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FDI in Defence: Need for Liberalisation and Simplification

Amit Cowshish is a former Financial Advisor (Acquisition), Ministry of Defence and presently a Distinguished Fellow with the Indian Institute for Defence Studies and Analyses. Click here for Detailed Profile
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  • May 04, 2017

    In April 2001, the ‘defence industry’ sector was opened up for full participation by the Indian private sector and foreign direct investment (FDI) was capped at 26 per cent, subject to licensing.1 In the last two years or so, the policy has been tweaked a couple of times, first by raising the FDI cap to 49 per cent in August 2014 and then to 100 per cent in June 2016 (subject to government’s approval beyond 49 per cent), as well as by making other changes in the FDI policy.

    But the government’s expectations in terms of attracting large scale investment have been belied, with the actual inflow at just about Rs 1.12 crore (USD 0.1 million) during this period. The total FDI in the defence sector since April 2001 does not amount to even 0.01 per cent of the total FDI inflow into India since the turn of the century.

    This is an unexpected statistic. Could it be that investments made for the manufacture of defence or dual use items or for the provision of defence-related services that do not require the manufacturer/service provider to obtain an industrial licence have not been accounted for under this category? Even if that were to be the case, the fact that there has been almost negligible investment in the core defence manufacturing sector calls for a serious review of the policy, which should, among other things, lead to the conditions attached to FDI being made more intelligible than is the case at present.

    The FDI policy currently in vogue was notified by the Department of Industrial Policy and Promotion (DIPP) vide Press Note 5 dated June 24, 2016.2 (Most of it was carried forward from the earlier FDI notification.) The relevant portion of Press Note 5 reads as follows:

    Sl. No. Sector/Activity % of FDI Cap/Equity Entry Route
    5.2.6 DEFENCE
    5.2.6.1 Defence industry subject to industrial licence under the Industries (Development & Regulation) Act, 1951.

    Manufacturing of small arms and ammunition under the Arms Act, 1959.

    100% Automatic up to 49%

    Government route beyond 49% wherever it is likely to result in access to modern technology or for other reasons to be recorded.

    5.2.6.2 Other Conditions:
    (i) Infusion of fresh foreign investment within the permitted automatic route level, in a company not seeking industrial licence, resulting in change in the ownership pattern or transfer of stake by the existing investor to new foreign investor, will require Government approval.
    (ii) Licence applications will be considered and licences given by the Department of Industrial Policy & Promotion, Ministry of Commerce & Industry, in consultation with the Ministry of Defence and Ministry of External Affairs.
    (iii) Foreign investment in the sector is subject to security clearance and guidelines of the M/o Defence.
    (iv) Investee company should be structured to be self-sufficient in areas of product design and development. The investee/joint venture company along with manufacturing facility, should also have maintenance and life cycle support facility of the product being manufactured in India.

    There are several issues with this notification. The very first issue arises from the fact that the term ‘defence industry’ used in the FDI policy has not been defined. One can, of course, draw the inference from the text that the FDI cap applies only to industrial units engaged in the manufacture of defence items that require an industrial licence under the Industrial (Development & Regulation) Act, 19513 or Arms Act, 1959 or the Arms Act, 1959. But that would imply that other industrial units, engaged in the manufacture of items which do not require industrial licence, including units providing services related to defence manufacturing, do not qualify as defence industry and, therefore, the FDI cap does not apply to them at all. This will be a fair inference to draw but a categorical statement in the FDI policy to that effect will go a long way in removing the doubts that linger in the minds of investors.

    Two, the stipulation that FDI beyond 49 per cent may be permitted by the government ‘wherever it is likely to result in access to modern technology or for other reasons to be recorded’ is quite ambiguous. ‘Modern technology’ is not defined, and there is no indication as to which ‘other reasons’ will be considered good enough by the government to permit FDI beyond 49 per cent.

    To be fair, it may be difficult to define what constitutes ‘modern technology’. But then why lay down a condition that lends itself to different subjective interpretations? It not only creates uncertainty and anxiety for investors but also makes it difficult for the bureaucracy to approve an investment proposal since it could always be challenged on the grounds that it did not entail access to modern technology or that the ‘other reasons’ were not good enough to accept the proposal. If nothing else, some of the ‘other grounds’ could be specified in the policy. For example, the creation of a specified number of jobs or setting up of the manufacturing unit in a notified backward area could be two of the many ‘other conditions’ that will complement the government’s development agenda.

