Standing down the guard and increasing FDI in defence

In one of most significant moves in modern times concerning the defence sector, the finance minister recently announced that the foreign direct investment (FDI) limit in the defence sector under the automatic route would be raised from the existing 49% to 74%. This change, which was long overdue, comes a decade after the Department of Industrial Policy and Promotion (DIPP) had recommended in a discussion paper increasing the FDI cap in the sector to at least 74%, if not 100%. While the fine print of the change is yet to be seen, it is debatable whether this change alone will provide the impetus required to boost the inflow of foreign capital and technology into the defence sector.

FDI in defence over the years: From May 2001, when the defence sector was first opened to FDI up to a maximum of 26% under the government route, until September 2014, total FDI inflow in defence was US$4.94 million. When the FDI cap was increased to 49% under the government route in September 2014, this merely resulted in an increase in FDI inflow of US$180,000. A further liberalization of policy in September 2016 that permitted FDI up to 49% under the automatic route and up to 100% under the government route, “wherever it is likely to result in access to modern technology or for other reasons to be recorded”, also failed to impress foreign players as it only resulted in an increased FDI inflow of US$4.4 million.

Failure to boost FDI in defence: India is currently the second largest importer of defence equipment and has the third largest defence expenditure worldwide, according to the Stockholm International Peace Research Institute (SIPRI) fact sheet for April 2020, making it a very attractive defence market. However, most of the defence needs of the country have historically been met by imports and have not resulted in an inflow of foreign capital or transfer of technology to satisfy this high level of defence consumption.

One of the main reasons for the low levels of FDI inflow has been the policy restrictions, especially the limit on foreign ownership. For instance, apart from setting investment limits the existing FDI policy also stipulates that the entities in which the investment is made should be self-sufficient in areas of product design and development, and should also have maintenance and life cycle support facilities for the products they manufacture. This leads to a disincentive for original equipment manufacturers (OEM) transferring critical, state-of-the-art proprietary technology to Indian entities because they are not able to own a majority stake in, or exercise control over the entity in which the investment is made. Additional factors limiting the inflow of foreign capital include the preference of the government to source a significant amount of defence equipment either through government to government (G2G) deals or from private players through an extremely complex and lengthy procurement process.

While on the one hand the government is taking measures to attract foreign defence manufacturers and OEMs by increasing the FDI limits, it has also proposed certain measures, which seem to tilt the scales the other way, in favour of residents in matters relating to procurement. For instance, under the Draft Defence Procurement Procedure, 2020 (currently awaiting public comments), preference is given to Indian owned and controlled vendors in the case of defence procurement. The government should revisit this matter in order to fully realize the objectives of the proposed FDI liberalization.

The ultimate objective: For years, the objective of the government to create a localized defence production ecosystem to aid India’s strategic and national security concerns has suffered due to the lack of a level playing field for foreign OEMs. This is due to FDI restrictions, a greater focus on G2G procurement and a long and cumbersome procurement process for the private sector. Therefore, in order to make the country a defence production hub by attracting more foreign capital and technology, the increase in FDI limits, while a long awaited and welcome step, needs to be augmented by consistent, simplified and holistic policy changes across the board. These include changes to the defence procurement policies to provide entities in which foreign companies have invested many more opportunities for participation in the procurement process and making a paradigm shift from the historic reliance on G2G procurement.

Damini Bhalla is a partner and Akshay Jain is a managing associate at L&L Partners.