May 1, 2010

Military modernisation needs FDI

The private sector was allowed to enter the defence industry in May 2001 when the government permitted—subject to licensing—100 percent equity with a maximum of 26 percent foreign direct investment (FDI) component. Recent media reports suggest that the commerce ministry is contemplating a proposal to do away with the FDI cap altogether.

Previously, industry associations have called for the FDI cap to be raised from 26 percent to 49 percent. The Parliamentary Standing Committee on Defence and the Economic Survey for 2008-09 had echoed these proposals. The failure of existing policy to attract any substantive FDI in the defence sector—only Rs 7 million over the last decade—underpinned these demands.

Notwithstanding the abysmal failure of the current policy, the defence ministry has unequivocally stated its view that as defence is a strategic sector, foreign investment in joint ventures would be limited to 26 percent. Any FDI beyond 26 percent would be considered on a case-by-case basis. The joint venture with Russia to manufacture multi-role transport aircraft and for manufacturing BrahMos missiles; and between HAL and French company Snecma for the manufacture of aircraft engines have been allowed by the defence ministry on a 50 percent FDI basis. But the ministry has recently rejected proposals for joint ventures between Mahindra Defence Systems and UK-based BAE Systems; and between L&T and Franco-German corporation, EADS involving 49 percent foreign shareholding. These exceptions of allowing FDI beyond 26 percent have been few and far in between, and have only involved public sector defence manufacturing units.

Clearly, the cap inhibits the entry of foreign firms into the Indian defence market. Few foreign firms are keen to invest resources in a venture where they have no significant control, face strict capacity and product constraints, have no purchase guarantees, no free access to other markets (including exports) and where the field is skewed in favour of the local public sector. Moreover when the defence ministry is already buying directly from foreign suppliers there is no incentive for that firm to create a 26 percent-owned subsidiary in this country.

Most major defence manufacturing units need a transfer of technology. However no foreign defence technology leader is comfortable with transferring proprietary technology to a company in which it does not own a major share. Advanced technologies cost billions of dollars to develop and the returns likely to be generated on the basis of current FDI regulations—coupled with the lack of control—make it unattractive for a foreign firm to enter the Indian market.

Furthermore, due to the current restrictions, India is losing out on a number of foreign companies who might be keen on developing India as a ‘home market’—both as a major domestic sales market and a global manufacturing hub in its supply chain. The United States remains home to some of the biggest and most advanced defence manufacturing firms in the world. Rather than being restricted to transactional defence deals with the United States, lifting the foreign equity restrictions will attract US firms and make India’s relations with the United States truly strategic in nature.

Indian firms seeking to diversify into defence production would also benefit from raising FDI limits. It will help them secure the transfer of key technologies and boost the capital available to them. Most importantly, it fulfils their need to mitigate commercial risks in the highly fraught development environment of defence production. Defence systems, which are usually at the cutting edge of technology, require enormous capital to develop and there are never any guarantees of actual orders. Private Indian defence manufacturers in effect have little choice but to look abroad for partnership, funding and technology.

The case against increasing the cap for FDI, as argued by the defence ministry, is founded primarily in Indian sovereignty, security of supply issues and promoting organic industry development. It believes that allowing greater levels of FDI, even below 49 percent level, would increase the amount of control exercised by foreign partners and consequently reduce the actual level of indigenisation and maintain the reliance on foreign suppliers.

The ministry has also argued FDI levels of more than 50 percent would imply that the management control would be with foreign investors. Therefore due to the strategic nature of the defence industry, there is an apprehension that such ventures would fail at critical times.

These concerns are understandable. But they can be addressed. For instance, the commerce ministry’s note argues that conditions could be imposed whereby the government can expropriate a manufacturing facility for reasons of national security, after paying suitable compensation. There are examples of other countries like the United States and the United Kingdom which have allowed 100 percent foreign equity in the defence sector without comprising on control, security and secrecy. Regulations can be imposed to ensure that, except for foreign ownership and investment, the company is essentially a domestic entity serving the domestic military requirements with absolute security and secrecy where required. The public sector defence units must also be restructured to prepare them to face the new competitive environment.

The offsets policy is often cited as a tool that attracts latest technology without compromising the national security interests. This requires a foreign arms supplier to produce in India goods and services worth 30 percent of the contract it is awarded. Yet offsets are a poor alternative to FDI. India lacks the capability to absorb the offsets obligations, estimated to be about $9 billion by 2012. In such cases, foreign vendors, faced with significant offset obligations, will end up seeing non-commercial and artificial offset trades with Indian businesses simply to meet these obligations. There is also the risk that offsets will be used for low technology components with a minimal value addition. In fact, greater infusion of FDI will help create the capabilities for India better capitalise on the offsets policy.

Increasing the FDI cap from 26 to 49 percent will perhaps lead to incremental benefits to India, if at all. But allowing 51 percent foreign equity, if not 100 percent, will make a significant difference to the Indian defence industry.

The fears and objections that surround opening the defence sector to higher foreign participation are not dissimilar to those expressed when the government was considering reforming the telecommunications and insurance sectors. Yet the evidence from these other sectors—strategic in their own way—clearly suggests that foreign investment has transformed the technological sophistication, generated employment, built local expertise and improved the reach and effectiveness of the services.

India’s cap on FDI is stunting the process of modernisation of the armed forces. It is a cap that India cannot afford.

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