04 Sep , 2014
It is time India makes up its mind whether it wants FDI in defence or not. If it is felt that FDI is not essential and India can achieve technological excellence through indigenous efforts; it should be stated upfront and all pretenses of seeking FDI should be shed. The current apathetic and uninspiring approach is a meaningless charade. The recent increase in FDI cap to 49 per cent is totally inconsequential and will not attract FDI. This fact has been amply established by joint studies carried out by the CII with KPMG and ASSOCHAM with Ernst and Young. Both studies indicate that foreign investors want a minimum of 51 per cent holding.
The budget speech of July 10, 2014 proved that the entrenched entities continue to call the shots…
There are times in the life of a nation when bold policy initiatives can prove vital and decisive for future generations. For that, the nation has to be blessed with bold, dedicated and mature leadership. In other words, the quality of a nation’s leadership can be judged by its capability to undertake radical, innovative and path-breaking reforms.
Notwithstanding the misplaced euphoria created by subjective reporters, raising of the upper limit of Foreign Direct Investment (FDI) in the defence sector from 26 to 49 per cent is an infructuous decision. The budget speech of July 10, 2014 proved that the entrenched entities continue to call the shots. Unfortunately, the government has lost the plot and succumbed to the pressure of self-serving elements. Resultantly, a rare opportunity to charter an inventive and courageous course to kick-start the development of India’s embryonic defence industry has been missed.
It was in May 2001 that the defence industry was thrown open to the private sector. The aim was to co-opt the private sector to achieve the much declared target of reducing dependence on imports to less than 30 per cent of the total requirement. The government permitted 100 per cent equity with a maximum of 26 per cent FDI component, both subject to licencing. Subsequently, the detailed guidelines were issued in January 2002.
Foreign investors have shown little interest in investing in the Indian defence sector as they consider most provisions to be highly dissuasive. In addition to limiting the FDI component to 26 per cent, the policy contains the following stipulations:
Foreign investors have shown little interest in investing in the Indian defence sector…
Licences for the production of arms and ammunition will be issued by the Department of Industrial Policy and Promotion in consultation with the Ministry of Defence (MoD), whereas all FDI cases will be considered by the Foreign Investment Promotion Board as well. However, it is the MoD which will have the final say as regards procurements, sales and exports (even for non-lethal items).
The applicant company has to be either an Indian company or a partnership firm. Management control must remain in Indian hands with majority representation in the board.
The Chief Executive has to be a resident Indian.
The licencing authority can verify the antecedents of the foreign collaborators and domestic promoters including their financial standing and credentials in the world market.
Though FDI limit is capped at 26 per cent, there would be no minimum capitalisation for the FDI. The Government would assess the adequacy of the net worth of a foreign investor with respect to the category of weapons and equipment to be manufactured.
A foreign investor cannot transfer his equity before the expiry of the lock-in period of three years. Even after that, such transfers would be with the approval of the government.
The licence will contain capacity norms for production, which will be fixed after considering existing capacities of similar and allied products. A licensee can produce only the licensed products and in the sanctioned quantity. He can neither diversify nor enhance production to cater for the market dynamics.
The government will verify all safety and security procedures once the production commences.
The world arms industry does not follow the dynamics of an open and free market…
As regards the sale of the products, the government can give no purchase guarantee but the proposed quantity for acquisition and overall requirements may be made known to the extent possible.
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.
The applicant company has to provide the standards and testing procedures for equipment to be produced to the nominated quality assurance agency. Further, the government retains powers to inspect the finished product and conduct audit of quality assurance procedures.
Original investment as also the returns on investment are fully repatriable. Payment of fee and royalty to foreign technology provider is permitted including that by a wholly owned subsidiary to its off-shore parent company.
As is apparent from the above, India expects a foreign investor 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). Such an expectation defies logic. Many feel that such a lopsided policy can never succeed in attracting foreign investment.
