Indigenization push in defence manufacturing a force multiplier
10 min read 30 Mar 2016, 02:42 AM ISTManufacturing arms in India will create thousands of jobs, cut the import bill and boost FDI inflows
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Mumbai: India is the world’s largest importer of defence equipment, with 60% of its requirements met from outside the country. This, in itself, translates into a great business opportunity for those building domestic capabilities in defence.
It is the reason why Prime Minister Narendra Modi wants local defence production to be at the heart of the government’s Make in India campaign that seeks to promote manufacturing and attract foreign investment.
Speaking at the inauguration of Aero India 2015 in Bengaluru, Modi said: “We have a reputation as the largest importer of defence equipment in the world. That may be music to the ears of some of you here. But, this is one area where we would not like to be No. 1...
“Our defence industry in the private sector is still small. But, it already employs thousands of people. This is despite the fact that nearly 60% of our defence equipment continues to be imported. And, we are spending tens of billions of dollars on acquisitions from abroad.
“There are studies that show that even a 20-25% reduction in imports could directly create an additional 100,000 to 120,000 highly skilled jobs in India. If we could raise the percentage of domestic procurement from 40% to 70% in the next five years, we would double the output in our defence industry.
“Imagine the impact in terms of jobs created directly and in the related manufacturing and services sector! Think of the spin-off benefits on other sectors in terms of advanced materials and technologies!
“That is why we are focusing on developing India’s defence industry with a sense of mission. This is why it is at the heart of our Make in India programme."
A new defence procurement policy or DPP that accords priority to indigenously made defence products and boosts the Make in India initiative will be effective from 1 April, defence minister Manohar Parrikar said on 21 March.
It will contain measures to promote indigenization and self-reliance in defence and also contain measures to ensure probity, accountability and transparency in defence procurements, the minister had said earlier in the month.
“If Make in India goes on at the same speed, growth will be in double digits, definitely more than the current 7-8%," he said.
The government has no plans to make the indigenization clause in the DPP mandatory, but it will be given preference in defence acquisitions, he added.
The minister said defence acquisition spending can come down by 25% if the system is clean, without compromising on quality. He also said that skill development will be included in the offset clause in future to boost technology transfer.
The government has increased the level of foreign direct investment (FDI) in the defence sector to 49%.
The idea of Make in India is now more than 18 months old. Launched on 25 September 2014, it was Modi’s brainchild to make India the world’s next manufacturing destination and attract FDI.
Twenty-five sectors were identified—from automobiles to aviation, pharmaceuticals to tourism and wellness. In the past year-and-a-half, Make in India has become a clarion call for domestic companies and multinationals to look at increasing their investments in the country.
Since its launch, the government has taken several steps to make it easier for companies to do business in the country. And FDI has been allowed in sectors besides defence.
FDI itself has received a dramatic boost since the launch of the initiative, according to the latest Economic Survey. Between October 2014 and June 2015, there was an almost 40% increase in FDI inflows.
Under the Make in India programme, the government has awarded 56 defence manufacturing permits to private sector entities in the past one year, compared with 47 granted in the preceding three years.
According to the ministry of defence, the value of procurement of defence items by the armed forces from Indian sources in 2014-15 was ₹ 49,531 crore, down 9.96% from ₹ 55,014 crore during 2013-14.
As part of Make in India, the government proposes to encourage the manufacture of defence equipment in the country through various policy initiatives including giving preference to ‘Buy (Indian)’, ‘Buy and Make (Indian)’ and ‘Make’ categories of capital acquisition over ‘Buy and Make (Global)’ or ‘Buy (Global)’ categories in the DPP.
The centre has also liberalized the industrial licensing regime for Indian manufacturers and most of the components/parts/sub-systems have been taken out of the list of defence products requiring industrial licences.
This has reduced entry barriers for new entrants in this sector, particularly small and medium enterprises.
Moreover, the initial validity of an industrial licence has been increased from three years to 15 years with a provision to further extend it by three years on a case-by-case basis.
Offset implementation has been made flexible by allowing change of Indian offset partners (IOPs) and offset components even in signed contracts. Foreign original equipment manufacturers are now not required to indicate the details of IOPs and products at the time of signing of contracts. Services as an avenue for discharge of offsets have been reinstated.
Offsets, currently, are a provision in the DPP that require any foreign company securing an order worth more than ₹ 300 crore from India to source components worth 30% of the value of the order from India.
The Defence Acquisition Council (DAC) has also revised the so-called defence offset clause, which will now be applied to contracts of more than ₹ 2,000 crore instead of the current ₹ 300 crore, thereby removing a hurdle to foreign firms eyeing the Indian market.
This rule will be applicable once the new DPP comes into effect.
The offsets opportunity is expected to be worth $15 billion within the next 10-15 years, assuming that several proposed purchases are completed on time, according to consultancy firm KPMG.
Parrikar said India has signed $5 billion worth of defence offset contracts while $10 billion of additional contracts are in the pipeline. He also said that better quality products will get weightage while calculating the price in special procurement cases.
Experts expect that the new DPP will boost Make in India.
“India’s oldest friend, Russia, agreed to take the initiative under the Make in India umbrella—perceived as a vote of confidence in India’s economy—in two key strategic sectors: nuclear and defence. It is the first-ever project for a major defence platform under the Make in India mission," said Bharat Mandot, co-founder and chief executive officer at management consultancy StelCore Management Services Pvt. Ltd.
