Israel’s Defense Industry and US Security Aid Sasson Hadad, Tomer Fadlon, and Shmuel Even, Editors Memorandum 202 Israel’s Defense Industry and US Security Aid Sasson Hadad, Tomer Fadlon, and Shmuel Even, Editors Institute for National Security Studies The Institute for National Security Studies (INSS), incorporating the Jaffee Center for Strategic Studies, was founded in 2006. The purpose of the Institute for National Security Studies is first, to conduct basic research that meets the highest academic standards on matters related to Israel’s national security as well as Middle East regional and international security affairs. Second, the Institute aims to contribute to the public debate and governmental deliberation of issues that are – or should be – at the top of Israel’s national security agenda. INSS seeks to address Israeli decision makers and policymakers, the defense establishment, public opinion makers, the academic community in Israel and abroad, and the general public. INSS publishes research that it deems worthy of public attention, while it maintains a strict policy of non-partisanship. The opinions expressed in this publication are the authors’ alone, and do not necessarily reflect the views of the Institute, its trustees, boards, research staff, or the organizations and individuals that support its research. Israel’s Defense Industry and US Security Aid Sasson Hadad, Tomer Fadlon, and Shmuel Even, Editors Memorandum No. 202 July 2020 התעשייה הביטחונית בישראל והסיוע האמריקאי עורכים: ששון חדד, תומר פדלון ושמואל אבן Institute for National Security Studies (a public benefit company) 40 Haim Levanon Street POB 39950 Ramat Aviv Tel Aviv 6997556 Israel E-mail: [email protected] http://www.inss.org.il Copy editor: Lisa Perlman Graphic design: Michal Semo Kovetz and Yael Bieber, TAU Graphic Design Studio Cover photo: Michael Mass Printing: Digiprint Zahav Ltd., Tel Aviv © All rights reserved. July 2020 ISBN: 978-965-92806-3-6 Contents Executive Summary 7 Preface 11 Part 1: The Security Industries in Israel and the World The Strategic Importance of the Defense Industries in Israel 21 Yaacov Lifshitz Challenges of the Israeli Defense Industry in the Global Security Market 33 Asher Tishler and Gil Pinchas Part 2: MOU Negotiators on Both Sides Share Their Perspectives Negotiating the MOU from the Perspective of the Head of the Israeli Negotiating Team 51 Jacob Nagel A Review of the Negotiations on the 2016 US-Israel MOU on Military Assistance 61 Daniel B. Shapiro Part 3: The Impact of the MOU on the Security Industries in Israel Possible Effects of the Change in Foreign Currency Aid on the Structure of the Israeli Defense Companies 71 Guy Elfassy, Ronny Manos, and Asher Tishler Tightening the Belt and Introspection – Preparing for the Cut in Shekel Aid 95 Saul Bronfeld New/Old Trends Affecting the Defense Industries 109 Guy Paglin Part 4: The Importance of the MOU to Israel US Military Aid – Still a Strategic Asset for Israel 129 Shmuel Even Is the Aid Agreement Essential for Israel? A Cost-Benefit Analysis 141 Sasson Hadad Executive Summary The defense industries in Israel are essential in a number of respects. For one thing, Israel cannot always rely exclusively on external procurement sources. Domestic production is thus an integral part of research and development. It makes it possible to adapt unique weapons systems to the changing needs of the Israel Defense Forces (IDF) – systems that provide a critical edge to the IDF on the battlefield. Independent production capability is particularly important during a conflict in which the supply chain is affected, or when there are political restrictions on the use of certain types of arms. In the economic sphere, although the defense industry does not account for an especially large slice of Israel’s GDP, it is one of the country’s high-tech engines and a source of quality work for thousands of employees. In the political sphere, its ability to supply advanced military solutions to other countries contributes to those countries’ support for Israel. In the summer of 2018, a research team on the subject of Israel’s defense industries was assembled at the Institute for National Security Studies (INSS) to focus on ways of dealing with a major change in the most recent US aid agreement: the end of the conversion of dollar aid into shekels.1 In the discussions conducted by the team, a number of negative effects of this change on the defense industries in Israel were highlighted. The first is a drop in the revenue of companies resulting from the expected reduction in local IDF procurement. Less IDF procurement is also likely to have a negative impact on arms exports, both because the viability of production rests on economies of scale and because part of Israel’s defense exports depends on the IDF’s reputation and experience. Some companies in the domestic supply chain may face the risk of closure. Furthermore, some local technological knowhow may well be lost when companies