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Abstract
The aim of the paper is to find out progress, problems and prospects of FDI in Indian defence
sector. India is the Worlds biggest defence importer; has the second largest military force and
is the ninth highest defence spender. Its half of defence hardware is near to obsolete. Its two
nuclear armed neighbours, China and Pakistan, have a long history of enmity with it. These
challenges can be faced by India through strong defence manufacturing complex coupled with
economy might. If it can attract FDI in defence sector in a large proportion, it can face
challenges successfully. The main finding of the study is that although a lot of changes have
been made for FDI policy and procedures by govt. of India, a lot of efforts are still needed to
plug the loopholes in smooth flow of FDI in defence sector. For this, some options have been
identified. Indian experiences can be very useful to others especially erstwhile socialist
countries which emulated their economies into market-oriented.
Keywords: Foreign Direct Investment(FDI), globalisation, development, Original Equipment
Manufacturers ( OEMs), Department of Industrial Policy and Promotion (DIPP), Defence
Public Sector Undertakings (DPSUs) , Defence Procurement Procedure (DPP), Financial
Year(FY).
JEL classification: F210
1. INTRODUCTION
Economists suggest two strategies for development viz., inward looking and
outward looking. The former is based on failed socialist model. It divorced from
reality. The latter is more realistic, though it has own flaws. For example, economic
recession in 2008 had engulfed most of the part of world through globalisation. One of
the most important ingrain of the strategy is development through external linkages.
Foreign Direct Investment (FDI) is one of them. It is considered one of the most
VOLUME 7 NUMBER 3 DECEMBER 2015
393
foreign OEMs to enter into strategic partnerships with Indian companies for
cultivating domestic and global markets.
It is estimated that opportunities of defence offset obligations to the tune of
approximately Rs250 billion during the next 7-8 years. The offset policy
(which stipulates the mandatory offset requirement of a minimum 30 per cent
for procurement of defence equipment in excess of Rs3 billion) introduced in
the capital purchase agreements with foreign defence players would ensure that
an eco-system of suppliers is built domestically.
The government policy of promoting self-reliance, indigenization, and
technology-up gradation will develop capabilities for exports in the defence
sector.
The countrys extensive modernization plans of defence forces and an
increased focus on homeland security will increase Indias growing
attractiveness as a defence sourcing hub.
High government allocation for defence expenditure will ensure defence
manufactures to develop smart weapons in India.
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396
2. HISTORICAL BACKGROUND
The production of defence equipment was, until relatively recently, entirely a
government function. The Industrial Policy Resolution, 1948, restricted the entry of the
private sector into this industry. The defence industry in India was declared open to the
private sector in May 2001 (Press Note 4 of 2001 Series) when the government
permitted 100 percent equity with a maximum of 26 per cent FDI component, both
subject to licensing. Subsequently, it issued detailed guidelines, after consultations
with the Ministry of Defence (MoD), for the issuance of licence for the production of
arms and ammunition in January 2002 (Press Note 2 of 2002 Series) (Tripathy, 2012).
Indian defence industry is primarily dominated by Defence Public Sector
Undertakings (DPSUs) and ordinance factories. Their share in total defence output is
estimated to 90 per cent. The 41 ordinance factories employ close to 125000 people
across 26 locations. These factories a wide spectrum of products including weapons
(small, medium and large caliber, and motor equipment), ammunition (small, medium
and large caliber, mortar bombs, grenades, signaling smoke, rocket bombs, demolition,
explosives, propellants and chemicals), vehicles(armored and transport), clothing,
general stores and equipment for defence services.
The DPSUs and ordinance factories have played a critical role in building a
domestic industrial base in this sector as they typically outsource 20 to 25 per cent of
their production requirements to private companies. In addition to these Public Sector
Undertakings, a number of medium and large private companies have entered or some
are seriously considering it to take stake in this sector. The import-export ratio of
Indias defence industry is less than the countries with small defence industrial base.
Therefore, Indian Government is seriously contemplating to correct it. Its main goal is
to promote the investment in both in R &D and manufacturing of defence hardware.
The sector is included in the Make in India campaign (ASSOCHAM & PWC,
2014).
