By Steven Scheer

JERUSALEM (Reuters) - Israel's defense industry faces layoffs, closures and a scramble to set up shop in the United States following the signing of a new U.S. military aid package that phases out Israel's ability to spend a quarter of the funds on its own businesses.

The 10-year, $38 billion agreement, signed on Sept. 15 after a year of negotiations, comes into effect in U.S. fiscal year 2019. It constitutes the most military assistance Washington has ever provided to an ally, but was clinched only after Prime Minister Benjamin Netanyahu accepted concessions.

Key among those is the gradual phasing out of a clause allowing Israel to spend 26.3 percent of the funds on its own defense sector, which competes actively with U.S. firms such as Boeing, Lockheed Martin, General Dynamics and Raytheon.

That means Israeli defense companies will miss out on up to $10 billion that might otherwise have been spent on home-made drones, missiles, tanks and other equipment, depending on the precise terms of the phase-out, which remain unclear. Once that phase-out is completed, all the funds in the agreement will have to be spent in the United States.

"It's quite a problem," said one Israeli defense industry official, who asked not to be named because of the sensitivity of the issue. "The bigger companies and most advanced ones with the best technology and capabilities will be able to survive, but the smaller you are, the bigger the problem is."

Netanyahu's office declined to comment on the domestic consequences of the aid deal but has said the agreement "will greatly strengthen the security of Israel".

Israel has about 700 defense-related firms, most of them with only 50 to 150 employees. They mainly act as subcontractors to Israel's four largest defense companies -- Elbit Systems, Israel Aerospace Industries, Israel Military Industries and Rafael Advanced Defense Systems.

Israel's defense exports totaled $5.7 billion in 2015, about 14 pct of all exports and a major driver of the economy.


None of the companies asked by Reuters to discuss the aid package were willing to speak on the record, mentioning concerns about future business. But several executives, speaking on condition of anonymity, said that as a result of the deal they were already considering contingency plans.

One option would be for larger firms to open subsidiaries in the United States, like Elbit has done, to compensate for the loss of business. They might also acquire smaller U.S. firms.

As one executive put it: "This should be translated into an opportunity for the Israeli industry, which should penetrate new markets and improve their competitive ability."

"We should face the global trends and the fact that Israel is losing its ability to compete," the official said, adding the company where he works would "accelerate the process" of searching for a U.S. company to buy.

Another area of concern is the loss of Israeli know-how, with aerospace engineers and scientists potentially moving abroad if there is a decline in inward spending and investment.

The executives said they hoped that when the time comes, the government will find the nearly $1 billion a year extra needed to keep the sector afloat under terms of the agreement, although the sum may be hard to come by given the fractured political environment.

According to Israel's Manufacturers' Association, even a 1 billion shekel ($265 million) cut in the defense budget will lead to the layoff of more than 2,000 workers, mostly from small- and medium-sized subcontractors that have a "to be or not to be" dependence on orders from the Israeli defense establishment.

A source close to Netanyahu said the prime minister didn't anticipate any closure of small defense companies, and noted the procurement changes would go into effect only in time.

On the domestic political front, the right-wing leader has drawn fire over the new pact from critics, including his former defense minister Ehud Barak, who said that Netanyahu's vocal opposition to last year's U.S.-led nuclear deal with Iran had jeopardized a potentially larger package.

However, with uncertainties surrounding a tightly contested election for the White House, Netanyahu was keen to wrap up an agreement, replacing the current $30 billion deal that expires at the end of fiscal 2018.

Addressing his cabinet on Sunday, Netanyahu called arguments that Israel was short-changed in the negotiations "distortions and fabrications of parties with political interests".

Avraham Bar David, a former general who works with some 200 small Israeli defense contractors through the Manufacturers' Association, predicted that "70 to 100 of them" will not survive the local procurement restriction.

"These companies are too small to sell abroad," he said.

($1 = 3.7734 shekels)

(Editing by Jeffrey Heller and Giles Elgood)