The consequences of mergers in Europe's defence industries - reply to the annual report of the Council REPORT1 submitted on behalf of the Technological and Aerospace Committee2 by Mr Kolb, Rapporteur

TABLE OF CONTENTS RECOMMENDATION 679 on the consequences of mergers in Europe's defence industries - reply to the annual report of the Council3 EXPLANATORY MEMORANDUM submitted by Mr Kolb, Rapporteur I. Cooperation arrangements (i) OCCAR and the LoI (ii) The role of the European Union II. Mergers in Europe's defence industries (i) BAe, an example of vertical integration (ii) Association agreements and mergers: the example of EADS III. The role of the state in EADS IV. Conclusions

Explanatory Memorandum (submitted by Mr Kolb, Rapporteur) I. Cooperation arrangements Since 1992, a number of structures have been set up within WEU and the European Union with a view to resolving the same problems of operational convergence, company law, exports, legal and taxation systems and coordination of research and development and procurements. Within WEU are WEAG (Western European Armaments Group) and WEAO (Western European Armaments Organisation) of which the Thales, Euclid and Socrate Memoranda of Understanding are part, as well as Eurolongterm4. The EU structures include POLARM, COARM and the European Code of Conduct on Arms Exports, while at intra-European (non-EU) level we find EDIG (European Defence Industries Group), OCCAR (Organisation for Joint Armament Cooperation), which has treaty status, and the LoI (Letter of Intent), which is also destined to become a treaty. Finally, NATO has its own structures: the CNAD (Conference of National Armaments Directors), NIAG (NATO Industrial Advisory Group) and various armaments standardisation groups. While each of these bodies, theoretically, has its specific instruments, all are striving towards the same objectives, with varying degrees of success. The status recently acquired by OCCAR and the LoI highlight the progress towards greater harmonisation in the organisation of defence Europe; indeed the legal and political results so far have exceeded all expectations. However, the abundance of such bodies is also evidence of the persistence of a number of fundamental problems which are easy to define, since each new structure is set up to deal with difficulties that could not be resolved by its predecessors. Operational convergence, synchronisation of procurements, industrial return, technology transfers and export duties, for example, are recurring questions. Europe faces two kinds of problem. The first is a matter of harmonising national policies, and can be resolved over time, as Europe moves towards greater legal and political unity. The second is due to the very nature of Europe, which, unlike the United States, is a patchwork of countries with different, and in some cases, divergent, cultures and interests. Thus problems pertaining to technology transfers and the harmonisation of legal standards, labour legislation and tax laws are routinely dealt with at European level, and will be gradually resolved, enabling defence companies to benefit from the same standards as industrial and commercial companies. The European Commission report COM (97) 583 Final, and more particularly the LoI, tackle these issues, and should go some way towards resolving them, especially once the LoI has been given treaty status. Operational convergence, the synchronisation of procurements and budgetary harmonisation are rather more sensitive issues. They have been under study for many years, particularly within WEAG and POLARM, but no ideal solution has as yet been reached. Indeed, operational convergence and procurement policy are determined by a country's military culture, international spheres of interest and defence budget, and in many cases also by strictly industrial considerations. Thus, although France and Germany both recognised the vital necessity of equipping their armed forces with a Tigre-type attack helicopter, the task of defining its missions was relatively arduous, essentially because they had different aims in mind for the common platform. Typically then, although the financial, industrial return and technology transfer aspects did not pose too much of a problem, the programme's gestation was difficult. One can easily imagine how such difficulties are compounded by the technological complexity of certain programmes, particularly in the aerospace sector. In fact, although issues of operational convergence and harmonisation of procurements do not constitute a structural problem in Europe, as we see from the successful implementation of a number of collaborative projects, they nonetheless present a considerable obstacle to industrial cooperation. Indeed, the countries concerned must reach agreement not only on a minimum level of joint capacities, which takes time, but also - and practically in parallel - on the allocation of the relevant budgets. Hence they must have the same defence equipment requirements at the same time, and with the same missions in mind. We can deduce that true operational convergence and harmonisation of procurements will only come about in Europe once all countries agree on the need for a common defence policy to serve common goals. Given the different national interests of its component states, this means that the EU must define for itself a role with regard to eastern Europe and the countries of the southern Mediterranean area, both regions being traditional zones of intervention for European states. The variety of theatres this entails would ideally call for the definition of a fairly wide range of different equipment, particularly for land-based operations. Seen from this perspective, the relatively wide disparities among Europe's defence industries are not really a handicap, since a wide range of equipment is available to the consumer. Hence, while some degree of rationalisation is essential, some variety in terms of the equipment on offer should make it easier to more finely tune the procurement process, since some countries give priority to continental defence, while others favour a more interventionist approach, in the field of peacekeeping, for example. This means not only that a range of different equipment is necessary, but also that any narrowing of that range would mean having to purchase - light equipment in particular - outside Europe. While we take the relatively optimistic view that the issue of operational convergence will solve itself over time, and that it will become possible to some degree to synchronise procurement programmes, a number of structural problems remain in connection with the industrial return on collaborative projects and the harmonisation of export legislation. Cooperation among European countries is founded on a number of conflicting elements. The first aim of collaborative programmes must be to reduce the procurement costs for the participating countries and to promote the development of their technological and industrial capacities. As a result, each country wishes to reap the benefits of orders placed with its own industry and expects a return - both financial and technological - on its investments. Experience has shown that the development of operational specifications and the duplication of production sites and research laboratories among the partner countries increase unit costs, making international projects a lot more expensive than national programmes. Moreover, any delays in a programme - whether at national or international level - entail extra costs. According to British sources, the 25 national and international defence equipment projects involving British industry in 1995-96 gave rise to "cost overruns of some £400 million (...) attributable to changes in the programme, about £180 million owing to changes in equipment specification, about £130 million attributable to poor estimating, and about £340 million attributable to the difference between defence-specific inflation rates which are high and the national inflation rate (...) Collaborative projects (...) do tend to feature prominently in that list of projects with time and cost overruns(...)"5. Furthermore, 25% of the delays encountered over that period in British projects were due to the difficulty of finding funding, 20% to the redefinition of specifications, and 15% to difficulties with international collaborative projects6. It is clear from these figures that to control costs, a perfect understanding of operational requirements, synchronous funding and some degree of standardisation of technical and production capacities are required. Clearly the cost overruns thus far can be attributed to the lack of those elements in international programmes. Conversely, a number of national industries have clearly benefited from such cooperation, particularly in terms of know-how. The German aerospace industry, for example, has acquired considerable expertise from its cooperation with American (F-104 and F-4) and European companies (Panavia Tornado and Eurofighter). Indeed, the COM 97 report and the IEPG7/WEAG documents state as one of the aims of cooperation to promote the participating countries' industrial development in that sector, an objective which so far has been broadly achieved. Furthermore, while subcontracting is conducive to the development of national industries, a clear definition of prime contractorships helps counter any drift of international programmes. It took some six years for the Franco-Italian FSAF (Future Surface-to-Air Family) programme, under French prime contractorship (Thomson CSF 33.3%, Aerospatiale Matra 33.3%, Alenia-Marconia Systems 33.3%) to go from the stage of an international programme to a demonstration project with contracts to place. In this case a clearly-defined prime contractorship and industrial specialisation seem to have been the keys to success. The creation of a European industrial defence programme on a par with American projects would most likely call for a strong degree of rationalisation, in other words a drastic reduction of clearly duplicate capacities, the specialisation of certain national industries and clearly identified prime contractors. Indeed, OCCAR and the LoI acknowledge that traditional approaches geared to the principle of juste retour and the simultaneous development of the national industries are no longer valid. The question is whether that recognition is compatible with the determination shown by European countries thus far to use collaborative projects as a means for developing their national industries. There are three choices: Europe may continue to promote the development of its national industries, or it may simplify the rules governing acquisitions among the industries of the different nations, relying on market forces to bring about mergers and allowing the strong to push out the weak, or it can try to preserve the different national entities by promoting cooperation and then mergers, while leaving the different countries sufficient margin for manoeuvre to avoid an erosion of their national industries. The first is no longer officially a real option, since while the coexistence of a number of national markets may help companies to develop, their potential volumes of orders are not enough to enable them to minimise costs and reach the critical size needed to compete with US companies. The second option would be the most profitable in strictly competitive terms. There is a resurgence of interest in it at European level, with OCCAR and the LoI apparently setting it as the ideal objective. Indeed, those bodies advocate abandoning the principle of juste retour, although they are prepared to accommodate interim solutions. If market laws are to be applied to European companies both before and after mergers, companies must be granted total independence, in particular as regards the choice of prime contractor and the location of production sites. Judging by the example of EADS (European Aeronautic, Defence and Space Company), it is necessary to eliminate redundant capacities, merge design departments and locate production sites according to strictly technological and economic criteria, with no regard for French, German or Spanish industrial policy. Companies must have the possibility of closing down non-competitive production sites and having wide recourse to cross-border technology transfers, without having their hands tied by governments. At that price they should presumably be able to propose projects which would be both economically and technically competitive. However, such an approach would probably be unacceptable, notwithstanding the arrangements recently