On the other side, India ranks among the top 10 countries in the world in terms
of military expenditure and as stated one of the largest importers of conventional
defence equipment as it strives to modernise its forces and replace obsolete equipment.
Its arms imports are now almost three times as high as those of the second and third
largest arms importersChina and Pakistan. India is among the top five arms
importer, besides China, Pakistan, the UAE and Saudi Arabia (Table 3).It isprojected
that the ranks of China and India will be second and third respectively in worlds
military expenditure in 2045.Indias defence expenditure in terms of Purchasing Power
Parity (PPP) in US$654 billion and Chinas expenditure on the same head projected
US$1270 billion for the year 2045. Projection of defence expenditure of major powers
for the year 2045 has been made (Table 4).
397
Source: SIPRI
Table 4: Projected military expenditure of the worlds major powers in 2045
Rank Country
Spending in PPP ($ Bn.)
1
United States
1,335
2
China
1,270
3
India
654
4
Russia
295
5
United Kingdom
108
6
Brazil
97
7
France
87
8
Japan
67
9
Germany
63
Source: Global Strategic Trends out to 2045, gov.uk, 15 July 2014
3. REGEULATORY REGIME
The policy for FDI in the Defence Sector was first notified vide Press Note 4
of 2001, wherein the Defence Industry Sector was opened up to 100 per cent for Indian
private sector participation, with FDI permissible up to 26 per cent later it was
increased to 49 per cent, both subject to licensing and Government approval.
Subsequently, guidelines for production of Defence equipment were notified, vide
Press Note 2 of 2002. Other than the FDI policy, two other policy regimes govern the
398
defence sector. These are the Defence Procurement Procedure and the Industrial
License regime.
The Defence Procurement Procedure (DPP) that governs the defence
procurement was first enumerated in 2002. After several iterations to the original
policy, the latest one is in pipeline. It is reported that Ministry of Defence has given its
nod to some amendments to the much awaited Defence Procurement Procedure(DPP)
emphasizing on higher indigenization in line with the Make in India programme and
providing a major role for the private sector in arms manufacturing. However, the new
DPP 2016 would be issued in two months time as some parts of the revised DPP needs
to be approved and will apply to only new projects and not to those which are already
in process. The new DPP basically plans to ease the procurement processes. The
highlight of the new DPP is a new category to promote indigenous design and
development and domestic manufacturing including Government funding for Research
& Development (R&D) and recognition of the Micro, Small and Medium Enterprises
(MSME) in technology development.
The DPP will have a new category called the Indigenously Designed,
Developed and Manufactured (IDDM) platforms. The Buy Indian (IDDM)
procurement category will be given the first preference. The significant proposed
changes/provisions to the DPP 2016 are as follows (DEFENCE PROCURMENT
PROCEDURE (DPP) 2016 :
It will be mandatory to have 40 percent local content in case the design is also
indigenous.
In case, the design is not Indian, 60 percent local content will be mandatory.
The domestic companies eligible under this will have majority Indian control
and operated by Indian nationals.
In DPP-2016, the Make procedure will be expanded into three types.
399
Make- III (MSME funded) While procedurally similar to Make II (IndustryFunded), this is reserved for projects with a development cost of less than Rs 3
crore, which will be exclusively reserved for MSMEs.
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4. PROGRESS
Table 6 shows that FDI in Indian defence sector attracted mere US$4.94
million out of total FDI of US$238747.65 million during the period April 2000 to
December 2014. It represents only .002 per cent of total FDI which flowed into
defence sector in India.
Table 6: FDI equity inflows into Defense sector in India from April 2000 to December 2014
Items
Defence industries
Total (FDI)
Amount(US$ million)
4.94
238747.65
Source:DIPP
401
then major overhaul in the sector has been made on the policy as well as
implementation levels. A lot of changes are in pipeline on DIPP, offset, export fronts,
etc. A new enthusiasm has been poured into defence manufacturing but it will take
some time to translate into reality. Overall perception about India and its growth story
have changed. Now India has been perceived differently. World cannot ignore India
because of its 4 Dsdemographic dividend, demand, deregulations and democracy.
