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President of Russia Vladimir Putin: Good afternoon, colleagues,

As you may recall, during our meeting in Tula in September 2016 where we considered ways to diversify the defence industry, we also discussed ways to maximise its potential for producing high-tech civilian products.

I toured the production shops, saw how the production process was organised, saw the new equipment and how people used it in their work. Frankly, and I think you will agree, it is sometimes hard to believe that we are doing this, that we were able to organise production at this level and class.

However, the production lines must not stay idle in the future when the volume of state defence orders inevitably declines once we are past the peak of the Defence Ministry’s orders. We need to transition to manufacturing civilian products while generally ensuring quality and competitiveness.

Today, we will continue to discuss this subject in order to identify key areas and the most effective mechanisms for diversifying our defence enterprises and for ensuring balanced development.

I would like to emphasise once again: this is, of course, a goal of prime importance. Its successful resolution will allow us to expand the technical and production resources of the enterprises and strengthen the work teams which include hundreds of thousands of highly skilled engineers, designers, and workers. I briefly talked with these people in the shops, and they also asked this question: what's next, how will we work? This is a natural question.

Of course, the production of civilian products should fully, to the maximum, use the existing capacities of these enterprises and ensure their financial stability, especially after 2020, when, as I said, the peak of orders within the framework of the state defence order will have been reached.

Notably, a lot of preparatory work has been carried out since the meeting in Tula. The information analysis systems on monitoring the procurement of civilian product made by our country's defence industry have become operational. The Konversiya (Conversion) enterprise was created, which will promote these products on the markets, both in our country and abroad.

In addition, Vnesheconombank and the Industrial Development Fund will provide easy-term financial instruments to support the diversification of the defence industry.

Notably, a number of companies have already joined this effort. Thus, the Moscow Institute of Thermal Technology produces water treatment equipment. Schwabe has established the production of medical equipment, and Kalashnikov is manufacturing civilian speedboats, motorcycles and unmanned aerial vehicles.

However, diversifying the production of defence companies should not be limited to isolated and successful projects. It is important to make this diversification consistent. Senior executives and all the employees of these companies should approach the release of civilian products as responsibly as they do with state defence order.

This is the only way for us to resolve the strategic task of increasing the share of civilian products to 30 percent of the total output of defence products by 2025, and to 50 percent by 2030.

I would like to point out some priorities.

First, we are carrying out many large-scale programmes, including upgrades in the power industry, developing the digital economy, introducing the best available technology, equipping medical institutions, enhancing the environment, and creating an industry for waste processing and disposal. Defence industry enterprises should be more active in joining these programmes and projects.

I want to emphasise that the products offered should be of high quality and competitively priced. It would be impossible, inappropriate and probably harmful to create artificial, ”greenhouse“ conditions.

Second, it is necessary to thoroughly analyse what barriers – primarily legal ones – impede the diversification of defence enterprises, for example during state procurements that make it impossible to sign so-called lifecycle contracts and so on. We need to work to remove these barriers as early as the spring parliamentary session.

Third, it is necessary to create starting orders that will help businesses have more confidence during the initial steps of diversification. Naturally, companies with public ownership have to play a special role in this respect: instead of foreign products they should orient themselves towards the purchase of existing or potential domestic products.

I can predict the criticism in advance: “We need to buy the best the world has, not just domestic products.” Naturally, this is true, but we must make domestic products the best in the world. I would like to ask the Import Substitution Government Commission to deal with this issue.

Fourth, it is necessary to find a balanced formula that will make it possible to divide economic risks and expenses between the state and enterprises. This is primarily important for R&D, certification, service support development and post-sale support. Naturally, in implementing diversification projects it is essential to use more special investment contract mechanisms.

Today, I would like to hear your opinion on the above issues, but if you think we should discuss something else, go ahead please.

Now I will give the floor to Mr Manturov.

Minister of Industry and Trade Denis Manturov: Thank you very much.

