Perspective

Suvojoy Sengupta Bob Mark Vikram Ramakrishnan Samrat Sharma

Investing in Indias Future Keys to Success For Indias Defence Offset Policy

Contact Information Canberra David Vrancic Principal +61-2-6279-1903 david.vrancic@booz.com Cleveland Samrat Sharma Senior Associate +1-216-902-4233 samrat.sharma@booz.com London Bob Mark Principal +44-20-7393-3477 bob.mark@booz.com Viniti Mahbubani Associate +44-20-7393-3433 viniti.mahbubani@booz.com McLean, VA Marty Bollinger Senior Partner +1-703-902-3819 marty.bollinger@booz.com Mumbai Suvojoy Sengupta Partner +91-99302-62101 suvojoy.sengupta@booz.com Vikram Ramakrishnan Principal +91-99302-62105 vikram.ramakrishnan@booz.com

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EXECUTIVE SUMMARY

Indias defence offset policy could be the instrument the country needs to grow and modernise its defence industry and further build its domestic technological capabilities. However, experience from other countries indicates that implementing a successful and efficient offset programme is no easy task. By failing to clearly define their objectives and trying to achieve too many things at once, many offsetting ventures do not realise their potential, do not show positive long-term returns on the additional costs, and do not create the local industry capabilities that the country actually requires. Clear objectives, along with specific success criteria, are crucial to ensuring sustained success. Similarly, companies seeking to capitalise on the offset programmes, both international suppliers and domestic recipients, need to follow a focussed strategy. Offsets should be viewed as a means to an end, allowing countries to build their own defence capabilities that will endure when the offsetting period ends. Indias plans for increased defence spending will attract foreign investment. The government, international suppliers, and domestic recipients would benefit greatly from the development of a clear and well thought out offset strategy to capture all the potential gains from this spending and investment.

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THE STATE OF SPENDING IN INDIAN DEFENCE

The Indian government currently ranks number 11 among the top military spenders worldwide and remains committed to robust military spending in the foreseeable future (see Exhibit 1). The country is expected to spend $100 billion on defence in the next three to four years, with its military budget exceeding $36 billion by 2013.1 Because the Indian government allows private participation in the industry, with

foreign investment capped at 26 percent ownership, numerous domestic and foreign companies are focusing their attention on the potential opportunities for investment that Indias growing defence spending will provide. Clearly, while funding levels and outside interest will not inhibit the development of Indias military capabilities, nonstrategic and inefficient application of these funds could hold the industry back.

Exhibit 1 Military Spending by Country

711

Military Spending, global top 20

122

Spending (in US$ Billions)

70 55 54 41 38 31 30 25 22

17

16

15

14

12

11

10

10

United States

China Russia United France Japan Germany Italy Kingdom

Saudi Arabia

South Korea

India Australia Brazil Canada Spain

Turkey

Israel Nether- United Taiwan lands Arab Emirates

Source: Center for Arms Control and Non-Proliferation, The FY 2009 Pentagon Spending RequestGlobal Military Spending, February 22, 2008

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As its military spending has grown, the Indian government has introduced an offset policy, which requires foreign suppliers to reinvest 30 percent of their total procurement spending in Indian defence-related industries. The offset policy, which has been implemented with varying degrees of success in other countries, springs from the governments understandable desire to develop indigenous defence capabilities.

What Are Offsets? Offsets are mechanisms for rerouting procurement funds paid to foreign contractors back into the spending country. The main goals of the offset policy of the Indian Ministry of Defence (MoD) are to build world-class capabilities, improve technical know-how for self-sustainability, and increase domestic employment in the defence sector. To help achieve these goals, all global defence vendors doing business with India are required to reinvest in India at least 30 percent of any defence procurement contract worth more than Rs. 300 crores (US$75 million). Such reinvestment could include purchasing equipment or services from public or private defence suppliers, channelling funds into domestic production, or supporting indigenous defence-related research and development.

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THE CHALLENGES OF IMPLEMENTING DEFENCE OFFSETS

The introduction of an offset policy presents as many challenges as opportunities. Examples of setbacks abound all over the world: Under Japans offset policy, for instance, domestic defence manufacturers produce goods on licence from international firms, but not at cost-competitive rates. Australia finally abandoned its offset policy after 10 years in which the policy did not deliver on expected objectives (see Australia Abandons Offsets after 10 Years). Offset policy failures in these countries could be attributed to governments attempts to achieve too many objectives at once. In implementing their offset strategies, policymakers did not clearly prioritise which defence capabilities were of the greatest strategic importance to the country. A well-crafted offset policy can help Indias domestic defence industry avoid these mistakes. The government understands that optimizing Indias defence capabilities will require an inflow of skills and knowledge from the most experienced industry players, as well as strong coordination across