5. HINDRANCES
Though beginning has been made in India to attract FDI in defence sector, a lot
of problems/roadblocks still exist. The major hindrances are:
Policy/Procedure: Defence sector has been opened up to 49 per cent FDI cap.
It is apprehension in some circles that global armament majors will not set up base or
transfer crucial technologies without management control of the joint ventures. It is
speculated that FDI cap of 49 per cent is a hurdle of transfer of front line U.S. defence
technology to India. Cumbersome procedures for establishing a defence unit is still
exist in India. Therefore, Indian firms, engaged in the manufacture of defence
equipments, have urged the government to simplify procedures so that they can
contribute effectively to the Make in India programme. They have asked the defence
ministry to create a single window for registration of their entities and products to cut
down the time taken for the process. Currently, entrepreneurs need to register with
each of over 40 defence agencies, and this process takes more than three years to
complete. The process for registering private entrepreneurs interested in serving the
Indian defence needs to be dramatically streamlined. The current process is a
needlessly expensive and time consuming process (Business Standard, 2015,
February 24). In front of policy of arms exports too, there is a need for greater clarity
and time bound clearances.
Technical Manpower: Shortage of a skilled workforce is a serious challenge
to the growth of the Indian defence and aerospace industry. For long, industry has
struggled to hire industry-ready personnel who can hit the shop floor running
(ASSOCHAM & PWC,2014). The state of Indias defence capabilities in terms of
design, development, manufacturing, training and maintenance of cutting-edge defence
equipment is significantly lower than the best. The dimension of the problem is also lie
in rigid labour laws which restrict the number of overtime hours employees may put in.
These labour laws are responsible to transform slow growth of the indigenous
manufacturing sector and stifle Indias ability to capture a larger share of the global
market of precision engineering. Thus, it may impact Make in India a win-win
opportunity (Business Standard, 2015, February 24).
402
Tax Regime: Though it has been resolved tax anomalies among foreign
OEMs, DPSUs and private sector players, the government needs to rationalize taxes
and duties especially for Maintenance, Repair and Overhauls (MROs) and Special
Economic Zones (SEZs) and resolve the inverted duty structure that makes domestic
companies uncompetitive, thereby placing the Indian private industry at a
disadvantageous position (ASSOCHAM & PWC, 2014). In this context Chinese
experiences are well eye-opener. One of the lesser known aspects of Chinas
emergence as a global manufacturing hub is the manner in which it completely
revamped its tax system in the early 1990s. The reforms have provided impetus for the
washing out of market distortions and have increased the incentive to invest in China.
India can look and replicate its success (Srivastava, 2008).
Cost Structure: A critical issue impacting investment in India is the high cost
of capital. While this impacts all Indian companies across sectors, it severely impact
MSMEs who face an even higher interest rate regime. While various schemes have
been launched to provide interest rate subsidy to MSMEs, these have largely remained
on paper. In addition, a lot of raw material, a number of sub system and components
for defence industries are not produced in India and have to be imported. But due to
fluctuations in forex markets often costs of defence products which are produced in the
country are overrun ((ASSOCHAM & PWC, 2014).
Intellectual Property Protections: The importance of intellectual property in
India is well established at all levels- statutory, administrative and judicial. India
ratified the agreement establishing the World Trade Organization (WTO). This
Agreement, inter-alia, contains an Agreement on Trade Related Aspects of Intellectual
Property Rights (TRIPS) which came into force from 1stJanuary 1995. It lays down the
minimum standards for protection and enforcement of intellectual property rights in
member countries which are required to promote effective and adequate protection of
intellectual property rights with a view to reducing distortions and impediments to
international trade. The obligations under the TRIPS Agreement relate to provision of
minimum standards of protection within the member countries legal systems and
practices (Lakshmana, Suriyaprakash, Kumar). In fact India has good IP protection
laws, but their track records of enforcement are poor. It would need to strengthen its
Intellectual Property (IP) protection regime to give confidence to defence sector
investors. The Global Intellectual Property Centre of the U.S. Chamber of Commerce
has scored India a very low 6.96 on a scale of 30 for IP protection, while the UK has a
score of 27.59 (KPMG,2014).
