Make in India: Challenges Before Defence Manufacturing

By S.N. Mishra

16 Feb , 2015

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There is a distinctive buzz about Prime Minister Modi’s new campaign for “Make in India”. The thrust is to increase share of manufacturing from the current level of 15 per cent of Gross Domestic Product (GDP) to 25 per cent and create additional employment opportunity of ten million per year. This has led a few cynics to observe that, “There is a lot of sizzle but where is the steak?” Columnists such as Swaminathan Iyer are of the view that “Make in India” is only an outcome and not a policy while Governor of RBI Raghuram Rajan is of the view that the government is putting too much of thrust on export-led growth and should give primacy to “Make for India”. Discerning writers such as Debasis Basu however, feel that what is germane to the debate is the “cost of doing business” in India.

The defence services account for nearly Rs 2.29 lakh crore of the Central Government Budget…

Defence manufacturing came out of the stranglehold of Public Sector Undertakings-Ordnance Factories (PSU-OF) monopoly with major liberalisation in 2001 with 100 per cent private sector participation and the recently announced 49 per cent in Foreign Direct Investment. Policy footprints such as the Defence Procurement Policy (DPP) 2013 have created a level playing field for the private sector. The Defence Production Policy 2011 aims at higher self reliance in critical technology and the Offsets Policy 2012 which seeks to leverage our big arms’ acquisition to bring in state-of-art technology, and long term partnership with Original Equipment Manufacturers (OEMs). The Self Reliance Index of our defence acquisition, however, remains at a wobbly 30 per cent despite spasmodic policy posturing to improve indigenisation.

Defence industry is a subset of a nation’s concern to ramp up manufacturing capability. The capability of our defence industry in terms of value addition, self reliance in critical technology and policy initiatives so far and their impact needs to examined and a possible synergy between “Make in India” policy and defence industry capability needs to be brought about.

Defence Manufacturing and Challenges in Self Reliance

The defence services account for nearly Rs 2.29 lakh crore of the Central Government Budget which is nearly 2.5 per cent of the GDP and 13 per cent of the Central Government expenditure. The trend of allocation to revenue and capital acquisition schemes is given below.

Table 1: Service/Department-Wise Break Up Of Defence Expenditure (Rs. Cr.). Source: Annual Report 2013-2014, MOD

It would be worth to note that while the increase in the revenue allocation roughly matches with the wholesale price escalation, the capital acquisition budget has witnessed significant growth of around 20 per cent per year, far outstripping the overall trend of increase in defence expenditure. Capital Acquisition constitutes nearly 40 per cent of the defence budget of which the value of production of the Defence PSUs and the OFs account for the following:

Table 2: Value Of Production And Value Addition Psus And OFB (Rs. In Crore). Source: Annual Report 2013-2014, MOD

It would be seen from the above that while the average yearly increase in Value of Production (VOP) of Defence PSUs is around five per cent per year, in case of the OFs it is only two per cent. It would be interesting to note that the value addition of different defence PSUs varies between 23 per cent and 57 per cent; it is very high, about 85 per cent, for OFB. PSUs such as HAL and MDL show a poor level of value addition as they are largely system integrators while Midhani and BDL have contributed handsomely to indigenisation. The higher indigenisation in case of OFBs is largely attributable to the low end technology.

Historically, India has been availing of technology through licence agreements from Russia and a smattering of Western countries. The exceptions are some of the missile systems, small arms and their ammunition and tanks where technology has been indigenously developed by the Defence Research and Development Organisation (DRDO). The Light Combat Aircraft (LCA) Tejas with Final Operational Clearance (FOC) will hopefully be a major “Make in India” platform. It must be mentioned that indigenisation has effected a substantial reduction in cost of the systems due to India’s labour arbitrage, good facilities and fairly well-trained labour force. The following table brings out the cost savings of a few major products through the Transfer of Technology (ToT) route.

Table 3: Indigenisation & Cost Savings through ToT. Source: Table prepared by Author based on data obtained from DPSUs/OF

Self-Reliance Trends

Self-reliance trends in defence acquisition present a dismal picture. A committee under Dr APJ Abdul Kalam, the then Scientific Advisor to the Raksha Mantri, had recommended that India should ramp up this quotient from 30 per cent (1995) to 70 per cent by (2005). The following table, however, brings out how the Self Reliance Index has remained sticky at around 30 per cent.

Table 4: Total Acquisition and SRI: Trends. Source: Table Prepared by Author based on data obtained from Ministry of Defence

The principal reason for this state of affairs is our poor design capability in critical technologies, inadequate investment in R&D and our inability to manufacture major sub-systems and components. The Transfer of Technology route has provided India with the know-how without providing the clue for know why. It is due to this that even for an upgrade of the systems, defence PSUs are critically dependent on the original licensors. A case in point is the SU-30 upgrade where the Russians often hold HAL to ransom.

The following table brings out the gaps in critical technology of different systems.

