FOREIGN DIRECT INVESTMENT IN DEFENCE SECTOR IN INDIA

PALLAV PALIT STUDENT 3RD YEAR NATIONAL LAW UNIVERSITY, LUCKNOW 23 JUNE 2011

INTRODUCTION
India ranks among the top ten nations in the world in terms of defence expenditure. It is one the largest importers of defence equipment. India has emerged as the world's largest arms importer overtaking China which shared the second spot with South Korea followed by Pakistan.1 Indias defence budget has grown 13.4% since 2006-07 to touch Rs1.5 trillion in 2010-11. The production of defence industry has been under the purview of the government since the First Industrial Policy outlined in the Industry Policy Resolution of 1948. The Industrial Policy Resolution, 1948, restricted the entry of the private sector into this industry. The main reason for keeping such a strong control and regulation by the government over the defence industry is because of its strategic and critical nature. Owing to such industrial policy of the government, the country depended mainly on import of defence equipment from other countries. According to estimates, nearly 70% of Indias defence requirements are met through imports, with only 30% being met through domestic production. 2 Even after being among the nations with the largest defence budgets, it fails to possess a state of art defence preparedness. The defence equipment of the country is vintage and needs replacement. The indigenous R&D has not kept pace with the requirements of present day warfare and manufacture through transfer of technology to Public Sector Units and Ordnance Factories has proved to be an ineffective and slow process. The landmark change in the governments policy on participation of private sector and influx of Foreign Direct Investment (FDI) in defence sector came into force in May, 2001 vide Press Note 4 of 2001 Series, where the government amended its policy on absolute restriction on participation of private sector in defence industry and permitted 100% for Indian private sector participation, with FDI permissible up to 26%, both subject to licensing and Government approval. Subsequently, the Department of Industrial Policy and Promotion (DIPP) issued detailed guidelines, after consultations with the Ministry of Defence , for the issuance of license for the production of arms and ammunition in January 2002 (Press Note 2 of 2002 Series). The change in the policy was primarily directed toward the idea of establishing an indigenous defence industry through the participation and contribution of private sector companies and foreign companies.

Stockholm International Peace Research Institute (SIPRI) Report, March, 2011 Enhancing the role of SMEs in Indian defence industry-report by Ernst & Young and CII-2009

Need for FDI in defence sector

FDI is not just a question of getting funds, but access to the latest technologies. FDI pre-supposes a long term commitment and lasting relationship between the foreign and local enterprise. FDI sets in motion a chain reaction wherein FDI upgrades local technology which, in turn, attracts more FDI with higher technology and the cycle goes on. This is of vital importance to the defence sector which is highly capital intensive and undergoes rapid obsolescence of technology. The collaborations of public sector utilities or private sector companies with the foreign companies will lead to growth of cut throat competition in the industry, leading to production of state of art defence equipment. The major problem in the indigenous defence manufacturing units in india is the lack of adequate technology needed for repair, modernization or upgrade of the equipment. The introduction of foreign giants in defence manufacture will tackle such drawbacks with ease. Other than the increased ow of funds from a foreign source, greater FDI leads to more employment opportunities for the local population. It also means that taxes and other revenues will ow back to the local economy. A large share of Indian foreign exchange goes towards defence purchases. Allowing more FDI in defence would result in significant savings in foreign exchange, as more foreign companies will establish defence industries in India. Thus, the introduction of FDI will lead to more efficient, indigenous and self-reliant defence sector, capable of producing high standard modern weapons of warfare.

FDI regulations in defence sector

RBI has issued Foreign Exchange Management (Transfer or issue of security by a person resident outside India) Regulations, 2000 (hereafter referred to as the FEM Regulations, 2000) Section 5 of the FEM Regulations, 2000 provides that a person resident outside India (other than a citizen of Bangladesh or Pakistan or Sri Lanka) or an entity outside India, whether incorporated or not, (other than an entity in Bangladesh or Pakistan) , may purchase shares or convertible debentures of an Indian company under Foreign Direct Investment Scheme, subject to the terms and conditions specified in Schedule 1 of the FEM Regulations, 2000.

