FDI in Defence: The Chicken-and-Egg Cycle May Not End Soon

Local players don’t have sufficient technology capability and foreign players are reluctant to engage in technology transfer without ownership rights. Prime Minister Modi had promised to tackle this problem but it is not clear the new policy will do that.

L&T''s ‘ADAMYA’ autonomous underwater vehicle, designed and developed in house by L&T Designed for deoployment from torpedo tube of submarines. Credit:

Larsen &Toubro”s ‘ADAMYA’ autonomous underwater vehicle, designed and developed in house by L&T Designed for deployment from torpedo tube of submarines. Credit:

New Delhi: The Modi government on Monday tinkered with foreign investment rules in the defence sector for the third time in two years, slightly tweaking the conditions under which foreign direct investment (FDI) beyond 49% would be allowed.

According to analysts, experts and industry insiders The Wire spoke with, while the new rules could potentially solve the issues of poor domestic capability and foreign uneasiness on technology transfer that currently plagues India’s defence industry, much of it would depend on the government’s intent and how effective changing the “state-of-art technology” condition to “modern technology” would be.

“Let’s be clear, 100% FDI under the government approval route is not new. It has been allowed for sometime, under the provision that it would result in access to state-of-the-art technology in India. The new condition and provision is that foreign players will now be able to wholly own a local operation if it leads to access to ‘modern technology’,” a senior executive of a US aerospace firm, which has partnered with local companies in India for a few projects, said.

The chicken-and-egg situation in the defence industry – where local players don’t have sufficient technology capability and foreign players are reluctant to engage in technology transfer without ownership rights – is a problem that Prime Minister Modi has promised to tackle.  A little over 60% of the country’s defence procurements, according to a number of estimates, comes through costly imports.

Defence and security analyst Subimal Bhattacharjee believes that even with the new rules, the battlefield for defence procurements largely remains the same.

“While it is true that many foreign companies are looking to set up shop, until now they haven’t gotten a sense of comfort in terms of coming here, partnering Indian companies as a minor stakeholder and engaging in technology transfer.  This could change… though it will heavily depend on whether the ‘modern technology’ condition is granted to most foreign players,” Bhattacharjee said.

The key question currently being discussed amongst industry insiders is whether the shift from ‘state-of-the-’art’ to ‘modern’ technology is the Modi government essentially admitting that its slow reforms in the defence sector over the last two years haven’t worked out.

The results of FDI reforms in the defence sector over the past three years speak for themselves.

In 2013, 100% FDI was allowed, by the previous UPA government, through the government approval route with the ‘state-of-the-art’ rider.

In August 2014, the newly elected Modi government increased the FDI limit in defence (through the automatic route from 26% to 49%).  Over the last one-and-a-half years, the total amount of FDI inflows in the defence sector was just a little over Rs. 1 crore, according to a written reply given by defence minister Manohar Parrikar in the Lok Sabha. “The actual flow of foreign direct investment takes time to mature. From August 2014 to February 2016, a total amount of Rs. 112.35 lakh (Rs. 1.12 crore) has come into the country as FDI in the defence sector,” Parrikar wrote.

Why has there been so little FDI? While it’s true that huge projects take time, multiple analysts told The Wire that issues of foreign technology transfer/IPR, questions over government defence procurement and even the niggling point of what constitutes ‘state-of-the-art’ still continue. According to one industry insider, at least one 100% FDI proposal has been waiting for the past four months because the defence ministry cannot decide whether it qualifies as resulting in access to state-of-the-art technology; similar flip-flopping has been seen in the case of Apple which wants to open its single-brand retailing stores in India.

Some of these issues have been slowly resolved with the government’s new defence procurement policy and the easing out of the questionable ‘state-of-the-art’ condition, while others (such as the strategic partner norms) will still take time.

“If the new ‘access to modern technology’ condition is something that is granted regularly and is a way of lowering the bar for 100% FDI in the government approval route, then this will move the needle. Otherwise, we are still stuck in the same situation,” the senior aerospace firm executive said.

Amber Dubey, head of aerospace at KPMG India, is firmly in the former camp. Dubey believes that while terms like “state-of-the-art” are misleading, “modern technology will allow most leading defence companies to come in unhindered”.

Blow to local companies?

The timing of this 100% FDI announcement is curious, and more than a little disappointing, for local defence manufacturers such as Larsen & Toubro (L&T), the Tata Group and even Anil Ambani’s Reliance Infrastructure, which have been gearing up for a big defence push.

On one hand, these local players lose out on almost two in every three defence projects because of a lack of technological and manufacturing capability.

On the other, the government still hasn’t announced the much-awaited “strategic partner” framework of its defence procurement policy. The strategic partner framework, which gels with the ‘Make-in-India’ initiative, when announced, will allocate a specific number of defence deals in a certain number of sectors to local manufacturing companies. According to analysts, this could account for nearly 50% of India’s defence procurement over the next 20 to 30 years.

“India’s defence industry has always been marked by the private sector versus the public sector and local players tending to oppose foreign OEMs. While the new rules may or may not change much, it will definitely put pressure on Indian firms to pull up their socks and actually start investing in research and development,” said Bhattacharjee.

A senior executive of Mahindra Defence, part of the Mahindra Group which makes military helicopters and systems for naval warfare, pointed out that it was a little disheartening for this announcement to come out before the new defence procurement policy was fully released.

“We were one of the first ones to acquire capability to completely build an aircraft and not just smaller components. While Modi has promised the private sector will be allowed to shine, and compete fairly against public sector companies, it’s difficult to cultivate technological capability through alliances and by ourselves without being supported by a confirmed procurement policy,” the executive said.

Small arms – A push?

One of the other key changes in the new FDI rules announced today was that the FDI limit for the defence sector has “also been made applicable to manufacturing of small arms and ammunitions covered under Arms Act 1959”. This provision too, according to analysts and industry insiders, is more hand-waving than anything of substance.

As author Sushant Singh, who recently published Operation Cactus: Mission Impossible in the Maldives, has documented, the manufacturing of small arms has been largely limited to the public sector in India.

For instance, in 2001, the Union Cabinet had allowed the private sector to manufacture small arms. Accordingly, firms such as Bharat Forge, Punj Lloyd and L&T were granted licences by the DIPP over 15 years ago. However, production never started, Singh notes, because the Union home ministry never ended up providing clearance. If any FDI is to happen in the small arms sector, these hurdles will need to be cleared first.