Recent reforms in the Indian Defence Sector

June 01, 2020 7:11 PM

India with the second largest armed forces and with the fifth largest defence budget in the world aims to achieve self-reliance in defence production.

Indian Defence Sector, armed forces, Minister of Defence, COVID 19, Ordnance Factory Board, FDI limits, Indian defence production, FDI in defenceA catalyst to the effective production by the domestic industry could be facilitation of timely procurement of defence equipment.

By Atul Pandey (Partner), Abhiroop De (Associate), Khaitan & Co LLP

India with the second largest armed forces and with the fifth largest defence budget in the world aims to achieve self-reliance in defence production. When the draft Defence Procurement Policy 2020 (DPP) was unveiled by the Hon’ble Minister of Defence, it was a push forward for higher indigenous content and encouraged initiatives for local material and software as a part of Make in India. Converting the unprecedented times of COVID 19 into an opportunity to propose structural reforms in the defence sector, on 16 May 2020, the Hon’ble Finance Minister (FM) announced a slew of measures taking the vision of the draft defence procurement policy even further.

The most important among the measures announced were raising the sectoral cap of foreign direct investment (FDI) (automatic approval) from the existing 49% to 74%, a negative list for the import of defence equipment in India, a separate capital budget for indigenous weapons procurement, corporatisation of the Ordnance Factory Board (OFB) and reforming the defence procurement. The increase in FDI limits could aid in attracting foreign funds and transfer of technology know-how by defence-oriented companies headquartered abroad with subsidiaries in India. On the other hand, to boost domestic participation in the defence sector, the negative list introduced could be a valuable tool. This list is proposed to be updated yearly in consultation with the Department of Military Affairs (DMA) and could facilitate the participation of micro, small and medium enterprises in Indian defence production. This protection to the domestic industry however comes with the caveat that the weaponry procured by DMA must not fall short of the standards drawn up in the ‘general staff qualitative requirements’.

A catalyst to the effective production by the domestic industry could be facilitation of timely procurement of defence equipment. The FM has announced instituting a mechanism that would be established to ensure ‘time bound defense procurement’. Setting up of a ‘Project Management Unit’ and providing support to the contract management purposes would go a long way in achieving this target of timely procurement.

Further, a separate budgetary provision for domestic defence procurement is proposed coupled with keeping a check on reducing the defence import bill. The introduction of this budgetary provision is expected to encourage domestic manufacture by facilitating them to assess the exclusive government kitty allotted to them. One more reform that is proposed by the FM on the regulatory front is the corporatisation of the OFB. It was however clarified that the move is not aimed at privatising OFB, it would eventually be listed on the stock market to improve transparency.

There is no doubt that these measures announced by the FM will provide a much-needed fillip to an industry which has historically been plagued by policy paralysis. However, the immediate step that the industry could now expect is a much-needed revision of the DPP in line with the changes suggested by the FM. A smooth and time-bound procurement policy will go a long way in boosting FDI in the defence sector.

Further, the Ministry of Defence (MoD) and the Department for Promotion of Industry and Internal Trade (DPIIT) take a contradictory view in the computation methodology followed by them for considering indirect foreign investment while calculating the 49% foreign shareholding in an investee company intending to engage in defence production. Whereas the DPIIT in FDI Policy 2017 provide for a percentage-based calculation of indirect foreign investment in the defence sector, in which at least 51% of the shareholding in the company would have to be held by an Indian individual or company (or group companies) which would in turn need to have at least 51% Indian shareholding. However, the MoD in its guidelines for ‘Revitalizing Defense Industrial Ecosystem through Strategic Partnerships’ (MoD Guidelines) provide for a proportionate system of indirect foreign investment calculation, in which if the majority Indian shareholder of an investee company has even a minority foreign shareholder, such foreign shareholding will be proportionately counted towards the total foreign investment in the investee company. Any such inadvertent discrepancy leads to confusion in the market and specific care should be taken to synchronize the change in law between various departments which would result from the FDI limit increase.

Another issue which would need addressing is the restrictive definition of an ‘Indian vendor’ under the existing DPP and MoD Guidelines, which need to be entities which are owned and controlled by resident Indian companies or individuals. This effectively means that the 51% Indian shareholding in an investee company will need to be held by a single resident Indian individual or Indian company (or group companies). Such rules prevent companies formed as joint ventures to participate in MoD requests for quotation and requests for proposal. It is worthwhile to note that the draft DPP 2020 does provide for a new category under the head of Buy (Global – Manufacture in India), which seems to allow foreign manufacturers to set up an Indian subsidiary to participate in the manufacturing and maintenance procurement processes. However, for all practical purposes the draft DPP 2020 continues with the ‘resident Indian’ ownership and control models. We believe that the step to increase FDI limit in the defence sector would be truly successful only if the DPP and the MoD Guidelines are revised and synchronized to accommodate joint venture entities to bid as investee companies.

Lastly, the impact of further relaxation of FDI, the actual commitment of the government in honoring the reforms in the procurement front and the voices from the labor unions against the corporatisation of the OFBs could actually determine how these structural reforms fits in the Indian defence sector’s evolution.

(The authors Atul Pandey and Abhiroop De are Partner and Associate with Khaitan & Co LLP respectively. Views expressed are personal.)

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