signed at European level, since it is economically selective, in that it would develop the industries of some countries, whilst relegating others to the role of mere sub-contractors. If the rules of competition were strictly applied, the most competitive production sites (essentially French, British and German) would be developed at the expense of the less productive ones, which, increasingly, would no longer be competitive. Not only would this be tantamount to signing a death warrant for most of the small enterprises specialised in assembling foreign equipment under licence, it would also very soon lead to a concentration of defence industries in a small number of countries, which at the end of the day would take all responsibility for procurement policy out of the hands of the smaller states. In all likelihood the final result will be an intermediate solution: there will quite naturally be a move away from the juste retour principle, as advocated by the LoI, as the merged companies specialise (as is already the case for Airbus), rather than dividing up a single activity among different companies. Nevertheless a company like EADS will never have a status comparable with that of Boeing, since the prime contractorship and the implementation of industrial projects will probably remain relatively fragmented and more costly than for the American competitor. Conversely, this type of structure involving all Europe's industries will doubtless play a decisive role in terms of asserting the European preference, since each country will have a vested interest in developing the trans-European group. From that perspective one should not push too hard for the total rationalisation of future multinational groups, for if a group like EADS is transformed into a commercial undertaking totally dissociated from national interests and requirements, some European states may lose interest in its survival. While the juste retour principle must be put into perspective, it should not be totally abandoned, but rather geared towards a system of specialisation based on the existing capacities of certain countries. The example of Airbus shows that for all its shortcomings, a production system divided among a number of countries can be competitive, while still enabling European projects to win national support. In any case, abandoning the juste retour principle would be totally incompatible with current export legislation based on offset and the development of the recipient industries. Hence, while in no way denying the evident advantages of rationalising Europe's different industries, it should be remembered that a collaborative structure is certainly a prerequisite for creating a defence industry involving all European countries, and not just the biggest states. Nonetheless, for certain specialised areas with relatively little spin-off in terms of dual technologies (munitions, light armaments, armoured vehicles and, to some extent, naval equipment), Europe could encourage the development of national poles of expertise. This would enable some degree of rationalisation to be achieved for land forces equipment, for at the moment three major European companies are building heavy tanks to increasingly similar specifications. Here there is already a degree of operational convergence and only the procurement procedures differ, particularly among France, Germany and the United Kingdom. Given that there are ten or so prime contractors in Europe in the military mechanical sector (as opposed to two in the United States), four programmes for heavy armoured vehicles (against a single one in the United States) and 16 programmes for armoured combat vehicles (three in the United States), there is clearly room for rationalisation8. Countries with the same requirements at the same moment, as is the case for Germany and the UK in the field of light and heavy armoured vehicles, could merge some of their activities. At the same time, however, due consideration must be given to the specific characteristics of those companies, their differences in terms of potential and the possible repercussions of such mergers on the industrial fabric and jobs in the countries concerned. How can Germany's heavy mechanical engineering industry, composed of several large groups, coexist with British industry, integrated in BAe, or French industry, chronically under-productive and showing large deficits? The most rational solution, under which the strong would absorb the weak, would raise questions that many governments are not yet prepared to answer. In the meantime differences persist, as noted by Yves Stierle, Director of Industrial Cooperation at GIAT Industries: "An analysis of the situation in our field does not encourage optimism. If we take the example of France and Germany - though this applies more generally - and look at the main vehicle, artillery equipment or munitions programmes, it is clear that for tanks and artillery, the timetable of requirements is going to differ. In the area of smart munitions, those two countries have embarked on competitive programmes. The only potentially common programme, the programme for infantry vehicles, is experiencing difficulties, so much that its future is now unclear. We shall no doubt have to reflect on why it is that this programme has not taken place in the best of conditions. Its very name may provide a clue - véhicule blindé de combat d'infanterie and gepanzertes Transportkraftfahrzeug - and perhaps indicate that the operational requirement was not strictly identical. There was probably a failure to appreciate in that programme the difficulty of getting industries that are organised so differently to cooperate"9. (i) OCCAR and the LoI As long as such alliances have not taken place, companies in Europe must rely on the arrangements set up with a view to facilitating cooperation. OCCAR and the LoI are important instruments in that respect, although they have their limitations. In its present format, OCCAR would seem to offer a most promising solution. It brings together seven European programmes (Tigre, FSAF, Cobra, Roland, Brevel, Hot and Milan) and is responsible for an armaments market estimated at 17.5 billion euros, which will grow as other programmes are added. OCCAR offers a number of major advantages over preceding bodies: it has a legal personality enabling it to place and manage contracts and organise its own procurement policy, as well as to harmonise the procurement policies of the participating states and to coordinate their R&D. Its prime objective is to promote genuine synergy among transnational programmes and, in so doing, to achieve the best value for money. According to OCCAR's founding texts, the analytical calculation of industrial juste retour on a programme-by-programme basis is to be replaced by the pursuit of an overall multi-programme/multi-year balance. That approach is already reported to have had positive effects on ongoing projects. A competitive tender was organised to select sub-assembly suppliers for the Tigre programme for example, with complete disregard for the previous rule calling for total parity in the sharing of development and production sites. The new approach has saved 5% of the total cost of the programme10. While the achievements of OCCAR are unquestionable, particularly for the harmonisation of procurement policy, governments are still not prepared to give up certain prerogatives. Abandoning the principle of juste retour, for example, is left up to the appreciation of individual countries, in particular if there is an imbalance between their financial contribution and industrial participation. Indeed, it is stipulated in one article of the OCCAR Convention that if a given country receives a volume of orders smaller than 66% of its financial contribution to a programme or sub-programme, or if a global imbalance of more than 4% is identified in relation to all programmes, then action may be taken by the Board of Supervisors in order to restore the balance. That transitional arrangement is valid for the three-year period following the signing of the Convention and may afterwards be renewed or revoked. Similarly, the harmonisation of procurement policies has been only a relative success, since those policies are still subject to fluctuations in national defence budgets. French Defence Minister Alain Richard explained this to the French Senate: "Let us be frank. Our different countries, notwithstanding OCCAR, will continue to choose their own defence procurement programmes. If a country takes the sovereign decision in a parliamentary framework to reduce its defence budget, then this will mean reviewing contracts which have already been placed"11. This is particularly true in the case of European countries like Germany, where individual military programmes - contrary to what happens in France and the United Kingdom, whose parliaments have little real say in the funding of industrial projects on a case-by-case basis - are minutely scrutinised by particularly meticulous parliamentary committees. Furthermore, the plan mooted at the end of 1996 by France and Germany to impose financial penalties in the case of any failure to comply with the contractual obligations of bilateral programmes was quickly dropped, although this would certainly have been a key tool for developing a coherent common European defence policy12. It has to be admitted that OCCAR's capacity to maintain a common programme will, at the end of the day, depend solely on how much interest is shown by individual countries and how much they are prepared to invest. There will be no genuine European policy, to the extent that if one or several countries are not prepared to fund weapons systems for which they feel no need, the other partners will have no choice but to bear the extra costs resulting from the smaller volume of orders. Furthermore, the harmonisation of procurement policies involves a number of pitfalls beyond the scope of any political arrangement and which OCCAR is powerless to remove. In the absence of a clearly defined prime contractorship, international collaborative projects may not be competitive, since they are designed to widely varying and incompatible specifications. The poor export performance of Tornado may be mentioned as one example, as well as the Tigre and Eurofighter programmes, which took more than 20 years to go from the project to production stage, and which were therefore unable to take on board the latest technological developments. More recently, the tripartite infantry combat vehicle project (involving France, Germany and the United Kingdom) was also plagued by all the problems of cooperation. As a result of operational and technical compromises among the different countries, the vehicle is considered to be too heavy, too high and ill-adapted to urban combat situations. The need to reconcile France's desire - to impose its own transmission system and a load capacity (11 men) dictated by French military standards - with German standards calling for a relatively powerful vehicle, led to a compromise which was unsatisfactory but difficult to renegotiate, even after France had left the programme13. In such cases where different operational requirements go hand in hand with unilateral technical choices, OCCAR's action will remain marginal. Only when the various armed forces have the same operational requirements for common operations will it be possible to define a satisfactory common denominator under the auspices of a body like OCCAR. Some progress has also been possible as a result of the LoI14. First of all, this document is one of the first to have been deliberately geared towards an integration of defence industries, its aim being to organise standard procedures for mergers among transnational companies. The LoI therefore advocates a number of rules governing access to research data, the standardisation of technology transfers, the harmonisation of export rules and the interdependence of European companies for the supply of defence equipment. However, while generally speaking the LoI represents quite spectacular progress, it also offers individual states a number of guarantees concerning certain prerogatives and special interests. As regards exports, for example, various aspects of the notion of global export licence remain unclear. Indeed, while a global licence, once adopted, avoids the need for each party to request specific authorisation for each export (article 12-3), its adoption must be agreed by all the countries concerned at the request of any one of them. Given that the adoption criteria are based on the national export rules of the country