Getting the Defence Offset Policy Right

The Economic Times

5th December 2008

Defence offsets are compensations that a buyer of defence equipment/services seeks from a seller. It may be in the form of co-production, licensed production, technology transfer, outsourcing of components, etc., related to the defence item imported or investment, collaboration and similar compensatory arrangements in civilian areas. The former is termed as direct offsets and the latter as indirect offsets.

The strategy of leveraging defence offsets gained momentum in the 1980s and today around 130 nations worldwide embrace it. India was, however, a late starter. It was only in 2005 that India unveiled its official offset policy through its defence procurement procedure (DPP).

The primary objective of the policy is to build Indias defence industrial base. This policy gave the government the option to seek 30% offsets in proposals valued at Rs 300 crore or more for import or indigenous production of defence equipment through transfer of technology.

As a matter of strategy, India adopted a hybrid version of direct and indirect offset forms. This may be termed as quasi-direct offset policy compensations not only related to the specific defence item imported but any other item in the defence sector.

The 2005 policy, however, did not yield any dividend and the government quickly revised it in 2006 making, among others, offsets mandatory and establishing the defence offset facilitation agency (DOFA) in the ministry of defence (MoD). The policy, however, suffered from many drawbacks and both MoD and foreign vendors had to struggle to conclude even the three agreements that India managed to ink in the two years since the 2006 policy introduction.

In view of the difficulties in implementing the policy, MoD amended the guidelines in August 2008 after studying world practices. The changes made include the listing of products that qualify for the discharge of offset policy, introduction of offset credit banking and removal of the need for domestic industry for licence unless required under the regulations of the department of industrial policy and promotion (DIPP).

But is Indias offset policy adequate to best serve the nations goal of strengthening its defence industry? Besides the three offset agreements already signed, today about 28 proposals are under consideration in MoD but more needs to be done to ensure that all the stakeholders, including foreign firms, have a stake in the successful outcome of offset agreements. Getting the policy right is of paramount importance as the stakes for the nation are too high.

India is the largest defence importer in the world and its defence expenditure is expected to rise further with economic growth. Even with the requirement of 30% offsets, the policy is expected to yield benefits of around Rs 47, 000 crore in the 11th Five- Year Plan (2007-2012).

Further, India is heavily dependent on imports to fulfil its defence needs and mandatory offsets would mean that its armed forces would get less from the nations defence expenditure. Therefore, the offset policy should be carefully calibrated to yield maximum dividends. To achieve this, the following changes in policy may deserve serious consideration.

First, equity in FDI in defence may have to be increased from the present 26%. Foreign firms in any case are reluctant collaborators in any mandatory offset arrangement. The experience of several nations reveals that with higher equity, collaborating foreign firms develop long-term stake in joint ventures (JVs), would be less reluctant to transfer technology and be more willing to outsource items from purchasing nations.

Again, as offset banking is now permitted, foreign firms having higher equity in JVs would be encouraged to strengthen such entities from whose profit they stand to gain. For this to yield optimum results, however, the validity of bankable credits may also require to be extended.

On the contrary, with low stakes for the investors, we may face the same problem Philippines experienced where a UK firm after importing eight armoured carriers and assembling the remaining 142 of the contracted number, closed shop and returned home.

Second, Indian industries should have access to advance information on defence acquisition plans. This can give them the lead time and the opportunity to raise funds and seek foreign collaborations.

To plug possible leaks, suitable regulations may be put in place like in the US. Third, the requirement of licence for Indian industry to produce defence items should be abolished. Government did well by opening the defence sector in 2001 to the private sector.

But just as it had let go of its control on other areas, it may be prudent to let the market forces regulate the as defence offsets come at a cost, the offset policy.

Fourth, offset credit trading (allowing firms to sell accumulated credit) could be introduced. Coupled with the offset banking provision, trading of credits would encourage firms hoping to get contracts to invest in India without fearing losses in case they are unsuccessful in getting the contract they may have competed for.

Importantly, it would also encourage those which are already discharging their offset obligations, to sustain with their ventures in India in the hope of accumulating credits for future contracts and selling them in case they are unsuccessful in securing future contracts.

Fifth, offsets should be directed to filling critical gaps in defence capability as opposed to listing generic items as in the present procedure. To encourage larger investment, value additions, etc., repeat orders, say for a period of ten years, to the same source that indigenously produces such critical items, would be omniscient.

Sixth, along with the critical areas/systems that may be included in the permissible list eligible for the discharge of offset obligations, multipliers (a system of assigning higher monetary values to identified offsets) could be adopted.

To sum up, as defence offsets come at a cost, the offset policy should be carefully calibrated. DOFA estimated that about Rs 9,400 crore per year would need to be strengthened with experts also inducted from outside the government.

Tax holidays for JVs, domestic entities producing critical defence equipment and subcontractors of JVs who are able to penetrate the defence supply networks of foreign vendors, would be prudent.

Lowering the requirement for offset from Rs 300 crore (world average today is $15 million Rs 70.5 crore), increasing offset requirement from 30% to say 60% and fixing a percentage of that proportion for dual-use technology inductions also deserve serious consideration.

The offsets policy would have to be dynamic and bold steps would have to be embraced for offsets to yield desirable results.