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Defence Industrial Licensing and FDI Regimes Require Further Tweaking

Though, since 2001, the Defence Sector was opened to 100% Indian private sector participation, with Foreign Direct Investment (FDI) up to 26%, both subject to licensing; however there are certain areas in both Industrial Licensing and FDI policy, which need further improvement to increase the participation of the private sector in Defence Industry in a significant manner.

 

Defence manufacturing was the exclusive preserve of the Defence Public Sector Undertakings (DPSUs) and the Ordnance Factories (OFs) till May 2001 when, as a part of the post-Kargil reforms the government decided to let the Indian private sector step in. It was a cautious step as their entry was subject to stringent industrial licensing and a cap of 26 per cent on Foreign Direct Investment (FDI). Despite these changes, however, the situation has not changed much as DPSUs and OFs continue to dominate defence production.

According to a government press release of July 2019, the private sector companies operating in aerospace and defence reported an annual turnover of approximately Rs. 15,000 Crores in 2018-19, while the corresponding figures for the DPSUs was Rs. 63,208 crores. The latter apparently excluded the value of production by OFs which, according to MoD’s annual report for 2018-19, was Rs 12,790 crore (provisional). Thus, the private sector accounted for just about 20 per cent of the total industrial turnover in the defence sector that year.

The continued dominance of DPSUs and OFs is as much due to what many believe to be Ministry of Defence’s (MoD) reluctance to walk the talk on private sector participation in defence production as it is on account of complexity of the licensing regime, cap on Foreign Direct Investment (FDI), procedural complications, and shortage of funds.

In 2014, the then newly elected government decided to break this logjam by easing the licensing and FDI regimes, followed by a comprehensive review of the procurement procedure in 2016. The problem of shortage of funds was and continues to be left alone. In anything, in the aftermath of Covid-19 pandemic, financial crunch will become more acute. Nevertheless, while procedural and financial issues dominate the defence discourse, there is lesser focus on the issues related to IL and FDI regime.

Licensing Regime

One of the first acts of the new government, in 2014, was to notify the list of defence products requiring an industrial license under the Industrial (Development and Regulation) Act, 1951 (IDR Act 1951) on 26 June 2014. The authority to grant IL remained with the Department for Promotion of Industry and Internal Trade (DPIIT), then known as the Department Of Industrial Policy and promotion, which had been the licensing authority all along. The notification also stated that no IL will be required for items not included in the list and the dual use items, having military as well civilian applications.

This position changed with the notification issued on 01 January 2019 which provides that certain defence items will require IL under the Arms Act, 1959. This Act is administered by the Ministry of Home Affairs (MoHA) which has delegated the authority to DPIIT to issue IL in respect of the items covered by the Arms Act, 1959. This notification has split all licensable defence items, which were earlier clubbed under four categories in the 26 June 2014 notification, into five categories under two different Acts. It is difficult to fathom the advantages of this move.

Be that as it may, this splitting would not have mattered much as, for all practical purposes, DPIIT continues to be the sole licensing authority in respect of all defence items, but it is significant that the delegation of licensing powers to DPIIT under the Arms Act, 1959 is conditional. The Secretary DPIIT is to exercise these powers subject to the supervision and control of MoHA and is barred from enunciating any new policy or issue any instructions in relation thereto without MoHA’s prior consent. These powers are also liable to be withdrawn if considered necessary in public interest. It is an avoidable complication, considering that the MoD and MoHA are consulted by the DPIIT anyway before granting IL in individual cases.

There is no reason why DPIIT should have to consult MoHA for laying down, or amending, the policy for grant of IL for manufacturing tanks, armoured fighting vehicles, or even arms and ammunition required by the defence services, which are now licensable under the Arms Act, 1959. Grant of IL for manufacturing all defence items is a matter best handled by the DPIIT as the licensing authority and MoD as the user department. At best MoHA can be consulted regarding grant of IL for manufacturing small arms.

The Arms Act, 1959 was not intended to deal with matters related to manufacturing of arms. The objective of the Act, as laid out in its preamble, is to ‘consolidate and amend the law relating to arms and ammunition’. By implication, the objective of the Act is to empower MoHA to deal with matters related to prevention of manufacturing and circulation of illegal arms through the network of the internal law and order machinery. This also entails laying down of the policy and procedure for grant of license to possess small arms and regulation of the arms trade in the civil market. The Act does not seem to have been made to regulate manufacturing of tanks and arms for the defence services, or even small arms legally.

Bringing of Arms Act, 1959 into defence production has resulted in dual control over Industrial Licensing for defence. This could create serious difficulties in future as and when manufacturing of tanks and arms for the defence services by the private sector picks up. In any case, it does not seem to serve any purpose, which is why the decision to split defence items between two Acts, administered by two different departments, requires a review, along with the following three issues that need urgent attention:

  • The 26 June 2014 notification provided that dual-use items, having military and civil applications, shall not requite IL. This notification was superseded by the 01 January 2019 notification which, however, did not re-promulgate the exemption for dual use items. There is also no order at present to the effect that such items do not require an IL.
  • The 01 January 2019 notification states that IL is required for manufacturing and test proofing of the items that fall in the categories covered by the Arms Act, 1959. However, what constitutes ‘test proofing’ is not specified.
  • The IL is granted by DPIIT under its own or under the delegated, powers after consulting MoD, MoHA, etc., but the applicants are not aware of the considerations on which these ministries recommend or do not recommend grant of IL in individual cases. The resultant uncertainty for the applicants militates against the government’s objective of improving the ease-of-doing business index.

Foreign Direct Investment Regime

Since 2014, FDI is allowed up to 49 per cent under the automatic route and beyond that with the approval of the government wherever it is likely to result in access to modern technology or for any other reasons acceptable to the government. Technically, therefore, it is possible for the foreign investors to set up wholly owned subsidiaries with 100 per cent FDI, subject to the said condition being met. This does not seem to have helped as evident from the DPIIT reports which, however, are at variance with the statistics recently disclosed by the MoD.

Going by the official data on the DPIIT website, the total FDI in the defence sector since 2001 has gone up from Rs 24.36 crore in April 2014 to Rs 51.93 crore in December 2019. This is an increase of Rs 27.56 crore in a little over five years. But, replying to a question in the Rajya Sabha on 23 March 2020, the minister of state for defence intimated that as per the data furnished by 79 companies in the aerospace and defence sector FDI of over Rs 3,155 crore had been received till December 2019, of which investment of over Rs 1,834 crore had been received after 2014.

It is possible that investment is counted as FDI in the defence sector only if it is made in the units manufacturing licensable defence items and the DPIIT figures denote such investments. On the other hand, the MoD figures probably denote the total FDI in the units manufacturing licensable and non-licensable defence items. In any case, it is important to have clarity on this issue as such discrepancies not prevent an objective assessment of the current FDI policy, which is frequently assailed by the foreign investors for being too restrictive on account of the present cap on FDI through the automatic route.

The existing policy also suffers from interpretational uncertainty about what constitutes ‘modern’ technology or what are the other grounds on which the government would be prepared to permit FDI beyond 49 per cent. The demand for greater clarity on this issue is bound to rise with the proposed introduction of Buy (Global – Manufacture in India) as an additional procurement category in Defence Procurement Procedure 2020 as it seeks to permit the foreign companies to manufacture the items or carry out maintenance, repair, overhaul (MRO) through their subsidiaries in India.

This can work smoothly only if they do not have to knock at the DPIIT’s door for permission to invest beyond 49 per cent in an existing production unit or in a new joint venture and to establish that the product to be manufactured, or the MRO to be undertaken, by them in India involves ‘modern’ technology.

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