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Understanding the Economics of Defence Procurement

N. Neihsial was on deputation from the Indian Defence Accounts Service to the Institute for Defence Studies and Analyses, New Delhi.
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  • January 25, 2008

    “It’s about time that the bureaucrats in the MOD and the military leadership in the Service Headquarters opted not only to do ‘the right things’ but also to do ‘the things right’ in as far as the procurement process is concerned.”
    - Defence & Technology, July/August 2007, p. 13.

    The above remark, perhaps, fairly represents the general feeling of those who are concerned with issues relating to defence procurement in India. These issues mainly revolve around two charges. One is in the form of allegations kick-backs and corruption in high places. And the second relates to delays in the procurement of equipment, resulting in surrender of substantial amounts of allocated funds year after year and thus denying the armed forces the expected state-of-the-art equipment.

    While impatience on the part of users and the general public may be justified, there are other relatively unfocused issues and problems that also contribute significantly to these delays or non-materialisation of expectations. Some of these are economic in nature. This article highlights some of these aspects so that the debate is appropriately focused on the problem in its entirety and better solutions can be explored.

    It is an accepted fact that delays cost money. Delays in defence procurement in particular can be associated with a number of consequential problems. These include: overall increase in cost due to increase in the project staff, technological obsolescence, changes in the equipment parameters, relatively lesser agility of the expected equipment, greater difficulty of the chances of exports, greater industrial cost, greater risk of the survival of the design, engineering and industrial capacity, and most importantly, denial of up to date equipment to the Armed Forces when they need them.

    Several pertinent questions arise in this regard. What is the objective of defence procurement? Is it only to secure better equipment for the Armed Forces? Is it to achieve better value for the tax payers’ money? Is it to ensure the building or preservation of industrial capabilities? Is it to make the defence industry feel good (make things profitable for them)?

    One could generally agree that while expeditious securing of better equipment is the primary and explicit objective of defence procurement, other objectives cannot be totally ignored. In which case, if these objectives are to be achieved in the same measure without ignoring any of them, is it really practicable to do so? Are there contradictory objectives within this bunch of individual objectives? Perhaps, to some extent, at least in the short term, though in the long run they should ultimately lead to the same goal. If that is so, the objectives to be achieved are quite complex and multidimensional. At some level in the Government, a delicate balancing has to be done among these possible objectives.

    Paragraph 2 of the Defence Procurement Procedure 2006 of the Ministry of Defence (MoD) states that the ‘Aim’ is “to ensure expeditious procurement of approved requirement of the Armed forces in terms of capabilities sought and time frame prescribed by optimally utilizing the located budgetary resources.” While achieving the same, it will demonstrate the highest degree of probity and public accountability, transparency in operations, free competition and impartiality. In addition, the goal of achieving self reliance in defence will be kept in mind. Excellent intentions indeed!

    In the defence procurement loop, there are three distinct players: (a) Users, i.e., the Services; (b) the Procurement agency, the MoD or Service Headquarters or Commands; and, (c) the market/defence industry or the suppliers.

    The Services initially conceptualise the needs and type of equipment required by them now and in the future. At any point, the equipment that they possess can be broadly categorized into: (i) the lowest tier or obsolete technology, which needs to be phased out; (ii) the middle tier consisting of mature technology, still relevant and having considerable residual value; and (iii) the upper tier consisting of state-of-the-art equipment which act as force multipliers and are generally expensive. It is the last of these categories that is generally in demand to cater for future threat perceptions, an equipment or technology that may or may not be available in the defence market. Once these requirements are finalised and approved at appropriate levels, they are passed on to the Procurement agency, namely, the MoD or the Services Headquarters for action. In this connection, it may be noted that the procurement agency like any other mechanism has its own elements of the structure, processes and culture: be this the Ministry or the Services Headquarters. Ultimately, the demands get transferred to the Defence industry or market for supply to the Users.

    Since the public debate mainly focuses on procurement agencies, considerable changes have been brought about in their functional relationship with the users. These reforms are either in the form of changes in the structure and processes, which include amongst others, integration of the Services Headquarters with the Ministry, the creation of a separate defence acquisition channel, and the initiation of substantial improvements in the procurement processes in the form of introduction and improvement of Defence Procurement Manual/Procedure etc. Another significant improvement is the increasing delegation of financial powers to the Services. The latest in this process, which began in 1975, is the revision of financial powers of 2006 in which the procurement of capital items have been delegated to the Services Headquarters.

    However, what is largely left unattended is the relationship between the Users and the Procurement Agencies on one side and the market/defence industry on the other side. Till date, policy measures that are in place are the opening of defence production to the private sector with Foreign Direct Investment permissible up to 26 per cent but subject to licensing (since May 2001). Till May 31, 2005, 22 licenses/Letters of Intent were issued to 22 private firms. Important items in these licenses include design, development and manufacture/production of small items like protective products (suits, gloves, tents, bullet proof vests, jackets) to heavy and complex hi-tech items like armoured vehicles, warships, submarines, mobile launchers etc. Then there is the institution of the Raksha Udyog Ratna/Champion in defence production. Of course, one could also cite the direct interaction of Services with industry like Army-CII [Confederation of Indian Industry] dialogue.