the armed forces, industry, academia, and defence research institutes. In addition, India has already experienced in a limited way some of the pitfalls that can come from an inadequately considered offset policy. Mistakes made from the first offsetting exercisesuch as lack of clarity and specificity surrounding policy rulesare now being addressed. The function of the Defence Offset Facilitation Agency (DOFA), which is taking on a prominent role in linking international vendors with domestic firms, has been redefined in hopes that the pace of defence industry development and formation of partnerships can accelerate: Between 2006 and 2008, only three deals were made.2 As it develops its own defence offset policy, India can learn from the past successes and errors of other countries. An important first step, which can go far in helping avoid pitfalls in developing the most effective offset policies, is to develop a battle-winning strategy that focuses on targeted areas and a longer-term

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Australia Abandons Offsets after 10 Years Australia originally introduced an offset scheme in the 1970s. The programme was revised to create the Australian Industry Involvement Programme in 1991, a time when Australias military expenditures were US$7.9 billion per annum (in 1997 dollars). The main directive of the programme was to promote self-reliance in the domestic defence industry; foreign suppliers were required to ensure that their proposals matched the Australian governments objectives or they were not granted contracts. The programme applied to all defence procurement above A$5 million. The success of Australias offset policy was marred by a number of difficulties. Local suppliers, with little incentive to become competitive, were not as efficient as their foreign counterparts, driving up programme costs. These local suppliers were also attempting projects far beyond their technological capabilities and skill levels, thereby increasing the risks of nondelivery. The local suppliers also used the offsets to fund individual projects instead of deploying the offsets in a strategic manner to create competitive market niches. Offsets often created low-value, short-term jobs, such as labour on assembly lines, as opposed to high-value jobs focused on system engineering, system integration, and research and development. Once the initial production contract ended, these low-value jobs disappeared. Offsets also provided incentives for high costs and inefficiency among foreign suppliers, as some contractors took the opportunity to transfer old, outdated support and test equipment, at inflated prices, to the Australian defence market. Foreign contractors also at times didnt provide associated training and instruction manuals, essentially rendering the test equipment useless. Over time, Australias offset policy earned a reputation for supporting inefficient local industry and permitting shortsighted development of Australias defence capabilities. The offset strategy was not clearly enough defined, or focused enough, to warrant success in the long term. Australia has since revamped its offset strategy, and todays programme promotes desirable local industries in a strategic and planned manner.
Source: U.S. Department of State, Bureau of Verification and Compliance, Worldwide Military Expenditures and Arms Transfers, January 2000

outlook for domestic defence industry growth. Policymakers must ask these key questions: Which manufacturing operations and platforms do we identify as areas in which domestic control is necessary and desirable, and which can be more profitably outsourced to international suppliers? How do we build domestic capabilities for a profitable export capacity in the future, while adhering to end-user monitoring clauses from supplying countries? How do we evaluate project costs and benefits based on the projects entire life cycle, looking well beyond simply the near-term acquisition cost? How can we build the right incentives into our offset strategy to satisfy the plethora of stakeholders: the government, Indian public sector units, Indian private players, and international companies?

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DEVELOPING A FIT-FOR-PURPOSE OFFSET STRATEGY

If India wants its defence capability to grow at a rate that matches its rapid economic growth, policymakers must first develop a thorough understanding of defence industry dynamics and devote careful attention to drawing out the details of the defence offset policy. Based on international case studies and past project experience, Booz & Company has identified five areas in which the Indian government can act to shape a successful defence offset policy. Selecting domains: Indias defence capabilities should be developed across air, land, sea, and electronics to build a comprehensive armed forces base. However, right now the United States is probably the only country that can afford to adopt a cradleto-grave approach to developing all

these platforms. Most countries will need to be selective in choosing which domains to develop most extensively in order to best grow their domestic industrial capabilities. For example, designing and manufacturing military aircraft is an area that requires significant amounts of capital and expertise. India took a step towards building its aircraft inventory earlier this year by purchasing eight P-8I reconnaissance planes from Boeing, a leading aerospace company and manufacturer of defence and commercial aircraft. In return, Boeing is purchasing $600 million worth of avionics and aerostructures from Indian companies, including communication equipment, radar, and electronic warfare systems.3 Under

Boeing is purchasing $600 million worth of avionics and aerostructures from Indian companies.

