By David Lague and Charlie ZhuPosted 2012/09/16 at 5:14 pm EDT

HONG KONG, Sep. 16, 2012 (Reuters) — When China turned to Russia for supplies of advanced weapons through the 1990s, it kick-started Beijing’s military build-up with an immediate boost in firepower.

It also demonstrated the failure of its domestic defense sector which was still turning out obsolete 1950s vintage equipment for the People’s Liberation Army from a sprawling network of state-owned arms makers.

Now, after more than two decades of soaring military spending, this once backward industry has been transformed — China is creating its own military-industrial complex, with the private sector taking a leading role.

With Tiananmen-era bans on Western military sales to China still in place, an innovative and efficient domestic arms industry is crucial for Beijing as it assembles a modern military force capable of enforcing claims over Taiwan and disputed maritime territories.

China has locked horns recently with its Southeast Asian neighbors over conflicting claims to strings of islets in the South China Sea. Tensions have also flared with Japan over uninhabited islands in the East China Sea, even as the United States executes a strategic military pivot towards the Pacific.

Well funded defense groups have rapidly absorbed the technology and expertise needed to build complex weapons, freeing China from its former heavy reliance on Russian and other foreign equipment, Chinese and Western experts say.

“A country’s defense sector should reflect the strength of the country’s economy,” says Wu Da, a portfolio manager at Beijing-based Changsheng Fund Management Co Ltd which invests in listed Chinese defense stocks.

But, he adds, the sector is so shrouded in secrecy it’s been hard to assess how viable it is.

“Some of the Chinese defense groups are already quite strong after so much military spending in recent years but you don’t know exactly how well they are doing financially or technologically because China does not want others to know.”

That could start to change.

INJECTING ASSETS

Beijing is enlisting the private sector to accelerate the rise of its best defense contractors, issuing new guidelines in July aimed at encouraging private investment in a sector traditionally sheltered from competition and public scrutiny.

Listed subsidiaries of top Chinese military contractors now intend to buy at least 20 billion yuan ($3.15 billion) in assets from their state-owned parents in the second half, according to their recent filings with the Shanghai and Shenzhen stock exchanges.

This would double the value of military related assets injected into these listed companies since 2007 with more in the pipeline, as Beijing presses ahead with an ambitious program to privatize most of a vast arms industry employing more than a million workers at more than 1,000 state-owned enterprises.

The long term goal is to transform some of the leading contractors, such as China State Shipbuilding Corporation (CSSC), Aviation Industry Corporation of China (AVIC) and China Aerospace Science and Industry Corporation into homegrown versions of American giants Lockheed Martin and Northrop Grumman or Britain’s BAE Systems.

AVIC, which is aiming to quadruple its sales to one trillion yuan ($157.7 billion) by 2020 from 250 billion yuan in 2011, plans to inject 80 percent of its main businesses into some of its listed companies by the end of next year.

Beijing has made repeated calls to speed up listings of all but the most sensitive military businesses. The authorities have also promised to allow public bidding for unclassified and minor defense contracts in a sector that is likely to enjoy strong growth if China continues its sustained military build-up.

China’s top 10 defense groups with estimated combined assets of 2 trillion yuan ($315 billion) have listed more than 70 subsidiaries, including over 40 with defense-related businesses. About 25 per cent of the assets of the top 10 are now held in the listed companies, according to market analysts.

Some of these stocks have been strong performers. Sustained military outlays and the expectation of asset injections have insulated them from the country’s current economic slowdown. They also tend to spike in price at times of increased tension between China and its neighbors over disputed territory.

The plan to buy more of their parent’s military related assets would allow these listed companies to raise extra funds for research and development, the companies say.

AVIC subsidiary Hafei Aviation Industry Co Ltd plans to issue shares this year to buy 3.3 billion yuan ($520.5 million) in assets from its parent, including helicopter manufacturing companies.

“AVIC’s injection of (its) helicopter business into the listed company will be a key experiment of China’s strategic upgrade and transformation of its domestic defense and science industry,” Hafei said in a July prospectus.

FALLING MILITARY IMPORTS

The growth of the domestic arms industry has allowed China to steadily reduce military imports. International arms transfer figures from the Stockholm International Peace Research Institute (SIPRI) show China’s defense imports fell 58 per cent between 2007 and 2011.