Mr President, colleagues,

When, at the meeting in Tula, we received an instruction from you to increase the share of civilian production in the defence industry, the goal was to ensure a 17 percent increase by 2020. Mr President, the share of civilian production by defence industry enterprises reached 17 percent as of the end of last year. Therefore, we are confident that over the next two years we will add at least two more percent. This certainty is based on our timely efforts to build the infrastructure required for diversification.

In this project, we focused on increasing the demand primarily for the civilian products that are already in the pipeline, as well as on creating conditions for the development and release of new items. We regularly update the electronic catalogue of civilian products you mentioned, to inform the market about what is available. Right now the catalogue includes more than 2,500 items. To encourage even more demand, by the end of the month we will develop a list of products, the purchase of which will be regulated by the Government Import Substitution Commission.

We propose expanding involvement in the government programmes – particularly, those you have already mentioned, and also Arctic exploration, while transitioning to the best available technology, and energy supply agreements. The Konversiya enterprise, established upon your instruction, will be responsible for selecting the defence industry’s civilian products to be covered by these projects. Additionally, Konversiya will coordinate civilian manufacturing skills training for workers of defence industry enterprises. Rostec and some other companies are already initiating their corporate programmes. We can provide money for co-funding without any extra burden on the budget.

As part of efforts to promote goods manufactured by defence industry enterprises, we suggest using a tried-and-tested approach: purchases by state corporations and companies – natural monopolies – of goods from small and medium-size enterprises. For that, we deem it necessary to oblige them to buy civilian goods from defence industry enterprises in fixed amounts.

We also hope to link supply and demand through adapting the special investment contract mechanism to diversification needs and reducing minimal cost requirements to investment contracts as stipulated by Federal Law No. 44.

In order to help defence industry companies establish direct ties with potential consumers, we encourage them to participate in major international industrial technology exhibitions in Russia and abroad. At least 20 such events are planned for the current year. A government subsidy to the Russian Export Centre enables us to reimburse defence industry enterprises for up to half of exhibition participation costs.

In addition to this, a wide range of the Russian Export Centre's tools has been envisaged to meet the task of stepping up exports. Last year, with these tools in place, we managed to export more than 45 billion rubles worth of civilian goods produced by defence industry enterprises.

Virtually all support tools in our sectoral state programmes are aimed at helping defence industry enterprises create new high-tech goods for the civilian segment and prepare the necessary industrial capacities. For example, last year, we provided 1.8 billion rubles in subsidies to defence industry enterprises for 23 projects for the production of civilian goods.

Mr President, you mentioned the Industrial Development Fund. Over a short period of time, it funded 25 diversification projects to a total of 4.5 billion rubles at a five-percent annual interest rate. To strengthen emphasis on this track, the fund created a special programme called Conversion with a one-percent annual interest rate during the first three years of the project’s implementation.

The state programme for the development of the defence industry for the current year envisages special funds intended to subsidise interest rates on loans from Vnesheconombank or, perhaps, other commercial banks, for conversion projects. We hope that this will make it possible to start pilot projects as early as this year.

In order to increase the motivation of defence industry enterprise CEOs, we believe it is necessary to encourage the achievement of target parameters for the production of high-tech civilian goods by introducing special annual bonuses. This will stimulate the management staff to pay equal attention to the fulfilment of both the state defence order and diversification tasks.

Mr President, this is the end of the report. We ask you to back our proposals.

Vladimir Putin: Mr Chemezov, please.

Rostec State Corporation CEO Sergei Chemezov: Mr President, colleagues,

As it has been said here today, you instructed the defence industry companies to increase the share of their civilian output to 50 percent by 2030. Rostec has an even more ambitious goal – to attain the goal of 50 percent, which is the average for the corporation, by 2025.

Vladimir Putin: What is the current figure?

Sergei Chemezov: It was 25 percent in 2016. We do not yet have the figure for 2017, but considering the overall volume, which is 460 billion rubles (compared to 374 billion in 2016), it is around 30 percent.

Vladimir Putin: In other words, you are moving forward?