Schedule I of the FEM Regulations, 2000, provides that a person resident outside India may purchase equity/preference/convertible preference shares and convertible debentures issued by an Indian company, via two routes 1. Automatic Route FDI in sectors/activities to the extent permitted under automatic route does not require any prior approval either by the Government or RBI. 2. Government/ Foreign Investment Promotion Board(FIPB) route Under the Government Route, the non-resident investor or the Indian company requires a prior approval of the Government of India through Foreign Investment Promotion Board (FIPB) for investment in India. Clause 3 of Schedule I lays down the procedure of issue of shares by a company requiring government approval. This clause makes it mandatory for defence and strategic industries to secure prior approval of the Foreign Investment Promotion Board of the Government of India in order to issue shares to a person resident outside India. Further, approval of foreign direct investment into the defence industry of India can be received from FIPB subject to industrial licensing. The Industries (Development & Regulation) Act, 1951, makes it compulsory for the defence industry to acquire an Industrial License. The application for industrial license is considered and issued by the Department of Industrial Policy & Promotion, Ministry of Commerce & Industry, in consultation with Ministry of Defence. There are certain specific conditions provided in the Consolidated FDI Policy for grant of industrial license. The conditions are enumerated as follows(1) The applicant should be an Indian company / partnership firm. (2) The management of the Applicant Company / partnership should be in Indian hands with majority representation on the Board as well as the Chief Executives of the company/ partnership firm being resident Indians. (3) The full particulars of the Directors and the Chief Executives should be furnished along with the applications (3) There would be a three-year lock-in period for transfer of equity from one non-resident investor to another non-resident investor (including NRIs & erstwhile OCBs with 60% or more NRI stake) and such transfer would be subject to prior approval of the FIPB and the Government.

According to the Consolidated FDI Policy formulated by the Department of Industrial Policy and Promotion, Ministry of Commerce and Industry, the Government of India has put a cap 26% on FDI in defence industry in India. The Consolidated FDI Policy provides that the approval or rejection of the applications will be normally communicated within a time frame of 10 weeks from the date of acknowledgement.

The policy also provides for the approval levels for proposals involving FDI under the government route (1) The Minister of Finance who is in-charge of FIPB would consider the recommendations of FIPB on proposals with total foreign equity inflow of and below Rs.1200 crore. (2) The recommendations of FIPB on proposals with total foreign equity inflow of more than Rs. 1200 crore would be placed for consideration of Cabinet Committee for economic Affairs (CCEA). The FIPB Secretariat in Department of Economic Affairs (DEA) will process the recommendations of FIPB to obtain the approval of Minister of Finance and CCEA. (3) The CCEA would also consider the proposals which may be referred to it by the FIPB/ the Minister of Finance (in-charge of FIPB). The Consolidated FDI Policy provides various other important points  The Government reserves the right to verify the antecedents of the foreign collaborators and domestic promoters including their financial standing and credentials in the world market. Preference would be given to original equipment manufacturers or design establishments, and companies having a good track record of past supplies to Armed Forces, Space and Atomic energy sections and having an established R & D base. The Ministry of Defence will not give purchase guarantee for products to be manufactured. However, the planned acquisition programme for such equipment and overall requirements would be made available to the extent possible. The capacity norms for production will be provided in the licence based on the application as well as the recommendations of the Ministry of Defence, which will look into existing capacities of similar and allied products Import of equipment for pre-production activity including development of prototype by the applicant company is permitted.

 

Adequate safety and security procedures would need to be put in place by the licencee once the licence is granted and production commences. These would be subject to verification by authorized Government agencies. The standards and testing procedures for equipment to be produced under licence from foreign collaborators or from indigenous R & D will have to be provided by the licensee to the Government nominated quality assurance agency under appropriate confidentiality clause. The nominated quality assurance agency would inspect the finished product and would conduct surveillance and audit of the Quality Assurance Procedures of the licensee. Self-certification would be permitted by the Ministry of Defence on case to case basis, which may involve either individual items, or group of items manufactured by the licensee. Such permission would be for a fixed period and subject to renewals. Purchase preference and price preference may be given to the Public Sector organizations as per guidelines of the Department of Public Enterprises. Arms and ammunition produced by the private manufacturers will be primarily sold to the Ministry of Defence. These items may also be sold to other Government entities under the control of the Ministry of Home Affairs and State Governments with the prior approval of the Ministry of Defence. No such item should be sold within the country to any other person or entity. The export of manufactured items would be subject to policy and guidelines as applicable to Ordnance Factories and Defence Public Sector Undertakings. Non-lethal items would be permitted for sale to persons / entities other than the Central of State Governments with the prior approval of the Ministry of Defence. Licensee would also need to institute a verifiable system of removal of all goods out of their factories. Violation of these provisions may lead to cancellation of the licence.