concerned, including the European Code of Conduct, but that also, according to the text, the different parties can invoke their industrial interests as grounds for their export requests, one can imagine all the obstacles that in some cases must be overcome to obtain a global licence. Indeed, while certain countries are not too meticulous about their customers' morality, particularly when exports serve to strengthen a strategic relationship, support national industry or to develop national programmes, the reverse is true of countries like Germany, for which the moral implications of armaments exports are playing an increasingly predominant role. The conflict between the Franco-British and German approaches can lead to deadlock situations. Germany's general export rules are very clear, as illustrated by the following text: "Political principles adopted by the Government of the Federal Republic of Germany governing the export of war weapons and other military equipment (...) In the pursuit of its arms exports objectives, the Federal Government reserves for itself in all instances the right to oppose through consultations specific projects of the cooperating partner. For all new cooperation agreements to be concluded, a consultation procedure shall therefore be agreed on in the event of exportation by the cooperating country, so that the Federal Government has the opportunity to make its objections known (...)" It is clear then that the German Government intends to enforce the principles underlying its national export legislation, and to apply them to cross-border companies. Furthermore, those same general rules clearly emphasise the fact that the marginal role of armaments exports in Germany's economy does not justify arms sales to areas of risk, even for the sake of jobs. Hence Germany's approach runs counter to some of the criteria laid down in the LoI, so the problem will not be so much to create a global export licence as to reach agreement on the definition of such a licence in the case of disputed exports to areas of risk. Moreover, while it may seem desirable to take the European Code of Conduct as a basis for the settlement of possible disputes, it may not provide all the answers. Indeed, the Code is sufficiently vague to allow room for interpretation, particularly as regards exports to areas of risk, where human rights are being infringed or a conflict is about to erupt. In all likelihood, then, a consensus will be difficult to reach. The problem of industrial juste retour is of a different nature. Following in OCCAR's footsteps, the LoI emphasises in Article 7.3 that governments should leave it to transnational defence companies to choose the economic and industrial criteria governing the distribution of industrial capacity among the different countries in which they are located. However, it also stresses in Articles 7.3, 8.1 and 8.2 that governments reserve the right, in cases in which they deem there is a threat to vital strategic capacities, to maintain or even rebuild certain national capabilities. To be more explicit, the LoI authorises governments to oblige transnational defence companies to maintain certain national capacities, even when economic arguments speak against it. That may prove to be a problem, particularly since no definition of strategic activities is given anywhere. Finally, as far as technology transfers are concerned, while the LoI has the advantage of being the first legal text to tackle this issue, it will probably be necessary to wait for its implementation to fully assess the consequences. However, it should be noted that Article 25 on the security of classified information stipulates that the system for communicating classified information will, save in exceptional cases, be the diplomatic bag. One may wonder how far such a provision is likely to hamper the internal operations of transnational companies, since it means that internal transfers of information will automatically take place under the watchful eyes of the governments concerned. This will probably discourage transfers of information and leave companies reluctant to communicate with their own branches. Worse still, it could mean that governments will interfere directly in the internal affairs of companies. Furthermore, the United States has publicly stated its reservations about the value of the security conditions set down in the LoI. According to Senator John Hamre, former Under Secretary at the Department of Defense (DoD), there is a major risk that the security standards set out in the LoI will be geared to the lowest common denominator, making transatlantic cooperation more difficult from the American standpoint. This potential shortcoming would, in the eyes of the Pentagon, justify the drafting of restrictive bilateral agreements which not only might make US participation in the LoI15 impossible, but also rule out cooperation with those companies which are party to the LoI system. Such considerations are in no way intended to belittle the contributions made by OCCAR and the LoI. Rather, the aim is to make it plain that, whatever may be claimed to the contrary, defence companies are not like normal commercial companies, and that mergers among defence companies at European level do not automatically make them more powerful, as might be the case for US companies. Hence the political support given to such mergers must necessarily be disinterested, since governments must agree to abandon their national strategic sectors of excellence in favour of European entities over which they have little or no control, without there being any real return on investment except the rewarding feeling of having contributed to the greatness of Europe. Therefore there should not be too much optimism in Europe concerning the synergy that will be generated by the ongoing mergers in the defence sector, which may prove disappointing in the short term. Furthermore, it is important to constantly bear in mind the notion of a European preference, even at the risk of upsetting the US Administration. Indeed, to imagine that a group like EADS is comparable with Lockheed simply because of a similar level of turnover would be a grave mistake. European industry is not yet as competitive as American industry, and does not enjoy anywhere near the same level of public investment16. Whatever happens it will be necessary to have the courage to talk in terms of fortress Europe, in other words, protectionism, in this sector, for the time it takes European countries to assimilate the rules of far-reaching transnational cooperation. Only once these have been fully assimilated will it be possible for markets to be systematically opened up. To do it the other way around would merely attract to the market the more powerful and better organised American companies which are systematically defended by an administration much more conscious of the interests of defence companies than all European countries put together. (ii) The role of the European Union The weaker position of European industry in relation to its American competitors has prompted a growing awareness of the special role that the European Union can play in strengthening it. This issue was already addressed in the report submitted by Mr O'Hara17, and here we will confine ourselves to recalling one or two facts. First of all, it is useful to emphasise the convergence that exists between measures adopted within the EU and those adopted in other frameworks. It is particularly significant in this respect that the work of POLARM and COARM serves the same aim as that of OCCAR and the LoI. Indeed, POLARM and COARM are proposing a simplification of the procedures for armaments sales at community level, a more open defence market, an extension of the normal public procurement rules to include the defence market and a harmonisation of export rules. The COM (97) 583 Final report addresses those issues, stressing in particular the decisive role that could be played by the Commission, particularly as regards regulating public procurements in the defence sector. The EU's role in these areas also reveals two shortcomings of the common armaments policy. Thus, although the different states have genuinely adopted a more flexible stance on the prerogatives they enjoy under Article 296 (formerly 223) of the Treaty on European Union (TEU), that Article remains a reality. Armaments contracts remain a matter of national sovereignty, and action at European level is perceived by states solely in terms of strengthening their industrial capacities. Yet clearly, any action at European level with a view to standardising the armaments market and simplifying the rules of competition will not only reduce control by governments over their national industries, particularly in terms of invitations to tender, but will also further weaken the position of the less robust industries in favour of the stronger ones. Even though highly sensitive defence equipment has so far escaped the standardisation process, one may wonder about the future of a number of companies which up until now have enjoyed extensive protection, should they find themselves confronted with powerful and highly integrated competitors. Furthermore, the process of consolidation of defence industries, which in Europe is most advanced in the aerospace sector, will confront the EU and its member states with the problem of managing a monopoly. Although EADS, for example, denies that it enjoys a monopolistic situation, it has to be admitted that if the industries of four countries (including Italy) join forces within in a single company, the result is a de facto monopoly, at least in the field of heavy systems such as combat aircraft. Indeed, it is hard to imagine governments choosing a different supplier of a future aircraft when it seems increasingly less likely that independent aircraft manufacturers will be able to develop new projects (apart from the Joint Strike Fighter, JSF). Although defence contracts and ordinary public procurement contracts are not strictly comparable, the fact of reducing the number of suppliers to two, and perhaps even, in the medium term, to one, is certainly not conducive to controlling costs and enhancing the transparency of defence markets. Indeed, the EU must adopt a subtle approach in its efforts to rationalise those markets, for while it is out of the question to maintain the present system of offset and national preference, it has to be admitted that the logic obeyed by the defence industry is one of state capitalism, rather than liberal capitalism. The flourishing health of the US defence industry clearly illustrates that point. While industrial mergers are often the result of liberal logic based on conventional financial criteria, the guarantees offered by the American Government are typical of state capitalism, with measures ranging from tax breaks for production sites, the adoption of ad hoc legislation conducive to mergers and loyal state support for exports and industrial reconversion, to pure protectionism. From that point of view, while EU involvement in the defence industry would seem highly desirable, in particular in order to define a number of common standards and principles for action, it is important that the EU should be willing to gradually take over the responsibility for defending the interests of the national industries from individual states. This means that the EU must agree to adopt clearly interventionist measures for the defence industry - in particular in the field of legislation and taxation - which run counter to the rules of free competition applicable in other sectors. A failure to do so would deprive companies of essential government support at a time when international competitors fully enjoy such assistance18. II. Mergers in Europe's defence industries The accelerated consolidation of the US defence industry over the past ten years and the growth of its export market share19 have prompted political leaders and industrialists in Europe to embark on a process of mergers among European defence companies. The process has been considerably more difficult than it was in the United States, where consolidation among the American companies was almost exclusively the result of market forces. The process initiated by the Administration was accelerated by the desire of private shareholders to increase the short and medium-term productivity of defence corporations. It was facilitated by the Administration's fairly broad interpretation of anti-trust arrangements (although it vetoed the Lockheed-Northrop merger) and adoption of strong financial incentives20. Conversely, Europe was