Sergei Chemezov: Yes, of course.

The creation of high-tech products is the main commercial goal at Rostec. But before creating such products, we need to develop a strategic approach and a clear view of the markets and competitors. You cannot create a high-tech product without this. To see if a product will be competitive, we must have marketing tools, access to markets and services, postsale service, as well as industrial design, something to which we paid little attention in the past.

We intend to attain the revenue target by concentrating our resources on the rapidly growing global markets of smart products, like electronics, information technology, automation, control systems, medical equipment, novel materials, energy, the urban environment, and transport.

In order to clearly formulate the diversification tasks, the corporation’s strategy has been cascaded to the level of clusters and on to the corporation’s holding companies. As a result, we have formulated our civilian targets by year and added them to the KPI of every company head.

We have done this to avoid repeating past mistakes, when companies did not have clear goals or detailed plans for the creation and manufacture of high-tech civilian products. As a result, they had a poor understanding of market niches and the specifications their products should have, which weakened their positions in this highly competitive environment compared to the other private players, who had a clear view of the market and clients.

Over the last year, three of our holdings – Kalashnikov, Tecmash and Shvabe – demonstrated substantial growth in civilian manufacturing. They were able to achieve high results through the timely adoption of strategies to develop civilian manufacturing and the creation of incentives for their executives.

For example, Shvabe devised a strategy for manufacturing medical equipment back in 2011, and is now viewed by many other companies as a model in terms of fostering growth. In 2016, the company’s revenue from civilian production exceeded 12 billion rubles, and increased by more than 30 percent in 2017 to reach 16.6 billion rubles. Most importantly, this was high-technology equipment for neonatology, emergency medicine, oncology, cardiology, ophthalmology, endoprosthesis replacement, orthopaedics, as well as diagnostics and laboratory testing. For example, I can say that 70 percent of the equipment for perinatal centres that are being built in Russia is made by Shvabe.

In 2017, Tecmash increased its output of civilian products by 15 percent by producing drilling, refrigerating and agricultural equipment that was brought to the market over the past years.

The Kalashnikov Group is also a leader when it comes to the transition to civilian manufacturing. Since the introduction of sanctions against this concern, the revenue share from civilian products increased substantially. Specifically, in 2017 it grew by almost 56 percent on the back of new small-weapon models, primarily hunting and sports rifles, as well as the riverboats that you have mentioned, unmanned aircraft and small arms for civilian use, as I have already pointed out.

Unfortunately, some holdings still live with the illusion that state defence procurement will always remain at the current level. Of course, this is not exactly the case. We now know this all too well. Defence procurement orders follow a cyclical pattern, which is common for many countries. For example, in the United States, the upward and downward fluctuations in defence procurement exceed 30 percent.

Russian companies have to adapt and be resilient to any fluctuations in defence orders. For that, they need to diversify their product portfolios. Of course, I am not speaking about defence manufacturers making pans or pots, as was the case back in the 1990s. I am referring to the manufacturing of cutting-edge, high-technology produce in order to make full use of the technology and manufacturing capability our producers have.

Investment in the civil sector carries greater risk, of course, than dealing with state defence orders, because there is a specific market and significant competition. Defence orders have stricter rules in deliveries and production. Nevertheless, we cannot get around promoting the risk involved in investing in civil production facilities. At the same time, it is necessary to increase liability for failing to reach the targets and key performance indicators (KPIs) in civil production.

Mr Manturov already spoke about it, and we have introduced that too – each of the leader’s KPIs states that if they do not have growth in civil production, they will receive a smaller bonus regardless of their state defence order results. As for defence procurement, it is even simpler: they could even face criminal liability; therefore, directors of production facilities pay more attention to it, and that is how it should be. Now, increasing the share of civil production is the next priority.

I would like to note that as the main stage of the army rearmament nears completion and due to the decrease in state defence orders after 2018 and in accordance with your instructions, Mr President, Rostec and Vnesheconombank have established a new company, Konversiya, which we have spoken about. It will be the main coordinating centre to assist our defence facilities in searching for products in demand.

