The Implementation of India's Defence Offset Policy

To paraphrase Jane Austen, it is a truth universally acknowledged that a rising power in possession of a good fortune must be in search of a strong defence industry.  In the case of India, the problem is becoming acute, with ample evidence that the long-term investments made in state run defence enterprises and previous (minor) attempts at procurement reform have not yielded a defence industrial base capable of producing technologically advanced defence systems in a timely fashion.   These shortcomings have become ever more obvious as India seeks major defence platforms that are far beyond the scope of her defence industrial base.

Just as India's geo-strategic position is leading her to want more from the defence industrial base, international defence firms (and their home states) are increasingly seeking to access the lucrative Indian defence market. India accounted for 10 percent of global defence exports during 2007-11 and estimates for likely Indian defence procurement spending during the 12^th plan period (2012-2017) range from a conservative US $80 billion to US $100 billion. In an otherwise austere global acquisition environment, this is a market opportunity not to be missed. 

Indian Offset Routes

In many ways, defence offsets are the means to marry these two interests and India is keen to ensure that her activities as a recipient serve her development as a producer. Although India has been receiving de facto defence offsets since the 1960s in forms such as licensed production and technology transfers, it is only since the Defence Procurement Procedure (DPP) of 2005 that she has had an explicit offsets policy.  India currently requires a 30 per cent offset on any deal over Rs. 300 million (around US $55 million).  Large procurements carry larger offset obligations; the Medium Multi-Role Combat Aircraft deal secured by Dassault in February 2012 involves a 50 per cent offset. 

Reflecting her strategic interests, India only accepts defence-relevant, i.e., direct, offsets.  Three offset routes are available:

1. Direct purchase of eligible products, components or services from Indian industries. Besides defence goods, since 2011 this category has included purchases from civilian aerospace, internal security and training providers;
2. Foreign direct investment in Indian defence industries including co-development, joint ventures and co-production of defence products and components. A recent decision put a 1.5 multiplier on investments into small and medium enterprises. In August 2012 technology transfers to a local partner were added to the FDI list, with a potential ten percent offset multiplier available on them and;
3. Foreign direct investment in government approved research and development projects (recently expanded beyond just defence R&D). 

The initial DPP has been revised several times, latterly in response to industry pressures. For example, there has been an evolution in the Indian Governments approach to offsets banking (with three different policies since 2008) and now offsets can be banked for up to seven years.

Challenges to Foreign Investors

The offsets policy has nevertheless created headaches for foreign firms searching for suitable R&D investment opportunities, eligible Indian products with export potential and qualified domestic defence partners.  The last requirement is particularly challenging as an Indian Offset Partner (IOP) has to be both approved by the government and have the absorptive capacity for significant defence offsets.

Despite the increasing clarity and direction of the DPP there is still much grumbling about it; increasingly focused more on the implementation of it than on the policy per se.  A new audit covering the government's application of the offsets policy provides grist to the mill of critics at home and abroad. [i] The purpose of the audit was to assess whether the terms of the DPP were being adhered to and whether the implementation of offsets contracts was being properly monitored. The conclusions do not make happy reading.

Overall the audit found that the monitoring of implementation of offset contracts was inadequate and had involved failing to recover penalties due for non-fulfilment of annual offset obligations. For foreign firms, two particular issues stand out.

First, according to the audit, of the sixteen offset contracts concluded between 2007 and 2011 five of them did not comply with the terms of the offset policy as set out in the relevant DPP. In particular, in these five contracts with international defence firms the Indian Ministry of Defence had accepted projects as direct offsets which did not provide any added value to IOPs; negating the whole point of the Indian offsets policy.

The audit also found that foreign firms were being permitted by the Ministry to provide foreign direct investment in kind (through provision of infrastructure or products) even after the issuance of a November 2010 guidance note which clarified that in kind foreign direct investments were not eligible as offsets.  These implementation issues were judged by the audit to be '...largely due to varying interpretation of various authorities about the legitimacy or otherwise of the offsets being offered.' 

Second, the audit also revealed that in some of these offsets contracts the firms accepted as IOPs by the Indian Government were not eligible to play this role due to the size of foreign holdings in the firm (which should not exceed 26 per cent according to the DPP). This raises the spectre that an IOP apparently approved by the government might lose that status and endanger the ability of a foreign firm to fulfil the offsets contract, leaving them vulnerable to a 20 per cent penalty.

For foreign firms operating in this evolving regulatory environment these inconsistencies in policy implementation further increase the risks and complexities of doing business in India. While the mantra to foreign firms has been to invest in India as a long-term relationship - not a short-term sales opportunity - the difficulties of implementing defence offsets remain a barrier to building such successful relationships.

NOTE

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[1] Report No.-17 of 2012-13 for period ended March 2011 - Union Government (Defence Services) Air Force and Navy, Chapter II: Ministry of Defence, pp. 17-25.