Higher cap needed to woo defence sector investment

On 5 April, the government of India issued its latest annual consolidated foreign direct investment (FDI) policy. Contrary to popular expectations, norms governing the defence sector did not undergo any change. As this was probably the last consolidated FDI policy to be released by the current central government, the absence of liberalization of the defence sector acted as a dampener for major foreign original equipment manufacturers (OEMs), which have been campaigning for an increase in the FDI cap of 26% and clarity in relation to the scope of the “defence industry”, which attracts various foreign investment restrictions under the current regime including the 26% cap, an industrial licence requirement, and restrictions on the composition of boards of directors and CEO appointments.

Procurement procedure

The Ministry of Defence (MoD) by way of press releases dated 20 and 29 April, announced a major overhaul of the defence procurement procedure (DPP), which broadly governs all capital procurement by the MoD and the Indian armed forces. The press releases stated that “these amendments aim at enhancing indigenization, reducing processing time and bring further clarity in the capital acquisition process” and were being carried out “with the twin objective of infusing greater efficiency in the procurement process and strengthening the defence manufacturing base in the country”.

The salient features are:

1. Preference to indigenous production and categorization of various forms of procurement in decreasing order of preference: (i) Buy (Indian); (ii) Buy & Make (Indian); (iii) Make; (iv) Buy & Make with Transfer of Technology; and (v) Buy (Global). Further, a proposal to select a particular category must now state reasons for excluding all higher preferred categories.

2. Simplification of procedure for Buy & Make (Indian) category.

3. Clear definition of indigenous content.

4. Advance consultation with various stakeholders for potential “Make” cases.

5. Transfer of “power to approve deviations from the DPP” from the defence minister to the Defence Acquisition Council.

Will it succeed?

Probably driven by recent criticisms relating to impropriety in defence procurements, the government may have ignored lessons from the history of defence manufacturing in India. Until 2001, the defence sector was a public sector monopoly. As over the years the public sector failed to innovate and provide timely deliveries, by way of Press Note 4 of 2001, the government liberalized the defence sector by permitting Indian private sector participation up to 100% with FDI permissible up to 26%, both subject to industrial licensing.

The past 12 years have seen many Indian entities venturing into defence and aerospace but most remain peripheral players in low technology sectors. Only a few big players, such as Tata, Reliance and L&T, have tried to enter high-technology areas with technology transfers from and joint ventures with global leaders.

The reluctance on the part of leading foreign OEMs to share their technology with companies in which they have a mere 26% stake may be a major reason why in the past 12 years, despite low manufacturing costs in India, India has not become a major defence manufacturer or a technology leader. The much maligned export restrictions in some countries including the US might not be the leading cause for lack of transfer of technology.

Promising start

Despite no changes in the consolidated FDI policy, the MoD press release dated 20 April states that a “defence items list” has been finalized by the MoD and will soon be notified by the Ministry of Commerce and Industry. Up to now, the scope of “defence industry” which attracts the 26% cap and other restrictions was undefined and therefore confusion prevailed especially in relation to dual use items i.e. items used in both defence and civilian sectors, which invariably led to delays in approvals of investment proposals. The clarification that dual use items will not be defence items and the announcement of a “defence items list” should go a long way in clearing the prevailing confusion in this sector, which will make doing business easier.

Details of the amendments are still awaited, however, until the FDI cap is increased, defence sector joint ventures and transfer of technology agreements will be few and far between. With limited transfer of technology, the Indian industry will find it difficult to fulfil the needs of the Indian armed forces for most defence items, and the objective of strengthening the defence manufacturing base in the country may remain merely an aspiration. It is therefore hoped that the policy will be revised sooner rather than later, to enhance the FDI cap such that the revised procurement norms may be successful.

Anuj Prasad is a partner and Kanishk is a senior associate at Amarchand & Mangaldas & Suresh A Shroff and Co, New Delhi. The views expressed in this article are those of the authors and do not reflect the position of the firm.