July , 2016
00:00 am

B.E. Bureau

The defence sector in India has great strategic importance. The recent policy decision to allow 100% FDI in the sector can structurally change the sector.

Amit Cowshish, former Financial Advisor (Acquisition), Ministry of Defence (MoD), and presently a Distinguished Fellow at the Institute for Defence Studies and Analyses (IDSA), New Delhi, spoke to BE’s Varsha Singh about the Indian defence sector and the Defence Procurement Procedure (DPP).

  1. What is your view about the defence budget declining in terms of its percentage to the GDP?
  2. It does not matter how much the defence outlay works out in terms of its percentage to the GDP. What is important is that the allocation meets that requirement for a given year. It is also important that the requirement is worked out accurately and realistically. The demand for increasing the defence budget is at odds with underutilization of the capital budget year after year. The resources are not unlimited and there are severe constraints on the government’s ability to generate revenue.
  3. The government’s defence deals are on the basis of L1 (lowest bidder) and not on T1 (technically advanced) basis. How has this been legalized and why?
  4. The L1 system is considered by many to be an imperfect system, which forces the user to buy the cheapest product even if it is technologically inferior to other products.This view overlooks the fact that the L1 system entails selection of the lowest bid out of only those offers, which are found to be compliant with the technical specifications of the product laid down. There is no compulsion on the users to compromise on the operational requirement while finalizing the specifications.

However, recognizing merit in your argument, it makes sense to pay a little extra to buy a product which is technologically superior to the cheapest product.

The Ministry of Defence (MoD) has introduced a new provision in the Defence Procurement Procedure (DPP) 2016.This provision is based on the L1-T1 concept. It implies that wherever considered appropriate, MoD will lay down Enhanced Performance Parameters (EPP) in the Request for Proposal (RFP). These EPPs will be in addition to the Essential Parameters.

While all products offered in response to the RFP will have to meet the Essential Parameters laid down in the RFP, products with EPPS as specified in the RFP will be given weightage in price for determination of the lowest bid. The manner in which the weightage is to be accorded is laid down in the DPP. This provision will enable MoD to buy a product that is technologically superior to the cheapest of all products that meet the Essential Requirements, even at a higher price.

  1. Is the defence procurement reform up to the mark?
  2. Reforms are a continuous process. The Committee of Experts set up by the government last year to examine the procurement procedure did not recommend any drastic changes in the basic architecture, which is predicated on categorization of procurement proposals into various categories and a 10 or 11 stage procurement cycle. The government has incorporated some of the recommendations in DPP 2016, while in case of some others, like adoption of the ‘strategic partnership model’ and the creation of a separate Defence Procurement Executive, they are still examining the merits and are yet to take the final call.
  3. Have the laws been made stringent enough for quality assurance?
  4. A lot of procurement is done based on self-certification, especially by the foreign manufactures, subject to pre-dispatch and/or joint receipt inspections of the consignments. The responsibility of quality assurance is otherwise discharged by internal Quality Assurance organisations like the Directorate General of Quality Assurance (DGQA). There are areas in quality assurance, which still need to be addressed.
  5. With 100% FDI what will be the DRDO’s future?
  6. There has not been any fundamental shift in FDI policy. Since 2014, at least in theory, 100% FDI could be allowed by the government provided it entailed access to ‘modern’ or ‘state-of-art’ technologies. The change made last month is that the condition related to ‘state-of-art’ has been dropped. The new norms would also enable the government to permit FDI beyond 49% for ‘any other reason to be recorded’. This makes it easier for strategic investors to come up with proposals for FDI beyond 49% and for the government to accept such proposals, though flow of FDI depends on many other factors, including the overall business environment which needs to be improved. I do not think this move will have any significant impact on the future of DRDO.
  7. What are the problem areas in defence procurement? Are we up to date in terms of having fourth and fifth generation warfare weapons?
  8. It is no secret that we are lagging behind in regard to modernization of the armed forces. From artillery guns to air defence capabilities and from submarines to fighter aircraft, Indian armed forces need a wide range of modern equipment and capabilities. There are several reasons behind this. The most debilitating of them has been the tardy decision-making process in the MoD. The fact that even the G2G (government to government) talks for outright purchase of 36 Rafale fighter aircraft have been lingering for more than a year bears testimony to the sluggish decision-making process.
  9. Is the private participation in (a) defence R&D and (b) defence industry up to the desired extent?
  10. It is difficult to define the ‘desired level’ but it is evident that there is tremendous scope for increased participation by private players in defence production as well as defence R&D.

