FDI in Defence: Dispelling the Myths

India should adopt a flexible FDI policy to import much needed technologies which cannot be mastered through indigenous efforts in the acceptable time frame. Unfortunately, every time the issue of increasing FDI limit comes up, the opponents resort to their time-tested subterfuge of raising the bogey of security concerns and threat to indigenous industry, thereby hiding their selfish reasons. In any case, India can incorporate necessary security clauses in the initial license to ensure that an unscrupulous entrepreneur does not play truant in crisis situations. India should reserve the right to take over a facility if required in an operational emergency.

India’s 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, 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.

As recounted earlier, it is an undisputed fact that the current Indian policy has been an abject failure. Whereas an intense debate is taking place to influence the decision makers, a number of articles are being planted in the media to sway the public opinion. Unfortunately, objectivity is conspicuous by its absence. Stakeholders have taken stands that suit their interests.

As the debate has been highly skewed, this article endeavours to remove some common misconceptions and put all issues 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 entrepreneur’s 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.

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.

Presently, India is procuring all critical weapon systems produced/integrated abroad. It is not understood as to how India’s 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.

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. If they wish to invest in India, the upper cap of 26 per cent will never be an impediment.

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-se appraisal 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-à-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.

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 Antony’s statement that building up India’s 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 India’s dependence on foreign countries for modern weapons.

Further, the Defence Minister has expressed confidence in India’s 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’).

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 outdated and useless equipment.

As the performance of DRDO over the last five decades has been highly unsatisfactory belying 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 has 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.