close down or relocate overseas with their employees. Employment will also be negatively affected – anywhere between several thousand and 20,000 of the 80,000 Israel’s Defense Industry and US Security Aid 7 Sasson Hadad, Tomer Fadlon, and Shmuel Even, Editors 8 I Israel’s Defense Industry and US Security Aid jobs in the defense industries in Israel will be lost. The Ministry of Defense believes that the higher number is more accurate, while the Ministry of Finance holds that the lower number is a better reflection of the situation and also believes that most of those who lose their jobs in this field will quickly find work elsewhere. Another consequence of the change is a negative effect on employment in communities that depend on factories selling to the Ministry of Defense. In addition to all these factors, it should be acknowledged that it is easy to dismantle defense industries, but far more difficult to rebuild them if and when they are needed. Principal Policy Recommendations The Israeli government must prepare now for the drastic change in the conversion of aid dollars into shekels scheduled for 2025. This should include the following simultaneous efforts: 1. Prioritizing the allocation of local funding for the survival and development of special defense industries, maintaining strategically important R&D, and retaining key personnel in the field. The defense industries should be mapped and criteria set for this purpose; 2. Granting aid to local companies in order to increase exports; 3. Consideration of mergers in the industry, mainly of small companies into large ones, in order to achieve economies of scale; 4. Efficiently using aid in foreign currency that also takes the defense industries into account. Examples range from the inclusion of Israeli companies in procurement orders from American companies to closer cooperation with American companies, and moving some production and subsidiaries of Israeli companies to the United States. 5. Encouraging reciprocal procurement by American companies (although the aid agreement does not require any reciprocal procurement by these companies); 6. Extending aid for the conversion of companies, units in companies, and personnel from defense production to civilian production; and 7. Offering advice and assistance, especially for small companies in the defense industry. In addition to the recommendations specifically referring to the state of the defense industry in Israel, the team contends that the aid agreement Executive Summary I 9 constitutes a key element in the special relationship between Israel and the United States. Future changes in the agreement must therefore be gradual and include the consent of both parties to avoid giving the mistaken impression of substantial damage to this relationship. The team emphasizes that the special relationship between the two countries must be preserved, even at the cost of short-term damage to the Israeli defense industry, because in the long run, adopting the recommendations listed above is likely to prevent long-term damage. The special relationship and the American aid, which began during the Yom Kippur War, were very important when the Israeli economy was not strong, and are still important now, when Israel is one of the world’s most developed countries. Note 1 The US aid agreement pertaining to Israel’s defense industries, signed anew in 2016, includes a clause that gradually ends Israel’s option of annually converting 25 percent of the aid from dollars to shekels, which was hitherto used for the procurement of equipment from Israeli defense companies. Preface The Israeli defense industry is one of the most prosperous industries in Israel. It originally emerged as a response to the country’s immediate military needs and to cope with restrictions on arms procurement from abroad. Today, the Israeli defense industry manufactures advanced weapons systems for the Israel Defense Forces (IDF) and enjoys a high rating in the global arms market. According to the Stockholm International Peace Research Institute (SIPRI), Israel is in eighth place in the world in arms exports, and in first place in defense exports in relation to its size. Despite the capabilities of the local defense industry, most of the IDF’s military procurement is from the United States through US Foreign Military Financing (FMF). At the end of the previous American aid plan, which covered the years 2009-2018, defense aid amounted to $3.1 billion annually, not including contributions to joint projects by the US Department of Defense. Since 1985, all American defense aid to Israel has been in the form of grants, due to Israel’s economic difficulties. In addition, since the 1980s, Israel has been allowed to systematically convert part of the aid into shekels (“conversions”) for the purpose of procurement from local industries. This money was used to fund the Lavi project and, since that project was shut down, to finance IDF procurement from local industries.