Table 5: Critical Technology & Gaps. Source: DRDO, BEL and HAL

From the table above, it would be seen that the major deficiency in terms of capability is in the areas of propulsion, weapons and sensors. Some of the critical technologies where progress made by the DRDO has been abysmally poor are Focal Plane Array (FPA), Active Electronically Scanned Array (AESA) Radar and Stealth Technology. India is presently engaged in the design and production collaboration with Russia for a Fifth Generation Fighter Aircraft (FGFA), that will have stealth features.

India is presently engaged in the design and production collaboration with Russia for a Fifth Generation Fighter Aircraft.

Procurement, Production and Offsets Policy in Retrospect and Their Impact

The Defence Procurement Policy 2013 envisages higher preference to Buy (India), Buy and Make (India), and Make options over the earlier thrust towards Buy (Global) or the import option. It ostensibly looks at creating a better level playing field between the Public and Private sector with greater impetus towards indigenisation. A major departure from the previous policy is allowing the private Indian industry to avail of ToT which was earlier the exclusive domain of DPSUs/OFs. The policy also encourages Joint Venture with OEMs. Prime Minister Modi’s “Make in India” campaign has added another category to Defence Acquisition though it would include cases coming under the panoply of ‘Buy and Make’ and ‘Make’ where technology is indigenously developed.

The Offset Policy guidelines (2012) have for the first time allowed ToT through the JV or through non-equity route. It has also allowed multiplier for critical technology areas such as FPAs, Nano Technology-based sensor, fiber laser technology and THZ technologies.

The Defence Production Policy (2011) aimed at achieving substantive self-reliance in design, development and production of critical sub-systems by forming consortia, JVs by involving academia and R&D institutions. It also promised to set up a defence technology fund to support public, private sector as well as academic and scientific institutions for pursuing high-end research. The impact of all such policies on FDI inflow, export, augmentation and long term partnership has been quite disappointing for reasons enumerated below.

Value addition in the global value chain for India was only one per cent in 2009 as against nine per cent in China and Germany…

FDI Policy

The OEMs for setting up business in India in partnership with public/private players want to have a major say in the management of manufacturing. While the announcement to scale up the FDI limit from 26 per cent to 49 per cent in the last budget has been a step in the right direction, it is unlikely to enthuse reputed global manufacturing houses to set up manufacturing bases and bring in front-end technology though some Joint Venture intents have been evinced for companies like the Tatas. On the other hand, countries such as China and South Korea have become major manufacturing hubs in aeronautics and ship building technology by being very liberal in their FDI policy and providing high modicum of ‘Ease of Doing’ business compared to India.

R&D Allocation

Besides the FDI policy, inadequate investment in R&D and lip service to technology funding by making a token allocation of Rs100 crore to Defence Technology Fund in the last budget is adequate commentary on our lack of seriousness in the area of Research and Development. The allocation to DRDO remains sticky – around six per cent of defence expenditure though successive parliamentary committees have recommended a minimum allocation of ten per cent. Private sector giants such as the Tata, L&T and Mahindra and Mahindra invest less than one per cent of their turnover in R&D unlike in countries such as France where corporate organisations invest more than ten per cent in R&D. It would also be interesting to note that the overall allocation to R&D is significantly lower (0.85 per cent) in India compared to advanced countries which spend in the range of 2.2 per cent to 3.5 per cent. The following table would bring out the trend.

Table 6: Major R&D Spenders in the World Vis-à-vis India. Source: Battelle and R&D Magazine, 2013 Global R&D Funding Forecast, December 2012.

Manufacturing

Manufacturing accounts for 14 to 16 per cent of the GDP with 85 per cent of employment in unorganised sector, with a ‘missing middle’. This is unlike manufacturing hubs in Korea, China, Germany and Japan where 50 per cent of the firms are large with the benefit of economy of scale and 20 per cent are SEMs. Value addition in the global value chain for India was only one per cent in 2009 as against nine per cent in China and Germany. National Manufacturing Zone (NMZ) 2011 policy is limping big time in the absence of Centre – State synergy, tardy land acquisition and long drawn environmental clearances. Subir Gokran has rightly observed that increase in Incremental Capital Output Ratio (ICOR) from 3.1 per cent (2005-2006) to 5.9 per cent (2012-2013) is largely attributable to supply constraints such as power-coal imbalance and inordinate project delays.

Export Promotion

The following table provides a trend analysis of exports by Defence PSUs and Ordnance Factories since 2008 – 2009.

Table 7: Export Performance of DPSUs/OFs (Rs. Crore). Source: Annual Report, MOD

Of the PSUs/OFB, HAL & BEL account for 66 per cent of exports. Export as share of Value of Sales (VOS) has remained around three per cent for HAL and around three to four per cent for BEL thereby showing the policies so far have not impacted on their export performance.

Almost 50 per cent of China’s GDP growth is attributable to total factor productivity growth…

Raghuram Rajan sounds a note of caution regarding the obsession for export-led growth by heavily subsidising inputs at the cost of fostering domestic demand. His call for “Make for India” to supplement “Make in India” is an extremely welcome alternative.

