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FDI in Aerospace and Defence

Neither the government nor the Indian private sector has the risk appetite to make the investments required to build the infrastructure for the aerospace and defence sector. Cmde. Sujeet Samaddar advocates inorganic growth must be recognised as a useful tool for the growth of this sector and FDI is the logical answer.

Going by the past trends and the clear requirement for much needed modernisation of the armed forces, the budgetary support covering the XIIth, XIIIth and XIVth Five Year plans could be at least INR 2,000,000 Cr. Assuming about 50 per cent of the allocation would be towards capital procurements and considering that the present delivery capacity of the national defence and aerospace industry being only about INR 35,000 Cr annually, it is well understood that domestic capability alone would not meet the targeted acquisitions in the allocated 15 years. Therefore, in-country manufacturing capacity and technical capability has to be augmented or the country would remain dependent upon imports. By some calculations the capacity enhancement required would be the equivalent of 2 more MDLs, 3 more HALs and 4-6 more BEL/BDL units. A back of the envelope calculation puts the investment in new capacity at not less than INR 50,000 Cr to meet these acquisition targets from within India. This investment would have to be in place by 2015 if the force level targets are to be met from largely indigenous sources. Since neither the government nor the Indian private sector has the risk appetite to make the investments required to build the infrastructure for the aerospace and defence sector inorganic growth must be recognised as a useful tool for the growth of this sector. Therefore, FDI is a logical answer.

There is no doubt there are different views on FDI, depending who is seeing what aspect from which angle but the crux of the matter is the alleged apprehension that FDI in the aerospace and defence sector is a security hazard. The following facts may be illuminative.

In the recent past, orders for 258 Mi17 helicopters from Russia have been signed but no production facility in India has been created. In effect, the induction of the Mi17s is at the mercy of the foreign OEM, fortunately friendly. Likewise, 197 helicopters for the army and air force, 56 utility helicopters of the Navy and another 135 multi-role helicopters for the navy are acceptable to be procured from foreign OEMs with their production facility abroad but amazingly, it is not acceptable that these OEMs set up a production facility either as a wholly owned subsidiary or even a majority JV in India to manufacture these helicopters in India. Which situation affords the larger security risk? Having these helicopter built in India by the OEM even as a wholly owned subsidiary or built abroad by the OEM and delivered in India?

For the 123+20 AJT Hawk and 272 Su-30 deals a licenced production facility at HAL has been created. Again such a facility is at the mercy of the OEM since there is no equity interest in this proposition and after the demit of the agreed number of licenced produced aircraft a new deal has to be negotiated. Indigenisation in a licenced production agreement is against the business interest of the foreign OEM because it dilutes his IP, reduces his work share, requires certification, possibly creates a competitor in the long run and directly impacts his business profits. Is it logical for a foreign OEM to empower the Indian vendor on these terms? Would not larger benefits be forthcoming if the OEM senses a business opportunity for growth through local production in its own subsidiary for a global market and structures his business case to be cost competitive by leveraging low cost manufacturing from India which does not impact his bottom lines, still protects his IP and generates legitimate wealth for his shareholders and yet builds Indian capacity and capability? In these matters Company Law and business practices cannot be overlooked. Such decisions require Board approval and shareholder acquiescence. Unlike pure equity investments capital investments through land and buildings, plant and machinery and tools and equipment plus the expenditure on human skill development add upto to a tidy number in terms of capital assets. Once committed expenditure, approved by the Board of Directors of the OEM, has been incurred towards establishing a subsidiary and investing in building capital assets walking away from these assets whimsically is not at all an option for OEMs. On the other hand, equity investments can be withdrawn at will. So higher the FDI the lesser the risk of asset or capital flight and better the chances of local production for the global market.

Hindustan Aeronautics Limited (HAL) has rejected a proposal of the IAF to produce Pilatus aircraft in its facilities. HAL is in favour of developing the HTT-40 aircraft in house by 2015, an unlikely milestone-since development, testing and certification are complex matters and invariably are bound by flying hours and flight safety considerations before air worthiness and type certificates are granted.IAF has already placed an order for 75 Pilatus trainer aircraft and is planning to procure 106 more of them after the completion of the delivery of first lot by the end of 2017. Of the total orders of about 500 Pilatus aircraft over 20 years the Indian order is itself more than 33 per cent covering half that span period. This would have been an ideal opportunity for pressing Pilatus aircraft to setup a facility in India to manufacture these and other Pilatus products even it is wholly owned subsidiary or even an attractive JV with the private sector. Would that not benefit the country? Similarly, had the AVRO and the AN-32 replacement program be consolidated it is possible that the total requirements clubbed together would be about 160 cargo and transport aircraft in the 6-10 category. Another opportunity for the country to insist these aircraft be manufactured in India whether by the wholly owned subsidiary or by a “reasonable” JV.