The degree of control that a foreign partner can exercise over the enterprise is of vital importance to him…
Dynamics of FDI
To be able to appreciate the complexities of FDI flow, it is essential to understand its dynamics. 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.
FDI is a need-based concept. The host nation needs funds and know-how for its accelerated growth while a foreign investor is guided purely by economic considerations. FDI sets in motion a chain reaction wherein initial FDI upgrades local technology which, in turn, attracts more inflows with higher technology and the cycle goes on. Further, the whole process brings in the latest managerial practices, techniques and skills; thereby upgrading the entire knowledge environment in the country.
In world commerce, investible funds are limited. It is natural for the prospective investors to carry out a comparative appraisal of all likely destinations to identify the best option for optimum returns. Therefore, any country that covets FDI has to convince the prospective investors of the advantages accruing to them as compared to competing suitors.
As foreign investment carries considerable risks, it is natural for an investor to be wary of unpredictable business environment in the host nation. Flow of FDI is dependent on a number of determinants such as stable policy, favourable investment climate, structural adjustments, economic freedom and a fair market access. In addition, factors like availability of abundant raw material, adequately skilled work-force, low cost of production and presence of lucrative market are also taken into account. Thus, it is an interplay of multiple factors that influences an investment decision.
Any foreign investor who brings in cutting edge and frontier technology should be allowed 100 per cent holding…
The degree of control that a foreign partner can exercise over the enterprise is of vital importance to him. With 100 per cent ownership, he gets total and unhindered control with a resultant ability to take any decision that he considers prudent for the venture. In other words, he can pass both special (buy back of shares, diversification and merger/amalgamation) and ordinary (passing of accounts, approving dividend levels and appointing directors) resolutions, provided they are in consonance with the host country’s policies and laws.
On the other hand, 51 per cent holding allows working control and day-to-day functional oversight of the Joint Venture. With 26 per cent holding, a partner can stall passage of special resolutions. Therefore, leaving aside a proportionate increase in the repatriable profits, there is very little difference between FDI limit of 26 per cent and 49 per cent. The control remains with the indigenous partner and in both the cases, the foreign participant can prevent passage of special resolutions. Similarly, there is very little to choose from between FDI caps of 51 per cent and 74 per cent.
Significance of FDI in Defence
For sectors such as infrastructure, insurance and retail trade, FDI means infusion of foreign funds. Control of the venture is of lesser importance. However, for the defence sector, FDI is sought both for funds and technologies. A foreign company is expected to share its closely guarded technologies and proprietary know-how with the local partner. Hence, all foreign investors want to have a controlling stake.
The world arms industry does not follow the dynamics of an open and free market. It is characterised by a number of distinct features. One, the initial investment in the defence industry is very heavy and the gestation period is unduly long. Rapid obsolescence of defence technologies necessitates regular infusion of funds for Research and Development. Therefore, there are very few defence equipment manufacturers who possess the latest technologies.
All Joint Venture proposals should be assessed and categorised on the basis of nature, level, depth and exclusivity of technology involved…
Two, most countries control export of sensitive technologies. Grant of license and issuance of sanctions is invariably a painstaking and protracted affair. At times, undue delays render the proposed projects unviable and anachronistic. Additionally, embargoes on technology export by some countries make the choice of source highly limited.
Three, market for defence equipment is extremely competitive and restricted. Most of the countries give preference to their indigenous manufacturers. Invariably, major defence procurements are an extension of a country’s foreign policy. Therefore, every prospective FDI investor wants a fair degree of assurance that the equipment produced will find buyers, more so as most of the defence equipment does not have dual-use and finds no application in non-defence sector.
Four, modern defence systems are highly complex and are not available from a single source. In addition to procuring/producing various systems, sub-systems and components, a systems-integrator has to be identified for optimum performance. This may entail negotiations with more than one foreign investor from more than one country.
Finally, FDI in defence could either be in a Greenfield project or through merger/acquisition. Normally, developing countries attract Greenfield projects, whereas acquisitions/mergers are more prevalent in developed nations.
