May, 12

DEFENCE SECTOR 2009

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Mahesh Babaria
maheshb@ghallabhansali.com
Mittal Dharod
mittald@ghallabhansali.com
Overview
India has a land frontier of 15,200km, a coastline of 7,516.6 km and an
exclusive economic zone of 2.2 million sq km, as well as island territories, vital
offshore installations and airspace to defend. The armed forces, therefore,
have to be kept prepared and well equipped to repel any external threat. India
is also a major participant in international peacekeeping missions with the
UN, sending its troops into conflict zones around the world.
A nation’s military strength is determined by its economic might.
Industry provides the military with the wherewithal to fight the nation’s wars.
Since independence the policy relating to Strategic Defence Production has
been evolving. For too long, India depended on foreign industries for its
military hardware. The desire to achieve self-reliance has always been there.
Constraints of technology and resources prevented the process from
fructifying to the extent desired. The first phase, was characterized by the
State led industrialization. Since the era of liberalization, which began in 1991,
the role of private sector and also that of competition, both domestic and
international is playing a much greater role in the national economy.
Naturally, this also meant changes in policy for Defence production.
Production of defence equipment has been under the purview of
Government right from its inception. The Industrial Policy of the country had
kept defence production in the public sector since First Industrial Policy
outlined in the Industry Policy Resolution of 1948. The Industries
(Development & Regulation) Act, 1951 gave statutory base to the Industrial
Policy. Under this policy, the Defence Industry, which required heavy
investments, strong R&D backing and on which there could be total reliance
because of its criticality, remained under Government Control at all times. The
control over defence industry was exercised under the Industries
(Development & Regulation) Act, 1951, which made licensing compulsory. As
a consequence of the then industrial policy, a large infrastructure for
Defence production consisting of 39 Ordnance Factories, 8 Defence PSUs
and 50 Research & Development laboratories was created in the country.
the Private Sector has been playing significant role in the Defence
industry sector as sub contractors and ancillary industry. The private sector
mainly has been involved in supply of raw materials, semi-finished products,
parts and components to Defence PSUs and Ordnance Factories to a great
extent and also to Base Workshops of Army and Base Repair Depots of Air
Force and the Dockyards of the Navy. Defence PSUs and Ordnance Factories
are outsourcing their requirements from private sector (mainly SMEs) in the
range of 20-25%. Out of this outsourcing, about 25% requirement is met
through small-scale sector.

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Several hi-tech equipments have also been successfully produced by

the private sector. In the quest for self-reliance in the crucial sector of defence,
the Government has been continuing its efforts to indigenize defence
equipment wherever technologically feasible and economically viable. It has
been a part of indigenization efforts to locate and develop broad-based
indigenous supply source – both in the public sector and in the civil trade for
many complicated and intricate equipments.
The economic liberalization in 1991 resulted in the high degree of
deregulation and allowed the private industry to progress more rapidly. With
the initial difficulties encountered by the Indian Industry today one has
witnessed positive impact of this liberalization. There has been tremendous
growth in the private sector and today many Indian companies are global
players.
After considering the capital intensive nature of defence industry sector
as also the need to infuse foreign technology and additional capital including
FDI, Govt. decided in May, 2001 to open Defence industry for private sector
participation up to 100% with FDI permissible up to 26% - both subject to
licensing. Now with this policy change all defence related items have been
removed from Reserved Category and transferred to the licensed category, as
a result of which private sector can manufacture all types of defence
equipment after getting a licence. Consequent to the Government’s
announcement about the policy change, Department of Industrial Policy &
Promotion (DIPP) in consultation with Ministry of Defence, issued detailed
guidelines regarding the modalities for consideration of applications for grant
of Industrial Licence. After the announcement of policy changes, there has
been a paradigm shift in the role of private sector in the field of indigenisation,
i.e., from the role of supplier of raw materials, components, sub-systems, they
have now become partners in the manufacture of complete advanced
equipment/system. The basic objective of allowing private sector participation
is to harness available expertise in the private sector towards the total defence
efforts and search for self-reliance. In-built advantages of the private sector are
its reservoir of management, scientific and technological skills coupled with
its ability to raise resources. The involvement of private sector with its world-
class expertise and high technology would not only augment India’s
indigenous defence production capability but also lead to creation of
employment and infrastructure in the country, giving a strong impetus to the
economy. It must be acknowledged that the policy change of May 2001 for
allowing private industry to produce any defence item under licence was a
logical outcome of liberalization initiated in India in 1991. The private sector
industry in India is now just beginning to become significant partner in
production and development of Defence items.

