Column: Firing up India’s defence production

Bold steps like increasing FDI levels to 74%, or even 100%, are needed

The Indian aerospace and defence (A&D) market is among the most attractive globally and the government is keen to leverage this in order to promote investments and build an indigenous manufacturing base in India. Though the sector was opened for private, domestic and foreign investment more than 12 years ago, the level of domestic as well as foreign investment has been way below its potential: the sector has managed to attract a meagre of $4.94 million FDI out of the total $234,928 million FDI across all sectors since April 2000. Clearly, the government needs to analyse the reasons for such a poor response.

The A&D value-chain is long and complex and our manufacturing capabilities can at best be described as patchy with small pockets of excellence at many levels, but without comprehensive coverage. As India continues with a massive acquisition programme to provide its armed forces with the latest and best equipment, it is pertinent to ponder over reducing its extreme dependence on imports by building indigenous capabilities across the entire value-chain—from research, design and development to manufacturing, integration, maintenance and repair.

Moreover, this is not a free market. It is a monopsony in which the sole buyer, the government, is also the regulator. Global experience has shown that proactive government support to the private sector is critical for building a domestic defence industrial base.

The new government has clearly stated its goal to promote investment in the defence sector. The current Make-in-India campaign launched by the government is an echo of the defence ministry’s long-cherished aspiration for achieving self-reliance in defence production. Both defence and aerospace are important sectors in the Make-in-India campaign launched by the prime minister.

The change in acquisition procedures with a hierarchy of procurement processes that places the ‘buy Indian’ category at the highest level will provide opportunity for large Indian companies to transform themselves into OEMs. The new government has backed its intent with action by announcing a slew of policy decisions to include increase in FDI  limit and streamlining licensing procedure—many long-pending in order to facilitate investments. It has also recently approved various programmes worth over R1 lakh crore, with almost 70% earmarked for the ‘buy’ category. This provides an attractive opportunity for domestic enterprises. Moreover, the new acquisition procedure will compel OEMs to establish partnerships with private Indian industry. These are welcome steps but not necessarily game changing.

There is a need to streamline policy contradictions for creating synergies and an ecosystem that stimulates investments in building domestic capabilities across the entire supply-chain. While the macro policies enabling private investment were mostly in place, there have been a large number of micro policies and interpretation and implementation issues that have acted as deterrent to both the domestic as well as foreign industry. For example, while the Offset policy stipulates that an Indian company is eligible to be an Offset Partner (IOP) if it satisfies the Industrial Licencing (IL) and FDI policies, the defence minstry disallows companies that have more than 26% FDI even if the product being bought by the OPEM does not require an IL and has no FDI cap. And the recent increase of FDI up to 49% in defence manufacturing might not
result in substantial inflows of either technology or investments.

Building an industrial base requires proactive support of the government in building a facilitative ecosystem: in funding R&D, creating a low-interest regime to bring down capital costs, addressing the disadvantages of exchange rate fluctuations, providing stability and assurance in policy and orders, correcting the inverted duty structure that discourages domestic value addition, and encouraging exports to achieve economies of scale and become globally competitive. The government needs to take both the small steps as well as some bold decisions like increasing the FDI cap to 74% or even 100% and should strive to make Indian industry an integral part of the global aerospace and defence supply chain.

The government also needs to create policies that will enable creation of MSME clusters to integrate dispersed MSMEs into the supply chains of major programmes right from the word go. Cluster frameworks and consortia biddings can resolve key issues faced by MSMEs. The high cost of capital and business makes MSME players risk-averse and affect their ability to build innovative technologies.

The move to liberalise this sector is clearly a step in the right direction. Laudable as government initiatives to promote investments are, it must be borne in mind that domestic capability cannot be built merely by issuing RFPs to Indian companies. Building a defence ecosystem requires a change in mind set of the government, the international OEM community, Indian industrial giants as well as the Indian MSME sector. Most important, private companies need firm orders in hand with visibility/assurance of future orders for them to make investments on the ground.

It would be worthwhile to consider developing up to two companies as OEMs (one or both private and the other DPSU) for the major platforms and give them firm purchase orders in say a 60:40 basis to the L1 and L2 on L1 rates (this is already being done by MoD for some equipment) so that they can make the investments and build their supply chains. This way there would be both price discovery and stability of orders.

There are multiple areas that need attention such as funding, R&D, taxation, protection of intellectual property, foreign investment and collaboration, the import and export regimes. There is need for a comprehensive review of all of these to create synergies rather than contradictions, and an ecosystem that stimulates investments in building domestic capabilities across the entire defence supply-chain.

By Dhiraj Mathur
The author is Partner and Leader Aerospace and Defence, PwC India

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