Can a Higher FDI Cap for the Defence Sector Stimulate Investment?

As a part of the larger package to rejuvenate India’s economy, savaged lately by the COVID-19 pandemic, finance minister Nirmala Sitharaman had announced on May 16 that the cap on foreign direct investment (FDI) in the defence manufacturing sector will be hiked from 49% to 74% via the ‘automatic route’.

Four months later, the Department for Promotion of Industry and Internal trade (DPIIT) notified the raise in the FDI cap on September 17, albeit with a thorny rider: 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.

It is not immediately clear whether the scrutiny and review refer to the same pre-approval process, or whether the government’s intention is to exercise the right to review the investment any time even after it has been approved. The chances are it is the latter, in which case the new FDI policy introduces yet another adverse point of control over foreign investments.

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Major hurdles

So far, foreign investments of up to 49% were permitted in defence through the ‘automatic route’. This limit could be exceeded only with prior government approval which depended on somewhat imprecise and subjective considerations: either it results in ‘access to modern technology’, or should there be some ‘other reasons’ to convince the government to permit higher FDI.

What is meant by ‘modern technology’ and what ‘other reasons’ can convince the government to allow investment exceeding 49% remained undefined. And though investment under the enhanced 74% cap will now not depend on these factors, the fact remains that it will still require prior government clearance, this time on security grounds.

Understandably, scrutiny of the investment proposal cannot be under the investors’ own purview, but even for a government agency it may not be an easy task.

The concept of national security is so wide, ambiguous, dynamic, and undefinable that it can pose problems when proposals are scrutinised by the designated agency which will need to consult with the defence, home, and external affairs ministries before according eventual clearance for FDI proposals, though the DPIIT notification makes no mention of consultation with the external affairs ministry.

With the involvement of such a multiplicity of ministries and departments, propelled by differing national security perceptions, proposal scrutiny could be time-consuming, and the outcome uncertain.

Ironically, this was already a major hurdle under the FDI policy which, as mentioned earlier, failed in suitably defining ‘modern technology’ or providing any indication of unstated ‘other grounds’ on which the government would be inclined to approve or reject proposals for investment in the defence sector beyond the mandated 49%.

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This is best illustrated by the proposal submitted by France’s Direction des Constructions Navales (DCNS) now Naval Group in 2016 for 100% FDI to transfer Air Independent Propulsion (AIP) technology to India for installation on the Indian Navy’s diesel-electric hunter-killer submarines.

The AIP technology enables submarines to remain underwater for long periods without surfacing to recharge their batteries.

The finance ministry’s Foreign Investment Promotion Board (FIPB), which then was the designated agency to approve FDI proposals, evidently rejected DCNS’s proposal on the flimsy and inexplicable logic that AIP technology was not modern and, in any case, it was already being developed by the French company in collaboration with the government-run Defence Research and Development Organisation (DRDO).

Four years later, the AIP system is still under development by the DRDO, although two ‘Kalvari’-class French Scorpene submarines on which these systems were to be fitted have already been commissioned.

In the process India lost out not only on local investment by DCNS, but also on a critical operational technology which could have been developed and integrated with the submarines much earlier. Such ambiguity in implementing FDI policy only discourages foreign investors from looking at India as a destination for collaborative ventures in defence or setting up wholly owned subsidiaries.

The uncertainty surrounding the FDI policy is poised to burgeon with the government reserving the right to review investments which it considers would adversely impact national security.

In the absence of any clarity on the possible outcome of such reviews and their impact on the investment already made, this edict can only increase the risk for the foreign investors.

Given this ambivalence, it is not surprising that several changes to the FDI policy since 2014 have failed to attract any substantial foreign investment in defence. According to the data available on the DPIIT website, the total overseas inflows in the defence sector between May 2001, when it was first opened to foreign investment, and March 2020 is a meagre Rs 56.88 crore.

And, though the minister of state for defence Shripad Naik made a startling revelation in the Rajya Sabha on September 14 that investment of over Rs 3,454 crore had been received in the aerospace and defence sector, the fact remains that it does not amount to even one per cent of the total foreign investment inflow into India in the last two decades.

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Global risk aversion

Broadly, three factors appear to account for foreign companies’ lack of enthusiasm for investing in India in the realm of defence production.

Firstly, there can be no lucrative business case for investing in an Indian defence company or setting up a wholly owned subsidiary, if there are no reasonable prospects for the investee to locally market his wares or services or both, or to export them.

While India is potentially one of the biggest defence markets in the world today, the Ministry of Defence’s (MoD) enduring indigence inhibits its capacity to buy defence materiel whether from within the country or abroad. No foreign investor can be expected to invest in the defence manufacturing sector in India and wait upon the MoD to determine whether and when it acquires their product.

As for exports, some of the world’s largest materiel buyers – Saudi Arabia, Egypt, Australia, China, Algeria, South Korea, the UAE, Iraq, Qatar, and Pakistan – are less likely to buy India-made equipment, opting for proven Western or even Russian military kit instead.

Given this reality, it is unlikely to be commercially lucrative for the foreign manufacturers to relocate their production facilities to India or to invest for setting up new ones.

Secondly, 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.

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And thirdly, ambiguities in the existing and imminent FDI policy in DPP 2020 which lend themselves to subjective interpretation, as in the case of DCNS proposal mentioned above, discourage prospective investors.

These ambiguities are poised to increase with the foreign investment over 49% being subject to prior scrutiny from an undefinable national security angle.

The added rider of investments approved with prior scrutiny possibly being also open to review in future and lack of clarity about the eventual outcome of such reviews further complicates matters. The new FDI policy could easily end up tying foreign investors in more knots and needlessly erecting barriers in an area ripe for growth.

In conclusion, erratic investment policies subject to frequent change, alongside equally complex procurement procedures and arbitrary and bureaucratic application of rules which foster interminable delays, collectively militate against creating an investment friendly environment in India’s defence sector.

Entrenched bureaucracies, like India’s, are invariably risk-averse and fundamentally opposed to bold changes in policy and procedures.

This needs to change if India is to compete with the more successful countries who treat their investors, innovators and manufacturers in the military sector as partners and not adversaries who need continually to be reined in through stringent controls.

Amit Cowshish is former financial advisor (acquisitions), Ministry of Defence.