confronted with companies of different nationalities, governed by different rules, whose ties with the state varied in strength from one country to another. Market forces were not enough to bring about consolidation and government involvement was necessary, vital even, for the major mergers. However, government intervention, contrary to what happened in the United States, was essentially political in nature. The economic logic behind mergers was ill-defined and no European authority was in a position to propose tax measures as an incentive for company mergers. Furthermore, the failure of EADC (European Aerospace Defence Company) in 1998 illustrated how such confusion between industrial and political logic could lead to deadlocks in cases where potential mergers involved very large armaments groups. One problem was that the state's huge share of the capital in the companies of the United Kingdom, France, Italy and Spain made any foreign participation impossible. Another problem was that the differences in the nature of the different industrial groups were not at all conducive to mergers. In the aerospace sector, for example, there were (and indeed still are) huge disparities among DASA, Aerospatiale and BAe, whether it be in terms of the state's share in their capital, their vertical integration in the defence industry or their strategic goals. For mergers to be a real success, therefore, two essential conditions must be met. First of all, companies must have the legal possibility to engage in mergers among themselves. Secondly, their various governments must create the conditions in which such mergers are truly possible, by harmonising standards, export legislation, the rules governing the transfer of technology, and so on. Generally speaking, in the rush to merge the major European defence companies, there was no time to create all the necessary conditions, both in terms of the level of state participation in their capital and the harmonisation of standards. In fact, European leaders were slow in waking up to the problems linked with a consolidation of defence industries and awkwardly tried to copy an American procedure which was clearly ill-suited to European circumstances. Thus, like the US Government, the European (i.e. German, British and French) Governments decided, arbitrarily, at a meeting in December 1997, to give the signal for the mergers race. At the time, local experience was confined to the acquisition of non-strategic companies, alliances among the major groups in specific sectors of activity (Eurocopter, Euromissile) and to multilateral programmes (Panavia Tornado GmbH and Eurofighter GmbH). States retained a high level of participation in the companies' capital and harmonisation remained a dead letter. Since 1998, the situation has evolved somewhat. The British Government, for example, which has a golden share in BAe, has now authorised the participation of foreign groups in BAe, to a maximum level of 15% per group. The French Government has similarly agreed to reduce its share in Aerospatiale Matra from an initial level of 49% to 15%, making it possible to set up EADS. Finally, the Spanish and Italian Governments, whose companies CASA (Construcciones Aeronaúticas S.A.) and Finmeccanica are involved in EADS, have started to disengage from those companies in order to allow their absorption into a major European group. While such disengagement constitutes a strong political signal, showing the resolve of the different European countries to create a common armaments pole, its importance should not be overestimated. Indeed, in the case of Aerospatiale and BAe, the French and British Governments maintain a strong presence21. Moreover, the merger of companies of recognised strategic importance is a particularly sensitive issue, because it implies a pooling of technological know-how that neither governments or companies may be willing to transfer. Hence it is difficult to be sure in advance that market laws will be fully applied to a transnational company such as EADS and that it will benefit from totally independent decision-making processes, particularly as regards the management of its production sites and the transfer of know-how among its German, French and Spanish branches. In fact BAe and EADS provide two models for the consolidation of European industries, each with its advantages and drawbacks. A brief description of the two groups and of the merger process in each case will help clarify the problem. (i) BAe, an example of vertical integration BAe is currently Europe's leading defence company. Although it is run according to typically Anglo-Saxon capitalist logic, the golden share of 49% held by the British Government prevents foreign groups from acquiring majority shareholdings. This is of decisive importance for the group's development strategy, which consists in a process of absorbing competitors or sub-contractors and ad hoc association agreements with European and American partners. In 1997 BAe absorbed General Electric Company (GEC), enabling it to attain a critical size and become one of the heavyweights in the European aeronautical sector. This was also an illustration of the UK's firm resolve to maintain its decision-making autonomy and to avoid all overly restrictive European alliances. The merger with GEC took place at a time when a possible merger with DASA was also being envisaged, the idea being not only to create a major European defence pole, but possibly also to counter France's inertia in the field of consolidating defence industries. In the end the DASA plan was dropped, since DASA was too powerful to be absorbed, but too weak for a merger as an equal partner with BAe. The GEC-BAe merger was indicative of a certain perception of the process of consolidation among Europe's defence industries, based on mergers among national companies, and mergers with or acquisition of foreign firms, rather than on cooperation with other European companies as equal partners. The UK's desire to play a key role in integrating the aerospace industry and its refusal to cooperate on an equal footing with other European partners has led BAe to adopt an acquisition strategy making it Europe's leading defence group, ahead of EADS. Its international holdings make BAe a European company, even if it remains under British ownership. It is a shareholder in CELSIUS (35%), Alenia Marconi Systems (49%), Thomson Marconi Sonar SA (49.9%), Airbus (20%), STN (49%), CTA International (50%), RGR (30%), Siemens Plessey Systems (100%), Heckler und Koch (100%). It has surrounded itself with companies from a wide range of different sectors and countries, although its most important links are with German, French and Italian industry. However, BAe's strong specialisation makes it highly dependent on defence contracts at a time when the creation of EADS is challenging its dominant position as Europe's leading prime contractor. Indeed, BAe's share in Eurofighter is now only 37% (compared with 63% for EADS in its joint venture with Finmeccanica), and 20% in Airbus (as opposed to 80% for EADS). Hence, while it remains a major player in Europe's defence industry, it is looking for its growth essentially towards the North-American market. In May 1999, Alison Wood, Director of Planning and Strategy at BAe, made the following observation: "BAe continue to believe that the United States is likely to set the pace at which we could begin this process across the Atlantic. In the meantime, we must continue to do what we can to bring elements of the European industry together so that, when the day arrives that we can put a transatlantic link in place, we have an entity with which the US can deal as an equal partner (...) The speed of this process will depend on finding the right partner and establishing deals in the right economic conditions, so the timescales for consolidation remain almost impossible to predict22. Hence BAe is involved in the JSF programme in cooperation with Lockheed23, as well as in the development of the Harrier (MDD/Boeing), and it has joined forces with Boeing for the acquisition of 30% of the Korean company Korean Aerospace Industry (the result of a merger of the aeronautics branches of Hyundai, Samsung and Daewoo). Indeed, BAe makes no bones about presenting itself as the sixth contractor in financial terms24 on the US market. Its loss of control over the Eurofighter programme to the benefit of EADS will doubtless encourage it to pursue its efforts in that direction. BAe's most ambitious programme remains the JSF, with a market estimated at $200 billion, more than 2 000 aircraft and considerable outlets in Europe. The Americans take pains to attract potential European customers (the Netherlands, Belgium, Norway, Denmark) by means of co-production offers, with a view to "Europeanising" the JSF (although the weapons system remains under Washington's tight control) and gaining ground at the expense of the Eurofighter 25. BAe's strategy may pay off, particularly since the US Government seems to be flexible in its approach to international cooperation with European firms. Indeed, since 1998, certain American officials have been talking quite openly about the need for armaments cooperation between the United States and Europe. The prospect of the European market closing its doors has forced the US to become more accommodating, while British participation in the JSF programme has obliged the Pentagon to take the first steps towards genuine transatlantic cooperation. The "Declaration of Principles for Defense Equipment and Industrial Cooperation" signed by the US and UK defence ministries on 5 February 2000 is thus designed to pave the way for an agreement covering export and technology transfer issues. Moreover, Lockheed Chairman Vance Coffman has called for Euro-Atlantic cooperation, an appeal which was probably aimed as much at the US Administration as at potential European candidates for cooperation26. BAe, which forms a transatlantic link all by itself - since it now presents itself as a European company in the US and as an American group in Europe - seems to be counting on such overtures. However, the almost vital need to keep the US market open will force BAe to cooperate with companies considerably more powerful than itself, which may give rise to a number of problems as regards developments on joint projects and exports. The British firm nevertheless has a number of assets enabling it to envisage cooperating profitably with an American partner. The creation of an increasingly institutionalised European defence pole does indeed tend to have the effect of excluding American companies, even though the European preference is supposed only to apply on a case-by-case basis. Hence it is in the United States' interest to join forces with a European competitor, and they could do so in conditions which may prove to be extremely profitable for BAe. The United States in fact needs the European market for its exports to NATO members. Furthermore, an Anglo-American partnership would be proof of the United States' openness to transatlantic cooperation, without obliging Washington to give up its traditional desire to be independent of foreign markets. However, it is to be feared that such cooperation might not always run smoothly. The proposals put forward in 1998 by Jacques Gansler, Under Secretary of Defense for Acquisition, Technology and Logistics at the DoD27, on opening up US markets more widely were quickly disavowed by Administration officials. Similarly, the "Declaration of Principles for Defense Equipment and Industrial Cooperation" is already coming under fire from the State Department, which was not involved in drafting the text, although it bears a number of responsibilities for military cooperation and exports28. Finally, there is still debate in the US Congress about allocating the JSF contract. While the House Procurement Committee seems to agree on sharing it between Boeing and Lockheed-BAe, the Senate appears to be rather more reserved about British involvement. Finally, any in-depth cooperation project must be scrutinised by the Committee of Foreign Investment in the United States (CFIUS), a panel of government agencies whose task is to examine the consequences of mergers for national security. As recalled recently (14 May 2000) by French Research Minister Schwartzenberg, while collaborative projects with American firms are not to be ruled out, they nevertheless depend on the willingness of the United States to apply industrial distribution and licence allocation rules which are fair and beneficial to Europeans. They also depend on the goodwill not only of the US