403
6. OPTIONS
Recently Government of India has taken a number of steps to iron out the
problems in promoting FDI as well as increasing Private sector role in defence
manufacturing. These are (The Economic Times, 2015 July 25):
1) The FDI policy for the defence sector has been reviewed and as per the revised
policy, the composite foreign investment up to 49 per cent is allowed through
government route (FIPB) and beyond 49 per cent with the approval of the Cabinet
Committee on Security (CCS) on case-to-case basis wherever it is likely to result in
access to modern and state-of-the art technology in the country.
Besides, the restrictions such as single largest Indian shareholder to hold at least 51 per
cent equity and complete restriction on Foreign Institutional Investor (FII) existing in
the earlier policy have also been removed to facilitate investment in the sector.
2) Preference to 'Buy (Indian)', 'Buy & Make (Indian)' & 'Make' categories of
acquisition over 'Buy (Global)' category, thereby giving preference to Indian industry
in procurement.
3) To establish a level-playing field between Indian private sector and the public
sector, the anomalies in excise duty/ custom duty have been removed. As per the
revised policy, all Indian industries (public and private) are subjected to the same kind
of excise and custom duty levies.
4) The Defence products list for the purpose of issuing industrial licences (ILs) under
IDR Act has been revised and most of the components, parts, sub-systems, testing e ..
5) Process of applying for Industrial License (IL) and Industrial Entrepreneur
Memorandum (IEM) has been made completely online and this service is now
available to entrepreneurs on 24X7 basis at eBiz website without human interface.
6) Guidelines have been issued to streamline the processing of applications for grant
of extension of validity of Industrial License. The initial validity of the Industrial
Licence granted under the IDR Act has been increased from 3 years to 7 years with a
provision to further extend it by 3 years on a case-to-case basis.
7) The 'Security Manual for Licensed Defence Industry' has been issued. With the issue
of the Security Manual, the requirement of affidavit from the applicants has been done
away with.
8) Partial commencement of production is treated as commencement of production of
all the items included in the license. Restriction of annual capacity in the Industrial
License for defence sector has been removed.
9) Licensee has been allowed to sell the defence items to the government entities under
the control of MHA, PSUs, state governments and other defence licensee companies
without approval of Department of Defence Production.
404
10) Application forms for Industrial License & Industrial Entrepreneur Memorandum
have been simplified.
11) To promote the participation of private sector, particularly SMEs for defence
manufacturing, outsourcing and vendor development guidelines for DPSUs and OFB
have been formulated and circulated to them. The guidelines mandate that each DPSU
and OFB to have a short-term and long-term outsourcing and vendor development plan
to gradually increase.
12) The Standard Operating Procedure (SOP) for the issue of No Objection Certificate
(NOC) for export of military stores has been revised and put on the website. Under the
revised SOP, the requirement of End User Certificate (EUC) to be countersigned/
stamped by the government authorities has been done away with for the export of
parts, components, sub-systems etc.
13) The list of military stores has been finalised and has been put in the public domain
to make the process transparent and unambiguous. The process of receiving
applications for NOC for export of military stores and for issuing NOC has been made
online to reduce the delay and to remove human interface in the process.
14) The advanced version of NIC Code (NIC 2008) has been adopted, which is a
highly contemporary industrial
classification.
In addition, a number of options/suggestions have been identified to remove
bottlenecks in promoting FDI in defence sector. These are:
Policy: The governments immediate focus should be to come out with a
comprehensive vision and roadmap for Indias aerospace and defence sector. The
vision should specify where India sees itself in the global world order 10 to 20 years
down the line. It should also highlight critical defence technology areas where India
should develop its complete self-reliance.
To avoid crossing through cumbersome procedures and time consuming jobs,
it would be desirable to suggest that defence ministry may create a single window for
registration of their entities and products to cut down the time taken for the process.
PPP MODEL: A key obstacle in public-private partnerships in India is
inadequate experience in designing contracts so as to address issues relating to
accountability, monitoring and measuring performance and outputs. Internationally,
there have been multiple instances of successful collaboration between the government
and the private sector, with the government taking the lead. One of the most prominent
examples of successful R&D programmes and implementation of new technologies
with government support and private sector collaboration exists in the form of the
Defense Advanced Research Projects Agency (DARPA) in the US (ASSOCHAM &
PWC,2014).