Thus, consolidation of acquisition cases is yet another means to develop the national defence industrial base through focussed FDIs as the chart below depicts. If the three services can be persuaded to select aircraft and helicopters with engines from a common source then more than 500 engines of a particular type (which may go upto 1100 engines for fixed wing aircraft and another 500 engines for helicopter) would be on order. For this very attractive number is it logical that we should import and not allow the engine manufacturer to set up a production facility in India even if 100% FDI in the enterprise is sought by the OEM? Also, each engine has maybe a set of 6 propellers? Would it not make sense to persuade the propeller manufacturer to set up a subsidiary in India for a potential domestic market of 3000 propellers in the military aviation side and another 2000 propellers in the civil aviation sector? This does not include servicing the pan-Asian demand which may well be at least twice that of Indian domestic demand.

Incidentally, in the Public Sector Government have approved Joint Ventures with FDI in excess of the stipulated 26%. BrahMos is a 50.5:49.5 JV, HAL/BAe is a 50:50 JV, HAL:RR is a 50:50 JV, FGFA is a 50:50 JV and these are all successful ventures. But a similar dispensation is not extended to the private sector. The reasons are unclear if not illogical.

The experience of other countries can also be helpful in appreciating the role that FDI plays in developing the indigenous industrial base. Brazil has the Embraer (earlier a 100% govt Company and then with partnering with Alenia/Aeromachhi has now become the 4rth largest aircraft manufacturer) and Helibras with Eurocopter success story. South Korea has the KAI-EC a 50:50 JV with Eurocopter and they are now developing the world's most sophisticated sub 10 tonne helicopter, Surion, with 12 tonne performance! South Africa has also succeeded in the MEKO frigate program, Infantry vehicles and the Roofolk helicopterapart from being the world leaders in fuzing technology and GIS (Diamond aircraft). In the United States the third largest supplier of defence equipment to its armed forces is a wholly owned subsidiary of a British company. None of these countries have collapsed or their security compromised because of higher FDI in the sector, In fact all of them have benefitted and prospered .On the contraryhaving persuaded foreign OEMs to invest and set up in-country manufacturing facilities provides greater security.

Similarly, orders for UAVs, SAM systems and Armoured vehicles are being placed on foreign OEMs but as per the existing guidelines these OEMs are not allowed to set up a plant in India either by themselves or in partnership with Indian companies on fair equity participation to directly deliver to the Indian armed forces. Apart from the fact that all assembly and integration, testing and delivery of systems manufactured in India by a foreign OEM will require local industrial support the moot point is that it will also spawn a satellite of SMEs feeding the national defence industrial complex. This would create the larger ecosystem for a successful defence industrial complex.

It is therefore, quite simple to comprehend that greater security is achieved if equipment is manufactured in India even by a foreign OEM than through reliance on imports. The sad state of affairs in the Indian aerospace sector is that even a simple trainer aircraft or a transport aircraft have to be imported into India and that is not only a security risk but a matter of national shame.

Core national priorities such as job creation and getting the right technology also dovetail easily into making a stronger case for larger FDI in this high technology sector which has natural spinoffs in other sectors also.The case for a higher FDI in the defence sector is in the national interest provided foreign OEMs set up legitimate companies in India under the Companies Act and comply with the taxation and regulatory framework of the country. All of these provisions are highly regulated and infractions are easily visible and punishable. Infringements by the OEM abroad are not subject to Indian law, not visible and neither subject to close oversight by Indian buyers. Hence, the country is often faced with alleged scams whose investigation is endless and which have, as on date, not obtained a single conviction but placed foreign OEMs on a blacklist!! The heart wrenching story of the Indian Artillery practically without guns for over 30 years is a strong case for local production whether by public, private or OEMs. Locating plants in India provides better leverage in such situations since even the plant itself can be attached for criminal or civil violations of Indian law.

