India: Defence industry is gradually coming of age

India’s defence budget for 2009-10 has witnessed an increase of 34 per cent over the previous year, making India one of the top global spenders on defence equipment. However, the defence procurement process has so far been slow and laborious despite recent policy reforms and is only now beginning to come out of the morass that it was languishing in. The following government initiatives are likely to make India a more attractive destination for foreign direct investment (FDI):

A Defence Acquisition Council headed by the Defence Minister has been established to give directional guidance to defence procurement at the political level.
Procurement reform as well as greater transparency have been brought in through the Defence Procurement Procedure, which was fist initiated in 2002. DPP 2008 brought clarity into the process by classifying defence procurements as “make”, “buy and make” and “buy” and evolved a step-by-step procedure for each category.
Equity participation in joint ventures is likely to be enhanced from the present 26 to 49 per cent.
An offsets policy stipulating 30 per cent offsets in large projects has been evolved. Banking of offsets has now been permitted and indirect offsets are likely to be accepted soon.
The government has agreed on a formulation for end-use monitoring with the US and has signed a Technology Safeguards Agreement in the space sector. These agreements will allow access to cutting edge defence technology from the US and further easing of the technology denial regime.
Among other pragmatic initiatives is one in which the government has agreed to share part of the costs incurred by foreign vendors for trials of defence equipment, as against its earlier policy of “no cost-no commitment”.

Stagnating modernisation plans

India is among the largest spenders in the global arms market. It is expected to spend US$ 50 billion on arms procurement over the 11th defence Plan period 2007-12 despite the fact that its defence budget is pegged at less than 2.0 per cent of the GDP. Even as the threats and challenges to national security have burgeoned in recent decades, the modernisation plans of the armed forces have been stagnating as large amounts of unspent funds on the capital account are surrendered each year, bureaucratic red tape slows down the acquisition process and defence procurement is dependent almost entirely on imports as the Indian defence industry has not yet come of age. 

The amount budgeted for defence in financial year (FY) 2009-10 is Rs 1,41,703 crore (US$ 32 billion). This is 34 per cent higher than the budget estimates (BE) for FY 2008-09. Of this, the amount earmarked for expenditure on the capital account is Rs 54,824 crore (US$ 12 billion) as against Rs 48,007 crore (US$ 10.5 billion) in FY 2008-09. However, this increased amount will not enable the Ministry of Defence (MoD) to initiate new plans for pending weapons and equipment acquisitions as carried forward contractual obligations and inflation in the international prices of weapons systems, ammunition and defence equipment, usually between 10 to 12 per cent per annum, will neutralise most of the increase. 

Public-private partnership in defence manufacture

Since India’s independence in August 1947, well over 70 per cent of weapons and defence equipment in service with the armed forces have been imported, primarily from the erstwhile Soviet Union and Russia. The rest have been produced or manufactured under license in 39 Indian Ordnance Factories and eight defence-related public sector undertakings (DPSUs) wholly owned by the government, in keeping with the government’s industrial policy based on the socialistic pattern of development. Indigenous research and development has been entrusted to the Defence Research and Development Organisation (DRDO) that runs 50 R&D laboratories. However, despite the much touted mantra of 70 per cent self-reliance in defence equipment by 2010, India continues to bank on foreign military equipment for its armed forces. The lack of progress in indigenous design and production can to a large extent be attributed to the fact that stringent technology denial regimes have been applied to India by the international community ever since India’s first “peaceful nuclear explosion” at Pokhran in May 1974.  

Following the lack of major success in producing indigenously designed defence systems, the government reviewed its policy. In keeping with the economic liberalisation and deregulation that began in 1991, the government decided to open up defence industry for private sector participation in May 2001. The government permitted the private sector to hold up to 100 per cent equity in defence manufacturing companies, subject to licensing, but limited foreign direct investment (FDI) to 26 per cent. At present, 25 to 30 per cent of the value of equipment produced is being outsourced by the ordnance factories and DPSUs to small and medium scale enterprises (SMEs). 

