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Foreign Direct Investment in Defence: Impact Analysis

The recent move to increase FDI limit from up to 49% to 74% through automatic route is debatable whether this change alone will provide the impetus required to boost the inflow of foreign capital and technology into the defence sector. An analysis…

India is currently the second largest importer of defence equipment and has the third largest defence expenditure worldwide, making it a very attractive defence market. However, most of the defence needs of the country have been met by imports and have not resulted in the desired inflow of foreign capital or transfer of technology to meet the growing defence requirements. This is because of the lack of confidence by foreign Original Equipment Manufacturers (OEMs) with regards to the FDI. One such concern that consistently was the 49 percent cap on FDI under the automatic route, which restricted majority control over their Indian joint venture and access to proprietary technology.

Factors Limiting Inflow of Foreign Capital

It is a known fact that the Indian defence sector has been one of the least popular sectors for FDI.Till date India has received a total of Rs 56.88 Crores as FDI in defence from May 2001 till March 2020, which is just 1% of the cumulative total FDI received by the country.From May 2001, when the defence sector was first opened to FDI up to a maximum of 26% under the government route, until September 2014,the total FDI inflow in defence was USD 4.94 Million. When the FDI cap was increased to 49% under the government route in September 2014, this merely resulted in an increase in FDI inflow of USD 180,000. A further liberalization of policy in September 2016 that permitted FDI up to 49% under the automatic route and up to 100% under the government route, “wherever it is likely to result in access to modern technology or for other reasons to be recorded”, also failed to impress foreign players as it only resulted in an increased FDI inflow of USD 4.4 Million.

Apart from setting investment limits the existing FDI policy also stipulates that the entities in which the investment is made should be self-sufficient in areas of product design and development, and should also have maintenance and life cycle support facilities for the products they manufacture. This leads to a deterrent for OEM transferring critical, state-of-the-art proprietary technology to Indian entities because they are not able to own a majority stake in, or exercise control over the entity in which the investment is made. Besides, factors limiting the inflow of foreign capital include the preference of the government to source a significant amount of defence equipment either through Government to Government (G2G) or Foreign Military Sales (FMS) deals or from global OEMs through an extremely complex and lengthy procurement process.

The New Provisions

In one of most significant moves in recent times concerning the defence sector, the Government recently announced that the Foreign Direct Investment (FDI) limit in the defence sector under the automatic route would be raised from the existing 49% to 74%. This change, which was long overdue, comes a decade after the Department of Industrial Policy and Promotion (DIPP) had recommended in a discussion paper increasing the FDI cap in the sector to at least 74%, if not 100%.

The raised FDI limit comes with a rider which entails that all foreign investments in the defence sector would be subject to scrutiny on grounds of ‘National Security’ and the government reserves the right to review any foreign investment that affects, or may affect, national security.

However, this comes with a rider which entails that all foreign investments in the defence sector would be subject to scrutiny on grounds of ‘National Security’ and the government reserves the right to review any foreign investment that affects, or may affect, national security. The ‘National Security’ clause is in addition to the existing four conditions specific to FDI in the defence manufacturing sector including security clearance and some guidelines of the Ministry of Defence. Through a more liberalised FDI policy, the Government wants Foreign Original Equipment Manufacturers (OEM) to shift operations to India and also encourage private players to play a larger role.

The policy change come into effect upon notification of the press note no. 4 of 2020 under the Foreign Exchange Management Act (FEMA).

As per the Press Note 4 (2020 series) dated September 17, 2020 released by Government, the key conditions for foreign direct investment in the defence sector as per the revised policy will be:

  1. For companies looking for new industrial licenses:
  2. FDI will be allowed under the automatic route up to 74%
  3. Above 74%, new FDI will be allowed further to Government approval and such new FDI should result in access to modern technology or provide other reasons for investment above the 74% limit.
  • For existing investments, where the investee company has already acquired industrial license or Governmental approval for FDI:
  • Infusion of new FDI up to 49% by way of a change in the shareholding of the company or by transfer of capital to a new investor, such company shall be required to disclose such new foreign investment to the Ministry of Defence (MoD) within 30 days of such infusion of foreign investment.
  • Every transaction that would increase the FDI in the company to beyond 49% will necessitate prior Government approval
  • The government may review or reject any FDI in any Indian defence company on grounds of national security even if such investment is below the varying thresholds as discussed above.

While the final change is yet to be seen, it is debatable whether this change alone will provide the impetus required to boost the inflow of foreign capital and technology into the defence sector.