However, industry bodies led by the big houses are against any increase in FDI caps. This rejection is purely driven by narrow business interest of these companies in complete exclusion of the national interest. Their logic has business merit though akin to the candle makers petition to ban electricity and the sun since they affect the candle business. Since they have already invested or are in the process of investing large sums in creating infrastructure and are yet to receive any substantial order allowing foreign OEMs to set up industry in India would queer their business interest. Of course.this logic is couched in terms of national security which these companies are hardly competent to comment on and on self-reliance of which there is little practical evidence.

Whilst the sector has been opened to foreign investment the central debate is on the cap on FDI. At the moment it is a relative cap that limits investment up to 26% in the manufacturing sector irrespective of the quantum of investment. So we see many foreign OEMs with 100% equity into the services sector for example in engineering support services, creating many thousands of high skill jobs but none in the manufacturing in the private sector. Though the Indian acquisition program is truly of gigantic proportions but clear incentives are required for foreign OEMs to locate manufacturing bases in India. A mere 26 JVs have been approved since opening up of the sector and the investment is a meagre US $ 4.8 million over 22 years. The details of joint ventures by the private players in defence manufacturing are given in Table.

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No matter how big the domestic demand maybe it is not possible for Indian industry to prepare a business case simply relying on Indian orders for the business to be sustainable and therefore addressing the larger global market is a must. Therefore, FDI has to be supported by a reasonable export policy. In addition, we also have a national target to get manufacturing sector to move to 22% of GDP by the end of the XVth Five Year plan, create 1 million jobs per month then the A&D sector cannot be ignored as it provides some opportunity to meet these daunting growth targets. But this requires investment in huge numbers and since these are not forthcoming from government or Indian industry the FDI route is a logical solution.

Therefore, in view of the foregoing a forward looking FDI policy in this sector is a must. Such a policy must address the core issues of both absolute and relative limits of investment, what that investment does towards building Indian capability and capacity and how that investment impacts the defence technology base of the country. Experience from the automobile, petrochemical and infrastructure sector show that FDI does bring in technology, creates jobs and most importantly spawns robust SME suppliers. Contrarily the liberal FDI policy in the Telecom sector has not spawned a manufacturing base but has brought in major improvements and efficiencies in the services segment of this sector.

In deciding the appropriate threshold for FDI both percentage and the absolute investment number are important. For example, an investment of only US$ 500,000 which buys 90% equity in a company is different from a US$ 2 Billion investment that buys 10% equity in another company. FDI decisions should be guided by three basic value propositions. First, FDI must build sustainable long term in-country production capacity, second must build technical capability through higher level skill sets in manufacturing such as system integration and production planning and services such as quality assurance and program management and, finally create a viable and sustainable business model for the investor as well as the new entity.

On balance the following FDI policy is proposed:-

Sectoral Relative Limits

» Upto 49% no approval is required

» 50-74% require approval of the FIPB

» More than 74% including 100% wholly owned subsidiaries for manufacturing high technology products require approval of the CCEA but would attract the attendant matters of permanent establishment, transfer pricing and relevant provisions of the applicable Double Taxation Avoidance Treaty.

Sectoral Absolute Limits

» Upto US$ 10 Million no approval is required irrespective of the equity holding

» Between US$ 10 to US$ 200 Million requires approval of the FIPB

» Investment of more than US$ 200 Million requires CCEA/CCS approval.

Segmental Rules

» FDI is only applicable to the manufacturing sector with its attendant tax and regulatory compliances of licences etc

» There are no restrictions for FDI in the services sector such as MRO, Engineering Support Services etcbut with its attendant service tax compliances.

In conclusion it can be said that recent policy guidelines of the Government of India on FDI in the defence and aerospace sector is an encouraging initiative in bringing together the requirements of the services and of industry to work together in creating a defence industrial complex that India can be proud of.

The investments required to meet the acquisition targets are immense and are not within the capability of the Government or Indian industry to make these investments at the cost of say, social or education expenditure. Hence, FDI is a necessity. It is a fallacy to believe that greater seurity is achieved through imports from OEMs and disallowing the OEMs to create a manufacturing base in India. For OEMs to set up plants and be organic to the national defence and industrial complex the FDI norms must be further liberalised. One method is to consolidate acquisition proposal of the three services and group them towards providing the economies of scale that make for a viable business case. The other is to address both relative and absolute caps in this sector.

Written By

Cmde (retd.) Sujeet Samaddar

Cmde (retd.) Sujeet Samaddar

 

1 Response

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