405
The legacy in India has been to focus on defence PSUs. However, it is felt that
a very strong PPP model is required in defence sector. If we look at the global model,
except for the final integration of an aircraft, they have strong consortium partners, say,
in Boeing etc, where outsourcing work is done. On the other hand, in India everything
is done in-house in Hindustan Aeronautics Limited (HAL). They have a few Joint
Ventures (JVs) and also outsource work. The Indian government should take a leaf out
of U.S. governments DARPA model. DARPA has roughly 200 employees about half
of whom are technical experts. They work closely with the private sector, universities,
government laboratories and talented individuals to come out with cutting-edge
defence technologies (KPMG, 2014). It has no laboratories of its own as compared to
the 52 laboratories of Indias DRDO. However, the scene in defence manufacturing in
India has been changing. Now, the govt. is seriously contemplating to manufacture
Light Combat Aircraft (LCA), Tejas, under PPP.
Clusters: A business cluster is a geographic concentration of interconnected
businesses, suppliers, and associated institutions in a particular field. Clusters are
considered to increase the productivity with which companies can compete, nationally
and globally (Januska,2011, Januska, Kurkin, Millar 2011, Porter 2000).
Porter (2000) claims that clusters have the potential to affect competition in three
ways: by increasing the productivity of the companies in the cluster, by driving
innovation in the field, and by stimulating new businesses in the field. Successful story
of business clusters are well known examples of Silicon Valley and City of Bangalore.
Therefore, India should replicate a cluster-based approach, with each aerospace and
defence cluster focusing on a particular sub-system or technology. This could help in
creating a focused ecosystem and capability building across three to four defence
clusters spread around the country. The government should work with the global
OEMs and Tier1 suppliers to set-up Centers of Excellence and vocational training
Centers at the proposed clusters. It may be pointed out that about6000 Micro,Small and
Medium Enterprises (MSMEs) operate across the country supplying components and
sub-assemblies to DPSUs,ordnance factories,DRDO and private players. The
government of India needs to developMSMEs into cluster line ((ASSOCHAM &
PWC, 2014).
Offsets: Offset agreements are a popular tool used by governments around the
world when they engage in large military procurement deals with foreign Defence
manufacturers. An offset is essentially an additional compensation given to a buyer by
a seller. In relation to Defence procurement, this means that foreign contractors are
required to fulfill certain offset obligations (in the form of FDI or purchase of
domestically manufactured products) when they supply arms to a country. The Indian
Ministry of Defence (MoD) approved offsets guidelines in 2005 and the
implementation process began after their inclusion in DPP-2006. Offset obligations in
India vary depending upon the acquisition category. In India, Defence Offsets was
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7. CONCLUSIONS
The paper commences with the hypothesis that FDI in Indian defence
manufacturing can cure its miseries. Modern defence hardware can be domestically
manufactured through FDI channel. Though Indias defence sector has wide network
under Public Sector Units, they have been unable to fulfill its defence needs.
Consequently, India ranks among the top 10 countries in the world in terms of military
expenditure and one of the largest importers of conventional defence equipment as it
strives to modernise its forces and replace obsolete equipment. Due to deteriorating
security environment around it, India cannot forgo its defence preparedness, though
huge defence expenditure is stressing its development.
It was realised in 2001 that Indian Public Sector defence units cannot fulfill
emerging needs of defence forces. Thus, the sector was opened up for private sector
and FDI was welcomed. In the recent past a lot of FDI policies and procedures in
defence sector have been overhauled and some changes are also in pipeline. The
success of a liberal FDI policy critically depends on how it is managed. As far as
progress of FDI inflow into Indias defence sector is concerned it is not satisfactory in
terms of amount. But due to highly capital-intensive and technology driven sector, it is
assumed that it will take time to get momentum. Perception about India and its
economy has changed. It is considered an emerging and vibrant economy which can
lead to the world economy.
407
408
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