tap their expertise and technology. Western companies must understand, however, that their primary partner will be the state, represented by the Ministry of Strategic Industries and its sole subordinate entity, UDI.
There are some promising signs of foreign cooperation. In September 2023, Germany’s regulators green-lighted a Ukraine-based JV between the country’s arms giant Rheinmetall and UDI that will see production facilities established in Kyiv. The initial phases of their cooperation will focus on the maintenance and repair of German-provided vehicles. Rheinmetall envisions moving eventually to joint production of certain products in Ukraine and joint development of new systems, including for export by Ukraine. The company’s caution and gradual approach to cooperation with UDI is understandable, given the previously mentioned challenges.
A second example concerns the Turkish defense company Baykar, which is allocating $100 million across three ventures in Ukraine, including a drone production plant that it hopes will open by early 2025. Baykar faces various challenges in these ventures, including the security of the supply chain, development of human capital, and the regulatory environment to protect investor rights.
Taking inspiration from these examples, the government hosted the inaugural International Forum of Defense Industries (DFNC1) in September 2023. According to the official press release, the event brought together 252 companies from over thirty countries, and led to the signing of twenty agreements and memorandums between Ukrainian and foreign partners. These documents encompass collaborations on drone manufacturing, armored-vehicle repair and production, and ammunition manufacturing. The cooperation frameworks involve joint production, technology exchange, and the supply of components. But it remains to be seen when and how these memorandums and declarations will translate into concrete joint projects.
In addition, author interviews with U.S. and European defense companies reveal several challenges. First are security concerns. Physical production lines in Ukraine are vulnerable to Russian attacks that can destroy multi-million-dollar investments in a single strike. There is no silver bullet for mitigating these risks. Relocating production underground, for example, would raise investment costs significantly and worsen working conditions. Air-defense systems are in short supply and cannot ensure total protection against evolving attacks, technologies, and methods.
These security concerns extend to the supply chain and labor force as well. A substantial amount of raw materials and resources are located in or near occupied territories. Foreign suppliers, meanwhile, are sometimes hesitant to directly provide materials to Ukraine, and logistical complications further add to the complexity of maintaining a secure and sustainable supply chain. The Ukrainian labor force is also under stress. Technical engineers have either emigrated, undergone re-skilling, or are serving on the frontline, resulting in a scarcity of skilled professionals within government offices and enterprises.
These challenges are so acute that even UDI relocated some of its production facilities to undisclosed NATO member countries, where there are established production lines, secure supply chains, and a skilled labor force. These ventures have reportedly contributed to the production of items such as 120-mm mortar rounds and 125-mm shells for T-64, T-72, and T-80 tanks.
Foreign companies face other obstacles to operating in Ukraine’s defense industry, just as their local counterparts do. Inadequate legal protections and deficiencies in the judicial system lead to a significant risk of IP theft, which is likely to disincentivize Western companies from technology transfer even if, as in Rheinmetall’s case, it has been promised in an initial concept. Moreover, Western companies face the persistent challenges of corruption throughout Ukraine’s defense industrial enterprises, political interference from top officials, unrelenting Russian industrial espionage, and a continued lack of qualified professional managers to run Ukraine-based JVs. All of these challenges require sustained reforms, but Ukraine’s defense needs are too urgent to wait.
Toward an Interim Joint-Venture Model
Considering Ukraine’s urgent defense needs and the long road ahead to secure and reform its domestic defense industry, Kyiv and its partners should consider interim solutions that can be operationalized quickly. Europe-based JVs with Ukrainian defense enterprises would be just such a solution, offering benefits to Ukraine and the West while sidestepping the challenges inherent in the country’s defense industry. They would offer Ukraine a way to integrate into, and benefit from, the West’s industrial base without having to wait for its legal and business environment to be fully reformed.
The concept is relatively straightforward. The United States and Europe can set aside a fraction of their aid to create a dedicated investment fund, under NATO or EU auspices, to kick-start the effort. U.S. and European defense firms would apply for investments from the fund to set up JVs with Ukrainian counterparts, either the state-owned UDI or a private startup. The fund should have a well-defined investment strategy based on Ukraine’s urgent military requirements and inputs from partner countries, as well as a governing board that includes a mix of skilled investors and military and defense industry experts from Ukraine and partner countries. With oversight from the fund managers and guidance from NATO and Ukrainian officials, the JVs would prioritize NATO-standard production to meet Ukraine’s military requirements, as well as to replenish U.S. and European stockpiles. Shareholder structure would vary by the venture, but in each case would represent a mix of Ukrainian and NATO member interests.
This model solves several problems while allowing Ukraine and the West to reap tangible benefits. First, locating the JVs’ physical infrastructure outside Ukraine—ideally in a nearby NATO country, to minimize the costs of, and time needed for, transportation to the front lines—would ease many of the security concerns of Western firms. The chances of a Russian strike against a factory on alliance territory would be minimal, as Moscow would rightly worry about triggering NATO’s Article 5 guarantees. The risks of sabotage and industrial espionage would also be substantially lower. NATO counterintelligence services have far greater resources and bandwidth than their Ukrainian counterparts to ferret out spies and implement cyber- and physical security measures.