“India has relaxed its offset policy, exempting foreign firms from obligations like declaration of Indian offset partners’ name, amount of FDI and value of equipment. Thus under the new deal, any foreign company will not have to declare name of its Indian partner. It can set up its factory in India under new offset rules without declaring FDI and value of machines installed there," Mandot said.
Moreover, vendors can give mandatory details at the time of offset credit under the revised offset rules, he said.
“Defence secretary (procurement) and not the defence minister—as in the previous offset policy—will be the final word on any changes within an offset proposal," Mandot said.
“There is, however, no change in rules of offset amount, which mandates a foreign firm to invest 30% of the contract value in India. The amendment is welcome, but there is an urgent need of a comprehensive policy. India is perhaps the only major arms importer that has a very modest offset percentage. It should be raised to at least 50% to ensure an enhanced flow of offsets to the Indian industry," he said.
But a lot more needs to be done.
“The entire conversation around defence manufacturing is limited to the eyecatching categories of aerospace, weapons and naval systems," said Kabir Bogra, associate partner at law firm Khaitan & Co.
“To bolster the manufacturing industry, the tier-I and tier-II vendors need to be included in the conversation. We need to ensure that irrespective of the larger OEMs (original equipment manufacturers), their vendors see value in manufacturing in India. Acquisition programmes are political and fiscal affairs which can take time but the vendors can be encouraged to leverage the cost advantage of manufacturing in India," Bogra said.
Bogra said though it may be difficult to delink the manufacturers of regulated products from their OEM base, the manufacturers of dual use products are easier to attract.
“We also need to reduce the burden of taxes. To rejuvenate the industry, transaction taxes need to be lowered to allow improved margins with lowering of costs. And, finally, the states need to play their part and ensure that projects actually take off. Apart from Karnataka, Andhra Pradesh, Telangana and Maharashtra, states have not shown any initiative to attract the defence industry," he said.
While there are ways and means to increase local production, what are the ways to boost defence preparedness?
The Make in India mission is a priority for defence procurement but “operational readiness" is the military’s primary task as “we don’t want people to look at us with big eyes", the Press Trust of India quoted Parrikar as saying on 19 March.
“We need adequate equipment and that cannot change. Make in India is in its place, our military preparedness is paramount," the minister said.
There have been calls for stepping up the country’s defence preparedness after the terror attack on the Pathankot airbase on 2 January.
The opposition Congress had in Parliament criticized the government for its handling of the Pathankot incident in which seven security personnel were killed.
“Facilitation of a conducive and pro-investment policy environment should be another focal point for the government, taking into account the best interests of various stakeholders. Currently, the sector is subject to numerous regulations and stringent monitoring, which makes functioning for companies in this space quite difficult. To overcome such challenges, the government must work towards harmonization of the policy environment including the FDI policy, licensing regime, offset policy, etc," Mandot said.
The government must channelize its efforts towards streamlining procurement processes, making them time-effective and unambiguous, he said.
“Similarly, the offset policy, which has the potential to stimulate indigenous defence manufacturing should be strengthened and made effective. Currently, these policies lack consis-tency and precision," he said.
Mandot said a fresh look at the operating mechanism of the defence public sector undertakings—Defence Research and Development Organisation (DRDO) and Ordnance Factory Board (OFB)—should be undertaken from the standpoint of productivity, innovation, efficiency and utilization.
“The government should analyse the gaps and take corrective action for their redressal. Additional investment should be made towards technological upgradation. Institutions like DRDO should be strengthened to produce leading edge technology," Mandot said.
The government should consider according ‘infrastructure’ status to the aerospace and defence or A&D industry and providing various concessions/benefits in the form of tax incentives to A&D manufacturers, both from a direct and indirect tax perspective, so as to augment domestic defence production, Mandot said.
“While the government has significantly enhanced the FDI cap in the defence sector (from the erstwhile 26% to 49%), such policy initiatives have not yielded the desired results. The government could reconsider enhancing the FDI cap to 74%," Mandot argued.
But how serious is the government about modernizing the defence forces?
Finance minister Arun Jaitley mentioned the word ‘defence’ only five times in his budget 2016-17 speech, and surprisingly made no mention of India’s defence allocation for 2016-17.
As part of incentivizing domestic value addition to help Make in India, Jaitley did propose some changes in customs and excise duty rates on certain inputs, raw materials, intermediaries and components, including those required for defence production.
For instance, the government has proposed to withdraw customs duties exemption on direct imports of specified goods for defence purposes by the centre or state governments with effect from 1 April.
Also, the government has withdrawn basic customs duty exemption on specified goods imported by contractors of public sector undertakings (PSUs) or sub-contractors of such PSUs for defence purposes, with effect from 1 April.
The defence budget estimate for 2016-17 is ₹ 3.4 trillion, about 10% more than the previous year’s estimate, which is broadly consistent with past increases.
“With the increasing threat from the neighbouring countries—Pakistan and China—modernization of Indian armed forces has become the need of the hour. China is developing infrastructure on Indian border and flexing muscle in the South China Sea. Growing Sino-Pak defence cooperation is worrying. Pakistan’s continued military-terrorist nexus is hitting India where it hurts," Mandot said.
He pointed out that the Indian armed forces have long suffered due to delayed acquisition processes, failure to take timely decisions, deficiency in qualitative requirements formulation and lack of future planning.
“The weakness of planning and budgeting has further been aggravated by the deficiencies in the procurement system that the defence ministry has been desperately trying to overcome since the early ’90s. The result is a depleting fleet of combat fighter platforms, submarines, guns, tanks, helicopters, night-vision devices and other critical defence equipment," he said.