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DEFENCE INFRASTRUCTURE
Ordnance factories
India’s 39 ordnance factories (OFs) are government units producing
armaments under five categories:
• Ammunition and explosives;
• Weapons;
• Vehicles and equipment;
• Armored vehicles; and
• Ordnance equipment (other military supplies, including general
stores).
They were built to meet the growing needs of India’s armed forces over the
past 60 years.

Defence public sector undertakings

The eight defence public sector undertakings (PSUs) are public-sector
corporations managed by the Indian government. They are:
• Bharat Dynamics Ltd;
• Bharat Earth Movers Ltd;
• Bharat Electronics Ltd;
• Hindustan Aeronautics Ltd;
• Garden Reach Shipbuilders and Engineers Ltd;
• Goa Shipyard Ltd;
• Mazagon Dock Ltd; and
• Mishra Dhatu Nigam Ltd.
The defence PSUs produce a range of defence equipment. They also provide
overhaul and maintenance facilities.

Defence research and development

India also has a defence research and development (R&D)capability:
the Defence Research and Development Organisation (DRDO). The DRDO
draws on the work of the 50 R&D laboratories/establishments.

Defence spending
India is among the world’s top ten countries in terms of defence
expenditure and it is the third-largest importer of defence hardware. Indian
defence procurements include strategic defence capabilities on land, sea and
air.

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World’s top ten countries in terms of defence expenditure

Rank Country Military expenditures (USD)

1 United States 651,163,000,000

2 People's Republic of China 70,242,645,000

3 France 61,571,330,000
4 United Kingdom 56,889,000,000
5 Japan 48,860,000,000
6 Germany 45,930,000,000
7 Italy 40,050,000,000
8 Russian Federation 39,600,000,000
9 India 32,700,000,000
10 Saudi Arabia 31,050,000,000

List of countries by size of armed forces

Rank
Active troops
by number of Country Tanks NS S Air Nu
(thousands)
active troops

1. People's Republic of China 2,250 7,580 8 55 1,700 200

2. United States of America 1,452 7,821 71 14 2,604 9,200

3. India 1,325 5,000 0 16 706 45-100

4. Russian Federation 1,245 22,800 40 20 1,600 16,800

Democratic People's Republic of

5. 1,106 3,500 78 400 0
Korea

6. Republic of Korea 687 2,300 0 11 388 0

7. Pakistan 650 2,451 0 8 530 55-90

8. Turkey 617 4,205 14 900+ 0
9. Iran 545 1,800 3 180 0
10. Vietnam 484 1,829 2 459 0
*NS – Nuclear Powered Submarine Air – Fighter Aircraft
S - Submarine Nu – Nuclear Weapons

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India’s Defence Budget 2009-10

In its interim budget for 2009-10 the Union Government has allocated
Rs. 1,41,703 crores for the country’ Defence Services that include three Armed
Forces (i.e., the Army, the Navy and the Air Force), and other Departments,
primarily Defence Research and Development Organisation (DRDO) and
Defence Ordnance Factories. This is apart from Rs. 24,960 crores which have
been earmarked to defray civil expenditures of Ministry of Defence (MoD)
and its affiliated organisations, including, the Coast Guard, and for defence
pension (Rs. 21,790 crores). In other words, the total resource available for the
MoD and its various establishments is Rs. 1,66,663 crores. By convention, only
budgetary provisions for the Defence Services constitute India’s defence
budget.
Though the allocations made in the interim budget are not binding for
the next government to follow, it is unlikely that the new government will
make any major changes in the allocation, given the mandatory increases in
certain components of the defence budget, the worsening security situation in
the country’s neighbourhood and the gap in the country’s defence
preparedness. This commentary examines the various components of the
defence budget, analyses the impact of the budget on the modernisation
requirements of the Armed Forces, and the problem of under-utilisation of
resources under the capital head.

Vital Components
The defence budget for 2009-10 has increased by 34.19 per cent over the
previous year’s budget estimate (BE) of Rs. 1,05,600 crores. However, BE of
2008-09 has been scaled upward by 8.52 per cent (Rs. 9,000 crores) to Rs.
1,14,600 crores at the revised estimate (RE) stage. This means, this year’s
allocations has increased by 23.65 per cent over the RE of 2008-09. Of the total
defence budget, revenue expenditure, which caters to the ‘running’ or
‘operating’ expenditure of the three Services and other departments, is pegged
at Rs. 86,879 crores. Capital expenditure, which mostly caters for
modernisation requirements, accounts for Rs. 54,824 crores. Of these two,
revenue expenditure has been increased - in comparison to its last year’s
growth of less than 7 per cent - at a much faster rate of 50.85 per cent (Rs. 29,
286 crores). The growth of capital expenditure has however declined, over the
previous year’s growth, to 14.20 per cent (Rs. 6,817 crores). The sharp rise in
revenue expenditure has taken its share in the defence budget to 61.31 per
cent, from 54.54 per cent a year before. In other words, the share of capital
expenditure has gone down by nearly 7 percentage points in these two years.