The key area of its activity, as I said, is marketing and the development of complex programmes for promoting high-tech civil production, particularly through the involvement of effective financing of projects to diversify defence industry enterprises.

As part of the development of a digital economy, we intend to implement the Smart Cities ecosystem project. We plan to implement such projects in 25 Russian cities; one is underway in Yaroslavl.

Today, we are facing an important challenge – to change the structure of human capital and implement new market competencies. As we work on achieving these goals, we must not only attract new people with the required profile from the open market, but we must also ensure competitive salaries and training for our workers. For this reason, it is important that we develop specialised training programmes to improve competencies that would enable people currently employed within the defence industry to create new, high-technology civilian products.

A mechanism for government co-financing of training costs could provide an additional impetus for companies to invest in the field of education. I propose launching such an educational project in 2018 for people employed in the defence industry. A programme of this kind already exists in Skolkovo, as far as I know. I think we can launch this programme by working together with the Industry and Trade Ministry.

Colleagues, Rostec is committed to developing high-technology civilian products. These efforts are primarily designed to facilitate industrial development in Russia and foster economic growth. In addition to this, efforts to expand civilian manufacturing would enable us to operate at a scale comparable to that of the leading global corporations. Rostec has identified tools for achieving this objective and implemented them. These efforts are already yielding results.

On the other hand, setting specific goals, strategic marketing, smart incentives and human resources development help companies reach new markets and development heights. This also helps them compete on an equal footing with global producers in defence as well as civilian manufacturing. Thank you.

Vladimir Putin: Mr Chemezov, is there a department in your corporation responsible for this area?

Sergei Chemezov: Do you mean developing civilian products?

Vladimir Putin. Yes. Is there a task group, perhaps a deputy of yours or someone else who is dealing with this on a regular basis?

Sergei Chemezov: Rostec and Vnesheconombank have established the Konversiya non-governmental organisation, which is responsible exactly for that.

Vladimir Putin: What is its status?

Sergei Chemezov: It is our joint subsidiary with Vnesheconombank.

Vladimir Putin: So they are dealing with this, and what is your relation to Konversiya? You created it. Are they isolated from your company, from you as the big boss? What is it like?

Sergei Chemezov: No. In fact, it is the target of every manager in the holding and every manager of the enterprise to increase the share of civilian production. It is in their interest as their KPIs, their salaries and bonuses are directly bound to this increased share. Therefore, it is in their interest to find a product that would be competitive and in great demand in the market.

Presidential Aide Andrei Belousov: I think Mr Chemezov’s special deputy Vasily Brovko is in charge of Konversiya.

Sergei Chemezov: He is not my deputy but Director for Special Commissions. It is his direct responsibility.

Vladimir Putin: It is important that there is a person dealing with this on a regular basis. You know, it is not enough to just set a task and include it in the KPIs. It is important to make sure that they analyse the enterprises’ capabilities, obtain proposals from these enterprises and then a deputy of yours reviews what is being done, and not just what is being done but also what can be done to help certain companies.

Andrei Belousov: Let me tell you briefly how the system works, very briefly. It was developed based on your directives given in Tula.

There is an information system for all defence industry enterprises to submit information about their civilian production capacities. This system is already in use. At the same time, the system processes requests from the Government based on a pre-approved classification. The list includes medical equipment, energy generating equipment and so on. The list can be extended.

Konversiya (which was launched about six months ago) has access to the database and, proceeding from demand, will communicate tasks to companies, “You produce this and you produce that. We know what your capacities are, as you reported them to the database.”

We worked with Vnesheconombank to create financial leverage. Mr Zolotaryov, who is the deputy of Vnesheconombank’s head, Sergei Gorkov, is in charge of Konversiya operations. They have been allocated funding. So far, the ties between VEB and Konversiya have not been very effective (the criticism goes to Mr Zolotaryov), but I think that we can resolve these matters.