Second, by operating in EU jurisdictions and under EU law, the JVs would benefit from robust legal structures, including protections for IP and investor rights. The risk of corruption or political interference would be relatively low. Europe-based JVs also could draw from the Ukrainian workforce that has moved overseas, offering competitive wages for potentially thousands of refugees as well as opportunities for Ukrainian managers to gain hands-on business development experience from Western counterparts that they can one day bring back to postwar Ukraine.
Third, the JV model could help alleviate rising concerns in the West about the sustainability of equipping Ukraine. U.S. public support for aid to the country is showing signs of weakening amid the prospects of an open-ended war of attrition and as the issue becomes subject to a widening partisan divide. It is uncertain whether the White House’s request for more than $60 billion in aid for Ukraine will be approved in Congress but, even if it is, it will only last until September 2024, when a large new package will need to be approved to keep Ukraine able to fight the war. Supporting Ukraine’s defense industrial capacity is therefore key to putting the country on a more sustainable track over the long term and gradually reducing Western partners’ overall aid burden. US aid to Israel since the 1970s, a portion of which was reserved for the country’s government to fund indigenous production, offers a useful example. Israel’s domestic arms industry is now one of the world’s most dynamic and can meet many of its military’s needs.
Fourth, the JV model is consistent with U.S. and European defense priorities. Russia’s war against Ukraine has revealed the inadequacy of the West’s defense industrial base and weapons stockpiles. NATO and the EU are working to align their members’ defense planning processes with their collective production capabilities, as well as to incentivize joint research and development, multinational procurement, supply-chain integration, and other forms of cooperation that will allow for the defense industrial scaling up needed to meet today’s geopolitical challenges. To keep up with technological advancements, NATO has launched DIANA, a defense accelerator program designed to incentivize research into dual-use technologies, and the NATO Innovation Fund, a €1 billion ($1.1 billion) venture capital fund supporting startups in fields such as AI, biotechnology, energy and propulsion, manufacturing, and space. But these initiatives do not allow Ukrainian participation and, even if they did, Ukrainian startups and enterprises lack the expertise and cutting-edge innovation to qualify. JVs would be a logical mechanism to foster this type of cooperation until Ukraine can be fully integrated into NATO and EU initiatives.
Europe-based JVs with Ukrainian firms could be scaled up in stages. In the initial phase, they could prioritize essential low-technology munitions and systems that can be mass-produced. One hurdle the United States will need to overcome in transitioning to more advanced technological collaboration with Ukraine are the International Traffic in Arms Regulations (ITAR), which impose onerous bureaucratic requirements on any US defense firm that seeks to form foreign partnerships involving the transfer of sensitive technology. As Kyiv implements key transparency and rule-of-law reforms, Congress might consider granting Ukraine the same ITAR status as NATO allies in order to lower the contracting hurdles.
After a few years of collaboration with Ukrainian partners, the JVs could transition to producing more advanced, NATO-standard systems. Over the long term, joint research and development initiatives can foster cutting-edge technology that will enhance Ukraine’s—and Europe’s—deterrence capabilities. As soon as security conditions warrant, these JVs can relocate to Ukraine. And, if the legal and business environment still requires reform at that time, Ukraine and its partners can look at options to apply EU law in any IP or investor disputes.
Conclusion
The West’s understandable focus on Ukraine’s urgent security needs cannot overshadow the long-term nature of the problem; namely, that Russia is likely to remain an acute threat to the country for the foreseeable future. If NATO is not willing to admit Ukraine until the war is over, its members should come up with a strategy to ensure Kyiv has all the tools it needs in the meantime to defend itself and deter a renewed large-scale Russian attack.
The West’s military aid will be crucial to this effort, but so is its support for the revival of an indigenous Ukrainian defense industrial capacity, especially in a long war of attrition and amid growing calls in the United States for a tapering of direct aid. Kyiv and its partners must, however, be realistic about the challenges they face in reforming the Ukrainian defense sector and instituting the rule-of-law improvements that will be necessary to attract meaningful Western investments and technology transfer, not to mention the security challenges inherent in building and maintaining production lines in a war zone.
Fortunately, there is a way for U.S. and European firms to begin cooperating more deeply with Ukrainian defense firms before security and rule-of-law circumstances allow for large-scale Ukraine-based partnerships. Strategically investing in JVs based in Europe, under EU law and NATO’s protection, can help pave the way for increased production of needed weapons systems, foster collaboration between Ukrainian and Western firms and professional managers, and ease the overall aid burden borne by the U.S. and European governments. This bridging solution can bring tangible benefits to Ukraine and NATO, and gradually integrate the country into the Euro-Atlantic security architecture as it moves toward formal membership in Western institutions.
Notes
1 Data provided directly to author by Ukroboronprom in 2020.
.jpg)