Congress, which is difficult to predict, but also of the Pentagon, which can be unreliable. UK firms are currently experiencing this with the FSCS/TRACER (Future Scout Cavalry/Tactical Reconnaissance Armored Combat Equipment Requirement), an Anglo-American collaborative project for the equipment of a future light combat vehicle, which the Pentagon tends to overlook in favour of a new national programme, with no consideration for its allies. Finally, the British are prey to a number of contradictions resulting from their desire to open up to American partners while playing a part in the construction of a European defence industry. The British Government's recent decision in favour of Meteor, despite intense lobbying from the US Administration and the company Raytheon, as well its announcement of an order for the A-400M, immediately, and probably not without reason, gave rise to fears within the national industry of American reprisals on collaborative programmes such as the abovementioned FSCS/TRACER project. The political decision in favour of European armaments could indeed be misconstrued by Washington, particularly since Raytheon had offered major concessions to the European (British and German) firms29. Generally speaking, it may be expected that the growing awareness of European countries of the need to support their own defence industry will create tensions with the US, which may have some repercussions for small programmes. But it is also possible that the more defiant European stance will prompt the Americans to look for other more solvent and more compliant partners who are technologically advanced and eager to work in cooperation. However, BAe's open approach to the United States does not mean a refusal of cooperation at European level. The group has a long-standing tradition in the field of European combat aircraft programmes. It is a fully-fledged partner (37%) in the Eurofighter programme and has a whole network of partnerships within western Europe's defence industries. Panavia and Eurofighter GmbH are cooperation models that could probably be used for EADS, albeit it under somewhat different conditions as regards, in particular, prime contractorships. Dassault's complete integration in EADS might pose problems that did not arise in the cooperation projects with German, Italian and Spanish firms. However, while such partnerships would certainly once again be possible for major armaments programmes, a complete merger between EADS and BAe seems unlikely. Not only would there be problems linked with the British Government's golden share, but above all the structures of the two groups are too much at variance with each other to allow a merger in conditions satisfactory to all sides. On the one hand, BAe's defence branch is stronger than that of EADS, while EADS is clearly the stronger of the two in financial terms. A 50-50 partnership, which would suit the British, would be unacceptable for the other nations involved in EADS, while the involvement of BAe on the same basis as the German and French firms would not be very satisfactory either, given the group's strength in the military sector and relative weakness in the civilian sector (Airbus). An ad hoc partnership along the lines of that between EADS and Finmeccanica does not really seem desirable either, because it could lead to deadlocks, particularly on the issue of prime contractorships, which would hamper the company's development. In fact, BAe does not appear to have the optimum profile for European cooperative projects. Although its integrated defence structure is certainly more competitive than the partnership-merger model of EADS, it offers little opportunity for transnational development. Indeed, although the company does, on the one hand, offer some degree of synergy by integrating a growing number of small defence firms, thereby creating a sizeable European defence pole, it does not have a structure which allows it to be merged into a group of such a size. Furthermore, any merger between BAe and EADS would call for explicit support from the UK Government, which would certainly demand that BAe, like DaimlerChrysler, take certain of its activities outside the new group, or that it accept equal treatment despite having considerably more weight than Aerospatiale Matra or DASA. One may wonder what BAe would stand to gain from a merger with EADS, particularly given the prospects of a merger with an American partner. Indeed, in the first instance, BAe would lose its traditionally dominant position without gaining significant markets in exchange, while the creation of a single European aeronautical pole would almost automatically deprive it of the US market, since the size of an EADS/BAe would be close to that of Boeing, making it a serious competitor for American firms30. Furthermore, the company's capital structure could prove to be an additional problem for any efforts at integration. In 1997, the late Michael Colvin, Vice-Chairman of the House of Commons Select Committee on Defence, put it this way: "One has to consider why companies should merge. Obviously, in terms of defence orders, the government can wield a very big stick. But very little mention has been made of the word `profit' and I think there is no real incentive for privately-owned British companies to merge with publicly-owned companies on the continent if the return on capital is so small. The average return on companies in continental Europe is around 4%, which is only about half the return to British companies, and boards of directors would perhaps have difficulty in persuading their shareholders that a merger is in their best interests when the combined results of such a merger might result in a bigger global mass and therefore an ability to develop new products, but nonetheless is also going to result in the short term in lower returns and dividends from their shareholdings. So the privatisation proposals (for European companies) that have been outlined (...) are one way forward which could help in this respect"31. In strictly economic terms BAe seems to consider, probably quite rightly, that access to the US market is crucial for its development. This gives particular significance to the rumours about a possible merger between BAe and Boeing, which so far have been denied by both companies. On the one hand, such a partnership might be a breath of fresh air for the market, including the JSF programme in which BAe is associated with Lockheed. On the other hand, it is likely that Boeing would offer BAe certain guarantees of independence, since BAe constitutes a last opportunity for the Americans to penetrate an increasingly closed European market. The European preference that is gradually emerging in Europe may well become a permanent feature if all the companies in Europe, and hence also a growing number of sub-contractors, find themselves involved in major defence programmes. A partnership between BAe and Boeing would offer a redoubtable alternative to EADS on all European markets, in particular for the replacement of the F-4 and F-16, together with their weapons systems. Furthermore, BAe would provide Boeing with a foothold in the Airbus and Eurofighter programmes, enabling it to be present on practically all military and civil aeronautical markets, with the exception of that for regional aircraft. In fact, BAe's position is totally paradoxical. While isolated in strictly industrial terms, it is still in a position to negotiate its potential integration in a larger group to its best advantage. Indeed, a merger between the British and US companies would be disastrous for the Europeans, for whom it would be like setting the cat among the pigeons. Even an indirect presence in the part of Boeing in the Airbus consortium seems impossible to imagine at the present time, while its actual presence in the Eurofighter project is an industrial paradox which is difficult to accept. Conversely, Boeing enjoys a fruitful partnership with BAe and would probably be prepared to make the concessions needed to bring a future fortress Europe crashing down. Hence BAe can expect that both protagonists will be prepared to offer it maximum flexibility. It is up to European firms to persuade the British Government and industry that they have more to offer than American companies. This could be done by guaranteeing BAe its independence and integration in a European structure built on the model of the Eurofighter programme, which could be extended to include other projects on the basis of identical arrangements. It remains to be seen whether the British will find the European offers sufficiently attractive from the economic point of view, or whether they will be prepared to sacrifice political unity to economic necessity. (ii) Association agreements and mergers: the example of EADS EADS, unlike BAe, is a fairly typical example of the kind of solution likely to be applied for the consolidation of Europe's defence industries. Indeed, while BAe owes its creation to market forces, EADS is more the result of a political and industrial agreement to pool what governments deem to be strategic industrial capacities32. EADS, which brings together the aeronautical activities of DaimlerChrysler Aerospace (DASA), Aerospatiale Matra and CASA, has a complex structure which reflects a complex situation. The Group's overall operational structure is based on a strictly equal sharing of power between the French and German companies. The two diagrams below illustrate the breakdown of capital and posts between the two: Diagram 1 * After the share offering, assuming exercise of the over-allotment option and stock option We should first point out that as a company under Dutch law, EADS has its statutory head office in the Netherlands, while its operational headquarters is divided between Paris, Munich and Madrid. Finally, as can be seen from Diagram 1, the merger is based on parity between Aerospatiale Matra and DASA, with a minority share for SEPI (Société étatique des participations industrielles), which owns CASA and is also a founding member of EADS. The shareholders of Aerospatiale Matra and DASA considered, following extraction by Daimler Chrysler33 of 700 million euros cash, that the two groups were of more or less equal value. In a second phase, Daimler Chrysler withdrew MTU from DASA and extracted a further 2.7 billion euros in order to ensure parity between the French and German controlling shareholders. In order to ensure parity between the French (Lagardère, the French Government and financial investors) and German controlling elements, the French shareholders placed shares on the market when the Group's capital was increased. After that capital increase (of some 2.5 billion euros) each side held 30% of the capital of EADS. Moreover, SEPI, as a shareholder, is in a position to ensure that the industrial plan - which was the basis for CASA's joining EADS - is implemented with no major changes. Finally, it should be noted that all the rights accorded to SEPI expire at the end of the three-year period following the integration of CASA and the creation of EADS. EADS then, composed of German, French and Spanish aeronautical firms, will have its statutory headquarters in the Netherlands, will be quoted on the Paris, Frankfurt and Madrid stock markets and will communicate in English. Mr Hertrich, CEO of DaimlerChrysler and CEO-designate of EADS, recently spoke of all the difficulties linked with the creation of such a group: " (...) the challenges involved in the creation of cross-border European structures in the defence industry certainly have a lot in common with the development of a European Security and Defence Identity (ESDI). The common features of these two projects are, for example, the numerous political, cultural and legal hurdles they have to overcome"34. Mr Hertrich also referred to other aspects of the creation of EADS, pointing out that "we need to determine how core competences can be focused at a European level, but without endangering national identities, which are all-important to our governmental customers. In view of the complexities involved, in both cases friction and delays can barely be avoided in the practical implementation". He went on, with regard to our American allies, "a further common feature is also a marked reticence on the part of the USA, to put it mildly. On the one hand, in the field of security policy, the USA has long wished to have a genuine burden-sharing between itself and its European partners. On the other hand, the USA is afraid of losing the global dominance in foreign security and economic affairs that it has enjoyed for