Introduction
In a major policy change in May 2001, the government opened up India’s defence production to the private sector as well as foreign participation. As regards FDI, the guidelines specifically mandated, among other things, a 26 per cent cap in the defence industry, subject to compulsory industrial licensing. As per the Indian Companies Act, 1956, 26 per cent cap empowers the government “to regulate the formation, financing, functioning and winding up of companies,” and can block a ‘special resolution’ whose intent is to alter the basic premise on which a company is formed.

Apart from the FDI cap, the 2002 guidelines also stipulate a three year lock-in period for all defence equity inflows; no purchase guarantee from the Ministry of Defence (MoD); detailed particulars of the management to be furnished to the government; and strict adherence to export norms as applicable to the government-owned enterprises.

Notwithstanding the detailed guidelines, the FDI policy has so far not succeeded in attracting any major financial or technological inflows into the country. It is primarily because the 26 per cent cap is viewed by many foreign companies as dissuasive, since it offers limited scope for meaningful returns on investment as well as little control over the technologies which they might want to transfer to the Indian joint ventures.

The total inflow of resources to the defence industry between April 2000 and May 2010 amounts to a meagre US$ 0.15 million, a fraction of the inflow into sectors that attract high-value FDI, namely services, computer software and hardware, and telecommunications, among others. Moreover, the defence industry ranks the last among the 62 indentified sectors where FDI has flowed in, even behind sectors such as soaps, cosmetics and toiletries, and timber products, among others (See Table 1).

Differing Perceptions on Raising FDI Cap

The absence of any meaningful FDI inflows – financial as well as technological – has led to a raging debate, starting with the Ministry of Finance (MoF) at the official level. In its Economic Survey (2008-09,) it had suggested increasing the FDI cap to 49 per cent across the board and “up to 100 per cent on a case by case basis, in high technology, strategic defence goods, services and systems that can help eliminate import dependence.”

Although the recommendations contained in the Survey are only in the nature of suggestions, they were supported formally by the MoC&I, which was circulated in May 2010 as a comprehensive Discussion Paper on Foreign Direct Investment (FDI) in Defence Sector.

The Paper made a strong case for increasing the present FDI cap by stating that the “established [global] players in the defence industry should be encouraged to set up manufacturing facilities and integration of systems in India with FDI up to 74 per cent under the Government route.” While making this suggestion, the Paper suggested that, “For future RFPs [requests for proposal] by MoD, a condition may be imposed that the successful bidder would have to set up the system integration facility in India with a certain minimum percentage of value addition in India. The successful bidder should be allowed to bring equity up to the proposed sectoral cap.”

In response to the MoC&I’s Paper, a cross section of industrial stakeholders including industrial associations, labour unions, law firms, foreign companies, consultancy and law firms have come out with their own views. The views of these stakeholders, which are divided along three major lines, are as follows:

• FDI limit should be retained at 26 per cent.
• FDI could be allowed to a maximum of 49 per cent, subject to certain conditions, such as: a. Minimum financial inflow is $100 million; b. Compulsory inflow of technology with approval of originating government with respect to items to be produced in India and their export to other countries; and c. Compulsory industrial licensing and government approval for the formation of such JVs.
• JVs formed in India with more than 26 per cent foreign equity to be barred from participating in “Make” projects.
• FDI should be increased to 74 per cent.

The rationale behind the opposition by some of the stakeholders to an increase in the FDI cap is based on the assumption that higher investment would impinge upon national security, ruin domestic technological development and destroy the nascent indigenous industry.

However, these fears do not seem to be based on sound logic.

The fear of national security being compromised is overhyped since a manufacturing facility of a foreign company within the country, governed by Indian laws, is a much better option than importing complete systems from abroad. The government can exercise greater regulation on foreign companies operating in India than on those operating on foreign soil.

Similarly, from the technological and industrial point of view, India lags far behind advanced countries in the ‘technology standing index’. FDI, if channelled properly, could prove to be a catalyst for stimulating India’s overall technological and manufacturing capability.

The National Manufacturing Council, a group constituted by the Prime Minister under Dr. Krishnamurthi to look into India’s manufacturing sector, had in fact recommended in 2008 FDI as one of the tools for facilitating technology transfer and enhancing India’s manufacturing capability in key strategic sectors, including aerospace, shipping, IT and hardware and capital goods.

