Increased Foreign Direct Investment in Defence Sector: A Transformational Change

If in the last fourteen years, the total Foreign Direct Investment (FDI) inflows in Indian defence sector have been a piffling USD four million, it really does not need rocket science to conclude that India’s FDI policy was crying for a change. Despite annual modifications to the capital acquisition procedures, the services today remain deficient of basic equipment. Long-standing issues pertaining to the Services hence need to be addressed on priority.

The strategic community and the industry greeted the consolidated FDI policy circular issued by Department of Industrial Policy and Promotion in April 2014 with a sense of disdain[i]. The newly elected government has now begun work on allowing up to 100 percent FDI in defence production sending a strong signal to global investors. The Department of Industrial Policy and Promotion has in a recently circulated cabinet note seeking comments from stakeholders has suggested a graduated foreign investment ceiling of 49 percent without  technology transfer, 74 percent with technology transfer and 100 percent for companies engaged in manufacture of state of art equipment/ technology. This is indeed a transformational change and is far removed from earlier policies, wherein it was not considered advisable to depend on foreign companies in this critical sector and be vulnerable to their policies. This was the policy adopted and articulated in the Defence Production Policy issued in 2011 and the Defence Procurement Procedure 2013[ii]. The domestic defence sector especially the Defence PSUs and the trade unions also vehemently opposed the increase in FDI in defence which unfortunately shaped the Ministry of Defence  decision in the past  as also was the case with denial of ‘Raksha Udyog Ratnas’ to selected private companies with expertise in defence.

The trigger to the current initiative by the new government is the huge arms import bill, which has reduced the modernisation budget to near zero in the current fiscal. Policy makers now realise that an increased FDI inflow can achieve a reduction on import dependence and relieve pressure on the modernisation budget, strengthen the defence manufacturing base eventually boosting defence exports as also affect acquisition of cutting edge technology.

India has increased its arms imports by 111 percent in the past five years and is today, the world’s largest arms buyer, accounting for fourteen percent of the world’s arms imports. Of the world’s top ten weapons buyers, India has the second lowest domestic production trailing only to Saudi Arabia. Analysts are projecting an overall spend close to USD 100 billion in the next five years.  The annual defence budget averages at less than two percent of India’s Gross Domestic Product, which will not affect any meaningful modernisation. With the diversion of Rs 6500 crore from the modernisation to the revenue head 2013-14,[iii] there are presently no funds in the modernisation head even to meet the first stage payments of Medium Multi Role Combat Aircraft deal with France.

India defence production units responsible to provide the Armed Forces state-of-the-art equipment are performing sub optimally resulting in import of arms worth billions of dollars every year. Most of them are themselves over dependent on imports for their production needs, and have a very low labour productivity level, negligible export, and a low research and development base. The defence industry is open for Indian private sector participation up to 100 percent subject to licensing. Thirty licensed companies in the private sector have so far commenced commercial production of the defence items after obtaining industrial license. The existing manufacturing base suffers from the ailments such as restricted access to state of art technology, particularly in the areas of electronics and communication, missiles and smart ammunition, which are closely guarded by firms and nations, delayed projects, and low research and development expenditure[iv]. India’s military industrial complex post increased Foreign Direct Investment hence has the potential to match the success achieved by Indian automobile sector.

For a developing country like India, technological prowess is mainly about adoption and adaptation of technologies from abroad rather than the creation of new technologies. Therefore, the transfer and diffusion of technology are crucial to building their domestic technological capabilities; and the role of Governments in supporting this process is fundamental[v]. Defence Research and Development Organisation (DRDO), since its establishment in 1958 has not successfully delivered even a single major weapon system.[vi] Development of the HF-24 Marut in 1970s to the more recent Light Combat Aircraft Tejas or even the Main Battle Tank Arjun was mired by time and cost overruns and sub optimal performance.  Even relatively basic projects such as Futuristic Infantry Combat Vehicle and Tactical Communication System have been stalled in red tape for years. To expect DRDO to suddenly master cutting edge technologies through the much touted make procedure or the offsets route would be highly unrealistic. The generation of new and advanced technologies is concentrated in the developed world, and takes place mainly in large corporations. These trans-national corporations account for about half of the world’s total research and development (R&D) expenditure and more than two thirds of the world’s business R&D. Currently, the research spending of some large corporations is higher than that of many developing countries. Twenty corporations – with Toyota, Microsoft, Volkswagen and Pfizer among the top five spent more than USD five billion on R&D in 2009. In comparison, among developing economies, total research spending exceeded USD five billion only in Brazil, China, Korea and Taiwan. India spent USD 9136 million which was lesser than Toyota Motors, which spent USD 9403 million. Today, FDI has become an important source of new technology to the developing world and India must ride the crest. China has already established certain critical technological capabilities through a coherent FDI policy.

For far too long high-value defence procurement systems have been looked upon as something that could be made more efficient by merely improving policies, adding regulations, and refining procedures[vii]. This is because of certain peculiar challenges specific to high value defence procurements when perused through a defence economics perspective. These challenges pertain to the very nature of high value defence procurements, which is enormously affected by stakeholder incongruence, special market conditions, bounded rationality, asset specificity and risk management. India cannot think of becoming a global player without reducing its dependence on imported arms. Even today, Indian Public Sector Units focus more on only assembling from knocked down kits rather than actually absorbing technology. DRDO flagship project Tejas has an American engine, a British ejection seat, a Canadian canopy sheath and Israeli radar. In such a milieu, the decision to boost FDI in the defence sector is a positive step.

The author is a Senior Fellow at CLAWS. Views expressed are personal.