Indian Defence Review

Airborne Warning and Control System (AWACS)

The offset policy is an important policy statement for the conservative defence manufacturing sector. It has to embrace design, development and manufacturing in its scope and encourage OEMs, design houses to have long-term partnership with the Indian defence industry. The private sector player must play a more dynamic role in this. The government should hand hold them in the matter of transfer of critical technology, and give tax relief for research activities. Brazil’s successful experiment with Embraer aircraft, where massive government support was provided in terms of galvanizing the scientific pool of the country and providing subsidy for research, should hold a useful template for India to emulate.

In February 1991, Dr Manmohan Singh as Finance Minister had quoted Victor Hugo in his budget speech, “No one can stop a moment, whose time has come,” to usher in the economic liberalisation for the country. The defence production sector, a monopoly of the Public Sector Units (PSUs) and Ordnance Factories (OFs), took a decade more to unveil liberalisation by permitting 100 per cent private sector participation and 26 per cent Foreign Direct Investment (FDI) from foreign companies. All the same, the private sector was still treated as a contractor, and not as a partner. The credit for sowing the seeds of Public Private Partnership (PPP) goes to the Kelkar Committee (2005), which recommended the introduction of an offset policy, to bolster indigenous manufacturing capability. This policy which is in vogue in 130 countries, aims at leveraging big ticket acquisition in defence to inveigle the OEMs to (a) outsource orders to the importing country (b) prop up their export (c) encourage FDI inflow and (d) transfer key technologies.

The Defence Procurement Procedure (2005) included this policy to take advantage of large arms acquisitions, with Rs 300 crore as the minimum threshold and direct offsets as the preferred option. Offsets accounted for 30 per cent of the contract order. The policy has been tweaked several times since then. The FDI policy, in particular, has been significantly liberalised after the NDA government has taken charge in 2014. Presently, the FDI limit has been put at 100 per cent, without the necessity of having to obtain CCS approval. The MOD and the MHA would take such decisions in tandem, as the internal security products now come within the ambit of offset criteria.

This paper takes kaleidoscopic view of the offset policy over the last decade, its impact on bolstering indigenous defence manufacturing capability and the road ahead.

Offset Policy Over the Years

The literature on the subject has been rather wafer-thin, with a collection of articles edited by Stephen Martin (1996), recounting the experience of several countries. Subsequently, several articles and a pioneering book by the author on the offset policy and its impact in India have appeared. The focus of economists on this seductive public policy, given the scanty information base in the public domain, has been on four areas viz its impact on overall cost reduction, general economic development, ability to generate additional employment and quality of technology transfer.

The overwhelming view has been that implementing the offset policy entails an additional cost of three to ten per cent of the contract value (Brozoska). The benefit is limited to indigenous arms industry and not general economic development. The job opportunities are extremely limited (Skons) and generally helpful to the SMEs. Technology transfer is generally of low quality (Hartley).

However, the development of the Embraer aircraft by Brazil has been the clearest example of a successful offset policy through which Brazil has become a world leader in the regional jet market. Parlo Breeman brings out how massive government interest and subsidy have helped to forge a synergy between military and civil technology to make the offset policy a real success in Brazil. On the other hand, Bhaskaran brings out how India’s experience of technology transfer in areas such as fighter aircraft (1960s), frigates and tanks, has built substantial indigenous military industry capability without “failing to close the technology gap.” The dependence on Original Equipment Manufacturers (OEMs) for even upgrades is perennial.

The offset policy since 2005 has been significantly amended to include areas such as (a) civil aerospace and internal security, (b) providing multiplier of 1.5 for investment in MSMEs and three for high technology areas (c) inclusion of eligible ‘services’ such as Maintenance Repair and Overhaul (MRO), upgrades, software development and (d) allowing investment in kind ‘TOT’ through the non-equity route. Most importantly, it now allows the private sector to compete in the production of surveillance vessels such as IPV and OPVs with defence shipyards. This has certainly brought in a whiff of fresh air in terms of timeliness in delivery, cost competitiveness and a level playing field in the shipbuilding sector. However, in the domain of aerospace, the private sector players are yet to play a definitive role in production of helicopters, trainers and transport aircraft.

The Impact of Offset Policy

Six years after the offset policy was introduced, there was cynicism from acknowledged experts on the subject that, “the economic benefits are unproven” (Paul Dunne). John Brauer was of the view that, “it is doubtful if relevant technology will be transferred by the OEMs.” Ron Mathew, drawing from the experience of the UK which allows 100 per cent FDI and China which allowed 51 per cent FDI to Embraer, concluded that India’s offset policy is, “overly prescriptive, complex and increasingly confused.”

