DR.

RAM MANOHAR LOHIYA

NATIONAL LAW UNIVERSITY

FINAL DRAFT OF
ECONOMICS
On: FDI in defence sector in India

Submitted to: Submitted By:

Dr. MITALI TIWARI Avinash Maurya
Assistant Professor Roll no: 35
DR. RMLNLU BA LLB (Hons.)Semester III
Acknowledgement

First of all, I would like to thank Dr. Mitali Tiwari for giving me this opportunity to make the
project on such an immense topic and all the support and guidance that I have received from her,
without which this project could not have turned into a reality. I would also like to thank all my
colleagues and seniors for providing me support and material facts and figures related to this
topic. Last but not the least, I would like to thank my parents for providing me appropriate
guidance and support to prepare the project. All the above mentioned people have very whole
heartedly helped me to make this project in the present shape.

-Avinash Maurya
TABLE OF CONTENTS

 CHAPTER 1: INTRODUCTION AND PLAN OF STUDY

 CHAPTER 2: WHAT S FDI WITH REFERENCE TO DEFENCE SECTOR?

 CHAPTER 3: HISTORICAL BACKGROUND.

 CHAPTER 4: REGULATORY REGIME.

 CHAPTER 5: HINDERENCES.

 CHAPTER 6: 100% FDI IN DEFENCE SECTOR

 CHAPTER 7: ADVANTAGE AND DISADVANTAGE OF FDI IN DEFENCE

SECTOR

 CHAPTER 8: CONCLUSION
CHAPTER 1 INTRODUCTION AND PLAN OF STUDY

1. BACKGROUND

Foreign Direct Investment (FDI) in India is the major monetary source for economic
development in India. Foreign companies invest directly in fast growing private Indian
businesses to take benefits of cheaper wages and changing business environment of India.
Economic liberalisation started in India in wake of the 1991 economic crisis and since
then FDI has steadily increased in India. It were Manmohan Singh and P. V Narasimha
Rao who brought FDI in India, which subsequently generated more than one crore
jobs.According to the Financial Times, in 2015 India overtook China and the US as the
top destination for the Foreign Direct Investment. In first half of the 2015, India attracted
investment of $31 billion compared to $28 billion and $27 billion of China and the US
respectively

India is the World’s 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.

2. RESEARCH QUESTIONS

 What is Foreign direct investment means?

 What are the advantages and disadvantages of Foreign direct investment?
 What changes has been made in FDI policy?
 Hoe India benefitted by FDI?

3. OBJECTIVES
 The aim of the paper is to find out progress, problems and prospects of FDI in
Indian defence sector.
 To find out india’s purchasing power in defence sector
 To understand the pros and cons of foreign direct investment
 To find out the importance of FDI.

4. RESEARCH METHODOLOGY

Research Methodology in the making of this Project will be Doctrinal Research

Methodology. This Methodology will be best suited for the Topic of the Project.
Researchers who deal with this type of research mainly concern with the philosophy of
Topic involved. Besides reference from books and journals, documents are given due
weightage which provided the needful contribution required in the proper completion of
the research. Above all, the data and statics are give more importance.

5. ANALYSIS AND INTERPRETATION

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 India’s 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
India’s 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.
6. CONCLUSION

For a country with hostile neighbours, it is the biggest priority of the government is to
ensure its safety. Any economy cannot be self-sufficient, and it is not possible to battle
against problems like terrorism just by risking of lives. Technology thus becomes an
important tool in covering such hazards. The harsh reality is that our defense sector needs
a good overhaul, and our government needs to allocate sufficient budgets for production
of defense material. The military expenditure of a developed nation like USA is around
600 billion dollars compared to a mere 65 billion dollar expenditure by India when it
comes to maintenance of the army and defense equipment. Thus to achieve the defense
capability dreams that India has, higher FDI may be a pure and important source that
needs to be brought up. It must however be kept in mind that it does harm the local
industries.

