FDI in Defence

Can 100% Foreign Investment Help India’s Defence Sector?

03 Jun, 2014    ·   4493

Aakash Brahmachari analyses whether India's decision to raise the FDI cap in the defence sector to 100 per cent is in line with the country's interests

India’s Department of Industrial Policy and Promotion has proposed raising the bar on foreign direct investment (FDI) in India’s defence sector from the current 26 per cent to 74 per cent and possibly 100% in select high-technology areas. The latest bid to revive India’s stagnating defence sector is characteristic of the new government’s urgency to revive investor confidence. The defence sector in particular has been hampered by policy paralysis, that, the ruling Bharatiya Janata Party has been openly critical of. The decision to boost FDI in the sector, if approved, will be marked as an example of the new government’s commitment to implement important reforms at a quicker pace. 

Old Wine in a New Bottle? 
In 2010, the United Progressive Alliance government had considered the same proposal. At that time, the consensus from the defence industry was that the 26 per cent FDI cap had done more harm than good. It had deterred foreign investors who did not see any financial incentives and had limited control over their joint ventures (JV) with Indian partners. This implied less control over intellectual property – which is a key differentiator in the defence sector and is often developed at great expense.

Shortly after the proposal was tabled, a survey by the Confederation of Indian Industry found that over half its members preferred a 49 pe cent FDI cap along with an Indian JV partner for foreign firms. Though the companies surveyed favoured raising the FDI cap to 74 per cent for select projects, they felt restricting it to 49 per cent would ensure a level playing field for domestic manufacturers. 

Given that the Indian defence sector was opened to private companies only in 2001, most domestic firms in a JV with a foreign partner benefitted from access to technology without heavy investments in research and development (R&D). With the new proposal, there is a real concern that Indian firms will be unable to compete with international corporations that have much deeper pockets and an established R&D base. Instead of benefitting from a JV, Indian companies may find themselves crowded out of the market. 

Foreign firms will now be able establish their own manufacturing base in the country without the need for an Indian partner. Resultantly, Indian firms could be relegated to ancillary suppliers for international corporations. A desire to protect domestic industry likely prevented the proposal’s implementation earlier with former defence minister AK Anthony expressing his confidence that the 26 per cent FDI cap was sufficient at the moment. 

Implications for the Domestic Manufacturing Sector
Is 100 per cent FDI the only cure for India’s ailing defence manufacturing sector? The answer is less than obvious. In the east, China’s defence industry has grown despite no foreign access; but there are indications that private domestic firms may be granted entry. India’s approach is markedly different from China’s. While India prefers to develop technologies and weapon platforms with foreign support, China’s government-run defence sector has been adept at replicating and mass-manufacturing foreign technology. India’s focus on development instead of replication has led to prolonging of projects such as the Light Combat Aircraft. Conversely, within a few years of purchasing the Sukhoi Su-27 fighters from Russia, China proceeded to develop their own fighter – the J-11 – based on the Su-27’s airframe. In many ways, this approach has helped China’s defence manufacturing sector outpace and outgrow India’s. 

Unrestricted FDI in defence may be a non-traditional approach for India, but it does have its advantages such as revitalising the moribund sector. Experienced international firms can establish manufacturing and integration facilities in India without the fear of losing valuable intellectual property due to a lack of managerial control. This will raise the levels of technology in the sector, promote competition, and boost business for ancillary domestic industries. Though domestic firms will face stiffer competition, over time, this promises to form the basis for a modern defence industrial complex.

An efficient and broad manufacturing base, even in private hands, allows for greater reliability of supplies in the event of war when products can be manufactured locally instead of being imported at exorbitant prices. A further corollary is greater transparency with a diminishing role for middlemen. However, if the US defence industry is a yardstick to go by, we may expect the emergence of cartels and lobbies which collude to raise defence expenditure. 

Increasing the FDI Cap Should Complement Other Defence Sector Reforms
In the larger scheme of things, increasing the FDI limit is only part of the battle won. India is the world’s largest arms importer, but a closer look at our purchases reveals gaps and inconsistencies. Expensive platforms such as the Boeing P-8I Poseidon maritime reconnaissance aircraft and the C-130J Hercules medium-lift aircraft have undoubtedly strengthened capabilities, but glaring gaps remain. The Indian Army urgently requires new field artillery and the Indian Air Force’s ground-based air defence systems are largely obsolete. Repeated tenders and isolated contracts have failed to address these shortcomings. To be effective, the proposed increase in FDI needs to be harmonised with procurement policies to address the armed forces’ requirements in a sustained manner instead of the piece-meal efforts we have witnessed in the past decade. 

Although increasing the FDI limit will almost certainly have several riders, this may be the most opportune time to implement such a decision. The new government’s economic growth-oriented policies have boosted business sentiment and this, combined with the demand generated by the modernisation and expansion of one of the world’s largest armed forces, may prove to be the wind in the sail for India’s defence sector.

Views expressed are the author's own