Need for change

Even with the policy of absolute participation of private sector with FDI permissible up to 26%, things with regard to FDI in defence hasnt progressed the way the government had hoped. There has been no such enthusiasm among the foreign investors to invest in India as anticipated. The principal reason inhibiting the entry of foreign rms into the Indian defence market is the cap of 26% on FDI. Few foreign rms are keen to invest resources in a venture where they have no signicant control, strict capacity/product constraints, no purchase guarantees, no open access to other markets (including exports) and an unfair advantage to the local public sector. Moreover when Ministry of Defence is already buying directly from foreign suppliers there is no incentive for the foreign rms to create a 26 percent-owned company in this country. Most major defence manufacturing units need a transfer of technology. But no foreign major is comfortable with transferring proprietary technology to a company in which it does not own a major share. Due to the current FDI restrictions, India is losing out on a number of foreign companies who would be keen on developing India as a home market, i.e. both as a major domestic sales market and a global manufacturing hub in its supply chain. Department of Industrial Policy and Promotion (DIPP) published a discussion paperon on its website on the subject: FOREIGN DIRECT INVESTMENT (FDI) IN DEFENCE SECTOR, the paper discusses the advantages and disadvantages related to liberalising the FDI regime for the defence sector. The various concerns discussed are enumerated below   Marginalization of role of the Defence PSUs and the Ordinance Factories by the introduction of private sector and foreign direct investment. FDI could lead to ownership and control of firms operating in a critical and highly sensitive industry being passed on to foreign hands. Concern relating to availability or reliability of supplies in times of war. The availability of maintenance and repair capability, spare parts, material and other support to keep critical systems functioning in all circumstances is a vital concern. This is related to the vital question of whether the foreign investor would continue to serve Indias defence needs in the times of war. Issue of passing on of the critical equipment, design or source code to other playersparticularly, countries inimical to Indian interests. Concern relating to the internal security aspect of manufacture of defence equipment especially small arms and ammunition.

 

These concerns have been discussed accompanied by necessary prevention or method to control of such problems.

The concern relating to the marginalization of role of PSUs, it is counter argued that if the major arms and weapon manufacturer companies set up their manufacturing units in India, there is strong possibility that they will collaborate with Defence PSUs and Ordinance Factories. Further, most of the major manufacturers are actually system integrators and would certainly like to outsource from the existing facilities in India. If the FDI policy is properly leveraged by factoring this possibility optimally, we can actually revive our Defence PSUs and Ordinance Factories and make them relevant to the process of modernization of Armed Forces. The flow of foreign capital and technology can therefore be used as a tool for strengthening the defence PSUs and Ordinance Factories. The concern relating to foreign control and ownership to the critical and strategic defence industry has been tackle by the fact that the ownership structure of many of the important defence production companies is in a state of continuous flux. Therefore, the fear that we may develop a relationship of exclusive dependence, with regard to a particular foreign country, for capital and technology, may not be well-founded in the present day context and the concern that increasing the cap would lead to control being passed on to foreign capital with a specific national denomination can be easily taken care of. The concern pertaining to availability or reliability of supplies in times of war can be met by imposing a condition that the Government has a right to expropriate a manufacturing facility in case there is a need to do so due to the exigencies of national security, by payment of suitable compensation. The concern relating to the internal security aspect of manufacture of defence equipment can be met by devising a strong surveillance system in each factory/unit. This could include posting of defence/security personnel on a whole time basis to these locations.

In the discussion paper, DIPP has proposed to raise foreign direct investment (FDI) in private defence manufacturing from 26% to 74%, or even 100%. After witnessing the failure of the FDI policy for defence, high profile ministers such as Mr.Anand Sharma, Union Commerce Minister; Dr.A.K.Anthony, Defence Minister etc have appealed to increase the FDI cap on several occasions. The IAF Vice Chief Air Marshal P K Barbora commented in CII seminar that India should be "bold enough" to allow more FDI in the defence sector. But the Ministry of Defence still stands strong on the view of strict imposition of the FDI cap and opposed the idea of opening up the FDI cap, which can be very well inferred after the rejection of two applications for setting up Joint Venture companies with 49 per cent FDI. The first application the Ministry of Defence rejected was that of a proposed JV involving Mahindra

Defence Systems and UK-based BAE Systems and the second rejection involved L&T and Franco-German corporation, EADS.

Conclusion
With India becoming one of the largest buyers of defence equipment in the world, the policies of the government to restrict foreign direct investment by imposing a cap, has been attracting tremendous attention worldwide. There has been a constant appeal to the government by important bodies and agencies in India and abroad to open up the defence sector to foreign investors. But the ministry of defence has been neglecting such demands to favour its vested interests of the DPSUs and its trade unions, existing private sector players and the old bureaucratic mindset of MoD. Such policies of the government have led to the country being held back significantly to possess state of art defence artillery. It must be noted that the fears and objections being raised with respect to fully opening up the defence sector for FDI are not dissimilar to those expressed when the government was considering reforming the telecommunications and insurance sectors. The evidence from this experience clearly suggests that foreign investment has transformed the technological sophistication, generated employment, built local expertise and improved the reach and effectiveness of the services. Indias cap on FDI is stunting the process of modernisation of the armed forces.