7. CHAPTERISATION

 CHAPTER 1: INTRODUCTION AND PLAN OF STUDY

 CHAPTER 2: WHAT S FDI WITH REFERENCE TO DEFENCE SECTOR?
 CHAPTER 3: HISTORICAL BACKGROUND.
 CHAPTER 4: REGULATORY REGIME.
 CHAPTER 5: HINDERENCES.
 CHAPTER 6: 100% FDI IN DEFENCE SECTOR
 CHAPTER 7: ADVANTAGE AND DISADVANTAGE OF FDI IN DEFENCE
SECTOR
 CHAPTER 8: CONCLUSION
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 important vehicles of
development if local resources/efforts are handicap to enhance the efficiency/productivity
of the economy. For long, Indian Private Sector and FDI were prohibited in defence
sector. It was only in 2001 when it was opened to Indian Private Sector participation with
FDI permissible upto 26 per cent. In 2014 it was increased to 49 per cent and in special
case it can go upto 100 per cent. It is assumed that raising FDI cap would attract latest
high-end technologies into India and assumes that defence Original Equipment
Manufacturers(OEMs) who control technologies and will supply /bring it to their own
operations in India, if equity cap is raised(FICCI,2010).

The Indian Defence Sector has been confronting many folds problem. First, it had
emerged the largest importer of major arms in 2010-14,accounting for 15 per cent of
global total. Between 2005-2009 and 2010-14 imports increased by 140 per cent. In
2010-14 India’s imports were three times larger than those of either of its regional rivals
China and Pakistan. Clearly, it reflects that indigenous efforts have been lagging in this
direction. Second, out of total defence equipment held by the Indian armed forces, only
15 per cent is considered ‘state of the art’ and nearly 50 per cent has become obsolete
(DIPP, 2010). This is a major deterrent to the operational capability of the armed forces.
Third, due to deteriorating security environment, China-Pakistan nexus and proxy war
against India are well known facts of increasing its defence expenditure. India has
allocated defence expenditure by hiking 7.7 per cent in the financial year (FY) 2015-16
over the allocation for 2014-15. It is allocated to US$40.4 billion in 2015-16 from
US$38.35 billion in 2014-15. Its military budget is still less than a third of China’s
US$145 billion expenditure as estimated by the Pentagon. Both China and India have
allocated around 2 per cent of their GDP towards defence allocation, and given the
difference in their respective GDP, the China-India gap is over US$100 billion in
Beijing’s favor. Total defence spending and that the actual amount allocated to the
People’s Liberation Army may be closer to US$250 billion.

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 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.

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 India’s
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.

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
importers—China and Pakistan. India is among the top five arms importer, besides
China, Pakistan, the UAE and Saudi Arabia.It isprojected that the ranks of China and
India will be second and third respectively in world’s military expenditure in
2045.India’s defence expenditure in terms of Purchasing Power Parity (PPP) in US$654
billion and China’s 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.

 The 10 largest exporters of majors weapons and their main clients

Source: SIPRI

 Projected military expenditure of the world’s major powers in 2045

Ran Spending in PPP ($

Country
k 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

Germany 63
9

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. Other than the FDI policy, two other
policy regimes govern the 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. 


Make -I (Government funded) -- Government funding to the Indian

private entities for R&D in order to encourage more local development. The
Government will fund up to 90 per cent of the R&D, of which 20 percent will be
given in advance and in 24 months the entity will be given tender. In case the
company develops a prototype and it is not given order within 24 months, its
remaining 10 per cent of the development cost would be reimbursed. 


Make- II (Industry Funded) – This category will involve industry

funding, rather than government funding, for prototype development. If a tender is
not issued within two years of the successful prototype development, the Defence
Ministry would refund the entire development cost to the duly selected vendor.