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Key Statistics of Defence Budgets, 2008-09 and 2009-10

2008-09 2009-10

Defence Budget (Rs. in crores) 1,05,600 1,41,703

Growth of Defence Budget (%) 10.00 34.19
Revenue Expenditure (Rs in crores) 57,593 86,879
54.54 61.31
Share of Revenue Expenditure in Defence Budget (%)

Growth of Revenue Expenditure (%) 6.50 50.85

Capital Expenditure (Rs. in crores) 48,007 54,824
45.46 38.69
Share of Capital Expenditure in Defence Budget (%)

Growth of Capital Expenditure (%) 14.51 14.20

The faster growth of revenue expenditure is primarily due to the hefty

increase in pay and allowances flowing from the implementation of Sixth
Central Pay Commission (CPC). To put the figure in perspective, total
budgeted pay and allowances debited from the Services’ budgets has more
than doubled from 21,891.67 crores in 2008-09 to Rs. 44,500.69 crores in 2009-
10.

Impact on Modernisation
The Indian Armed Forces are on a modernisation drive. The shopping
list of the Services includes virtually all types of weapons and systems,
including big-guns, fighter aircrafts, armoured vehicles, radars, missiles, naval
vessels, among others. The most pertinent question is whether the latest
budget makes necessary provisions to meet these requirements. Given the fact
that the modernisation programme of the armed forces largely depends on
capital acquisitions, it boils down to how capital budget is allocated.

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Assuming that nearly 80 per cent of the capital budget is meant for
capital acquisitions, the latter consisting of 60 per cent of committed liabilities
and 40 per cent of new schemes, the main sub-divisions of the capital budget
are as below:
• Total Capital Budget: Rs. 54,824 crores
• Capital Acquisition: Rs. 43,859 crores
• Committed Liabilities: Rs.26,316 crores
• New Schemes: Rs.17,544 crores
From the above, it is evident that a substantial amount will be available for
capital procurement. Moreover, over Rs. 17,500 crores (nearly 30 per cent of
the capital budget) will be available for new weapons and systems that the
Armed Forces have planned for induction. While this augurs well from the
modernisation point of view, much depends on how much and how the
resources are spent in the coming fiscal.

Higher Allocation and Under-utilisation of Resources

The growth of over 34 per cent in India’s defence budget is one of the
highest in the country’s history of defence spending (the last time the defence
budget was increased by over 30 per cent was in 1987-88 when allocation was
increased by 43.4 per cent to Rs. 12,512 cores). In the recent past, the defence
budget, despite registering modest growth rates, has been subjected to
criticism in view of its declining shares in total central government
expenditure and gross domestic product. In fact, the defence budget had
decreased to below two per cent of GDP in the last fiscal year. The new
budget, defying all criticism, has made a substantial increase in allocations.
From the perspective of resources allocation, the defence budget for 2009-10
represents 14.87 per cent of total central government expenditure, and 2.35 per
cent of gross domestic product (GDP). The corresponding figures for 2008-09
are 14.06 per cent and 1.95 per cent respectively.

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However, accompanying the growth in defence budget is the problem

of utilisation of resources under the capital head. As the latest budget reveals,
the budgeted capital expenditure for 2008-09 has decreased by Rs. 7,007 crores
(15 per cent) from Rs. 48, 007 crores to Rs. 41,000 crores at the RE stage. Its
implication is also seen in the wide variation in the growth of the capital
budget. If the defence establishments had fully spent the entire 2008-09 capital
budget, the 2009-10 capital expenditure would have seen only 14.2 per cent
growth instead of 33.72 per cent rise (Rs. 13,824 crores) that has been
registered over the previous year’s RE.

Government Control
Production of defence equipment has always been under the purview
of the government. India has kept defence production in the public sector
since its first industrial policy, outlined in the Industry Policy Resolution of
1948. The Industries (Development & Regulation) Act 1951 gave statutory base
to that policy. As a consequence, a large infrastructure for defence production
was created in India.

