FDI in Defence – Revisiting the Conundrum

The defence sector was opened to the private sector and FDI up to 26 per cent through the government route was allowed in the defence industry in 2001. Between then and March 2014, a princely sum of Rs 24.36 crore (US$ 4.94 million) has come as FDI in the defence sector. It does not constitute even 0.01% of the total FDI received by India during this period.

In August 2013, FDI policy was formally relaxed to permit FDI up to 49% on a case to case basis with the approval of the Cabinet Committee on Security (CCS) but this has not resulted in increased inflow of FDI.

One thing is clear. We have not been able to attract FDI in defence, though it is difficult to say whether this is because of the existing cap on FDI, stifling eco-system or both these. It could probably also be because of some other factors. Should this worry us?

Do we need FDI in defence?

Those opposed to the idea of higher FDI in defence would argue that this is no cause for concern as there is no dearth of capital in the Indian hands. That may well be true to some extent (it is doubtful if the entire private sector, including the MSMEs , is flushed with funds) but there is little evidence of that capital being invested in a big way in defence, with some notable exceptions, for coming up with import substitutes. We continue to import even extreme cold climate clothing.

Had that been the case, we would have seen the private sector coming up in a big way. Consequently, there would have been a significant decrease in our reliance on import of defence equipment over the past 13 years since the defence sector was opened to the private sector.

It is possible that this has not happened because the Indian industry too is discouraged by the eco factors that account for India figuring so embarrassingly low on the global ease-of-doing-business index. It would, therefore, be logical to infer that things will start looking up for the Indian industry once the eco-system becomes conducive to investment, which will also obviate the need for greater FDI inflow.

This is a fair argument but it is not going to be easy to improve the eco-system, which includes such ticklish issues as laws governing labour and acquisition of land. As a part of favourable eco-system, the Indian industry also expects to be assured of the supply order from MoD whenever it makes substantial investment in a project. There may be some merit in this but such a change in the procurement system in unlikely in the near future.

Even if ideal conditions are created immediately, the Indian industry cannot be expected to design and develop state-of-art technologies through indigenous research and development within a short span of time. Developmental projects could take several years, even decades, with no certainty that every project would eventually succeed within the projected timeframe. There are lessons to be learnt from the history of the Defence Research & Development Organization (DRDO) in this regard.

Is there a case for allowing 100% FDI?

The need for fast-tracking modernization drive of the armed forces cannot be overemphasised. Viewed in this context, MoD may be in no position to afford the luxury of waiting for the Indian industry to design and develop some state-of-art product which is required by the armed forces immediately.

In a situation like this, it would be pragmatic to allow 100% FDI, provided it brings in the state-of-art technology for manufacture of the desired product. This cannot be more harmful to the national interest than having to import that product to meet the urgent requirement.

As a sovereign nation, India would also be perfectly within its rights to impose any other conditions, such as employment of Indians at various levels in the unit set up in India, its CEO always being an Indian, lock-in period for investment, and so on.

It is obvious that this dispensation will have to be permitted only in exceptional cases. The areas in which this should be permitted will have to be carefully selected. Some would argue that permitting 100% FDI will not guarantee inflow of state-of-art technologies because of the bar imposed by the national laws of the country of origin. At a time when even the US is keen to offer technologies to India, this is least likely to happen. But, assuming it to be likely, it will mean that, at worst, there will be no inflow of 100% FDI. How are we going to be worse off because of this? What harm will it cause?

On the contrary, if some foreign investor brings in capital without waiting for India to bring about any change in the eco-system, why not seize this opportunity? Why, then, close the option, especially since the inflow can always be regulated?

This also implies that where MoD can afford the luxury of waiting for a period of 10 to 15 years for a new state-of-art product to be developed indigenously, it should rely exclusively on the Indian industry to meet the requirement through indigenous research and development, as envisaged under the ‘Make’ procedure.

Increasing the cap to 49% and permitting 74% FDI

Since it makes no material difference in regard to control over management of an entity whether the FDI is 26% or 49%, the existing cap could be revised to 49% across the board, subject to the permission being accorded through the government route.

In other areas where we need to augment the existing capacities, as in the case of MRO and other engineering services, the cap could be fixed at 74%, subject to transfer of technology by the foreign company to the Indian entity. This should result in fast-tracking of additional capacity creation not just to meet the domestic demand but also to meet the demand from abroad, making the Indian entities a part of the global supply chain.

Will liberalization of the FDI regime be against national interest?

It is argued by some that no country in the world allows FDI – at least not to the extent of 100% – in the strategic sector as it is considered to be against the national interest. This is an awesome argument. But this should not deter us from doing what is right for us. What works for a country which is a member of a strategic alliance or a country with a translucent political system which facilitates reverse engineering with impunity may not work for us and vice-versa.

We need to ask ourselves whether getting the equipment manufactured/integrated here in India will be worse than being dependent entirely on foreign suppliers who manufacture and supply the desired product from abroad. The concern that the wholly-owned subsidiaries may cause trouble in times of war can be addressed through suitable legislation on expropriation of such companies.

Will this kill the domestic industry in India, sound the death knell for indigenization, and make us perpetually dependant on foreign companies? Why should it? Liberalization of the FDI regime does not imply unregulated and wanton inflow of investment. The policy has to be so formulated as to ensure involvement of the Indian industry in research, design and development of futuristic technologies through the ‘Make’ – or some such – procedure with full control over the management of the enterprise involved in such development.

Meanwhile, inflow of FDI in other s areas should be allowed only with a view to hastening the process of indigenization of defence production, transfer of technology, savings in foreign exchange, generation of employment and expansion of the talent pool essential for all greenfield projects.

To make the most of the liberalized regime, MoD must stipulate in all RFPs for new equipment that all up-gradation, life extension and MRO will have to be done in India. It goes without saying that 100% FDI need not be allowed in these areas.

In the ultimate analysis, whether permitting 100% FDI will pay any dividends or undermine the national interest – be it promotion of indigenization through self-reliance or fast-tracking of the modernization programe – will depend on the fine-print of an efficient FDI policy. FDI caps would only be one of the enabling provisions of such a policy.

The concerns of those who are opposed to the idea must be kept in view while evolving the policy as they are as much driven by national interest as those who support it even at the risk of being taunted for being advocates of ‘outsourcing of defence and security’ of the country.

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