These are the questions on today’s agenda. Can I say a few words? We are currently seeing certain restricting factors. We have had meetings with our colleagues on several occasions to discuss them.

The first restricting factor (as both Mr Manturov and Mr Chemezov have said) is that the executives currently have no real incentives or are not sufficiently interested in turning out civilian products. In fact, failure to deliver on a defence procurement order may lead to criminal charges, while when a conversion project fails managers lose only 20 percent of their bonuses. For this reason, simply setting KPIs will not help. The penalty for failing to reach these indicators should be the entire bonus.

The workforce should also have an incentive to take part in these programmes. For this, all or part of the profit should go toward additional bonuses for the workers, and people should know about it. This way, workers will urge managers to be more diligent in their efforts. This is the first factor.

The second factor has to do with demand. Despite all our discussions, major companies continue to buy Western products, even though similar products can be bought locally. Helicopters that Russian oil companies, Gazprom and others buy are a case in point.

We have good experience in setting strict requirements on state-owned companies awarding contracts to SMEs. At the time, this initiative was also subject to intense criticism, by the way. Nothing prevents us from doing the same for the defence industry. Of course, instead of requiring a specific share of procurement contracts to be awarded to Russian companies, say, a 10 percent share, we must take into account the inventories. To put it in crude terms, if you want to buy 20 helicopters, of this total 15 have to be purchased from Russian defence manufacturers: in Arsenievo, Ulan-Ude or anywhere else, of course subject to availability and so on. For that, we have the import substitution commission. These indicators could be factored into the requirements, and they should work. At least, it will be easy to monitor compliance.

Furthermore, there is yet another problem. From the point of view of cooperation and organising production between military output and high-tech civilian goods, there is no major difference – it is the same cooperation. Building a cooperation system for military products is regulated by law 275, and everything is normal there, moreover, it allows the Federal Anti-Monopoly Service (FAS) to impose punitive sanctions for shirking from participation in the state defence order, whereas civil products, for example, medical equipment, fall under law 223, and it is just the other way round: a tender is required. As a result, our colleagues, and I think that they will speak about this, face the fact that building cooperation is not so easy.

Therefore, exemptions are needed, of course, from federal law 223 in terms of cooperation with regard to high-tech civilian goods produced at defence industry enterprises. It should all be just the same – creating a line, a cooperation system, just as in the previous case.

What was said here is very important; this is, in fact, an educational programme, as today defence industry management cannot find a common language with investors, with a few rare exceptions. Kalashnikov is certainly worth mentioning as an example, and yet, as a rule, discrepancies emerge. Such programmes have already been developed and they definitely need to be launched.

Finally, one more thing. I would like to say that we need to significantly increase state funds for research and development. When it comes to high-tech products, being able to reach international levels or just keeping up with the trend, so to say, being present on the market, requires R&D expenses of around 10 percent of net revenue. It is easy to calculate the required amount of R&D expenses from 400 billion roubles. If we have 1.8 billion roubles in co-funding from the Ministry of Industry and Trade, then, clearly, this is almost nothing, so, in fact, there is virtually no reserve. Creating a scientific reserve in the form of experimental design and research is the most important task, and here, unfortunately, we simply must increase budget spending. Thank you.

Denis Manturov: 1.8 billion roubles, this sum is only for subsidies, this is only the interest rate, while in real terms it is around 200 billion in borrowed funds.

Vladimir Putin: All right.

What is the situation like in Tula Region? Mr Dyumin, please.

Tula Region Governor Alexei Dyumin: Thank you very much, Mr President.

Colleagues, Tula Region’s defence sector unites 25 enterprises. Implementing the state defence order, as well as diversifying production, are two strategic tasks that are constantly monitored both by local enterprises and the regional leadership.

The latest developments were presented at the defence industry for medicine exhibition, held in 2016 with your direct participation, Mr President. It featured the Angel diagnostic system, which makes it possible to carry out complex examinations in the format of telemedicine – at regional outpatient clinics, midwife stations, and in the mobile mode to reach remote, hard to access areas such as the Arctic and the Far East. Tactile endo-surgical and laser equipment was also presented that makes it possible to perform minimally invasive high-precision examinations and surgery.

