Road map for a robust defence industry

The Hindu

March 31, 2016

After the Modi government came to power, one of the early reforms ushered in was the raising of the Foreign Direct Investment limit in defence from 26 per cent to 49 per cent under the automatic route.

The reform could have hardly been deferred. India, the world’s largest arms importer, relies on imports to meet more than 70 per cent of its defence requirements. This figure could rise embarrassingly if the value of foreign components in defence ware, touted as indigenous products, is not excluded from the category of defence imports.

The new policy evidenced the rejection of misplaced notions of patriotism and protectionism that had previously, in all but name, frustrated the entry of both the domestic industry and foreign companies into the defence sector. The reform was further leavened by the Prime Minister’s statement that a robust indigenous defence industry is imperative to make India “self-reliant in the area of security”.

Upbeat response

Major corporate houses are now scrambling to forge tie-ups with foreign defence companies. While this is a very encouraging development, many attendant reforms need to be embraced to achieve the policy goal outlined by the Prime Minister. This is because the defence industry is like no other. It is evolutionary, highly technology-intensive, and demands continuously high levels of research and development (R&D) investment.

Therefore, the focus of any policy should be to draw foreign defence manufacturers to India and, in the process, gain technology transfer. To accomplish this, an enabling architecture that would guarantee the protection of their Intellectual Property Rights (IPR) and commercial interests is key. This would require two strategic changes: the FDI ceiling in defence should be revised upwards and the Defence Procurement Procedure (DPP) has to be fine-tuned to integrate its various components with the liberalised investment regime.

The following strategies related to these two aspects could be implemented to yield rich dividends. First, with regard to FDI, we are almost there. Given the peculiarities of the sector, it would be pragmatic to permit even 100 per cent under the automatic route, subject to certain conditions. The case for this is compelling. Even after raising the ceiling to 49 per cent, the inflow in 2015 under the head “defence industries” was only $0.08 million. A major reason is that there is no real difference between 26 per cent and 49 per cent for investors, save their entitlement to larger profits.

Profit is not the main issue; it is the absence of the desired level of control that investing entities will have over their technologies with 49 per cent ownership that acts as the dampener. As economics professor Jurgen Brauer has cautioned, no transferring country will idly stand by while their products are “shipped abroad and effective competition is created”.

Given the overwhelming concern for safeguarding IPR, the removal of the FDI ceiling would yield rich dividends. The transformation of the Indian automobile industry after 100 per cent FDI was permitted may be an educative example. It helped India become an important export base for some of the best brands. Arguments that lifting the ceiling on FDI in defence would “decimate” the local industry do not deserve any serious consideration as they are starkly similar to the fears expressed when limits were lifted in the automobile sector.

Offset obligations

Second, use the mandatory offset (compensations that buyers obtain from sellers) to bolster the ‘Make in India’ programme. When using this strategy, it would be wise to remember that offsets do not come free. They are indeed paid for by the buyer. A study conducted in Belgium concluded that an additional cost of 20-30 per cent was loaded on contracts as expenses for discharging offset obligations. Such loading emanates from the fact that offsets are trade distorting.

As offsets come at a substantial cost, they would need to be steered. For fulfilling offset obligations, identify equipment from a shelf of projects carefully created to fill identified gaps in Indian defence technology. Make it compulsory for companies to locally produce such equipment with predetermined levels of indigenisation to be achieved over the years. For such projects, permit up to 76 per cent FDI under the automatic route, thereby giving foreign investors sufficient control over the established entity.

Third, complement the above strategy by employing multipliers (assigning higher value) where foreign companies manufacture defence wares identified to be of critical need for the services. In such cases, allow 100 per cent FDI, mandating only a reporting requirement to the Ministry of Defence.

Fourth, establish a separate Department of Overseas Acquisitions in the Ministry of Defence for establishing Special Purpose Vehicles with identified private sector entities to take over foreign companies. The department should in effect function as a Defence Sovereign Wealth Fund.

Fifth, finance and support R&D/production in the private sector as the U.S. does (the development and production of U-2, the highly successful reconnaissance aircraft, in the 1950s is a good model).

Sixth, create a body in the Ministry of Deference consisting of civilian officers, defence personnel and industry leaders to evaluate FDI flows, steer these flows and offsets, identify foreign companies for acquisition, etc. The mandate of this body should be to achieve convergence of various strategies being implemented by multiple bodies.

In conclusion, development of the indigenous industry in the country would require multiple strategies, a synergic approach and unconventional thinking, taking some lessons from China which has successfully adopted many of them. With the present conducive political environment, it is a goal that is immensely achievable.