Make- III (MSME funded) –While procedurally similar to Make II (Industry-

Funded), this is reserved for projects with a development cost of less than Rs 3
crore, which will be exclusively reserved for MSMEs.
Under the Industries (Development and Regulation) Act 1951, an Industrial
license (IL) is required in India for manufacturing defence equipment. The
applicant must be an Indian company or partnership and has to apply to the
Department of Industrial Policy and Promotion (DIPP) (DIPP, 2010). India is not
a only country which exercises restrictions in defence sector but also defence
majors in the world have been following restrictions too in strategic sectors as
listed by FICCI(Table 5) (FICCI, 2010).
  FDI equity inflows into Defense sector in India from April 2000 to December
2014

 Items Amount(US$
million)

Defence industries 4.94

Total (FDI) 238747.65

4.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 The state of India’s
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 India’s ability to capture a
larger share of the global market of precision engineering. Thus, it may impact Make in
India a “win-win” opportunity.

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 China’s 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.

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
st
(TRIPS) which came into force from 1 January 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.

5.100% FDI in Defence

FDI or Foreign Direct Investment is an investment which is made by any company into a
particular economy/country. It is a method of direct investment into any economy. It is a
key component in global integration. It is one of the major forms of cross-border
investment. A company or enterprise, resident in its nation, can operate its enterprise in
another country by investment. FDI is amongst the key issues of foreign policies for
almost all the countries. The enterprises based in developed economies can invest directly
and open its branches in another country (underdeveloped or developing). It can use its
resources for its work and in return give money to the workers. This not only helps in the
development of the economy but also gives the workers a fair idea of how an enterprise
operates. It provides long lasting interests to the enterprise as well.

The investing company can make its overseas investment in some ways – either by
setting up a subsidiary or associate company (with the same name of the company) in the
foreign country and also by a partnership with shares of an overseas company, or through
a merger or joint venture. In India, the FDI was first brought up after the economic crisis
of 1991. Former Prime Minister Manmohan Singh and the then Prime Minister Shri PV
Narasimha Rao are credited for bringing FDI in India which relaxed the economy and
generated more than one crore jobs. In 2015, India became the largest destination for FDI
surpassing China.

An example of FDI can be an Indian company taking a majority stake in a company in

China. Another example would be a Canadian company setting up a joint venture to
develop a mineral deposit in Chile.
For a developing nation like India where over-population and poverty together are a
major issue, FDI is an important sector with which the government can bring
employment to all sectors at large scale. Recently, the Modi-led government enacted
100% FDI in defense as well as the civil aviation department (the FDI has been eased in
other departments as well such as food, medicine, etc.). It is to be noted that all this FDI
has been allowed via approval of the central minister Shri Venkaiyah Naidu as he stated
that it is a need of the hour.

