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INDIAN DEFENCE INDUSTRY REGULATIONS AND REWARDS

Indias defence spending has consistently been on the upswing, both because of its adverse security environment and because it now has the economic muscle to do something about it. The main driver appears to be emerging rivalry with China especially as Beijing seeks to increase its presence in the Indian Ocean. However, traditional rivalry with Pakistan as well as increasing internal security issues are also factors. Rather than just buying hardware, transfer of technology (TOT) is now a consistent feature in Indian procurements. Indias defence procurement budget expanded 450% from 2003 to 2010, and the nation is expected to spend more than USD30 billion on new hardware in the next five or so years. With such buying clout in an increasingly competitive world market, the Indian government is trying to obtain as much as it can for the best price. The government aims to manufacture 70% of its military equipment domestically in the future, the reverse of the 70% it presently imports. But for this to occur, Indian industries need a massive infusion of technology and investment to produce state-of-the-art systems for the Indian Armed Forces.

India is seeking more than just a buyer-seller relationship, and is banking on a rigid regulatory framework as the ideal way of achieving the required level of cooperation. Defence industry operations in India are considered to be frustrating and even murky by most business entities, both within the country and abroad. When discussing the current state of affairs, it is pertinent to remember that the worlds second most populous nation opened up its defence production sector to private industry just eight years ago. The Attractiveness of India All major defence companies are now actively pursuing opportunities on the subcontinent. As most multinational companies now realize, it is necessary for them to be a member of the club, which means it is necessary to make long term commitments. Even though it may take seven or eight years for a sale to fructify, with

perhaps 100 steps in between, India is a market that cannot be ignored. India is searching for a bigger domestic ability and striving to increase the proportion of weapons it makes at home. It therefore creates joint ventures, but any foreign company remains a minority partner. On a scale of ten, the Indian market rates as a ten for Rafael (whose Eurofighter the Indian Air Force is now buying in a ten-billion dollar deal) in terms of its importance. In monetary value the Indian market is second only to Israel for Rafael. While Israel tends to keep a low profile, scientists from the two countries are now collaborating on at least 30 important projects, with Israel transferring technology without fuss. There seem to be five main reasons why India is so important to international companies: 1. Indias capability is expanding, especially through an injection of more money; 2. India has real national security issues that need to be addressed; 3. There is great capacity for local production; 4. There are latent internal security threats; 5. Future spending will see steady increases and new demands. The importance of India is amply portrayed in the Indian Air Forces 126-fighter Medium Multi-Role Combat Aircraft (MMRCA) programme. bargaining power with aircraft manufacturers. For this reason it can stipulate 50% offsets and extremely high TOT levels. Saabs Gripen bid was offering full TOT and the sharing of AESA radar source codes, for example. The likes of Boeing and Lockheed Martin, both MMRCA contenders, have never promised so much to buyers before. This single programme serves to illustrate the lengths foreign companies will go to in order to gain a slice of the lucrative Indian market. More than 70% of Indias military equipment is of Russian origin. The USA is now marketing aggressively, although things are moving slowly because of tough American laws on the export of advanced weapon systems. Nevertheless, India has used the Foreign Military Sales (FMS) route several times to obtain equipment like C-130J

Hercules aircraft. A potential USD5.8 billion C-17 Globemaster III sale currently in the works will be the USAs biggest ever defence deal with India. A US trade mission that visited India in November 2009 estimated future contracts with India could be worth USD15-20 billion over the next three to five years. There is no doubt that India is an extremely alluring market. Regulations and red tape We now proceed to examine the governmental regulations that dictate business dealings in the subcontinent. The foremost among these is the Defence Procurement Procedure (DPP), a document that is regularly updated, and which outlines procedures for both suppliers and buyers. DPP was first introduced in December 2002 to formalise procurement procedures and to bring clarity and transparency to the process. Because of persistent corruption allegations, more transparency and a level playing field for both foreign and domestic players was definitely required. An important milestone occurred with DPP-2005, which oversaw the introduction of offsets as a tool to indigenise production, boost local defence industry and introduce new cutting-edge technologies. Offsets require foreign companies to invest a specified proportion of a contract value into local industries. Originally there were Buy (Indian) and Buy (Global) categories for outright purchases of new equipment. The former category requires a minimum of 30% local content while Buy (Global) is used only as a last resort when equipment is needed urgently and timeframes do not permit local production. An amended version was introduced in November 2009, aiming to streamline DPP-2008. An important element in it is the new Buy and Make (Indian) category that requires a minimum of 50% indigenous content, and seeks to encourage greater local private company participation via tie-ups with foreign technology providers. The Buy and Make (Indian) category permits requests for proposals (RFP) to be issued directly to Indian companies with the requisite financial and technical capability of absorbing technologies and undertaking joint ventures. However, some critics argue the addition of new categories complicates the process rather than streamlining it. To keep pace with a dynamic industry, DPPs are updated regularly - five times in the past seven years so far. DPPs should thus be seen as part of the process rather than