Apart from the academics, acknowledged practitioners of offset such as M/s Lockheed Martin of the US was of the view that, “there is no real appetite within the Indian MoD to change the offset rules such that they achieve the goal of increasing indigenous capability of the Indian defence industry” (Philip Gergiaous).

The year 2011 witnessed a spate of new policy initiatives. The Defence Production Policy (2011), recommended simplification of procedure of the “Make” category giving preference to indigenous design and development, involving private sector in design and development of equipment and providing separate funding to academics and scientific institutes. The Rama Rao Committee (2011) advocated for the creation of a Defence Technology Fund. The Parliamentary Standing Committee (2011) also recommended the creation of National Design Institute in areas such as aerospace, naval and land systems.

Despite such enticing policy postulates, India’s dependence on arms imports continue to be humungous at 70 per cent. Our design and development capability in the areas of sensors, propulsion and state of art weapons continue to remain abysmally low. No wonder that India is the largest importer of arms, weapons and platforms globally, as the following table will show:

FDI Inflow

The policy on FDI has been liberalised significantly over the years, with 49 per cent in 2014 and 100 per cent now. The FDI has largely flown into sectors such as the services (18%), construction (1.3%), telecom (7.1%), computer software (5.7%) and drugs (5%). However, FDI inflow till 2011 for the defence sector was paltry. The total inflow of FDI to all sectors of the Indian economy and the defence sector in recent years is shown below.

It would thus be seen that increase in FDI cap to 49 per cent has come a cropper. India has finally adopted the right global model of allowing more than 50 per cent FDI into the defence sector. This will hopefully entice the OEMs to have a long term stake to invest in India and nurse India as part of the ‘global supply chain’. This can also spur them to bring in critical technologies, since they will have a major say in the management of the production entity and IPR.

Multiplier

A novel feature of the DPP-2016 has been to afford a multiplier of one and half times to SMEs and three to critical technology to DRDO where there is no restriction. The DPP (2016) brings out some of the areas where a multiplier of three can be afforded.

Dr APJ Abdul Kalam, as Special Advisor to the Raksha Mantri, chairing a committee for improving Self Reliance Index for India, had identified all the above technology areas way back in 1992. He had suggested substantial investment in these technology areas by having partnership with reputed OEMs and design houses. The Committee had expected the SRI to go up from 30 per cent (1992) to 70 per cent (2005). Sadly, the SRI for India remains glued at 30 per cent even now. The Dhirendra Singh Committee (2015) on strategic partnership model hopes that India would achieve SRI of 70 per cent by 2022!

Offset Contracts

12 offset contracts were concluded during the period 2005 to 2012 with a value of $1.5 billion. Subsequently, ten more contracts have been concluded in the period 2013-2016 with a value of $1.5 billion approximately. The experience so far has been that OEMs outsource low-end manufacturing and machining jobs to private and public sector companies in India. The offset limit has now been increased from Rs 300 crore (2005) to Rs 2,000 crore (2016).

One of the major contracts where there could be a major offset spin off is the contract for 36 Rafale fighter jets with Dassault Aviation of France with a contract value of Rs 39,000 crore. Of this, close to Rs 22,000 crore worth of offsets would be discharged by Reliance Defence which has formed a JV with Dassault. This would indeed be a major trigger for private sector investment in India in the defence sector. The Tatas have also been eyeing the UAV segment and Mahindra and Mahindra is looking at armoured vehicles.

However, the “Make” procedure is still limping as the DRDO’s record in delivering critical prototypes such as the Kaveri Engine, FPA, AESA radar, Ring Laser Gyro and Astra has been poor. However, in ‘Buy’ (India) and ‘Buy & Make’ category a healthy trend is noticed in recent years as compared to the ‘Make’ category, as the following Table shows.

The Way Forward

From a conservative cautious hobble, the offset policy has become more robust with a liberal FDI policy (100 per cent), inclusion of multiplier for MSMEs and critical technology and allowing offsets for services and synergistic sectors like civil aerospace and internal security. All the same, the mood of the Foreign OEMs and design houses to invest on a long term basis in India is not particularly upbeat. A number of MoUs have been crafted but in concrete terms the JV of Reliance Defence with Dassault is the most promising development.

A few concerns would need to be grappled by the government in order to galvanise the indigenous military industry. Defence manufacturing is not about manufacturing fuselage for aircraft or a hull for the frigate and tanks. It starts with major design capability and culminates into bulk production. Most of the defence PSUs such as HAL and MDL have become a system integrators, but they remain assemblers of imported parts rather than being significant value adders.