The ghost of security concerns is raised by self-seeking entities to defend an indefensible decision…
India’s Half-hearted Policy will Prove Infructuous
Increase of FDI limit in defence from 26 per cent to 49 per cent was greeted with the thumping of desks in the Parliament. It was also announced proudly that the control of the Joint Ventures would remain with the Indian partners. In other words, the revised policy has changed nothing except that a foreign investor can invest more and repatriate more. All other provisions including those relating to capacity constraints and market access remain unchanged. On the whole, it has been an infructuous exercise.
It is time India makes up its mind whether it wants FDI in defence or not. If it is felt that FDI is not essential and India can achieve technological excellence through indigenous efforts, it should be stated upfront and all pretenses of seeking FDI should be shed. The current apathetic and uninspiring approach is a meaningless charade. The recent increase in FDI cap to 49 per cent is totally inconsequential and will not attract FDI. This fact has been amply established by joint studies carried out by the CII with KPMG and ASSOCHAM with Ernst and Young. Both studies indicate that foreign investors want a minimum of 51 per cent holding.
On the other hand, if India covets FDI in defence, it must make India an irresistible destination. Vacillation or policy paralysis will serve no purpose. For that, it must be ensured that all the genuine concerns of the foreign investors are addressed, their proprietary technologies protected and their economic interests safeguarded. India must position itself as the most lucrative FDI destination with improved ‘FDI Confidence Index’ and make structural changes to provide functional freedom to joint ventures to respond to market dynamics.
To start with, FDI cap should be made technology-centric. Defence industry covers too vast a spectrum to be branded as a single entity for the formulation of FDI policy. Therefore, India should adopt a flexible and proposal-specific approach. All Joint Venture proposals should be assessed and categorised on the basis of nature, level, depth and exclusivity of technology involved for the fixation of FDI cap. For low-tech and high-tech proposal, limits of 26 and 49 per cent respectively may be adequate. However, proposals that bring in latest and exclusive technologies should get a 74 per cent cap. Similarly, any foreign investor who brings in cutting edge and frontier technology should be allowed 100 per cent holding.
If India is serious about attracting FDI in defence, it has to position itself as the most lucrative FDI destination…
Equally importantly, there is a need to change other policy provisions as well. Necessary freedom should be provided to a foreign investor to cater to market dynamics albeit within the broad regulatory policy framework. He should not feel stifled or handicapped due to excessive monitoring by the bureaucracy. Economies of scale should be enabled through the removal of capacity constraints. This in turn will reduce India’s cost of procurement as well. In short, all help should be provided to ensure economic viability of an enterprise.
Although MoD can give no purchase guarantee at the time of issuance of licence, a level playing field should be provided to both the public and the private sector including Joint Ventures. Exports should be encouraged to earn foreign exchange to offset the initial foreign exchange outflow and repatriation by foreign investors. Given its favourable geo-political position and technical manpower, India must strive to be a hub for global outsourcing and partner co-production of defence products as a part of multi-nation consortiums.
Price and/or purchase preference to items produced in the country should be followed. This single step will make all foreign vendors explore the feasibility of local production. Nevertheless, local production has to be categorised in terms of value addition and technology transfer lest mere assembly/integration of imported sub-assemblies gets passed as local production.
Investment promotion to attract FDI has become indispensable. It is generally defined as ‘activities that disseminate information about, or attempt to create an image of the investment site and provide investment services for the prospective investors’. Investment promotion in defence sector needs expert handling as investors are few and highly selective.
Almost all countries provide various forms of investment incentives as well. These include fiscal incentives such as tax breaks/holidays and financial incentives like grants/loans. It is equally essential to give maximum publicity to the incentives being offered.