6.The advantages and disadvantages of 100% FDI in defense sector

While this move may prove to be a big boost for our economy, there are some points
against it as well. Firstly, let’s take a look at what are the positives of 100% FDI in
defense sector:
FDI is better than debt.
It will push for growth and development.
Intends to transform India into one of the manufacturers from one of the largest
importers.
Will bring technological advancement to India.
Make economy widely open.
Like the two sides of a coin, despite being beneficial, the liberalization of FDI has also
bought some negatives. To mention a few:
• Might kill domestic sector.
• Indian investors may not comply with foreign defense manufacturers.
• Most nations would know the defense manufacturing limits of India.
A good FDI can significantly pave the way for an increase in farmers’ income,
employment to youth and an impetus for the growth of the small and medium industry.
This would help start micro, small and medium industries which would pave the way for
jobs to the youth. FDI can lead to the creation of a congenial atmosphere to attract the
investment. It is better to take debts and pay them later than loans at higher interest rates
that too with the currencies all around the world being highly unstable, especially in a
developing country like India.
At present, India is amongst the largest importers of machinery in the defense sector.
Compared to the developed countries, India lacks defense equipment production
capability. Greater FDI inflow in defense provides a chance of substantive economic
• advantages. The increased flow of funds from a foreign source leads to more
employment opportunities for the local population. It also means that taxes and
other revenues will flow back to the local economy. Most industry associations
and foreign firms have demanded that FDI cap be increased to 100 percent since
they believe that the Government of India will insist on Indian control over any
defense manufacturing company. India’s main aim is technology enhancement
and foreign vendors will not transfer critical technologies without ownership and
management control of the Indian venture. An increase in FDI levels to 100
percent may thus overcome a few of the drawbacks currently faced by the FDI
cap with the previous percentage. The FDI cap thus needs to be at a higher rate so
as to make a significant difference to the Indian defense industry.
• How will 100% FDI in the defense sector hurt India?
• Naturally, it is going to kill the domestic sector and Indian defense manufacturing
sector related organizations such as DRDO are going to suffer major setbacks.
While the transfer of technology from foreign sources may increase, the
advantages of having homemade products will decrease. It is not necessary that
the Indian manufacturing sector will be able to give 100% cooperation with the
foreign companies. It is a clear fact that Indian companies won’t be able to
compete with the international manufacturers. This will even prove to be worse
 for DRDO, which has not been able to give its 100% since its establishment due
to lack of local resources.
• One of the major setbacks that India will face with 100% FDI in the defense
sector will be that the economies that will invest in production in India will know
the defense product manufacturing limit of India. If India aims to be a
superpower, it cannot be possible just with the production of what the other
developed nation are or have been producing. The technological setback thus
makes the FDI a matter of concern.
•
•

7. CONCLUSIONS

The challenges/problems of FDI inflow into defence sector have been identified as lack
of investor friendly procedure, shortage of technical manpower, unfriendly tax regime,
uneconomical cost structure, lack of enforcement of intellectual property protection, etc.
Therefore, there is need to plug these loopholes. In addition, we should not ignore but to
continuously look into depth on regulatory regime of FDI, PPP model, clusters, special
defence zone, offsets, etc. More importantly, while reviewing FDI proposals it should be
taken care of that India should not become dumping ground of inferior technology.
Various incentives such as tax rebates could also be used as a lever to induce higher
technology through FDI. If India is succeeded in its efforts in establishing modern
defence manufacturing complex through FDI route, it will be path breaking concept of
erstwhile socialist countries which remodeled their economies into market-oriented.

The experiences of other countries like Brazil, South Korea, Turkey, etc can be helpful to
India to replicate the success of FDI in defence sector. Even in the United States the third
largest supplier of defence equipment to its armed forces is a wholly owned subsidiary of
a British company. India’s own successful joint venture with Russia in production of
Brahmos cruise missile can be considered as useful model. But on the other side of the
picture of coin is not very rosy. For instance, recently U.S. Department of State refused to
grant licenses on four of the 25 Lockheed Martin technologies promised to South Korea
for its 5th generation fighter jets programme dubbed KF-X. It also denied Moog Inc re-
export clearance for actuators which were to be installed on India’s Rustom-2 HALE
Class UAV. In case of Russia too, in 2007 Russia and India agreed to jointly develop the
Fifth Generation Fighter Aircraft (FGFA).But India is not taken in loop in the
development of FGFA. In fact, no defence majors will share front line technology to
others.
For a country with hostile neighbours, it is the biggest priority of the government is to
ensure its safety. Any economy cannot be self-sufficient, and it is not possible to battle
against problems like terrorism just by risking of lives. Technology thus becomes an
important tool in covering such hazards. The harsh reality is that our defense sector needs
a good overhaul, and our government needs to allocate sufficient budgets for production
of defense material. The military expenditure of a developed nation like USA is around
600 billion dollars compared to a mere 65 billion dollar expenditure by India when it
comes to maintenance of the army and defense equipment. Thus to achieve the defense
capability dreams that India has, higher FDI may be a pure and important source that
needs to be brought up. It must however be kept in mind that it does harm the local
industries.