FDI in Defence: Some Thoughts

"Why do we need FDI in Defence sector? The first order effect is that Indian Armed Forces get hi-tech weapon capability. It must be capability whose technology we do not possess and are unable to develop or invest in for many reasons..."

FDI in Defence: Some Thoughts

When our Finance Minister announced the raising of Foreign Direct Investment (FDI) limit in the defence sector under the automatic route from 49% to 74%1 it was reported as a ‘big push’ for Make in India. It was simultaneously reported that it will encourage multinationals to set up manufacturing bases in India or acquire local companies but will hit hard the local companies who do not have any access to technology or government orders. Almost one month has passed and the only sound is of silence on this front. Even defence experts have not discussed this issue. Hence it needs some discussion.

Why do we need FDI in Defence sector? The first order effect is that Indian Armed Forces get hi-tech weapon capability. It must be capability whose technology we do not possess and are unable to develop or invest in for many reasons. The second order effect is that such investment will bring in technologies that will proliferate into other sectors or create a holistic ecosystem as part of a defence industrial complex resulting in some exports after reducing imports.

The third order effect is that it creates jobs and supply chain spin offs. The third order effect is especially important in the long term - employing security guards, janitors, renting an office, setting up nice interiors, creating blue collar jobs, senior executives etc. It is just what the doctor ordered for Indiain a post pandemic scenario.

Let us see things in a wider perspective. Way back in 2001, participation in Defence was opened to private sector in which upto 26% FDI was permitted. The policy was liberalized later. The Make in India portal of DDP reads “Foreign Direct Investment Cap is 100%. Foreign Direct Investment up to 49% is allowed through automatic route and above 49% under government route wherever it is likely to result in access to modern technology or for other reasons to be recorded”.2 Now the cap has been hiked to 74%.

Traditionally FDI has been coming into Services, Automobiles and Chemicals3. That is simply because gestation periods are low, technology levels are low, and business cases have short time loops. ‘Return on Investment’ (ROI) is visible. In the Defence sector, many proposals were received, approved and licenses also given for manufacture of weapons and equipment.

However, on ground there has been no serious investment and defense majors are conspicuous by their absence. Two industrial corridors were announced. After the initial euphoria, these corridors are nowhere near taking off. Now with the hike in FDI cap to 74%, it is presumed that investment will flow in and these corridors will start functioning. It is also hoped that if the FDI cap is hiked then it will attract those OEMs to India who want to relocate from China.

In the absence of any informed discussion on this issue, some ‘all-knowing desk man’ will frame some rules and publish them with fanfare. I have no issues. However, if FDI does not come in for a green field venture and FDI comes in only to divest us eventually, of the technology and capacity we have, then I think it warrants a discussion. Let us see the issues involved.

The first question which pops up is that in the absence of any significant FDI so far, are we reinforcing failure? Any FDI will be based on ROI. In defence sector investments, there will invariably be a geopolitical angle. If it is a Government to Government deal with OEMs involved, then it is a different matter altogether and openly welcome. That has probably not been the case or intent. If it is so, it is not in public view. In case of an MNC /OEM investment coming on its own, it will look at a possible order. In our case no order can be assured.

If it is assured then there are severe problems of probity and it is a ‘no go’ from the scratch. In case of a competitive procurement then the time frames and vagaries of procurement inhibit any kind of green field investment. So look at it anyway. No one will come here and set up a facility unless India buys that equipment in volumes or on a long-term basis in the first place. Export is a later day phenomenon.

The likelihood of an OEM investing in the defence sector in India and parting with technology is consequently quite remote. Hence, while a 74% stake may reassure OEMs, there is no doubt in my mind that unless there is a Government to Government understanding and deal, there is no way this reform will succeed. Alternately, this should have been factored and vectored into the ‘Request For Proposal’ itself initially. Hence FDI rules must be framed accordingly. The MOD needs to enable FDI coming in. Mere raising the FDI cap might not work.

The easier route for an OEM/ MNC to enter the Defence Sector in India is to acquire stake in an existing Indian Entity. The chances of taking over an Indian defence major are quite remote. Even a hostile takeover is not likely since the order book of India Defence Industry is not that healthy in the first place. Hence the best-case scenarios will be to take over a MSME or a Start Up.

Taking over an existing MSME has huge risks for India. There are chances that some of these companies might suffer the same fate as our telecom/electronics sector to end up being part / sidelined/ insignificant players. More importantly, there might be a disruption in own supply chains to affect our defence preparedness. There could be security risks also. The worst-case scenario would be that an OEM who has been awarded a contract could use an acquired MSME/ Indian Entity for offset execution only.

That means round tripping on offsets legally facilitated by FDI rules. Alternately, an OEM/MNC could invest in a Start Up as part of venture capitalism. As is well known, each Start Up will have one technology on which it focuses. If a start up with a successful / promising product is taken over, that technology is lost to us. Further scaling up in India is a problem due to our intricate tax laws.

The chances that the Start Up, now taken over through increased FDI norms; might see its technology leaving Indian Shores for good is extremely high. We will be forced to buy it back later at cost multiples. Hence, the rules which are framed need to ensure that FDI route is not exploited to our detriment.

Of course FDI in defence should not be a Hot/ Chinese money conduit. That will be the worst-case scenario. Hence, I do hope some verification and transparency norms are put in to uncover shell companies, fronts, and such subterfuges. As a thumb rule, we should be clear of the credentials of the company, technology that is coming in and the end effect of the enhanced FDI.

MOD must have its foot on the pedal, hands on the wheel and clearly see the road ahead before it starts driving on this path. Most importantly, rules and regulations must be framed accordingly. India needs this reform to succeed.

(This article first appeared in the 'Vivekananda International Foundation' and has been reproduced with due permission from the author. Views expressed are the authors own, and do not reflect the editorial policy of 'Mission Victory India')

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