Without getting sufficient control and freedom to cater to market dynamics, no foreign investor will be willing to invest in India…
Opposition on Selfish and Fallacious Grounds
Although the national leadership is fully aware of the fact that raising of FDI cap to 51 per cent and above will be in India’s interests, it faces strident opposition from two quarters – MoD bureaucracy and the privates sector giants. MoD’s bureaucrats want the status quo to continue wherein Defence Public Sector Undertakings import sub-assemblies against Transfer of Technology under the ‘Buy and Make’ route, put their own label on the assembled product and sell it to the captive services at a huge profit.
As regards the major industrial houses, they fear that their growing clout and business prospects maybe adversely affected if the foreign companies are allowed an entry into India. They propose 49 per cent cap, knowing well that no foreign investor will come without getting control of the Joint Venture. Thus, the opposition is purely from the selfish elements.
When all other arguments fail, the ghost of security concerns is raised by self-seeking entities to defend an indefensible decision. It is said that the ownership of core strategic industries like defence must always remain under Indian control. Furthermore, FDI is painted as a threat to the fledgling indigenous defence industry. Both the arguments are outlandish, to say the least.
Sanction for FDI in defence will always be through the grant of license. It is for India to weigh all aspects before fixing the FDI limit. For items that are being imported in fully built up form, even 100 per cent FDI should be acceptable. Production in India through Joint Ventures is infinitely more reassuring than imports that can be cut off unilaterally by foreign suppliers. No company, even fully owned by foreign investors, can shut shop at will at short notice and withdraw its invested resources.
In addition, the license can contain adequate safeguards. India can reserve the right to take over the licenced facility under certain extraordinary circumstances of national emergencies. Most nations that allow FDI follow the same route. Therefore, fears expressed are totally unfounded and highly exaggerated. Additionally, indigenous manufacturing facilities will also ensure better life-time support for the equipment.
Most of the major defence equipment producers follow ‘Global Factory’ concept, wherein various functions are spread over a number of locations in different countries with a view to draw maximum benefits in terms of geographical locations, availability of technical manpower and accessibility to raw material. When they invest in any country, they make it an integral part of their overall production chain. Thus, every facility gets intrinsically integrated in the production cycle. In such a scenario, it is not easy for the company to shut down any facility and disrupt its worldwide production network.
As regards the perceived threat to the nascent indigenous defence industry, it is for the government not to grant licence for the production of defence systems that the Indian industry is developing or producing. As stated earlier, defence is a vast sector and no uniform rule can be applied to all segments. A flexible and technology-centric approach will ensure that all security concerns remain addressed and the indigenous industry gets adequate protection.
Finally
If India is serious about attracting FDI in defence, it has to position itself as the most lucrative FDI destination. Foreign investors are not enthused by the talk of raising FDI limit to 49 per cent. Without getting sufficient control and freedom to cater to market dynamics, no foreign investor will be willing to invest in India and part with his closely guarded technology.
Opposition to higher FDI cap in defence is based on bizarre arguments…
In conclusion, it will be prudent to cite an example. The Kaveri Engine for the Light Combat Aircraft (LCA) was scheduled to be ready by 31 December 1996. Despite spending close to Rs 4,000 crore, no product is in sight or anywhere near development. The government has been forced to sign a contract worth Rs 3,000 crore for the import of 99 GE 414 engines from the US, with the option to procure 100 additional engines. As India may need up to 300 LCA, the requirement of engines will increase proportionately. Will it not be beneficial to allow GE Aviation 100 per cent FDI to establish manufacturing facility in India? In what way will it be a bigger security risk than imports from the US? How does such a facility impede indigenous industry when no Indian producer manufactures aero-engines?
On the contrary, immense benefits will flow to the country in the form of less expensive products, reduction in foreign exchange outflow, boost in ancillary industries and creation of employment opportunities. Latest technologies will permeate across multiple fields and disciplines. India has nothing to lose or fear.
Opposition to higher FDI cap in defence is based on bizarre arguments. Decisions which have a far-reaching effect on the defence potential of the armed forces must be taken with due diligence. Defence matters cannot be held hostage to the selfish interests of a few; decisions taken as a matter of political and populist expediency can prove disastrous for a nation in the long run.
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