The Indian government under Prime Minister Narendra Modi has been keen to project India as an investment-friendly destination for foreign capital. The government has, since its inception, been in favour of opening up Indian markets more overtly for foreign capital. The recent decision to allow 100% Foreign Direct Investment (FDI) in the defence sector has been met with much enthusiasm by Indian defence manufacturers. According to a report by Ernst and Young, if the government’s ambitious plans for indigenous manufacturing take off properly, India can save as much as $50 billion from its likely spend of over $260 billion on defence equipment in the next 12 years.

Indian defence market is huge and worth millions of dollars. Globally, it is one of the most promising defence markets. Indian industry body, the Confederation of Indian Industry (CII), has published reports stating that the defence industry not only has the potential to augment manufacturing but also has potential to add nearly one million direct and indirect jobs.  The body has also welcomed the release of the Defence Procurement Procedure (DPP 2016), which is expected to expedite defensce procurements. The new guidelines seem to be more flexible and leave more space for end-users and the industry to work together on development projects. A new category had been formulated by the government, termed as Indigenously Designed, Developed and Manufactured (IDDM), which has been given top priority. The Ministry of Defence (MOD), in a major policy decision, to encourage the MSMEs associated with the industry has decided it would fund up to 90% of their project’s prototype development cost. Adding another safeguard, the ministry has also stated that it will reimburse the remaining 10% prototype development cost, if the order is not placed within a stipulated timeframe after the successful test of prototypes.

The MOD is also making minor policy alterations to ease the field for stake-holders in the defence industry. In July 2015, the ministry eased export regulations and stopped demanding multiple assurances on end use from foreign governments even for sale of parts from Indian entities. In case of defense equipment, it is often seen that different parts are manufactured in different regions and are later assembled in one place. This is a multi-layered process as assembling takes place at different levels and at various regions prior to the final assembly. Earlier, rules required Indian firms to obtain clearances from all the governments in the process. Due to such rules, the small and medium enterprises lost international orders as foreign companies were not interested in such complex processes. The change in rules has immediately benefited players in the industry who are now being preferred by international companies. Private players have exported about `600 crore of defense material in the last financial year, which is substantially more than the last year where the figure stood at around `132 crore.

The Modi government has also shown its intent of improving the performance of the defence sector by simplifying the offsets policy, which was initiated during the United Progressive Alliance (UPA) regime. The policy required that foreign players who had secured defence contract, had to invest 30% of the value of their contract in local defence and aerospace industry. The policy had cumbersome permission taking and monitoring processes at different levels, which acted as a major impediment. The NDA government has made significant changes to the policy, allowing foreign companies more flexibility in choosing local partners. This has helped unlock nearly $3.5 billion foreign investment in the sector. The policy change has also entailed the provision for the foreign companies to give out contracts to local manufacturers at the ‘execution’ stage. This is bound to be a shot in the arm for domestic defence manufacturers. A new policy is to review work orders worth `44.5 billion that has been signed in 2008. Only about 25% of those orders have been fulfilled as of now.

The MOD has also restored ‘services’ as eligible offsets of military contracts. It was discontinued after allegations of corruptions arose over a $530 billion chopper deal, which involved some service providers. The change is also seen to be a game-changer for the domestic defence manufacturing industry.

These changes have made the private sector content. In a bid to encourage more involvement of the private sector, the MOD had issued 56 licences, a record number, to national players till June last year. The government has also revoked the policy, which forced Indian firms to freeze rates at the time of bidding. This left them at the risk of currency fluctuations. The new amendments protect them from variations of currency fluctuations.

The Indian defence industry was always more dependent on foreign technology than on indigenous designs. The move by the government to pull in more foreign capital in the sector is bound to reflect in the manufacturing sector as it will be cheaper to manufacture in India. By easing the export regulations, the government seems to give out a well-directed signal to international players to invest in the setting-up of manufacturing units in India. The government seems intent in clearing the red tape, giving ample incentive to foreign players to pump in funds in India. The result might unlock a plethora of new economic opputinites for India, which may have long-standing political impact on the country’s global moorings.

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