decades". Finally, according to Mr Hertrich, another factor that is common to the ESDI and EADS is "the overriding aim: the aim of taking on an important and independent role as European partners - but let me stress this - without putting the reliable transatlantic links at the slightest risk". At the time of its creation in June 2000, EADS had a workforce of 87 000, a turnover of 22 billion euros and an estimated value of the same order of magnitude. Airbus accounts for 40% of that turnover, Eurocopter 9%, military aircraft 9%, space activities 14%, missile systems 10%, defence electronics and telecommunications 8% and other aeronautical activities 10%. EADS is world leader in the field of helicopters (Eurocopter) and commercial launchers (Ariane). It is in second place for civilian air transport (Airbus) and missile systems, third for satellites (Astrium) and military air transport and finally, in fourth place for combat aircraft. A number of figures illustrate the prominent position of certain products in the new group. As at 31 December 1999, Airbus accounted for 18% of the existing fleet, 32% of deliveries, 49% of order books and 55% of new orders. Moreover the new company could decide to launch its A3XX programme for a future 550-seat Jumbo aircraft at the beginning of 2001. Finally, EADS is the world's third aerospace and defence company, behind Boeing and Lockheed Martin. However, it has a fairly balanced programme of activities: 25% military and 75% commercial. However, it must be realised that the creation of EADS alone is not enough to overcome all existing problems. EADS is certainly a step in the right direction, but it is built on a number of markedly different cultures and it will be necessary to develop an "EADS mentality" by taking the positive aspects of each of those cultures and merging them into a strong whole. Indeed, much of the French part of the group is of public sector origin (and the Spanish part is totally state-owned) while Germany has a strong private-sector tradition. Similarly, we find a strong technological bent in France, while Germany leans more towards a financial culture. However, it can be expected that France's reputed adaptability combined with Germany's traditional talent for organisation will provide the ideal conditions for the birth of the new company. Moreover, they are not starting from scratch, since Aerospatiale Matra, DASA and CASA are already partners for more than 70% of their activities. Another important point concerning DASA and Aerospatiale Matra, and this is also true of CASA, is that they are not head-on competitors as is the case, for example, for Boeing and MacDonnell Douglas. In principle, this should mean that the merger should not have any major repercussions for jobs. Mr Camus, co-CEO with Mr Hertrich, underlined this point in an interview with the Le Monde35. He also pointed out that the challenge was "first and foremost to understand each other well, know the scale of values of the other side and to know what means yes and what means no. Our decision-making procedures differ somewhat". Finally, the EU Commission's position on the merger between Aerospatiale Matra, DASA and CASA, which it deferred giving twice in order to request further information and introduce a few minor changes, turned out to be favourable, which was a prerequisite for the creation of EADS. Furthermore, after several months of consultations and hesitation, the Italian group Finmeccanica finally chose EADS, rather than BAe - as a strictly equal partner - for its military aeronautical activities. It was decided to set up a joint company with a workforce of 17 000 and an annual turnover of some 2.5 billion euros. The joint company is to control 62.5% of the Eurofighter programme, 71% of the A-400M military transport aircraft programme, 57.5% of the Tornado programme and 100% of the naval patrol aircraft and regional transport aircraft activities. Finmeccanica's Vice-Chairman and Managing Director, Mr Lina, explained his decision as follows: "Our British friends could not offer us what we obtained with EADS, namely, equal treatment. Our choice was not based solely on financial, but also industrial, considerations". Indeed, a decisive part of the agreement is Italy's participation in the Airbus programme, for EADS has offered it a 5% share in the consortium. Once the Airbus consortium becomes an integrated company, Finmeccanica will have three years in which to validate its option. The merger of Aerospatiale Matra, DASA and CASA within EADS was formally approved at the general meetings of the three companies and the new group was officially created and its shares floated on the stock market on the same day, 10 July 2000. The share price on the Paris, Madrid and Frankfurt markets was set at 19 euros for institutional investors and 18 euros for private investors. The relatively low share price was a key to the success encountered by this operation despite the rather volatile market and the doubts expressed in financial circles on the future profitability of the new company. Finally, the creation of EADS marks the birth of Europe's first cross-border aerospace and defence group; it constitutes a core around which it can further develop and consolidate its position. Indeed, the agreement with Finmeccanica on the merger of their combat aircraft activities is the first step in that direction. Airbus, Ariane, Eurocopter, Eurofighter and other programmes are demonstrations of the ability of European companies to develop technologies on a par with those of their American competitors. With its technical know-how, very competitive high-tech products and a sizeable internal market, EADS is destined to become, indeed it is already, a global partner. As observed by Mr Hertrich, the American reactions to the new company are proof that it has fulfilled the necessary conditions to be taken seriously as a competitor and equal partner. Moreover, it should be pointed out that the new situation that has arisen in Europe since the creation of BAe and EADS makes it not only impossible, but probably also undesirable to create a single European aeronautical company by merging those two groups. Nevertheless this does not rule out cooperation in certain fields of activity, quite the contrary. A case in point is the missile sector, in which a joint subsidiary has been set up by EADS (37.5%), BAe (37.5%) and Finmeccanica (25%). Finally, as has been said time and again, the purpose of EADS is not to create a fortress Europe. Quite the contrary, it is a unique opportunity to allow negotiations with American firms on an equal footing. It is perfectly possible that partnerships with American defence firms will in the medium and long term increase European technological know-how and contribute to reducing costs. For such cooperation to be possible, it will be necessary to take a number of political decisions to solve problems of national security and independence. A US-UK agreement has been signed on the rules governing technology transfers and the acquisition of companies. Discussions are underway with other countries. In the meantime, EADS has already looked into the possibilities for medium- and long-term cooperation with Raytheon (in the missile sector) and would welcome similar cooperation with Lockheed Martin in the military aircraft sector. Let us not forget that for its military contracts EADS will continue to rely on European governmental customers. While those governments strongly encouraged the creation of EADS, they have made little progress themselves towards achieving the same level of integration as that reached by European industry. Indeed, such integration involves not only common rules at European level such as those already referred to, but also a genuine European defence policy. This means, among other things, developing joint defence equipment programmes in order to reduce costs and bolster competitiveness. The administrative structure of EADS, in which the posts are shared alternately among the different nationalities making up the group, with strict decision-making parity between France and Germany, is illustrative of the difficulties involved in creating a transnational group out of companies considered by their respective states to be of strategic importance. One might deduce from this strictly equal sharing of power among the different shareholders that EADS is for the moment far from being a coherent entity and that it is rather a group in which French, Spanish and German aeronautical companies exist side by side under a common label, rather than a truly multinational structure independent of individual states. In the short term this could lead to a number of problems, not least of all, of an administrative nature. Pending the introduction of a European procedure for harmonising the policies of the different defence companies in the group, EADS will be confronted with problems pertaining to the transfer of technologies and to export duties, not to mention the day-to-day legal difficulties inherent in the merger of companies of different nationalities. Notwithstanding its undeniable longstanding experience in the field of industrial cooperation, EADS remains highly vulnerable to problems of operational convergence and synchronising procurements. Although the European cooperation bodies in this field are promoting a common definition of armed forces' requirements, the problems are far from having been solved. The example of A-400M illustrates the kinds of difficulties encountered. While it has both the technological and financial capacity to develop this aircraft, Airbus refuses to do so out of its own capital and is waiting for sufficient demand from the armed forces of the different European partners before embarking on the project. Thus, while most of the countries concerned recognise the need for this type of equipment to replace the C-130s and C-160s, it will remain a dead letter for as long as the orderbooks do not contain orders for more than 150 to 180 aircraft. The programme's survival was therefore contingent upon the goodwill of the British Government which, for political reasons, finally opted in favour of the A-400M. Furthermore, the uncertainty in Germany caused by budgetary difficulties and the competition with the Antonov, have cast a shadow over the programme's future. In view of the fact that the technological and financial risks are small, since the aircraft is based on a tried and tested airframe and has a certain export potential, and that the award of the prime contractorship to CASA does not seem to raise fundamental problems, we see here all the difficulty of coordinating the requirements of a few European partners. Finally, the decision-making problems were foreseeable. Back in 1997, BAe's military adviser Sir Patrick Hine took the following line with regard to the possible creation of the EADC: "But this raises the question of who will truly control the company. Models which envisage national shareholders (that is to say, Aerospatiale-Dassault, DASA and BAe) each holding, say, 33% of the European company and thereby exercising in a proxy manner a national shareholder prerogative, will hinder rather than hasten the restructuring on rational commercial lines which the industry sadly needs. Such a solution will tend to encourage the adoption of national positions, still more so if they are nationalised or have significant government shareholdings. (...) Therefore, and as I have said before, the new European company should be owned directly by a distributed international shareholder base. We recognise that, in the short term, the existing companies will inevitably have to play a role but this should be transitory and they should, in due course, disappear"36. These issues clearly pose less of a problem in the short term, since EADS currently has a comfortable supply of orders for Eurofighter, NH-90, Meteor and Trigat, so there is no imminent risk for the company's profitability and operations. However, one may well wonder about the longer-term rationale of the merger in a context of limited defence budgets. If a more satisfactory solution to those problems of operational convergence, industrial juste retour and harmonisation of defence budgets cannot be found, EADS runs the risk of failure in the longer term. Indeed, if the approach to military programmes does not fundamentally change, the company will be confronted with a number of difficult hurdles to overcome. If it cannot finance development work out of its own funds, the timing of projects will hinge on the time it takes the different partners to harmonise their requirements. Production