    Three, each of the four conditions stipulated in the FDI policy (reproduced above) needs to be reviewed to bring it up to date and ensure greater clarity. According to the first condition in paragraph 5.2.6.2 quoted above, ‘infusion of fresh foreign investment within the permitted automatic route level, in a company not seeking industrial licence, resulting in change in the ownership pattern or transfer of stake by the existing investor to new foreign investor, will require Government approval.’ It is difficult to understand this. The government had notified a list of defence items that can be manufactured only after obtaining an industrial licence.4 A company will not seek an industrial licence if it is not engaged in the manufacture of any of these notified defence items. As no FDI cap is prescribed for investment in such companies, investment up to 100 per cent can be made in them through the ‘automatic route’. Is it the intention of the government that foreign investors should seek permission if they want to infuse fresh investment in a company where 100 per cent FDI is otherwise permitted through the ‘automatic route’, if such infusion leads to change in the ownership pattern or transfer of stake by the existing investor to the new foreign investor? Hard as it is to understand the logic of this stipulation, greater clarity is required about the actual import of this condition.

    The second condition laid down in paragraph 5.2.6.2 is that the ‘licence applications will be considered and licences given by the Department of Industrial Policy & Promotion, Ministry of Commerce & Industry, in consultation with the Ministry of Defence and Ministry of External Affairs.’ This seems to be outdated. A notification on the government’s e-biz portal5 has the following to say in regard to electronic, aerospace and defence equipment which is subject to industrial licence under the Industrial (Development & Regulation) Act, 1951:

    “Subsequent to the notification of Arms Rule 2016, items configured for Military use have come under the purview of Arms Rules 2016. Hence, no further processing of Industrial Licence application pertaining to Defence Sector will be considered in Department of Industrial Policy & Promotion. The applicants may apply directly to (the) Ministry of Home Affairs (Arms Section), IS-II Division NDCC Building, Jai Singh Road, Connaught Place, New Delhi under Arms Rules 2016 for obtaining manufacturing license for Defence Items.”

    This requires suitable amendment in the FDI policy but, more importantly, some clarity about the check points applied by the ministries of defence and external affairs to the licence applications will help investors in coming up with acceptable proposals that do not get stuck for unknown reasons with these ministries.

    The third condition in paragraph 5.2.6.2 of the FDI policy says that ‘foreign investment in the sector is subject to security clearance and guidelines of the M/o Defence.’ A Security Manual was issued by the Ministry of Defence (MoD) in June 2014.6 It would remove all doubts about which ‘guidelines’ are to be followed if the FDI policy states that the investment will be subject to adherence to the provisions of this manual. The FDI policy should also make it clear whether this condition applies only to units that require industrial licence under the Industrial (Development & Regulation) Act, 1951 or generally applies to all investment in the ‘sector’.

    The last condition in paragraph 5.2.6.2 requires that the ‘investee company should be structured to be self-sufficient in areas of product design and development’ and that ‘the investee/joint venture company along with manufacturing facility, should also have maintenance and life cycle support facility of the product being manufactured in India.’ These conditions are onerous. It may not even be practical in all cases to ensure that the investee company itself also has the maintenance and life cycle support facility. What if such facilities are already being run by someone else or if some other company is prepared to set up a separate facility for maintenance and life cycle support? Equally important, it not clear who will decide whether these conditions are met where the investment comes on the automatic route. The investee company will operate under the perpetual fear that someday someone may point out that the investment was not in order as these conditions were not met.

    In an interview to the Economic Times,7 Commerce and Industry Minister Nirmala Sitharaman has indicated that the government intends to make more people participate in sectors like defence. This will happen only if the investors find a compelling case for making the investment which, in turn, would depend not just on further liberalisation of the FDI policy but also on its being absolutely unambiguous.

    The government should set up a task force to engage with potential investors and investees and evolve a simplified FDI policy, which has different slabs for different kinds of activities and is free from terms and conditions that are difficult to understand and implement. It will also make for better coordination if permission for FDI (wherever required) and grant of industrial license are handled by the same ministry. The proposed dismantling of the Foreign Investment Promotion Board opens a window for this reform. This will go a long way in making it easier to do business in defence.

    Views expressed are of the author and do not necessarily reflect the views of the IDSA or of the Government of India.

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