First-ever open debate on foreign investment in Indian defence

India’s business media thrives on reporting possible changes in foreign direct investment (FDI) limits that range over legally significant figures from nothing to 26% and 49%, and on to 50%, 51%, 74% and 100%. The figures give foreign companies varying degrees of control, and each level provides easy media stories and catchy headlines – and simple facts for sources to plant with minimal briefings on gullible journalists.

In the past the debates – or, rather, the pushes and pulls of (often suitcase-carrying) vested interests – have been invisible behind the headlines. But that has now partly changed. The Commerce Ministry’s industrial policy department (DIPP) has publicised a debate about whether FDI should be raised in defence production by issuing a discussion document that covers all the issues. More discussion documents are planned on FDI in retail and low cost housing and other subjects.

This is surely good. I wrote here in February last year that one of the biggest weaknesses affecting India’s economic liberalisation was the way that industrial and allied policies are made and changed without apparent reasoned analysis and debate. The biggest-ever changes in assessing foreign control for as FDI had then just been announced, leaving virtually everyone totally confused. The general conclusion was that the changes were designed to facilitate specific big company deals – and that big funds had accordingly flowed into the Congress Party’s election coffers. No-one denied it – how could they – but the then commerce minister Kamal Nath extolled the changes’ virtues without much clarity.

The government’s defence manufacturing discussion paper has raised the basic question of whether FDI is needed and, if so, how much. This is a good question, and it has rarely been asked on any Indian FDI in the past.

Responding to vested interests

Instead, responding to vested interests, the government has gradually opened the floodgates – for example in telecoms, but only after Indian companies such as Bharti AirTel had had time to establish a leading Indian presence. It has blocked it in general retail because of pressure from big Indian companies such as Reliance, Tata and the Future group, though Kishore Biyani who runs Future is believed to be changing his mind. It has also blocked it at 26% in insurance because of public sector resistance to a higher limit even though many private sector insurance companies urgently need foreign funds, and at various levels in media to please influential media interests such as the Times of India group.

Some of these decisions were surely sensible. Indian companies need time to establish themselves before FDI is allowed at such high percentages that foreign companies swamp the market and make India in effect a virtual subsidiary of powerful developed economies.

That is the issue now in defence – is it time to open up and how far? Currently the FDI limit is 26%, apart from a very few higher exceptions, and it is generally accepted that this is not enough to attract commitment, top executives and high technology from most foreign defence companies. A notable exception is the UK’s BAE Systems, which has a 26-74% joint venture with Mahindra & Mahindra (M&M ) for products (land systems to use the jargon) ranging from trucks to guns, which I mentioned about four months ago.

It is now fashionable to argue that it is illogical to restrict defence FDI because foreign companies from Russia, Israel, Europe and the US control the market by supplying about 70% of India’s defence equipment, as they have done for years. If there is already such foreign control goes the argument, why not let the suppliers into India with higher FDI. This would boost India’s auto industry-based and high-end manufacturing industry, generate employment, and enable the country gradually to become a defence equipment exporter.

Strengthening that argument is the government’s evolving “offset” policy that requires foreign defence suppliers to spend 30%-50% of a contract’s value on defence equipment investment and purchasing in India. This is making it more attractive for the foreign suppliers to set up joint ventures here, and is correspondingly leading to increased foreign pressure on the government for FDI above 51%.

CII-KPMG Defence FDI survey

The domestic industry, led by companies such as Larsen & Toubro (L&T), M&M and various Tata group businesses, however wants the limit raised only to 49% so that they maintain control and have a chance to grow, having been restricted till relatively recently from doing more than supply components. This view has been backed by a recent Confederation of Indian Industry-KPMG survey with 57% of respondents saying “yes” to a higher FDI limit and 26% more saying “maybe”.

There have been various unsuccessful attempts in the past ten years to reform India’s slothful defence manufacturing capability, which is dragged down by public sector corporations (DPSUs) and ordnance factories that dominate production, generally perform badly, and block change along with trade unions and the defence ministry. Currently, they are opposing any increase in the 26% limit.

India’s armed forces are however becoming tired of being saddled both with poor domestic equipment and by the defence ministry’s failure to award foreign contracts on time. As the government’s FDI consultation paper says, “only 15% of equipment can be described as ‘state of the art’ and nearly 50% is suffering from obsolescence”.National security coindserns

National security concerns

There is some concern that India’s security interests will be endangered if FDI is raised, but most of these can be dealt with by detailed regulations. For example, India will presumably pick and choose which countries to admit  – presumably not China, despite that country’s invasion of India’s telecoms equipment market. It will also need to insist (as it has done with media FDI) that Indian nationals hold top managerial posts, and that it also controls export destinations and have some influence over changes in foreign management control. (The US allows 100% FDI in defence but imposes security-related restrictions, including an ability to block takeovers).

There is also concern that a foreign-invested defence company might be forced by its owner to stop production, or not receive components from its home country, if India was involved in a war or other activity that did not get international backing. The US has blocked supplies, most recently after India’s 1998 nuclear tests. That risk however would presumably be no greater than it has been in the past with foreign supplies, and might turn out to be less serious.

The Commerce Ministry DIPP discussion document firmly recommends 74% – and does not oppose even 100% – in order to “have state of the art technology”. Raising it only to 49% might, it says, lead to accusations “by posterity of doing too little too late”.

Personally, I don’t agree with this. Indian companies need time to grow, as they have in telecoms and insurance, so the limit should be raised to just 49%. That would, I believe (having talked to many contacts), be sufficient to bring in commitment, management expertise and technology, despite foreign companies’ protestations to the contrary.

Unfortunately this seems unlikely to happen. The Commerce Ministry has started a public debate on the issue with a spectacular attempt to crack the defence establishment’s luddite grip on policy – but the decisions will be still dominated by the defence ministry cabal. I guess that means we can expect no more than a fudge of 49% in “special cases”, which will help a bit but lead to confusion and manipulation.