Impact of Offset Contracts

After promulgation of this policy in 2005, 24 contracts have been signed for $4.8 billion. However, discerning analysts observe that the expected benefit in terms of FDI inflow, high end technology, increased export and outsourcing have not taken place. The C&AG, in its performance audit of Fleet Tanker Contract (2010), has brought out how the full benefit of offsets provision has not been availed of from the OEM. Further, the C&AG’s comprehensive report of 2012 on offsets contracts severely castigates the inept contractual arrangement that underlies such offset arrangements and additional cost implication.

Manufacturing, “Make In India” Policy and Defence Manufacturing

Since liberalisation in the 1990s, the sectoral share of the primary, secondary and tertiary segments shows a tectonic shift wafting through the corridors. The share of Agriculture in the GDP shows a significant reduction while the share of Industry has remained stagnant with the Service sector showing the way as the sunshine sector.

The following table brings out the trends in the compositional shift.

Table 8: Sectoral Share of GDP. Source: CSO

A disaggregation of the Secondary sector shows that the share of manufacturing sector has increased from around 15 per cent to 25 per cent. The experience of manufacturing giants like Germany, South Korea and China reveal that manufacturing accounts for 30 per cent of their GDP.

The defence industry, be it public sector or private, has to be part of the national manufacturing policy mosaic…

Therefore, the thrust of the government to encourage “Make in India” option by facilitating the enabling environment to manufacture, improving ease of doing business, encouraging creation of national manufacturing zones in tandem with the states and investing one trillion dollar through the PPP route in the infrastructural sector make eminent sense. Professor Basu rightly observes out that the success of the “Make in India” policy will critically hinge on the cost of doing business in India.

Two critical factors for this would be the quality of human resources and cost of capital. India’s education system is presently mired in a mess and needs millions of skilled workers coming out of the ITIs with quality training. While access to education at the primary level through the Right to Education has improved access significantly, the quality deficit, both in the primary segment and higher education is palpable. While the private sector has contributed handsomely to the growth of technical and management education, the quality of education and lack of research impact on the employability of students adversely despite the global opportunity.

As regards the Cost of Capital, the following table would bring out the disturbing trend of exorbitant Costs of Capital in India compared to the developed countries.

Table 9: Cost of Capital: Global Comparison. Source: The Economist- 13th December, 2014

What is interesting also to note that most of the BRIC countries are bedeviled by high Cost of Capital and unacceptable levels of inflation accentuating their “Misery Index”.

Importance of Total Factor Productivity

Professor Solow, a Nobel Laureate, in his seminal paper had brought out the importance of factor productivity. His equation Q=A * K∆ Lβ where Q is the production function, A is the level of technology and scale, K & L are factors of production ∆ & β are factor efficiency has demonstrated how US has become the premier technological hegemon after World War II. A case in point is the phenomenal growth in China from 1979 as would be evident from the following table. Almost 50 per cent of China’s GDP growth is attributable to total factor productivity growth.

Table 10: Sources of Growth in China. Source: A.P. Thirlwall - Economics of Development-Theory and Evidence

Lessons for India’s Defence Industry

The defence industry in India cannot be impervious to these trends. It has to be sensitive to skill requirements in order to absorb high technology which comes as part of ToT. One of the predominant reasons for Japan’s phenomenal growth since the 1950s has been their highly skilled labour force which could absorb front-end technology from the US quickly and adopt it to harness commercial success through dual use technology. Japan’s success in electronics and automobile is testimony to this.

The DRDO remains mired in inordinate delay, huge cost overruns and deficient in critical technology areas like ‘seekers’ and ‘stealth’…

In India, on the other hand, the ToT experience reveals that the technology absorption has been inordinately slow leading to continued dependence for our foreign collaborators well beyond the originally contracted period. Experience of HAL in terms of production of the MiG series of aircraft and SU-30 and for MDL for producing Scorpene submarines are grim reminders of our poor high skill absorbing capability.

Conclusion

India is witnessing a significant stickiness in its manufacturing sector which is bedeviled by the huge presence of small scale and informal sector that are bereft of requisite skill levels and economy of scale. Their access to capital is also seriously impeded. However, the manufacturing sector provides a wonderful opportunity for India to be part of the global supply chain and generate high levels of employment opportunity to absorb around ten million young Indians who will come in to the market in search of employment every year. They also need to be properly skilled and trained and networked with their global peers.

The defence industry, be it public sector or private, has to be part of the national manufacturing policy mosaic. Unfortunately, the defence sector often chooses to distance itself in its interface with other civilian sectors. There is opportunity aplenty in areas such as aerospace and ship building where there is considerable civilian and military market. Lack of design capability to manufacture critical subsystems remains a major handicap. The DRDO remains mired in inordinate delay, huge cost overruns and deficient in critical technology areas like ‘seekers’ and ‘stealth’.

Tokenism like Rs. 100 crore allocation towards Technology Acquisition Fund or lip service to FDI policy by increasing to 49 per cent are not the way forward. Public Private Partnership, Joint Venture with foreign OEMs and design houses will require bolder policies such as FDI ceiling higher than 50 per cent and the political will to mentor and hold together the different stakeholders who are often at cross purposes. The new Prime Minister has set his foot in the right place. The Ministry of Defence, however, has to match his steps, shed its ghetto mentality and strive for better synergy with other manufacturing sectors to make “Make in India” the mantra for the days ahead.