FDI IN DEFENCE

HISTORY:

Most prospective foreign investors consider the Indian FDI policy in the defence industry to
be dissuasive in intent and content.

Indias policy on Foreign Direct Investment (FDI) in defence industry is symptomatic of
bureaucratic obduracy and perverse intransigence. Unwillingness to learn from experience
has been the bane of Indian governance. Persistence with failed policy initiatives can never
yield results. In May 2001, the defence industry was thrown open to the private sector. The
Government permitted 100 per cent equity with a maximum of 26 per cent FDI component,
both subject to licensing. Unattractiveness of the policy became evident in a short span of
time. By 2004, then Defence Minister George Fernandes was forced to admit in the Lok
Sabha that India had received no FDI proposal till then.

Observing the lack of enthusiasm amongst the prospective entrepreneurs at Aero India 2005,
Defence Minister Pranab Mukherjee considered it necessary to exhort interested foreign
companies to invest in the Indian defence industry. As per the reports appearing in the press,
India has received less than US$5 million of FDI inflow in defence manufacturing during the
last decade. Most prospective foreign investors consider the Indian FDI policy in the defence
industry to be dissuasive in intent and content.

In 2010, the Commerce Ministry circulated a note recommending the raising of FDI cap to 74
per cent to encourage established players in the defence industry to set up manufacturing
facilities and integration of systems in India. It was vehemently opposed by the interested
parties, with Ministry of Defence (MoD) insisting that the 26 per cent FDI limit should be
retained. In May 2013, modifying his earlier proposal, Commerce Minister Anand Sharma
suggested that the upper cap be raised to 49 per cent as a first step. It has also been shot down
by the MoD. However, in a deft move, the MoD has suggested that higher FDI may be
considered for modern and state-of-the-art technology by the Cabinet Committee on Security
on a case to case basis.

The World Bank defines FDI as net inflows of investment to acquire a lasting management
interest (ten per cent or more of voting stock) in an enterprise operating in an economy other
than that of the investor. FDI comprises funds provided by the foreign direct investor to the
FDI enterprise as equity capital, reinvested earnings and intra-company loans. Attractiveness
of a nation for foreign investments in any sector is judged by its FDI Confidence Index
which depends on various factors such as stable policy, favourable investment climate,
structural adjustments, economic freedom and a fair market access. India fares rather poorly
on this account.

Unwillingness to learn from experience has been the bane of Indian governance. As
recounted earlier, it is an undisputed fact that the current Indian policy has been an abject
failure. Whereas an intense debate was taking place to influence the decision makers, a
number of articles had been planted in the media to sway the public opinion. Unfortunately,
objectivity was conspicuous by its absence. Stakeholders had taken stand that suits their
interests.

As the debate had been highly skewed, some of the common misconceptions have been
discussed below and all issues are put in their proper perspective.

Misconception One: Indian policy is highly investor friendly and does not require any
changes.
The MoD continues to insist that the Indian policy is highly investor friendly and requires no
changes. It attributes lack of response to the individual entrepreneurs decision depending on
his commercial perception. However, a closer look at the policy reveals that virtually every
provision is dissuasive in nature management control of the company must remain in Indian
hands with majority representation in the board. The Chief Executive has to be a resident
Indian; a licensee can produce only the licensed products and in the sanctioned quantity and
he can neither diversify nor enhance production without prior sanction. A foreign investor
cannot transfer his equity before the expiry of the lock-in period of three-years. Even after
that, such transfers have to be with the approval of the Government.

Although the Government can give no purchase guarantee, the proposed quantity for
acquisition and overall requirements may be made known to the extent possible. The policy
directive further stipulates that arms and ammunition will be primarily sold to the MoD.
Their sale to other security organisations in the country and exports will be with the prior
approval of the Government. Non-lethal items may be sold to non-Government agencies but
with the concurrence of the MoD.

FDI is a need-based concept; whereas a host nation needs FDI for accelerated growth,
prospective investors are guided purely by economic considerations. Oddly, India expects a
prospective foreign investor to be excited by such an asymmetrical policy wherein he is
expected to invest his resources in a venture where he has no significant control, faces strict
capacity/product constraints, gets no purchase guarantee and has no open access to other
markets (including exports). It defies logic. Such a lop-sided policy can never attract FDI.