formulaic solution for Indias goal of indigenisation. Contracts worth Rs 80 billion have been signed since the offset policy was introduced, with the aerospace sector consuming 94% of this amount. But the question at the heart of the matter is whether true technological transfer is actually taking place. A likely loophole in the policy is that India does not designate where offsets should be invested, nor does it target the growth of particular capabilities. Vendors invest their offsets wherever they like, rather than where industry really needs them. Obviously, companies are going to opt for offsets that are easiest to fulfil, not necessarily those that are best for India. So far, the typical procedure is for India to purchase the initial quantity of equipment directly from the supplier, and for the remainder to be license-produced in India, as typified by recent Hawk trainer jet and T-90S tank programmes. One other consideration is that offsets do not come free. Studies show a 50% offset level inflates contract prices by approximately 10%. Because foreign vendors incur costs in offsets, these will surely be factored into the final price. Hence, India does not always get optimal value for money through its offset scheme. The question India needs to ask itself is whether offsets are truly upgrading indigenous industries, or are they taxing the defence budget and making life difficult for the Indian Armed Forces? On the other hand, the development of indigenous industry could well be worth any such expenses. In an attempt to make offsets more palatable to foreign investors, offset banking is now allowed. Offset credits can be banked for up to 36 months, permitting foreign companies to spend offsets even before a contract is finalised. This will supposedly lead to greater planning flexibility in the discharge of offset obligations. The results of our offset policy have already started coming, and we expect this to grow, according to A. K. Antony, the Minister of Defence. However, the usefulness of this scheme may be seen in the fact that no offset credits have been banked thus far. A major impediment to growth in Indias defence industry has been a lack of information regarding future defence requirements. A recent initiative publicised by Minister of State for Defence, Dr. M. M. Pallam Raju, should go some way to alleviating this shortcoming. He has announced the release of a Technology Perspective and Capability Roadmap

covering a 15-year period, which will supposedly aid long-term planning. This will enable the domestic industry to plan investment in the defence sector and take up R&D, technology upgradation and tie-up collaboration with associated foreign industry partners in order to meet the future requirements of the Forces. Requests for information (RFI) are now mandatory for all defence acquisitions, so these will also give the defence industry advance notice of upcoming requirements. In a mass of tangled red tape, defence acquisitions fall under the purview of 13 different agencies, and four further agencies oversee the implementation of a signed contract. The typical process is that the user (the Indian Army, for example) issues a requirement, bids are entertained, and trials of contenders subsequently take place. The Defence Executive Council (DAC) is the body with the overall supervisory role in MoD procurements, and it can give approval in principle. The DAC, a department of the MoD, is chaired by the Minister of Defence. The DACs decisions are then implemented by the Defence Procurement Board, Defence Production Board and Defence Research & Development Board. Assuming the MoD gives a particular acquisition the nod, the Ministry of Finance must also approve the contract. Thus a deal can be quashed at the last hurdle, even after the MoDs tacit approval for a particular purchase. This is what happened to the Airbus A330 Multi-Role Tanker Transporter (MRTT) contract, with the Ministry of Finance blocking the deal in January 2010 because it said the aircraft were too expensive. Foreign Direct Investment limitation or catalyst?

India has permitted foreign direct investment (FDI) since May 2001, but only up to a level of 26%. Never keen to share industrial secrets, TOT is not the reason for foreign companies to enter into these partnerships. Furthermore, they are unlikely to transfer critical technologies. Instead, indigenous production tends to mean assembly of subsystems or kits, which does little to induce self-reliance or technical know-how. Indias private sector is still evolving, with large firms like Ashok Leyland, Larsen & Toubro (L&T), and Mahindra & Mahindra all moving into the defence sector.

Interestingly, even local industry recognises the limitations of the current system. The Associated Chambers of Commerce and Industry of India (ASSOCHAM) have called for the government to raise the FDI limit in the domestic defence sector to 49%. The association said this would facilitate increased investment in the private industrial base and result in faster adoption of the latest technologies. Private versus public Our quest for self-reliance in defence underlines the importance of private sector participation on the one hand, and revitalising the public sector on the other. We want the public sector and the private sector to work in close cooperation, as friendly partners, according to A. K. Antony. India has an industrial base of 40 ordnance factories and eight defence public sector undertakings (DPSU). Historically, the MoD always nominated a PSU as the production agency, and private companies never got a look in. It therefore remains pretty much a public sector production model, with PSUs careful to protect their favoured status. DRDO is the largest PSU cog, but its history of delays and cost overruns is notoriously well known. Its major programmes have an accumulated 40 years of delays and are estimated to be USD1.6 billion over budget, according to the defence minister. DRDO is usually not able to complete its primary mission of establishing indigenous production, despite consuming 6% of the defence budget. Although vast amounts of money are poured into DPSUs, they seldom produce the expected results. However, the MoD recently instituted a series of measures to transform and revitalise DRDO.