In this period, China slipped to fourth place in the ranks of global arms buyers after holding top position in the five years to 2006.

“The PLA has clearly turned away from acquiring foreign developed platforms,” says Scott Harold, a China analyst for the Santa Monica, California-based Rand Corporation.

After double digit, annual increases in outlays over most of the last 20 years, China’s military spending is now second only to the United States.

In March, Beijing announced its defense budget for this year would increase 11.2 per cent to $106 billion but some foreign analysts believe this understates the country’s overall military budget.

In its annual report on the Chinese military, the Pentagon in May estimated Beijing’s total 2012 spending would be between $120 billion and $180 billion. Washington will spend $614 billion on its military this year.

Private data analyst, IHS Jane’s Defense Budgets, forecasts that Beijing’s annual outlays will reach almost $240 billion by 2015, more than the combined budgets of all nations in the Asia Pacific region and four times Japan’s military spending.

About 30 per cent of China’s military budget goes to weapons and equipment, according to Beijing’s most recent defense White Paper published last year.

CASH OVERCOMES INEFFICIENCIES

Military experts say that alongside reorganization and streamlining launched in the late 1990s, this avalanche of cash has sharply improved the output from key sectors of the Chinese defense industry despite the inefficiencies of many big state-owned companies, widespread corruption and a lack of official or public oversight.

“There is just something about money, and the more of it the better,” says Rand Corp’s Harold.

Russian weapons, including Su-27 fighters, Kilo-class submarines and Sovremenny-class cruisers, remain some of the PLA’s most potent hardware.

However, some Chinese-made equipment is now thought to be comparable to their Russian or Western counterparts, military experts say, although they acknowledge that accurate information about the performance of PLA weapons remains scarce.

Over the last decade, China has launched two classes of locally designed and built conventional submarines that are now the mainstays of the PLA’s underwater fleet.

It has also built versions of the Su-27 combat aircraft and begun mass production of its J-10 fighter that some experts rank with the U.S.-made F-16 in performance. China reportedly has developed its first stealth fighter, the J-20, but details of its capabilities remain unclear.

Chinese factories also appear to have made rapid progress in developing a range of advanced missiles. These include up to 1,000 ballistic and cruise missiles deployed against Taiwan and new mobile launchers for the PLA’s nuclear weapons.

Even in more basic equipment, China’s arms industry appears to have made significant improvements. In little over a decade, shabby uniforms and poor quality footwear have been replaced with smart, comfortable looking camouflage uniforms, lightweight helmets and solid combat boots.

Ground troops carry new assault rifles and small arms, while modern tanks, armored personnel carriers and artillery have been introduced to replace equipment derived from Soviet designs of the 1950s.

Arms trade experts conclude that China’s factories are now capable of satisfying most of the PLA’s needs – and that of other nations as well.

In the 10 years to 2011, China’s foreign military sales increased 95 per cent, making it the sixth largest arms supplier behind the UK, SIPRI figures show. Sales of jet fighters, warships and tanks to political ally Pakistan, however, account for much of this increase.

TECHNOLOGY WEAKNESS

Despite clear progress, some glaring weaknesses remain in Chinese defense technology, military experts say.

The PLA still appears reliant on imports of high performance jet engines from Russia for its most advanced fighters despite decades of research and development aimed at developing local power plants.

It also depends on dual-use, imported engine technology from Europe for its warships, submarines and armored vehicles.

Domestic aerospace companies have so far been unable to build big military transport aircraft that are important for military mobility in a country as big as China. These companies also remain heavily dependent on European, U.S. and Russian designs and technology for locally built helicopters.

Beijing is pinning its hopes on competitive market forces to help close these gaps as it continues its military spending spree.

That means more business for listed arms makers such as China Shipbuilding Industry Ltd which raised 8 billion yuan ($1.26 billion) in May from a convertible bond issue to buy military assets from its parent, the giant China Shipbuilding Industry Corp.

“With the construction of our country’s navy steadily pushed forward, we expect our company’s income from defense business to keep increasing,” the company said in a May stock exchange statement.

(Editing by Bill Tarrant)