The following three areas would read to be addressed for revamping and bolstering defence manufacturing in India.

Busting the Public Sector Monopoly

The 1956 Industrial Policy resolution made the DPSUs and OFs the sole recipient of technology from abroad and nominated as production agency. This has constantly disheartened the private sector players who have built significant sinews over the year to manufacture, integrate and deliver major weapon systems and platforms in time. The Kelkar Committee (2005) set the tone for PPP and the Dhirendra Singh Committee (2015) has also triggered a real hope of kick-starting a strategic partnership model. This will enable identification of private sector players who would be on a par with Navratna Defence PSUs. The OEMs are generally keener to partner with such private sector players, given their reputation of being technically fleet footed, dynamic and tine as well as cost compliant. The fillip to the MSMEs by the present government through the Mudra initiative for funding, IT relief the sector in the last budget and allowing a multiplier of one and half times are in sync with best global practices. The MSMEs indeed play a critical supportive role to the big manufacturing hubs. The government must ensure that the strategic partnership model is taken to its logical conclusion, without being waylaid by vested interests in DPSUs and OFs.

Bolstering Indigenous Research Capability

The record of DRDO for delivering critical platforms such as the LCA and MBT has not been edifying. The failure of the Kaveri engine for powering the LCA has been a major setback in our ‘propulsion’ programme. The ‘Make Procedure’ envisages providing 80 per cent funding to private entity which makes a successful prototype. This has so far come as a cropper. The major ‘Make’ programme for communication links up to the unit level is the field areas is still caught up in the tussle between private and public sector to be implemented. The suggestion for creating a National Institute for Design is yet to be operationalised. India spends around 0.8 per cent of its GDP on R&D compared to five per cent by most developed countries. The major private sector players hardly spend money on research. The design capability of Navratna PSUs such as HAL and BEL is wafer-thin. The Navy has some design capability but not in state-of-the-art areas like nuclear submarine technology.

It is high time that the suggestion of the Rama Rao committee for creating a Defence Technology Fund and setting up a National Institute for Design on Aeronautics, Naval and Land Systems be put in place. India can ill afford to be an assembler of critical subsystems imported for abroad. It must ink partnerships with major design houses for bolstering design capability.

Including Indirect Offset and Civil Ship Building Sector

It is important that the offset policy allows indirect offset in its ambit. It would help investment in sectors such as education, health and infrastructure. Countries like Germany, South Korea, Brazil, Australia, Turkey, Spain, Poland, Israel and Canada profit substantially from indirect offsets. The Make-In-India initiative has fortunately brought the defence manufacturing as part of national manufacturing momentum. Fortunately, the policy makers in defence, who have looked at defence manufacturing as a water tight compartment, have realised the imperative to work in synergistic sector and dual use technology items.

It is surprising how the civil ship building segment has not been made part of the synergistic sectors, unlike aerospace. During the 10th Plan, a subsidy scheme was introduced for the ship building sector as per which 30 per cent subsidy was being given for export order. This increased India’s global share for 0.2 per cent (2002) to 1.3 per cent in (2007). This scheme was withdrawn in 2007, plummeting exports to 0.01 per cent, while countries such as South Korea and China are out competing their Western counterparts. The government needs to revisit its policy on ship building sector in a synergistic manner.

Dual use technology such as laser, cryptology, nano technology, Artificial Intelligence, sensors would have a cascading impact on all sectors. Investment in biotechnology, energy, higher education and agricultural research, investment in infrastructure are where India is seriously lagging behind. Indirect offsets to these sectors would go a long way in bolstering the overall manufacturing and design footprint of India.

The offset policy is an important policy statement for the conservative defence manufacturing sector. It has to embrace design, development and manufacturing in its scope and encourage OEMs, design houses to have long-term partnership with Indian defence industry. The private sector player must play a more dynamic role in this. The government should hand hold them in the matter of transfer of critical technology and give tax relief for research activities. Brazil’s successful experiment with Embraer aircraft, where massive government support was provided in terms of galvanising the scientific pool of the country and providing subsidy for research, should hold a useful template for India to emulate.

South Korea and China, who have became major manufacturing hubs in areas such as shipbuilding and aircraft manufacturing have struck viable partnerships with OEMs and design houses. India must close the technology gap and overcome the impression of non-Indian defence contractors that it is not keen to bolster its indigenous manufacturing capability and be policy friends. The present policy on offsets need to be further revamped to give more meaningful role to the private sector, encourage dual use technology and improve the design capability of India in critical subsystems.