costs, if the juste retour principle is applied, will almost inevitably be higher than those of competitors. Indeed, although Airbus has, with some difficulty, managed to offer competitive prices in the civilian sector, practically all European military projects have encountered cost overruns, in some cases with disastrous results for cost-effectiveness. The Trigat, Tigre, Tornado and Eurofighter programmes are just some examples37. Moreover, the need to reconcile different operational specifications may lead to projects which are difficult to export because of their complexity and high costs. While that phenomenon is on the decrease in the transport and missile sectors, it remains a problem for combat vehicle platforms. Furthermore, it is doubtful whether the internal structure of EADS will allow that problem to be settled internally by eliminating duplicate industrial capacities and rationalising the company's know-how. That company is the result of bringing together the expertise of the aeronautical sectors of three different countries, each of which wishes to see its industry prosper. Since the LoI makes no provision for giving precedence to transnational companies over individual states when the latter consider their strategic interests to be at stake, it may be expected that the question of how industrial expertise and production sites are shared among the different countries will remain a recurring problem for the group, particularly in the civilian and combat aircraft sectors. The tandem decision-making structure is also likely to pose a problem in the case of disagreement between its French and German components, as happened with Airbus. Furthermore, the merger of national sub-divisions into technical divisions of no distinct nationality within the new group is likely to prove difficult. Eurocopter, for example, is currently 75% French-owned. It is doubtful whether Eurocopter's transformation into the EADS helicopter division will suddenly lead to a shift of emphasis towards German (or Spanish) teams and programmes, not least of all because the programmes under French prime-contractorship remain in the majority. Moreover, the production of new aircraft will necessarily call for prime-contractorships to be awarded to French or German firms, or, in the case of cross-border production, to a redistribution of the industrial work which may be difficult. The best solution might appear to be to maintain France's dominant position in the division, hence that predominance may continue for quite some time. In this respect we must also consider whether it is a good idea to juxtapose competing programmes, at least in the field of combat aircraft. The coexistence of Rafale and Eurofighter (Typhoon) is indeed worrying. Eurofighter would, in absolute terms, appear to be the most promising programme, since it has the largest volume of orders and has already been successfully exported. However, it involves four countries and the two biggest European aeronautical groups (BAe and EADS). The participation of DASA, CASA and Finmeccanica within EADS nevertheless means that the German, Spanish and Italian firms now form the majority in a programme which was originally under British prime-contractorship. Eurofighter has therefore become the major programme of EADS, well ahead of Rafale, although the latter also is conducted within the group through Dassault. Whatever the qualities of the two aircraft, which unfortunately are of the same type, Eurofighter is likely to maintain its predominant position in EADS, whatever BAe's part in the programme. The production of Eurofighter, like that of Airbus, is geared to the principle of dividing the aircraft into its component parts which are produced in the different countries in order to give a return on investment proportional to their financial participation in the programme. This model of European cooperation, as in the case of Tornado, has demonstrated the importance of industrial return, whereby the fact of awarding the prime-contractorship to a single nation - in this instance the United Kingdom - was compensated by tapping the industrial expertise of the other participating countries. Once such an exchange becomes impossible, the scope for cooperation is considerably reduced, as illustrated by the long list of Franco-British cooperation attempts, in which prime-contractorship issues led to deadlock situations or semi-failures. The Rafale programme appears to be in a much less comfortable position than its competitor. First of all its orderbooks (60 out of 300 possible orders, as against 680 to 710 for Typhoon) do not look very encouraging. Furthermore, Dassault is more reluctant than its competitors to relocate the production of its aircraft. Finally and above all, the French army already has Mirage 2000-5 aircraft, which means that the French Government is in no hurry to purchase Rafale, which has led to frequent delays in orders, and a reduction in their volume, leading in turn to poor export prospects and higher unit costs. Seen from that angle, one may well wonder what support Rafale is likely to get from EADS once it is in competition with Eurofighter. The market is not large enough to allow a company the luxury of offering two aircraft of exactly the same category at precisely the same moment and more or less the same price. The turbulent start with Rafale and Typhoon is illustrative of some of the problems in store for EADS with its future major programmes. Although it is a company under private law, it will continue to rely heavily on orders from the different European governments and will therefore be relatively sensitive to any disagreement among them. Furthermore, the policy of return on investment which seems to underlay the EADS structure will certainly not be conducive to cutting programme costs. Although the company has announced that there will be major economies of scale, nothing could be less certain, in particular in sensitive sectors where several countries have strategic capacities. With the participation of Spain, and possibly also Italy in the programme, things will not become easier on that score. Moreover, even though the British, French, Italian, Spanish and German firms have, with some difficulty, managed to achieve the operational and industrial convergence necessary for the production of Tornado and Typhoon, the fact remains that for any major European programme a difficult balance has to be struck. EADS will need to have optimum conditions in which to execute its major programmes. The French, Italian, Spanish and Germans will need to have the same operational requirements at the same moment, and governments must be prepared to provide the necessary funding at the same time so that projects can be launched. In addition, EADS is relying on there being a systematic European preference which will work in its favour, which cannot be taken for granted. The UK Government's hesitation - between Meteor on the one hand and BVRAAM or Raytheon on the other - for the procurement of long-range missiles for Eurofighter, clearly shows that issues of programme development costs continue to be crucially important. On top of prime contractorship issues there are problems of rationalisation. The example of Lockheed is particularly interesting in this respect, for it gives an idea of the potential weaknesses of EADS. Given that the productivity of the American labour force is estimated to be 30% higher than that of Europe, the Lockheed Martin Marietta merger led to the closure of 1.2 million square metres of production shops, a reduction in the number of laboratories from six to three and in the number of head offices from five to one. It would be difficult to carry out such streamlining in the case of EADS, because the removal of superfluous structures would lead to an erosion of national expertise, which governments are not prepared to accept. At a more general level, the restructuring of the US defence industry led to the loss of nearly a million jobs38. Such problems of rationalisation are bound to arise if EADS is to transform itself into the European company it aspires to. The different parts of the company, which for the moment are based on the national capacities of its component firms, will have to evolve to become sub-divisions specialised in different sectors, regardless of national origin. For that to happen, national identities will have increasingly to give way to economic logic, with a view to enhancing the competitiveness of the different sectors and generating real synergy among the companies involved. In the long run this may mean doing away with certain production sites and hence jobs. Given that the creation of a fragmented production system of the Airbus type will probably not be viable in the military sector, EADS may be confronted with strong political and social tensions when it needs to rationalise its production system. Conversely, if the "denationalisation" of its sub-divisions were to fail, the result would be high costs for military products, as it currently the case for the Tigre helicopter. While no-one is likely to question the ultimate objectives of EADS, it will nonetheless inevitably remain more vulnerable than initially foreseen to international competition and more dependent on assistance from the participating European states. III. The role of the state in EADS In fact, EADS owes its complex structure to the desire of the participating states to play a role within the company. Officially they have practically no influence. The German Government had no right of veto over the activities of DaimlerChrysler Space, a totally private company. The French state, which is a shareholder in Aerospatiale through SOGEPA (see Diagram 1) and involved in Lagardère in the French pooling company, is constantly pointing out that its concerns relate exclusively to the ballistic missile sector which it wishes to control for obvious reasons. EADS, aside from that reservation, is a commercial company, as its representatives never tire of repeating. However, in reality the situation is much less clear-cut. Generally speaking, one may wonder whether it is really possible for a European defence company to cut itself off entirely from state funding and support. POLARM, for example, points out that the costs incurred by R&D are such that these companies cannot really be competitive without state assistance: "Many products in the armament sector carry disproportionately high Research and Development costs. High standards are required, as technological advances are necessary to national defence. However, returns on this investment are uncertain. Mass production, which might offset high R&D costs, is rare in comparison with civil industry. The need for confidentiality can preclude the wide circulation of technological developments and the financial benefits of such a circulation. There will always be a need for one-off products, which it may be uneconomical to produce. Numbers of programmes are limited and R&D teams sometimes cannot be supported by purely commercial means during intervals between programmes. Commercial organisations driven by market forces could not be expected to make the necessary investment in R&D and government support could therefore be required"39. Direct government intervention in the defence industry may also be considered necessary, including in the case of private defence firms driven by market forces. The American Government has a number of production sites and keeps up its level of R&D investment spending, even when defence budgets are decreasing40. It would therefore be desirable for European states to be able to build similar structures whenever this may become necessary. Unfortunately, in Europe the role of the state is perceived more in terms of controlling industry than of supporting it by means of a dynamic approach to capitalism. The difference of approach between the French and German governments is likely to produce constant deadlocks within EADS. Although DaimlerChrysler's relationship with the German Government is totally different from that between French companies and the state, the German Government nevertheless has a certain perception of the role of the armaments industry in international relations which could lead it to intervene, if only through authorisations for export licences. While DaimlerChrysler Aerospace is theoretically independent, it is nonetheless subject to pressure from the Government through Germany's particularly stringent export legislation. Indeed, its export capacities depend on how freely the Government is prepared to interpret the legal texts, which