Misconception Two: Higher FDI limit is a threat to national security
When every other argument fails, the spectre of security concerns is raised by the interested
elements in the MoD to stymie any proposal to raise FDI limit. Apprehensions are often
expressed that during operational emergencies, foreign investors may shut down their
factories and choke supplies to the armed forces. In his recent letter to the Commerce
Minister, Defence Minister Antony has opposed the raising of FDI cap on grounds that the
country could not afford to be dependent on foreign companies and be vulnerable to policies
of their countries of origin in the field of defence on the long-term basis.

India is procuring all critical weapon systems produced/integrated abroad. It is not
understood as to how Indias security would get threatened if the same weapon systems are
produced/integrated in India. As a matter of fact, indigenous production will insulate India
from unilateral imposition of embargos on contracted supplies by whimsical foreign
governments. The degree of assurance and resulting comfort accruing from indigenous
facilities will always be significantly more than dependence on imports. Additionally,
indigenous manufacturing facilities will also ensure better life-time support including supply
of spares.

As regards dependability during crisis situations, no foreign investor can risk loss of his total
investment by shutting down his production facilities. Further, all major defence equipment
producers follow Global Factory concept, wherein various manufacturing functions are
spread over a number of locations in different countries. When a major defence company
invests in any country, it makes it an integral part of its overall production chain. In such a
scenario, it is not easy for the company to shut down any facility and disrupt its worldwide
production network. If India is serious about attracting FDI in defence, it has to position itself
as the most lucrative FDI destination.

Most importantly, adequate safeguards can be incorporated while issuing licenses. India can
reserve the right to take over the licensed facility under certain extraordinary circumstances
of national emergencies. Most nations include such an enabling provision. It is ridiculous that
imports are considered more reliable than production in India. Needless to say, security
concerns are overhyped to perpetuate status quo by entrenched interests by resorting to
specious logic. Fears expressed are totally unfounded and highly exaggerated.

Misconception Three: Investment decisions are taken by foreign companies and India
has no role to play
It is often claimed by the MoD that foreign investors are guided purely by economic
considerations and that they are neither influenced by the FDI limit nor by other provisions.
The above argument reflects ignorance of the dynamics of FDI flow. It is often forgotten that
FDI is a need-based concept. Whereas a host nation needs FDI for accelerated growth,
prospective investors are guided purely by economic considerations. As investible funds are
limited, all countries covet them. Foreign investors carry out an inter-reappraisal of all likely
destinations to determine the one that appears most lucrative for optimum returns. Therefore,
every host country has to strive to project itself as the ideal FDI destination vis--vis other
competing suitors.

It is prudent to understand what motivates an investor to invest his resources in another
country and undertake risks associated with it. As investment in defence production means a
lasting and protracted relationship, he seeks a stable environment with long-term, well-
defined economic policies which are fair and consistent. In addition, there are four factors
which influence such decisions availability of abundant raw material, skilled work force,
low cost of production and lucrative market. It is the interplay of all these factors which
influence an investment decision. If India is serious about attracting FDI in defence, it has to
position itself as the most lucrative FDI destination with improved FDI Confidence Index.
For that, it must make structural adjustment to provide functional freedom to joint ventures to
respond to market dynamics.

FDI pre-supposes a long term commitment and lasting relationship between the foreign and
local enterprise. As regards the FDI cap of 26 per cent, no foreign investor is going to part
with his closely guarded technology unless he has adequate control over the enterprise and is
assured of sufficient autonomy as regards capacity enhancement and access to markets to
ensure commercial viability through economies of scales.

Misconception Four: FDI will stymie the growth of indigenous defence industry
Defence Minister Antonys statement that building up Indias own indigenous capabilities for
designing and developing weapon systems is vital cannot be disputed at all. However, his
assertion that allowing foreign companies to set up manufacturing/assembly facilities in India
would be a retrograde step and stymie the growth of indigenous capability is certainly
misplaced. He expressed apprehensions that such a move would perpetuate Indias
dependence on foreign countries for modern weapons.

Further, the Ex- Defence Minister has expressed confidence in Indias capability to build-up
defence industry through indigenous efforts, especially with the help of the private sector.
According to him, only immediate requirement of weapon systems is being imported till
India develops its own weapon systems. It will not be incorrect to term the above optimism as
a case of self-delusion. One has been hearing such declarations since early 1990s when
confident predictions were made that defence imports would be reduced from 70 per cent to
30 per cent within a period of ten years. On the contrary, after two decades, imports have now
climbed to close to 75 per cent.

