No cap on FDI in defence

The New Indian Express

8th April 2010

The abolition of FDI limit would outweigh any perceived drawbacks as also bring additional benefits.

In India, the defence industry has gained opprobrium as the laggard that missed out on the economic liberalisation initiated in 1991. Other sectors benefited from the synergy through collaborations, joint ventures and even the direct presence of large foreign companies. In contrast, the defence sector continued to be the sole preserve of the public sector undertakings stymieing its growth. It was only in 2001 that the defence sector was opened up to private players and foreign companies were allowed FDI to the extent of 26 per cent. But almost nine years on, these steps have not yielded the desired result. Even today, around 70 per cent of India’s military requirements are imported while defence budgets continue to rise. (The only area in which India has made significant headway is in warship building; thanks to the prescient step taken by the navy to create a design cell as early as in 1962).

India’s defence allocation under the capital head (around 80 per cent for purchase of equipment and balance for works etc) for 2010-’11 is Rs 60,000 crore. It is expected to grow at the rate of 10 per cent per year (according to the growth projected by the XIII Finance Commission). This would imply that in the next five years we would spend a total of around Rs 2,25,644 crore (nearly $50 billion) on imports.

Now the moot question is if an innovative, robust and sustainable indigenous defence industry could be built by lifting the cap on FDI. The question of enhancing the FDI limit in defence was debated in a well-attended conference on Defence Offsets that was held at the Institute for Defence Studies and Analyses (IDSA) in October 2008. During the conference, a strong pitch was made for allowing even 100 per cent FDI in the sector. The majority was, however, only in favour of an upward revision in the FDI limit and there was no consensus on what the ceiling on FDI should be.

The government had fixed the upper limit of 26 per cent with a purpose. A minimum of more than 25 per cent shareholding is required to block the passage of any special resolution in a company as a two-thirds majority (75 per cent) is the least that is required for making fundamental changes in the entity; for amending the Memorandum of Association and Articles of Association for instance. Therefore, the government, by allowing 26 per cent FDI, gave potential investors the comfort that no far reaching changes can be made in the company against their wishes. But it is below the 50 per cent plus the ‘golden’ share required for the passage of resolutions like those for the election, removal and remuneration of directors. These limitations may explain the reluctance of the foreign firms to bring in technology and make large investments, as with the ceiling of 26 per cent, they are neither assured of control of the management of the company nor of adequate returns on their investment.

In view of the lack of interest among large foreign defence entities to invest in India, the government should take into consideration the peculiar nature of the military industry while deciding on the FDI limits. First, it is the most complex of industries. Companies have to continuously make heavy investments in R&D to even survive. Second, the market for defence equipment is small on account of their high costs. Hence the cost of defence equipment would have to be amortised on small volumes. Third, governments carefully control the kind of equipment that is sold to foreign countries. Fourth, companies are fettered by the technology control regime imposed by owner nations that closely regulate the establishment of any defence industry outside their territories.

Given this reality, there has to be a strong incentivising policy to attract foreign defence companies to invest in India. It should focus on the two mantras — giving the investing companies control over the entities they create through larger shareholding and through it, higher return on investments. For this purpose, the cap on FDI should be lifted. Depending on the kind of technology that is envisaged to be brought in and the investments to be made, the percentage of permissible FDI could vary. For investments in critical areas, even 100 per cent FDI should be allowed.

It cannot hurt India. When companies set up base in India, there would be a diffusion of technology to supporting ancillary and auxiliary units given especially India’s expanding knowledge society. (The development of the automobile sector in India followed this path). There need be no fear either of increased FDI destroying the domestic industry as we have none worth its name in the country at present in the private sector.

The abolition of FDI limit would outweigh any such perceived drawbacks as also bring additional benefits. Most importantly, foreign companies could determine the extent of the FDI they could make depending on the technology they plan to induct to make a success of their venture. It could dissolve the stubborn resistance to the transfer of high-end technology as foreign companies can establish a wholly owned subsidiary or a joint venture entity without the fear of their intellectual property falling into the hands of firms that could create ‘effective competition’ to the transferor. In course of time, the collaborating or parent company may take advantage of the cheap factors of production in the country and outsource components form its subsidiary or joint venture.

As offset banking has now been introduced, the company set up in India could accumulate credits to discharge their future offset obligations creating a stake in the success of their project. Further, when high investments are made, such companies would have an incentive in continuing operations in India whose market for defence equipment is projected to grow substantially.

One of the fears that have been expressed by some Indian companies is that lifting the cap on FDI could result in take over of Indian companies by foreign entities. While the fear is genuine, the same can be prevented if takeovers are subject to prior permission of the government.

Abolition of the cap on defence industry should also be accompanied by a slew of other enablers, the conjunction of which would lure foreign defence companies. Companies that invest in identified areas to fill critical defence gaps for instance, should also be assured of repeat orders for a long period of time of a decade or so. It could be made contingent on the company making periodical upgrades in the product, to be eligible for such orders. Combine it with multipliers (giving higher value) in the defence offset policy in critical sectors and we would have found some good answers to our problem of building a strong indigenous defence industry.