The Tula defence industry continues to expand the range of civilian products. Based on the Angel system, Moscow State University together with the company Splav has developed an up-to-date intensive-care system, which is currently undergoing testing.

The region’s government, together with leading designers and heads of defence industry enterprises, has established a permanent working group to expand the range of civilian products. As part of its activities, the list of civilian production to be manufactured has been systematised. In addition to medical equipment, the list includes diesel generator sets, diesel pump systems for the Emergencies Ministry and other ministries and departments, pulse combustion boilers, small and multifunctional modules with hinged cleaning units for the housing and utilities sector, radar stations for agriculture, gas purifiers for metallurgy, meteorological systems and other products.

We are supporting the development of civilian production facilities. Tulamashzavod has received from the regional budget subsidised interest rates for investment loans to set up the production of hard-alloy metal-cutting tools, lathes and motor cultivators. We also supported the provision of a loan from the federal Industry Development Fund to the Oktava production facility for civilian production. Individual – I want to emphasise this word – work has begun at each facility and with each project, with the use of federal and regional support mechanisms.

Mr President, the most difficult aspect is the transition from small batches to serial production. At this stage, the most effective state support measure would be the signing of a long-term contract. On the international market – you spoke about it – we will face the toughest competition, so before entering it we need to create sustainable domestic demand, using first of all state procurement by agencies and state corporations. We have begun this work: we have executed regional agreements with Rostec, Rosneft and are negotiating with Gazprom.

As part of the working group, we are looking for an opportunity for defence enterprises to manufacture products that are in demand among state companies. This may seem unimportant and even funny, but several such enterprises are already manufacturing workwear, electric drives, rubber rings and other accessory components for Rosneft.

The hardest part is organising state procurement at the federal level. Serial deliveries of the Angel cutting-edge diagnostics system to clinics are possible only after medical service standards are changed. The situation is similar with purchasing mobile firefighting units by the Emergencies Ministry from Tulamashzavod, which are in demand in hard-to-reach areas and in rural towns.

Today, it is important to organise interdepartmental interaction, which would allow us to quickly make decisions regarding placement of long-term state orders for civilian products. The long-term order for a period of three to five years will allow us to launch mass production, to draw bank loans and, of course, to bring aboard the specialists to fill the staff needs of a particular production facility. I am talking about this based on our experience of working with defence industry enterprises on state defence orders.

I would be remiss not to mention such an issue as direct accounting of spending on civilian products. The new production will never become effective and will never meet the standards and targets that are set for it, if overhead costs of the core weapons production are attributed to it.

Tula Region took part in a pilot project to introduce a system of separate cost accounting at enterprises. Deputy Minister Shevchenko and I reported to you about this at a meeting that you chaired, and you approved this pilot project. Of course, this needs to be applied to calculations of the civilian products’ production costs as part of placing the state order for their production.

Thus, already at the initial stage of diversifying the defence industry, we propose concluding long-term state contracts for supplying civilian products, including, if necessary, its service support, and the mandatory organisation of accounting for costs separately for civilian and defence production.

Diversifying defence industry output in the civilian sphere is a complex task, which may be resolved only on the basis of effective interaction at the federal, regional and, of course (we already discussed it) corporate levels. The Tula Region Government and defence enterprises are ready and will work to achieve the goals set for them by way of introducing combined best practices.

Mr President, in closing, I would like to support Mr Chemezov's initiative regarding the organisation of an educational pilot project on the platform of the Higher Technical School at the Oktava Creative Cluster. This cluster is a joint project of Rostec State Corporation, the Tula Region Government and a private investor. The Higher Technical School will open soon and will, in turn, allow us to develop competencies in the sphere of the defence industry diversification and digital economy. Our region has everything it needs to do so.

Thank you for your attention.

Vladimir Putin: Thank you very much.

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