A look at the dismal performance of the Defence Research and Development Organisation
(DRDO) and the public sector hardly inspires any confidence in their capability to deliver.
Both are equally responsible for the current abysmal state of affairs. Although DRDO has 51
laboratories with 5,000 scientists and over 25,000 support personnel, it has not been able to
develop a single system in the promised time-frame and conforming to the accepted
parameters. Mediocrity thrives due to lack of accountability.

Even after spending crores of rupees, the only success it has to its credit relates to replication
of some imported products (fancifully called reverse engineering and indigenisation).
India needs defence technology desperately. Even if the DRDO is able to make some
progress in a few cases, it is always done with major compromises with respect to the stated
qualitative requirements. In most cases, by the time equipment is developed and delivered, it
becomes obsolete. Thus, the services are forced to live with out-dated and useless equipment.
As the performance of DRDO over the last five decades has been highly unsatisfactory elying
all hopes of development of indigenous competence, it will be unrealistic to expect DRDO to
change overnight and make India self-reliant. The defence public sector consists of nine
defence public sector undertakings and 39 Ordnance Factories. Despite getting preferential
treatment from MoD, it has singularly failed to keep pace with technological developments. It
thrives on periodic infusion of transferred technology and has developed no indigenous
competence at all.

Purchase of technologies under Buy and Make route has failed to ensure infusion of
meaningful technologies. Even Antony had admitted that India had not benefitted much from
the transferred technologies. Most unfortunately, the Indian military is a captive customer of
the Indian public sector and is forced to buy what it produces. With assured orders in hand,
the public sector carries on with its lethargic and inefficient manner, without bothering about
the quality parameters or the time frame. Indias private sector has certainly come of age but
needs hand-holding in the interim to be able to graduate to the production of complex weapon
systems. This hand-holding can be done only by foreign technology majors. For that,
establishment of joint ventures with equity participation is a prerequisite. India has to make
up its mind whether it wants FDI in the defence industry or not. It was left to Anand Sharma
to remind the policy makers that it was unrealistic to expect domestic manufacturing to make
state-of-the-art equipment without sourcing high-end technologies. He advocated
encouraging foreign defence manufacturers to help catalyse the growth of the indigenous
industry.

Misconception Five: Foreign technology can be sourced through offsets
In a paradigm shift in Indias approach towards offsets, the Defence Offset Guidelines (DOG)
issued by MoD in August 2012 allowed the Transfer of Technology (ToT) as a permissible
avenue for discharging offset obligations. DOG offers three recipient-centric options to
foreign vendors to earn offset credits against ToT.
One, the foreign vendor can make investment in Indian enterprises in kind in terms of ToT
through joint ventures or through the non-equity route for co-production, co-development and
production or licensed production and/or maintenance of eligible products and provision of
eligible services. Offset credit for ToT would be ten per cent of the value of buy-back by the
OEM during the period of the offset contract, to the extent of value addition in India.

Two, ToT can be provided to government institutions and establishments engaged in the
manufacture and/or maintenance of eligible products and provision of eligible services,
including DRDO. It includes augmentation of capacity for research, design and development,
training and education. However, there is no mandatory buy-back stipulation.

Three, DRDO can acquire technologies and test facilities in areas of high technology. A
highly imprecise list with open-ended description of vast array of related technologies that
DRDO seeks has been made public. It is left to a foreign vendor to study the list and offer
technology of his choice. Overlooking the basic fact that it is not the type of technology but
its relevance that should dictate the selection, India has abrogated that right in favour of the
vendors. Thus technologies that will flow to India will be availability-based and not need-
based. Needless to say, every vendor will try to pass off low-end technologies that do not
require export licenses and are cheap to implement. Production of high-tech systems by a
foreign company in India would be infinitely better than India importing systems from
abroad.

Further, multipliers are normally used to assign additional weightage to different offset
programmes to provide vendors with incentives to offer offsets in targeted areas.
Unfortunately, India has trashed the concept of multipliers by making their assignment usage-
based and not as per the degree and exclusivity of technology. Resultantly, vendors will have
no incentive to offer high-end technologies. As seen above, DOG demonstrates the muddled
thinking of the policy makers. It is extremely doubtful if the new policy can lead the country
towards the achievement of much touted aim of self-sufficiency in defence production,
especially as the upper cap for FDI has been retained at 26 per cent for offset cases as well.