    Given that these policy measures have been in place for some years now, not much tangible outcomes are noticeable in the public domain. The procurement figures below, from the report of a committee on review of financial powers delegated to Services, fairly seems to represent the state of the relationship between the demands of the Services and the degree of response from the Market/defence industry.

    Procurement Data for Services, 2005-06 (in percentages)
    Ordanance Ex-Trade PSUs/OFs Import
    Delegated Powers 37 59.15 3.85
    MoD 27.9 64.1 7.61
    Delegated Powers 17 56.12 26.88
    MoD 26 52.90 21.10
    Air Force
    Delegated Powers 19.22 10.03 70.75
    MoD 4.79 5,64 89.57

    The basic idea of delegation of financial powers to the Services was to shorten the time gap between demand and supply, thus enabling them to directly interact with the market (defence industry) and facilitate the purchase of requirements from sources other than Government production agencies. But the above table shows that Government production agencies continue to be the dominant procurement source, followed by imports particularly in the case of the Air Force which is a ‘High Tech force’. This shows that domestic defence industry is yet to respond adequately to the expectations of the Government or the Services, which continue to be dependent on Government suppliers and imports that are always costly and time consuming. As such, when there is room to cut down delay in the procurement process, reform the structure and streamline procedures, the fact that the market is not able to respond to the demands of the Services has to be recognised and appreciated.

    When one talks about defence procurement, it could cover a wide variety of items and equipment. While some of these procurements could be of simple stores of non- military or semi-military nature, there could also be complex hi-tech systems. Procurements in the former category may be relatively easy and attendant issues may remain relatively unnoticed in the public debate. But the hi-tech category draws public attention and sometimes gets ill-formed and unjustified adverse comments. Of late, the Government has come up with formal categorisation of these items and the general guidelines for its procurement in the Defence Procurement Procedure of 2006.1

    The economics of defence technology has a certain degree of peculiarity. Apart from the need for heavy investment in infrastructure and production facilities, defence technology has the propensity for rapid obsolescence, and for ever demands sustained investment in research and development for upgradation. Unlike most other technologies in the civilian sector, a success in a particular military technology does not increase its market size literally and the possibility of bringing down the unit cost is virtually ruled out. In fact, since the improved technology does or is capable of performing higher functions with fewer physical numbers, the unit cost increases with improved technology instead of bringing down the cost. On the other hand, horizontal expansion of the market size even theoretically remains restricted to a potential of 200 customers (countries). Then the system integration of machines or complex weapons systems is a major problem area.

    These factors generally inhibit the private sector from entering the defence arena. In case an item is not accepted or does not get orders for a reasonable quantity, the cost of investment would turn out to be too high and risky for ordinary business ventures. Moreover, the manufacture of many equipments and items will not become sustainable unless these also have civilian applications. This situation also results in intense competition between various defence businesses. Competition has, in fact, compelled the consolidation of defence industries in North America and Europe after the Cold War. In order to enable suppliers to capture a greater share of the market on the one hand and on the other to help buyers extract the maximum benefits, the concept of ‘Offset’, even to the extent of 50 per cent of the total value of orders, has come into being.

    In this situation, one finds that defence technology has its own peculiarity and its consequential economic dynamics in the defence market/industry. It obviously does not fall into what may be called ‘Perfect market place’ as the market forces of demand and supply are not able to operate logically. The policy behaviour of the Governments acting themselves as goal keepers in production, import and export is an added dimension. There is therefore bound to be ever greater shortages and delay of supply, a situation that is likely to be quite severe for countries like India for some years to come if not for decades.

    This being the situation, it is not fair to place the entire blame for delays on the procurement mechanism or agencies or the operating functionaries. This is particularly so when the industrial base is in the process of establishing its credibility. Of course, a substantial portion of the delay is contributed by the system and its functionaries. Even in advanced countries like the UK, a similar situation is prevalent though the degree of delay may differ. For example, the much talked about idea of ‘smart acquisition’ procedure (October 2001) captured by the slogan ‘faster, cheaper and better’, which aims to establish closer customer/supplier relationship, has attracted the adverse comment of the House of Commons Defence Committee, which stated that the armed forces are being let down as a result of ‘endemic’ and systematic’ problems in the defence procurement agency. The committee is also reported to have highlighted that there was an average delay on major projects of 18 months and in-a year increase of some 3.1 billion pounds.

    It is therefore imperative that the discussions and debates on defence procurement should be wider than what it is today and must include the connected economic dynamics involved, including the policy measures essential for building a wider domestic defence industrial base.