Limited Private Sector Involvement

The private sector has played a significant role in the defence industry as sub-
contractors and ancillary industry, although until recently its participation
was largely restricted to the supply of raw materials, semi-finished products,
parts and components to:
• defence PSUs;
• OFs;
• the base workshops of the army;
• the base repair depots of the airforce; and
• the dockyards of the navy.

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Opening Up The Defence Sector

In its quest for self-reliance in the crucial sector of defence, the Indian
government has been continuing its efforts to indigenise the production of
defence equipment wherever technologically feasible and economically viable.
It originally planned to source 70% of its defence requirements from
indigenous suppliers by 2010. In May 2001, the Indian government decided to
open the defence industry for private sector participation up to 100%om of
equity, with foreign direct investment (FDI) permissible up to 26%. Both were
subject to licensing restrictions. Following the policy change, all defence-
related items have been removed from government’s reserved category and
transferred to the licensed category. As a result, the private sector can now
manufacture all types of defence equipment after obtaining a government
licence.

India Offset Policy Attract Global Attention

The overwhelming presence of the foreign stamp on the final product is
not changing—not just yet. However, the ‘Made In India’ stamp on what goes
into the final product is set to see a manifold increase. The trigger for this
change is the fleshing out, in August, of a clause introduced in the Defence
Procurement Policy 2002: the ‘offset clause’. Under this clause, all companies
that get a defence contract of above Rs 300 crore from the Indian government
will have to bring back 30% of the contract value into the country, either by
way of purchases or as investments in the sector.
China, which is tipped to see the biggest increase in defence spending
in the next 10 years, has a 100% offset clause. India has given the offset clause
a new twist—unlike most governments, it has specified the plough back can
only be in the defence sector.
The ramifications for India Inc are significant, bigger than anything that
has happened so far. In the short- to medium-term, foreign defence
manufacturers and their vendors will start or step up their purchases from
Indian vendors to meet the 30% requirement. This will build an ecosystem. If
Indian companies are able to deliver good quality at low cost, foreign defence
manufacturers could set up facilities in the country and even Indian
companies can think of making top-of-the-line defence equipment.The
opportunity unfolding for Indian companies is huge. Between now and 2012,
India needs to spend $100 billion. At 30% offset, that’s a plough back of $30
billion (Rs 1,50,000 crore) into the Indian defence industry.

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Recent News
• MKU Pvt Ltd., a manufacturer and exporter of armored solutions in
Asia and one of the biggest suppliers to the Indian forces, has bagged
the prestigious contract of armoring the high speed patrol boats from
Goa Shipyard and Garden Reach Shipyard and Builders for Ministry of
Home Affairs, India with an fleet of 186 boats worth US $ 35 m.
• Mahindra Defence Systems (MDS), one of India’s leading providers of
special light military vehicles, inaugurated the Mahindra Special
Military Vehicles (MSMV) facility at Prithla in Faridabad. Spread across
six acres, this modern plant has facilities for specific military
manufacturing applications. Aside from manufacturing, the plant also
has an advanced facility for R&D, product development, design and
prototyping of special vehicles to meet specific customer requirements.
• Larsen & Toubro announced the formation of a JV company with EADS
Defence & Security to develop and manufacture defence electronics
products including radars, avionics, electronic warfare in India to cater
to domestic and overseas markets. The venture, which is awaiting
clearances from the Government, would target to clock Rs 2,000-2,500
cr revenue in 5-7 years. The JV would be based at Talegaon in Pune,
where the engineering major has an existing facility, and will invest Rs
100 crore to start with which would go up as per the requirements.

Conclusion
India is forging a reputation as a manufacturing hub for world
corporations wanting to exploit the sector’s proven skills in product design,
reconfiguration and customisation with creativity and assured quality. With
its defence sector now more accessible for foreign investment, India is poised
to become a key outsourcing hub for global defence majors.
The Indian government is fully committed to the development of a
vibrant and proactive defence industry. Its objective is to ensure that the
resources, capabilities and infrastructure, including intellectual capital,
available both in the public and private sector are treated as national assets
and harnessed to the fullest extent.
For a foreign company, the benefits are twofold. On the one hand,
equity investment in an Indian defence company will appreciate rapidly,
while on the other, the Indian company can act as a manufacturing base to
supply high-quality components in a cost-effective manner. A strong and
healthy partnership between the public and private sector will be critical in
delivering the defence capability the country needs and in sustaining a
powerful domestic industrial base for the future.

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Company Prospects

Bharat Electronics Ltd.

L&T

Astra Microwave Products Ltd.

NELCO

BEML

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Information Source:
Wikipedia
IDSA
CII Defence
Business Outlook

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