Misconception Six: India can do without foreign funds in defence.
An influential segment of decision makers had been propagating the view that India does not
need foreign funds and can afford to pay for what it wants. It cites Indias huge shopping list
to buttress the argument. For an aspiring power like India, FDI is not just a question of
acquiring funds, but more importantly, it represents access to the latest technologies. Most
defence products involve a relatively high level of technology and this technology gets
transferred only if the foreign partner has a long term stake in the company. FDI pre-supposes
a long term commitment and lasting relationship between the foreign and local enterprise.
FDI sets in motion a chain reaction wherein FDI upgrades local technology which, in turn,
attracts more FDI with higher technology and the cycle goes on. This is of vital importance to
the defence sector which is highly capital intensive and undergoes rapid obsolescence of
technology. India needs defence technology desperately. It is lagging behind by up to twenty
years. It is foolhardy to waste time and resources in trying to reinvent the wheel. India needs
to import latest technology through FDI to bridge the current gap. Thereafter, the imported
technology should be used as a spring board for developing newer technologies indigenously.
India must exploit its favourable geo-political location and aspire to be a regional hub for
global outsourcing of defence equipment.


PRESENT SENARIEO:

On 10
th
July, 2014, the Finance Minister Mr. Arun Jaitley proposed to raise the limit of FDI
in Defence to 49% from 26% in the Union Budget for 2014-2015.
On 6
th
August, 2014 the cabinet approved raising FDI limit to 49% in defence sector. The
move was made with an aim to boost domestic industry of the country, which presently
imports up to 70% of its military hardware. The Cabinet Committee on Security (CCS) will
be the final decision making body for Foreign Direct Investment (FDI) proposals in Defence
beyond 49 per cent.
According to the new rules on FDI in Defence notified by the Department of Industrial Policy
& Promotion, based on the Cabinet decision taken on 6
th
Aug, 2014, FDI proposals beyond
49% vetted by the CCS need not be cleared by the Cabinet Committee on Economic Affairs
(CCEA). So far, all FDI proposals with foreign investments over 1,200 crore had to be
cleared by the CCEA.
The FDI limit to be cleared through the Foreign Investment Promotion Board (FIPB) route
has been raised to 49% from 26%. The press note clarified that the cap is composite and
includes different types of foreign investments such as FDI, Foreign Institutional Investors
(FIIs), Foreign Portfolio Investors (FPIs), Non-Resident Indians (NRIs), Foreign Venture
Capital Investors (FVCI) and Qualified Foreign Investors (QFIs), it said.
Further, portfolio investment by FPIs, FIIs, NRIs, QFIs and investments by FVCIs together
will not exceed 24 per cent of the total equity of the investee or Joint Venture Company.
The final clearance for FDI proposals within the 49% limit will be given by the CCEA in
case foreign investments exceed 1,200 crore. All decisions on FDI applications will be
normally communicated within a time frame of 10 weeks from the date of acknowledgement,
the note said.
Ownership

The licence applications will be considered and given by the DIPP in consultation with the
Ministries of Defence and External Affairs.
The note specifically laid down that the applicant company seeking permission of the
Government for FDI up to 49% should be an Indian company owned and controlled by
resident Indian citizens. The management of the applicant company should be in Indian
hands.
However, for proposals seeking approval for foreign investment beyond 49 per cent, the
applicant could be an Indian company or a foreign investor. The condition of Indian
management control is also not applicable in this case.
Latest Update:

Foreign Investment Promotion Board (FIPB) on 16
th
September, 2014 cleared 21 proposals
including that of Bharti Shipyard, but turned down the Sistema Shyam's request to raise
foreign holding. The FIPB, headed by Finance Secretary Arvind Mayaram, at its meeting
considered 35 proposals. The proposal of Bharti Shipyard -- an Indian company in ship
building sector which has existing FDI through FIIs and NRIs -- to undertake defence
activities was cleared.
The proposal of Verizon Communications India which sought approval to increase foreign
equity participation by its foreign parent from 74% to 100% was also approved by the FIPB.
The board also gave a go ahead to Indusind Bank's proposal with regard to foreign
investment.

The other proposals cleared by the FIPB include that of Kineco Kaman Composites India Ltd
in the defence sector and ANZ Capital Ltd in the financial services sector. However, the
proposal of Sistema Shyam Teleservices Ltd (SSTL) to raise foreign stake holding in the
company beyond the current 74% was rejected by the FIPB. The company has not specified
the extent to which the foreign holding would be raised. Russian conglomerate Sistema JSFC
holds 56.68% in SSTL, Russian government 7.14% and 0.13% other foreign entities.