Originally the private sector simply supplied raw materials to PSUs, but now it is gradually taking up systems integration and manufacture of complete weapon systems. In the light of persistent failings in the public sector, India has realised the need for private-sector involvement. Eurocopter is one overseas corporation seizing new opportunities, and has partnered with HAL (Hindustan Aeronautics Limited). Eurocopter already has an agreement with HAL to outsource Fennec fuselage parts for its global supply chain. However, the worlds largest helicopter manufacturer has been at the receiving end of bitter disappointments in its Indian journey too. After winning the

197-craft Light Utility Helicopter (LUH) contract, the deal was eventually annulled because a militarised Fennec AS550 C3 was not available at that time. According to MoD procedures, the contract had to be cancelled. However, Eurocopter is again competing in the reincarnated Reconnaissance and Surveillance Helicopter (RSH) programme, which will entail 50% offsets and local production. This raises an important issue for foreign companies seeking local partners. The company has also stated that Eurocopter could shift half of its global production capacity to India in the future, which would be an astounding move if it fructifies. Again it underscores how, despite all its frustrations, India is just too big a market to ignore for many global corporations. Transparency versus corruption Weve made our defence equipment procurement procedures transparent and are also endeavouring to speed up the defence acquisition process, according to A. K. Antony. This quest for transparency has been necessitated by well-known bribery scandals. Many prominent defence manufacturers have been blacklisted for corrupt practices, though only a handful have ever been indicted. A case in point is ST Kinetics of Singapore, which entered its Pegasus lightweight howitzer in an Indian competition last year. Immediately after delivering a gun to India for evaluation, the process was suddenly suspended because of corruption allegations. Alarmingly, ST Kinetics only learnt of the situation through media reports. Were perturbed by the change of events and feel strongly that we have not been fairly treated as a legitimate bidder who is committed to helping the Indian MoD with its modernisation efforts, said Gaius Ho of the Singaporean company. ST Kinetics is definitely a victim of the whole situation. Denel was also blacklisted in 2005 amidst allegations the company offered bribes to obtain sensitive information. HDW was similarly banned for bribery and kickbacks involving Type 209 submarines. The Bofors scandal in the late 1980s is perhaps the most famous case, and the Swedish firm was banned from future dealings. This action resulted in the Bhim self-propelled howitzer (SPH) project being abandoned, which consequently set back Indias artillery modernisation efforts. Another result of such bans is that spare parts have to be obtained via expensive middlemen. Blacklisting bidders severely curtails the number of choices available in rerun or future competitions, which

is of special concern when allegations are so rarely upheld by prosecutions. Of interest, not one artillery piece has been acquired since the 1987 Bofors deal soured. India introduced robust regulations and DPPs to bring clarity to large defence acquisition projects. However, a side effect is that things now proceed more slowly in the face of potential bribery accusations, where everyone is afraid of scandals. Military and civilian leaders are wary of making hasty decisions in case they are later prosecuted. The legacy of past witch hunts is a pall hanging over the industry. The outlook The Indian government is reportedly considering a system whereby state-owned industries in every sector must procure at least 20% of components from domestic small and medium-size enterprises (SME). The Foreign Investment Promotion Board (FIPB), which sets and implements nationwide FDI rules, is also launching an electronic filing system for foreign proposals to streamline the process. There is no doubt India is slowly developing its indigenous defence industry, as evidenced by its growth as an outsourcing defence industry hub. Companies like Eurocopter and AgustaWestland are setting up operations in India, for instance. Many Indian firms are also expanding globally - Tata Motors is one example. Yet despite MoD assurances about speeding up defence purchases and enhancing local sourcing, the Indian Armed Forces are still seriously under-equipped. A recurrent problem is that long periods pass before deals are finally inked. The evaluation process for new hardware is usually lengthy as systems undergo trials in different climatic extremes (summer and winter trials are common), but this is not the main reason for routine tardiness. Perpetual delays caused by red tape are affecting Indias pace of modernisation and operational readiness, and this is of concern to the Indian military. Likely, the Indian government will begin to see procurements as a diplomatic tool to help it rub shoulders with other advanced countries and gain more influence on the global stage. India is providing more funds for modernisation, but this does nothing to eradicate the fact that Rs 500 billion has been returned unspent to the Indian Treasury over the past 15 years because procurements never moved forward as they should have. Up to 30% of the defence budget earmarked for modernisation is regularly

surrendered. Thus the vagaries of annual budgets need to be replaced by rolling nonlapsable budgets. It can be seen that there are major challenges before the defence industry in India starts thriving, but there are financial rewards to be had in the large and expanding Indian market.