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this arrangement, India stands to gain technologically advanced equipment while simultaneously developing its own operations, support, and technology base for military aircraft. Building an acquisitions business case: The acquisitions business case defines the acquisition strategy and aligns it with a countrys national strategy for associated defence industries. In developing military capabilities, some types of equipment may be more vital to national security than others, requiring greater sovereign control. The manufacture and design of such key defence products ideally should be completed inside the country. Other equipment may offer no military advantage, in which case procuring items at the cheapest price may be the best acquisition strategy. It is therefore not ideal to apply an equal offset percentage for combat boots, surveillance sensors, unmanned aerial vehicles, and search and rescue helicopters. Getting these fundamentals right can make or break the development of indigenous defence capabilities. Focusing on specific stages of the life cycle: The life cycle of military decision making involves defining strategy and requirements, acquiring or

producing equipment, handling service operations, and ultimately disposing of equipment. The military can operate defence equipment for decades once it has been built or acquired, depending on a countrys ability to provide superior maintenance and enhanced operational support over time. India therefore could focus on building capabilities around support and service, enabling it to service defence equipment during periods when it would not be building or acquiring equipment. Setting up in natural geographies: The capital intensity of manufacturing military equipment is extremely high; choosing advantageous locations to develop manufacturing facilitiessuch as proximity to parts suppliers or ports and railroadscan significantly enhance the costeffectiveness of the entire venture. With more than 5,000 Indian companies supplying only 25 percent of the components and subassemblies required by the Defence Public Sector Units (DPSUs)4, selecting and building around other suppliers and manufacturers for military infrastructure will ensure that capital

is concentrated in areas where it can be used efficiently and effectively. Benchmarking and assessing capabilities: To understand inherent strengths and weaknesses, India should benchmark itself against other military powers. India has already established itself as a leading software player: In fact, the offset programme is likely to generate US$700 million in revenue for the countrys IT industry over the next 10 years. Players such as Tata Consultancy Services and Wipro Technologies actively target foreign defence contracts, and Wipro plans to set up a Centre of Excellence for Network Centric Operationsa battlefield management environment encompassing equipment, command and control, and logistics. Focusing on such core strengths ensures that the countrys resources are not spread too thinly (see Defence Industrial Strategy in the U.K., page 8). Another consideration in determining the best areas in which to build capabilities is which countries could potentially be markets for Indias future technology and products and what requirements exist regarding associated end-user monitoring clauses. Tact and diplomacy should be

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exercised when exporting to countries that might be under sanctions from supplier nationsfor instance, Myanmar, which is under sanction from the E.U. Conducting these exercises will also provide guidance on how the country can best manage periods of fluctuation. Defence industries are very cyclical, making it difficult for most countries to sustain ongoing production levels. While political conflict tends to trigger investment and production, facilities may sit idle during periods of relative peace. For example, during the late 1950s, Indias underutilised defence units switched to producing commercial goods such as coffee percolators, consumer electrical items, and construction equipment.5 To avoid situations like this, the offset policy needs to align its production plan with overall strategy, and direct resources towards building or acquiring appropriate capabilities over the long term.

Defence Industrial Strategy in the U.K. In the United Kingdom, the Defence Industrial Strategy (DIS) is based on two guiding principles: (1) achieving operational independence with an appropriate level of sovereignty and (2) building through-life management capabilities. This entails shifting away from design and towards supporting and enhancing various categories of military equipment and services. The benefits for the U.K. of choosing a capabilities-based programme (focused on through-life management and maintenance) instead of a platform-oriented programme (focused on design and development) include enhanced domestic productivity, long-term contracts, and access to the most technologically advanced machinery at the best possible price. Foreign vendors have vested interests in the U.K.s domestic success, as contracts are not one-off purchases but ongoing technological improvement engagements. At the same time, domestic suppliers, spurred on by open international competition, are continually motivated to improve performance.

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THE WAY FORWARD

The Indian governments goals for increasing its self-reliance in defence procurement are ambitious: The government plans to increase domestic share of this industry from 30 percent to more than 70 percent in the coming years. In order to achieve its targets and at the same time obtain the highest-quality military capability, the MoD needs to ensure that its defence offset policy does not become a shield for inefficient practices or for the production of substandard, poorly supported military platforms. A successful policy cannot merely stipulate a percentage of reinvestment and compel foreign participants to comply. Instead, a properly constructed defence offset policy can work to achieve the objective of promoting foreign collaboration in defence production while supporting the upgrade of Indias defence technology and product base. If done properlyand with the high targets the government has setIndias defence offset policy not only could be successful but could prove to be a model for other countries to follow.

Endnotes
Newswire Today, Indian Defence Industry: $100 Billion Investment Opportunities, May 28, 2008 2 The Economic Times, Getting the Defence Offset Policy Right, December 5, 2008 3 Mint Corporate News, Boeing to Buy Products Worth $600mn from Seven Indian Companies, February 1, 2009 4 Cygnus Business Consulting & Research, Indian Defence Industry Report, July 2007 5 Deba R. Mohanty, Changing Times? Indias Defence Industry in the 21st Century, Bonn International Center for Conversion 2004
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