can be practically ignored or very strictly applied. Paradoxically, while international cooperation was perceived for many years by German industry to be the ideal way of avoiding the red tape of export controls, the German Government now obliges foreign companies associated with German firms to comply with German export legislation. Hence exports of the Tigre helicopter (Eurocopter) were compromised by the German Government's refusal to authorise test flights over Turkish territory, because the Green Party in the coalition was concerned about the possible use of the aircraft for the purpose of repression. Furthermore, the Government does not officially consider arms exports to be a strategic sector and is becoming increasingly cautious in its choice of non-European customers. This attitude has a negative effect on the operations of German firms, and hence for the companies with which they cooperate. The approach in France is even more complicated, because there is closer interaction between the French state and private companies. The French Government, taking note of the decisions of 9 December 1997, participated in the reorganisation of the different French aeronautical companies into two major groups. Overriding differences between various individuals and firms, the Government finally opted for the merger of Aerospatiale and Matra, in the process bringing Dassault under the control of the new group. Above and beyond the structural problems that can arise when a merger is imposed by the authorities in the face of reluctance from certain partners (Dassault in particular), it is difficult to assess the position of Aerospatiale-Matra within EADS. First of all, the company has the same aims as its competitors, namely to be profitable and competitive. Before its merger with Matra, Airbus accounted for the largest share in Aerospatiale's turnover (48%), well ahead of DASA (28%) and BAe (16%). Thus, like the other European companies, it was used to having to contend with market forces, except in the case of the domestic defence market where it had a long-standing partnership with the French state. Furthermore, the state share within Aerospatiale is to be reduced to 15%, giving the group a structure similar to that of its European competitors. The fact remains, however, that Aerospatiale's market culture probably differs from that of the other firms, if only because of the state's presence in the group and the fact that Aerospatiale has not become a subsidiary of Lagardère (in the sense that DASA is a subsidiary of DaimlerChrysler). Rather, it is a privileged partner and remains bound to the state by a shareholders' pact. While for a long time, then, French defence companies were characterised by systematic state control, that is increasingly less the case, even when national independence is at stake. This has facilitated the consolidation of the major European private companies, although certain cultural differences remain. In the case of EADS, the difference of approach between its French and German components could be a source of difficulties. Indeed, as we have seen, the German Government does not consider the armaments sector to be different from any other industry and expects it to comply with the common export rules, while France continues to see it as a strategic sector requiring special treatment and support from the state. In fact there is duality in France between the traditional emphasis on national independence (financially no longer feasible) and the new desire for European independence, in which France wishes to receive a fair share, for example through prime contractorships. Unlike the United Kingdom and Germany, however, France continues to lay down political conditions for all forms of transatlantic cooperation, even at the risk of losing out on the industrial and financial benefits of such cooperation agreements. Finally, it is to be feared that the coherence of EADS' policies may sometimes suffer from the strict parity between the two components of its tandem structure, each of which has its own ideas on a company's role and obligations, with the emphasis on profitability for one, and on the maintenance of specifically European capacities and the development of a national and European industrial fabric, for the other. IV. Conclusions The time has come, then, to redefine the role of the state in Europe's defence industries. The emergence of a European defence industry must go hand in hand with a European vision of that industry's interests. Gradually we must do away with the cultural, economic and social protectionism which has prevailed thus far. The European Union clearly has a role to play in that respect, not only by relaying the determination of the states concerned and settling the differences between them, but also by putting forward a genuine plan to promote the defence industry at European level, comparable to the efforts made thus far at national level to promote national industries. It will be the EU's duty to look into the intrinsic weaknesses of that sector, particularly as regards financing, profitability and investment aid, in order to take the measures needed to ensure that the companies concerned do not suffer unduly from competition with non-European firms which still have the unconditional support of their governments. From that point of view, rather than challenging the state share in defence companies like EADS, and to a certain extent also BAe, it would make mores sense to promote the transfer of national expertise to a common European decision-making pole. Furthermore, a European armaments agency should be set up in parallel to that decision-making pole. OCCAR could be the precursor of such an agency, which would have the task of developing a common European procurement based on harmonised requirements, procurement regulations and timetables within the European Union. Other possible short-term measures would be to draft common European arms export control regulations and to strengthen POLARM and COARM, in order to achieve implementation of the LoI at European level. Finally, the process of industrial restructuring should continue to be encouraged. That process should embrace not only the systems companies, but also suppliers. All this with a view to the longer-term aim of opening up the defence markets in the United States and European Union, among other things by promoting multilateral free trade and avoiding bilateral preferential treatment.

Adopted on 15 November 2000 by 19 votes to 0 with 2 abstentions. Members of the Committee: Mr Atkinson (Chairman), MM Cunliffe (Alternate: O'Hara), Kolb (Vice-Chairmen); Mrs Aguiar, MM Arnau Navarro, Ceder, Cherribi, Diana (Alternate: Provera), Díaz de Mera, Dimas, Dolazza, Etherington, Haupert, Jung, Le Guen, Luís, Maass, Marshall (Alternate: Wray), Martínez Casañ, Monfils, Neuwirth, Olivo (Alternate: Lauricella), Rigo (Alternate: Turini), Thönnes, Valk, Valleix, Wodarg, Mrs Zissi. Associate members: MM Bergvinsson, Eörsi, Kalkan, Macé, Malat, Marthinsen, Pokol, Saglam, Yürür, Zemke, Zielinski, Zlotowski. NB: The names of those taking part in the vote are printed in italics. Adopted by the Assembly on 6 December 2000 (12th sitting). For detailed information on armaments cooperation structures see Assembly Documents 1483, on "WEAG: the course to be followed" (Rapporteurs Mrs Guirado and Lord Dundee) and 1671 on "Armaments cooperation in the future construction of defence in Europe - reply to the annual report of the Council" (Rapporteur, Mr O'Hara). Address by UK Deputy Chief of Procurement Policy John Howe to the Munich Symposium of 1-2 October 1997 on "European cooperation on the procurement of defence equipment", page 33 of the proceedings. Ibid. Independent European Programme Group, which became WEAG after its transfer to WEU. Otto Gärtner in an article on the basis, present status and prospects for European armaments cooperation, L'Armement No. 61, March 1998, page 101. Munich Symposium of 1-2 October 1997 on "European cooperation on the procurement of defence equipment", page 83 of the proceedings. Jean Guy Branger, Rapporteur for the draft legislation on OCCAR, Report 44 (1999-2000), Foreign Affairs Committee of the French National Assembly. Address by Defence Minister Alain Richard to the French Senate on 9 November 1999, on the occasion of its ratification of the OCCAR Convention. Keith Hayward, Chaillot Papers No. 27, June 1997, "Towards a European weapons procurement process", page 14. TTU Europe No. 318, 4 May 2000. For detailed information on the LoI see Assembly Document 1671. Douglas Barrie: "European giants to unify industrial policies", Defense News, 17 April 2000, pages 1 and 26. For the purposes of comparison: the volume of state sector contracts placed with Boeing are equivalent to Germany's defence budget and account for 54% of the company's turnover, according to Jean-Louis Fache at the Symposium of 1-2 October 1997 on "European cooperation on the procurement of defence equipment". Assembly Document 1671 on "Armaments cooperation in the future construction of defence in Europe - reply to the annual report of the Council". The scope for action is fairly wide, ranging from the creation of a special legal framework for European companies to measures to protect defence companies from majority holdings by non-European investors. In the field of taxation, it would seem desirable to adopt a special tax regime similar to that of the United States. The US share of the export market grew from 25% in the mid-1980s to 56% in the mid-1990s. Florence Delétang recalls the fundamental role played in these mergers by capitalist logic and government assistance, explaining how the Administration agreed to refund the costs incurred by mergers if they subsequently generated major savings for the Pentagon. Hence the refunds granted by the State amounted from 1994 to 1997 to $850 million, not counting the aid programmes introduced in connection with industrial conversion activities. Florence Delétang, "La consolidation de l'industrie américaine: un défi pour l'Europe", L'Armement No. 61, pages 37-38. The British State is present within BAe not as an economic agent, since the company operates according to market laws, but as the guardian of its independence, by virtue of its golden share. Alison Wood, "BAe plans for success as a global player", RUSI Journal, April-May 1999, page 44. The British Government may procure JSF to replace Harriers. See www.defence-aerospace on BAe. See article in De Defensa, Vol. 15, No. 8. Financial Times, 5 May 2000. Giovanni de Briganti, defense aerospace.com See Colin Clark "US critics assail export pact with British", Defense News, 21 February 2000, page 3. After proposing 62% of the local production of the ERAAM+ missile and some 50% of production for the US market to British firms, Raytheon offered the German missile producer BGT (Diehl VA Systeme) a real partnership for the production of AMRAAM (ERAAM+) derivatives for the US and European markets, the production of Harm C and Paveway III modules and the development of the Armiger project (even though it is a future competitor of the Harm C). See article by Jean Dupont "Raytheon rallie l'allemand BGT au BVRAAM", Air et Cosmos/Aviation magazine international No. 1739, 3 March 2000, page 35. The consolidated turnover of EADS/Alenia/BAe would be 40 billion euros, as opposed to 50 billion for Boeing and 23.5 for Lockheed. Michael Colvin at the Symposium of 1-2 October 1997 on "European cooperation on the procurement of defence equipment", page 85 of the proceedings. For further information see Chaillot Papers No. 40, July 2000, "From cooperation to integration: defence and aerospace industries in Europe", Burkard Schmitt, WEU Institute for Security Studies. TTU Europe, supplement to issue No. 300 of 16 December 1999. On the occasion of the XVIIth International NATO workshop on political-military decision-making: panel of NATO Defence Ministers: "ESDI and Defence Capabilities", Berlin, 4 June 2000. Le Monde, Friday 25 January 2000. Sir Patrick Hine, Munich Symposium of 1-2 October 1997 on "European cooperation on the procurement of defence equipment", page 79 of the proceedings. The negotiation phase for the Trigat programme lasted 12 years (1976-1988). See the abovementioned article by Florence Delétang. COM(97)583 Annex I, 10 December 1996 "Definition of specific characteristics of the defence-related sector", POLARM. See the abovementioned article by Florence Delétang, page 40. The author explains that these GOCO (government owned, company operated) sites can deal with major programmes such as the F-16 and C-130.