FDI in the defence sector: Should India allow more?

By Gautam Khaitan, OP Khaitan & Co
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India’s global perspective, with its pioneering concepts and vision, has made it a lucrative market for foreign defence giants. In addition to being one of the fast developing economies, India has also focused on elevating its military and arms base. Statistics show that India (with 15% of the central government’s expenditure allocated for defence) is one of the world’s top 10 nations in terms of defence expenditure.

Gautam Khaitan
Gautam Khaitan

Statistics available in public domain also confirm that India spends 2-3% of its GDP on defence, which is in line with other big nations and signifies India’s steady focus on its defence sector. Some recent statistics show that the US leads the ranks with defence expenditure of US$610 billion (3.7% of GDP), followed by China with US$96 billion (1.5% of GDP), and India with US$33 billion (1.8% of GDP).

About 70% of India’s defence needs are procured from abroad and 30% are sourced from public sector undertakings (PSUs) and private sector companies in India. India looks for high-quantity imports of materials and equipment and the proposed budget estimate for defence spending in this financial year is reported to be about US$35 billion.

Opening of the sector

The defence sector was thrown open for Indian private players in May 2001, with 100% private equity allowed and a sectoral cap for foreign direct investment (FDI) of 26%, subject to licensing under the Industries (Development and Regulation) Act, 1951, and government approval. Unfortunately, the sector failed to attract any substantive FDI due the 26% cap. The Department of Industrial Policy and Promotion (DIPP) has reported that only US$3.6 million in FDI flowed into the sector from January 2001 to September 2012.

Stepping forward to augment FDI, the Ministry of Defence (MoD), under Defence Procurement Procedure 2008, allowed up to 49% on a case-by-case basis, and the DIPP’s Press Note 2 of 2009 effectively permitted higher FDI, through multi-layered structures or cascading holding, at the ministry’s discretion. Still, no venture with 49% FDI has yet been cleared by the Foreign Investment Promotion Board (FIPB).

Raising the cap

Several bodies and experts have proposed raising the FDI cap to 49%, 50%, 51% or 100% but after chaotic discussions, the proposals were shelved. If not resolved, the situation might require firm steps by the government to boost India’s defence independence.

Incessant debates have gone on among the DIPP, FIPB, Reserve Bank of India and other government bodies, and many national and international organizations have also expressed their views with recommendations and suggestions. The DIPP, after prolonged discussions on its discussion papers, concluded in a report that raising the FDI cap to 74% would encourage foreign investors, benefit the Indian market and help in procuring latest technologies. The FIPB said that any cap below 49% would be of no effect and suggested 50-51%.

The Federation of Indian Chambers of Commerce and Industry commented that enhancing the FDI cap should be conditional on exceeding 26% with a maximum of 49% allowed strictly under the conditions stated in the DIPP report. A study by the Confederation of Indian Industry (CII) and the Boston Consulting Group found that more than 50% of CII members favoured increasing the FDI cap to 49% with certain conditions such as requirements for joint ventures (JVs) to do research and development, for intellectual property rights to vest with JVs, and for foreign partners to ensure JVs’ access to the global market and introduce high-level specialized technology.

A report from a Prime Minister’s Office committee recommended raising the cap to help India’s defence manufacturing sector obtain the latest technologies developed overseas. Some experts said a higher cap would also encourage original equipment manufacturers, create incentives for the transfer of know-how, and help achieve the government’s goal of 70% indigenization of defence production. They favoured permitting FDI above 50%, if not 100%.

Meanwhile, the MoD has expressed concerns about the dangers of Indian players’ vulnerability to competition by the foreign giant players. Threats to the interests of people working in Indian PSUs and private-sector companies and to these companies’ aspirations for growth and development opportunities can also be not ruled out. Indian companies may prefer to shift their focus permanently in foreign markets.

Some experts and Indian defence think-tanks see all the threats as vague and weak. They believe that India could protect sensitive information and adopt management processes like those in the US and UK, where 100% FDI is allowed.

Having obtained the views of many authorities and institutions, it is now up to the government to decide whether to make it a conservative defence market with maximum indigenization or to initiate steps to make India a market of global prominence for foreign defence players with acute surveillance and superintendence.

OP Khaitan & Co is a 40-lawyer law firm, based in New Delhi. Gautam Khaitan is the firm’s managing partner.

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