Policy prescriptions to ignite FDI in defence production

By Alina Arora and Apurva Zutshi, L&L Partners

The foreign direct investment (FDI) policy allows foreign original equipment manufacturers (FOEM) in the defence sector to acquire up to a 49% stake in Indian joint ventures (JV) under the automatic route and up to 100% if it is likely to result in access to “modern technology or for other recorded reasons”. Despite the government’s efforts, FDI inflows into the Indian defence industry continue to be abysmal.

Foreign Direct Investment
Alina Arora
L&L Partners

A significant entry barrier for FOEM has been identifying reliable Indian partners who have financial and technical capabilities to absorb complex technology and meet international standards in intellectual property (IP) and brand goodwill. With a limited number of companies operating in the defence sector, India does not have the depth in the industry that is needed for FOEM to find suitable partners.

Key technologies and IP are critical to the success of a defence manufacturing company. FOEM are apprehensive about sharing their technology with Indian partners because of the 49% cap on shareholding, which does not give the foreign partner control over the JV. FOEM spend significant resources in conducting due diligence and assessments to identify Indian partners, incurring high establishment costs along with significant delay and opportunity cost.

FOEM argue that the defence industry is a monopsony, a market which caters primarily to one customer, where a purchase assurance from the Ministry of Defence is a prerequisite for any commercial success. In the case of proposals for up to 100% FDI being allowed under the government approval route, the phrases like “wherever it is likely to result in access to modern technology” or “for other reasons to be recorded” are neither defined or explained under the FDI policy. This ambiguity provides the bureaucracy unfettered discretion, thereby deterring FOEM.

foreign direct investment
Apurva Zutshi
Senior associate
L&L Partners

The government should consider taking additional measures to encourage FDI in the sector.

The Draft Defence Production Policy (2018) talks about undertaking a competency mapping of the Indian defence industry to identify technologies in which India is critically deficient (critical technologies). More than 49% FDI may be allowed under the automatic route in such critical technology areas, thereby, reducing uncertainty among FOEM. This will be an incentive for FOEM, both in terms of financial returns and management control.

To boost FDI in case of non-critical technologies and to allay national security-related concerns, FDI of up to 51% may be allowed under the automatic route for non-critical technologies, subject to the condition that the government may, on the grounds of national security, direct the FOEM to dilute its stake and cede control by transferring such shares to the Indian partner, which results in the Indian partner holding up to 51% shareholding. The FOEM would need to provide an upfront undertaking agreeing to the above condition. This may also help address FOEM’s concerns about control and provide them the much-needed assurance for their IP.

While the above proposal allows for FOEM to retain control under the automatic route, a true game changer would be allowing FOEM to undertake 100% FDI in the defence sector through the automatic route (irrespective of the technology involved). This will provide FOEM control over their IP and international quality standards associated with their brand and to that extent FOEM would be more amenable to making large and long-term capital investments without necessarily having an assured market or contracts for the equipment.

It would remove concerns about the cost incurred and the delay caused due to the lack of an adequate pool of suitable Indian partners. It may also provide an impetus to Indian-owned and controlled entities acting as tier-1 and tier-2 vendors, to act as system integrators, leading to capacity and capability building within the Indian defence industry. The policy may require the managing director or CEO and other key managerial persons to be Indian citizens along with compulsory employment quotas for Indians along with local sourcing requirements. The government will retain the power to reject or cancel the industrial license for FOEM, if their motives are suspect.

While the policy prescriptions may facilitate FDI in the defence sector, a responsive bureaucracy backed by political will can truly ignite FDI in it.

Alina Arora is a partner and Apurva Zutshi is a senior associate at L&L Partners. The views expressed are personal and intended for general information purposes. They are not a substitute for legal advice.

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