Potential implications

The increased FDI cap by the Government aims to ensure the defence supply chain developed in India is sustained and continues to grow, fulfilling the larger objectives of selfsufficiency and cost reduction. However, when we analyze this raised FDI and its implications, then in actuality, it does not seem to make much difference and does not hold much incentivises for foreign OEMs.

Differential treatment

Currently, FDI rules tend to treat the sector as homogeneous. The range of defence manufacturing is varied and complex, ranging from ancillary components, defence equipment components, software, fuselage, missiles to aerospace technology. Hiking FDI limits across all types of defence manufacturing may not adequately address this complexity. For instance, developing advanced defence aerospace technologies is an expensive and a very complex process involving enormous entry barriers and vast R&D. It would be advisable to look at 100% FDI under automatic route in aerospace defence to incentivize global aerospace defence players to part with their proprietary technology.  The current 74% FDI under automatic route may be a good step for other types of defence manufacturing such as missiles, ancillary components, etc.

Raised FDI is contradictory with respect to DPP rules

The reality of the Indian defence sector is that most foreign investments are made for offset fulfilment purposes, and are, at least initially, limited to manufacture of low-technology products, spare parts and components. With the allowance of control in foreign hands, with the increased 74% limit, the initial road-block to such technology transfer has been removed. However, this technology transfer will only be incentivised if the Indian joint ventures with 74% foreign participation are allowed to participate in domestic procurements as “Indian vendors”. 

Interestingly, the Defence Procurement Procedure (DPP) does not permit Indian companies in which the FDI exceeds 49% to participate in all acquisition programmes as prime vendors.

Interestingly, the Defence Procurement Procedure (DPP) does not permit Indian companies in which the FDI exceeds 49% to participate in all acquisition programmes as prime vendors.

For example, only Indian companies owned and controlled by locals with 51% equity can be the principal vendors under the strategic partnership model, which under the DPP is mandated to domestically manufacture aircraft, helicopters, submarines, and armoured fighting vehicles, including main battle tanks via collaborative ventures between private Indian companies and overseas original equipment manufacturers (OEMs).

This, in effect, means that there are no prospects for foreign investment exceeding 49% for any of these mega projects, further limiting the manufacturing envelope for overseas companies as prime vendors. It remains to be seen whether they will be willing to invest over 49% for undertaking smaller manufacturing projects, and if so, how much foreign investment can India receive for such projects.

Additionally, the draft DPP-2020 also disincentivises offset fulfilment through foreign investment in parts and components manufacture, by specifying a negative multiplier for such investments.

Ambiguous Provisions

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 74 percent. Due to ambiguity on what constitutes modern technology, such conditions have and could continue to be a hurdle for 100 percent FDI in the defence sector.

Further, a new condition imposed on all foreign investments, and not just those exceeding 49 per cent, is that these will be subject to scrutiny on grounds of national security and the government reserves the right to review any foreign investment in the defence sector that affects or may affect national security.

This contradicts the notion of investments up to 74 per cent being permissible through the automatic route, as scrutiny from the national security angle implies that it will be carried out before any investment is made. It cannot obviously be left to the investors to self-scrutinise their own proposals.

Summing-Up

For years, the objective of the Government to create a robust Defence Industrial Base (DIB) which has suffered due to the want for of a level playing field for Private sector as well as  foreign OEMs providing technology. As, it is a known fact that the Indian defence production units and the emerging competent private sector do not have the expertise to develop a complete sophisticated military system on their own. They need to tie-up with a foreign entity. The, increasing of the FDI limit to 74 percent might draw global firms to set up manufacturing and integration facilities in India without the apprehension of losing valuable intellectual property due to a lack of managerial control. This in turnis expected to elevate the levels of technology in the sector, encourage competition, and enhance business for subsidiary domestic industries.

Therefore, in order to make the country a defence production hub by attracting more foreign capital and technology, the increase in FDI limits, while a long awaited and welcome step, however, the Government should take a look at the ambiguities and riders that is tagged along. As these certainly has left us with several unanswered questions such as:

  • What is intended by ‘modern technology’ and what ‘other reasons’ can persuade the Government to permit investment higher than 49% remainsvague?
  • What basically is the objective of raising the defence FDI cap from 49 to 74 percent?
  • Is there going to be differential dealingof Indian companies with 49 percent foreign ownership compared with those that have 74 percent foreign ownership?
  • Why would global OEM make a 74 percent investment in the Indian defence sector when that entity will not even be considered an Indian vendor; and would, therefore, be ineligible to bid for projects reserved for Indian companies?

Thus, the raised FDI limit needs to be augmented by consistent, simplified and holistic policy changes across the board or else it many not prove to be beneficial.

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