The existing procedure for defence procurement of 1992 vintage has been revised. The new Defence Procurement Procedure 2002 (DPP 2002) came into effect on December 30, 2002. Based on the experience gained since then, it has been regularly updated and DPP 2008 is now in vogue (for details see: The Defence Minister heads the newly established Defence Acquisition Council (DAC), which makes all major decisions related to defence procurement. The Chiefs of Staff of the three Services, the Defence Secretary and the Scientific Advisor to the Defence Minster, who also heads the DRDO, are members of the DAC. DPP 2008 classifies defence procurements as "make" (items that the DRDO will develop and Indian defence industry will manufacture); "buy and make" (items where the technology and manufacturing capability will be imported and Indian defence industry will manufacture); and "buy" (items which will be imported outright). “Buy” items are classified as “buy Indian” (systems integrated by an Indian vendor with minimum 30 per cent indigenous content) and “buy global”. 

In May 2006, the government announced its “offsets” policy. The offsets policy makes it mandatory for foreign companies winning large value contracts (above Rs 300 crore, US$ 670 million) to procure items of at least 30 per cent of the value of the contract from Indian sources. In some cases like the Request for Proposals (RfP) issued for 126 multi-mission, medium-range combat aircraft, the offsets requirement has been placed at 50 per cent. Offsets may be offered in the form of technology transfer, licensed production, co-production or outsourcing of components from Indian companies. The policy recently permitted “offset credit banking, which will enable foreign participants to create offset programmes in anticipation of future obligations.” According to the government’s calculations, with 30 per cent offsets being implemented, India will benefit to the extent of Rs 47,000 crore (US$ 10 billion) during the 11th Defence Plan (2007-12). The new defence procurement system is expected to hasten the defence procurement process, enhance India’s defence technology threshold and ensure transparency. 

Overcoming the present lacunae

Though several joint ventures have been formed between leading Indian companies such as Tata Industries (with Boeing Company), Larsen and Toubro (with  Raytheon Space and Airborne Systems, Boeing Company and EADS) and Mahindra and Mahindra (with BAE Systems), the new policies have not so far yielded the dividends that the government had hoped for.  A major stumbling block is the restriction on FDI to 26 per cent. Defence MNCs do not find this low level of equity participation attractive enough for them to invest in the Indian defence industry. The “no cost-no commitment” (NCNC) procedure adopted by the government for equipment trials, in which companies pay the full cost of trials themselves, has been found to be daunting by many companies. Also, major MNCs doubt the ability of Indian companies to absorb 30 per cent offsets as the manufacturing base in India is deemed to be quite low at present. 

The government is conscious of the challenges faced by MNCs in bringing in FDI into the defence sector in India and is eager to address them. The Economic Survey for 2008-09, released by the Ministry of Finance on July 2, 2009, has suggested a hike in FDI in defence from the present level of 26 to 49 per cent. While this is unlikely to come about during the current financial year, the government’s long-term thrust is clearly evident. Mandatory licensing requirements are also being gradually relaxed, particularly for investments aimed at meeting offsets commitments. As for trials on NCNC basis, the government is gradually veering around to the view that in recessionary times many smaller companies, which may have equally good products, are likely to shy away from investing their own funds in trials that may not yield a contract. For trials for 45-calibre 155mm howitzers for the mountains, the government has agreed to bear the logistics costs and the cost of ammunition. 

During the visit of US Secretary of State Hillary Clinton in July 2009, India signed a Technology Safeguards Agreement for the space sector and agreed on a formulation for end-use monitoring of defence technology supplied by the US. The government clarified in Parliament that no blanket agreement had been signed. “The agreed formulation provides that when the US government desires to undertake the end use monitoring of specific equipment, they shall undertake consultations with India and that it shall be pursuant to such consultations and mutual agreement that the relevant articles would be made available for verification at an agreed date, place and time.” The EUM arrangement would substantially enhance India’s access to state-of-the-art technology for its national security requirements. 

The new initiatives launched by the Government of India will encourage overseas firms to enter into long-term relationships with their partners in India for growing mutual benefits. Under the leadership of Prime Minister Manmohan Singh and the industry-friendly Finance Minister Pranab Mukherjee, the government can be expected to continue to take more pragmatic initiatives to further enhance the attractiveness of India as a destination for defence-related FDI. Defence Minister A K Antony is also keen to further streamline the defence procurement process so as to reduce the voluminous paper work and to cut down the time that it takes to acquire new equipment. With a politically stable regime in power, gradual progress on these fronts can be expected.

(Gurmeet Kanwal is Director, Centre for Land Warfare Studies, New Delhi.)