FDI in Defence: Making the Most of the Status Quo

The Ministry of Defence (MoD) has yet again rejected the idea of increasing the cap on Foreign Direct Investment (FDI) in defence beyond the present cap of 26 per cent. It puts paid to the proposal floated by the Ministry of Commerce to increase the cap to 74 per cent, though a committee, headed by the Secretary Economic Affairs, had recommended a more modest increase from 26 per cent to 49 percent.

It seems that the MoD is of the view that allowing foreign companies to set up manufacturing and assembling facilities in India will stymie the growth of indigenous design and development activities and perpetuate our dependence on the foreign original equipment manufacturers (OEMs) for modern weapons. This argument presupposes that indigenous design and development activities have been flourishing, or have started looking up, even under the existing restrictive FDI regime and that any relaxation in the FDI cap will adversely affect these activities.

This presupposition is at odds with the ground reality. The allocation for capital acquisitions had been growing significantly in the last ten to fifteen years, opening up good opportunities for the Indian private industry but there have not been many significant indigenous breakthroughs in research, design and development of new equipment and weapon systems. In fact, India has now become the largest importer of the defence wares. This suggests that either the industry does not have the financial capacity to invest in research, design and development or it has the capital but it is unwilling to invest because of some other reasons.

If it is because of the financial incapacity, the case for relaxing the present limitation and making it more attractive for the foreign investors to bring in the investment would be quite strong. But, the Indian private industry is not really complaining about the paucity of funds. Therefore, the only inference one can draw is that some ‘other reasons’ are holding it back from investing in developmental projects. What could these ‘other reasons’ be?

Design and Development projects usually entail a long gestation period and there is an inherent risk of failure. Therefore, no one would run the risk of making heavy investment in such projects unless there is clarity about the products required to be developed indigenously, there are incentives for making such investments, there is some mechanism to mitigate the risks and there is an assured market for the product developed through this process.

The Technology Perspective and Capability Roadmap 2013 released by the MoD in June 2013 aims at making the future requirements of the armed forces known to the industry in terms of the technologies and capabilities rather than specific products but the industry might find the information inadequate for the purpose of developing future business plans. There is a need to fine-tune the TPCR on the basis of the feedback from the industry. There is also a need to consider incentives and mitigating the risk involved in making investment in research, design and development. The incentives could come in the form of making it easy for the investors to undertake such projects and tax breaks. The risk mitigation could come in the form of substantial funding of such projects by the government, but with an exit clause.

These are comparatively easy steps; the difficult part is assuring a market for the product. It assumes a greater significance where the anticipated demand of the armed forces is not enough to make a project commercially viable. This calls for formulation of an export policy.

It is not going to be easy to make an export policy for defence products. Permitting export of dual-use items may not pose much of a dilemma but evolving a policy for permitting export of military hardware/software could be difficult. Discovering potential markets would be an even greater challenge.

In any case, it will take a long, long time for the Indian industry to make products through entirely indigenous research, design and development that would be technologically superior, or even equal, to what the established players in the field have to offer. It is also difficult to second-guess whether the Indian product, even if technologically comparable with the best in the world, will have an edge over products offered by foreign OEMs, in terms of price.

Assuming that the information contained in the TPCR is enough for the Indian industry to start planning future projects, funding of such projects could be an issue. Presently, there are no schemes for funding of such projects and there are no tax breaks or other incentives. (The provision for funding of ‘Make’ projects by the government to the extent of 80 per cent would not cover green field research, design and development projects, unrelated to any specific demand of the armed forces.)

The Press Reports suggest that the MOD would be willing to relax the FDI cap with the approval of the Cabinet Committee on Security (CCS) on a case-to-case basis if it results in access to the state-of-the-art technology from the foreign companies. But, if the past experience is any guide, this is unlikely to happen, primarily because of lack of clarity on the policy front. For example, would the MoD be willing to relax the FDI cap if the foreign vendor wants to set up a wholly owned subsidiary for absorbing the technology? Many such issues are likely to come up. A comprehensive policy needs to be evolved for relaxation of the FDI cap for the sake of transparency, rather than the decision being taken on a case-to-case basis.

The foreign direct investment is not just a simple transfer of capital. It could bring along with it technology, spawn economic activity in the country, generate employment and create a pool of skilled manpower. These are the very resources that are required to kick start indigenous green field research, design and development projects.

In the short run, dependence on joint ventures set up in India with FDI that is higher than the existing limit of 26 per cent cannot be more harmful and risky than dependence on imports. If nothing else, it will save precious foreign exchange. If higher limits of FDI in other fields have not stymied the growth of the indigenous industry in those areas, it is unlikely that the impact of increasing the FDI cap would be very different for the defence industry.

But this is not a plea for increasing the FDI in defence. The argument essentially is that some of the scepticism about relaxing the FDI cap, as well as the expectation that higher FDI would cure all ills besetting the Indian defence industry, might be misplaced. If the defence needs are to be met through indigenous production by the private industry, increasing the FDI cap may not be as material as the need to address other concerns such as those related to licensing, taxation, incentives, funding, assured market, exports – just to name a few.

Views expressed are of the author and do not necessarily reflect the views of the IDSA or of the Government of India.