Economist Dr. Arvind Virmani had argued before the FDI group in Planning Commission in 2004 that 100% FDI in high technology defence equipment is preferable to being perpetually dependent on imports for the same items. Dr. Kaushik Basu also strongly supports a liberal FDI policy in defence so that it brings in critical manufacturing capability.

Going by the global experience, Malaysia provides for varying FDI between 30-70 per cent, depending on the quality of technology coming in and ensured technology transfer of manufacturing skills in high-end subsystems. In the case of China, FDI moved in a big way from early 1990s i.e. ($5.5B) to $67.3B by 2007 and has been directed towards manufacturing, providing capital, technology and skills.

Some of the FDI has been centred on high technology operations such as semi-conductors, telecommunication, optic fibres, IT and aviation. FDI has been viewed far more important than portfolio capital, venture capital or commercial bank finance. At the heart of policy efforts to promote FDIs were SEZs which provided an open economic environment conducive to business. IPR projections remain a challenge, but WTO membership ensures that the authorities are committed to strengthening measures to protect IPR.

Hand in hand with such liberalization has been the changing structure of FDI – i.e. moving from contractual JV operations to Joint development projects to equity joint ventures providing a template for long term relationship /partnership. This has encouraged greater access to foreign technology. With more market based structure, policies have promoted FDI wholly owned subsidiaries of foreign corporations.

Regulatory Framework

The United States, which is the main source for both inward and outward flow of FDI, has one of the oldest laws in the form of Exon-Florio Amendment to the Defence Production Act of 1950, which was recently amended through the Foreign Investment and National Security Act of 2007 (FINSA). Under the Act, the US president is authorised to “suspend or prohibit foreign acquisitions of U.S. companies if they are determined to pose a threat to national security.” The presidential power to investigate such acquisitions is, however, delegated to a huge inter-agency, known as the Committee on Foreign Investment in the United States (CFIUS), which is headed by the treasury secretary and includes among others the secretaries of commerce, defence, state, homeland security, energy, and labour.

While the US has established strong institution-based rules and regulations, other countries are not far behind. As a 2008 GAO report noted, of the 10 countries (Canada, China, France, Germany, India, Japan, the Netherlands, Russia, UAE and UK) examined by the supreme auditor, eight have a formal review process, usually overseen by a government economic body with inputs from other government security bodies.

Regulations in FDI globally in a few countries in the matter of FDI into Defence sector is shown in Table 2.The security concerns are presently being addressed in India through licensing conditions of DIPP with right to verify antecedents, lock in period for transfer of equity, right to inspect or control and despatches in these facilities. However, other forms of control of FDI that could be put in place can be summed up as:

• A minimum number of Board of Directors (20 per cent) be nominated by the Government, and at least 50 per cent should be Indian citizens.
• All defence sector companies could be granted one golden share which will have veto vote on specified decisions which are against “national interests”.
• Investment could be in the form of equity with lock in period of 3 – 5 years.
• Controlling sale of stake from one entity to another.l Disallowing pledging of shares for the purpose of external commercial borrowing.
• Change of control provision to specify that if any new entity acquires management control, then the Indian partner /Government will retain the right to bring out this stake at a price to be determined by a valuation agency.
• Stake can’t be sold without the Government’s consent.
• USA and UK allow 100 per cent FDI by ensuring electronic access control to sensitive information and management process. A similar procedure could be adopted in India.

Conclusion

The success of a liberal FDI policy critically depends on how it is managed for the benefit of the domestic industry.

Lessons in this regard are particularly relevant from practices in other countries like China which has used FDI as an instrument for developing its strategic industries and is geared towards enabling its industries to “integrate into the global value-chain...accelerate its industrial and technological transformation [while avoiding reinvention] of the technological wheel.” To induce foreign investors into its hitech industries, China provides various incentives such as tax rebates and lower tariff rates.

India’s Foreign Investment Promotion Board (FIPB), while reviewing the incoming FDI proposals, needs to adopt a similar approach in order to ensure that the FDI leads to technology transfer to Indian companies and their value addition is increased over the years.

Various incentives such as tax rebates and the like could also be provided to induce higher technology through FDI.

Joint venture arrangement with Russia for the Brahmos cruise missiles is considered as a useful model.

The Brahmos JV was formed with Russia in 1998 with 50:50 equity participation ($300 m). Today it has successfully delivered Brahmos and has an order book of $4 billion which is likely to swell to $12 billion soon.

Similarly for design, development and production of a Multi Role Transport Aircraft (MTA), India has formed a JV partnership with Russia on 50:50 equity participation basis. This should lead to a significant stride in transport aircraft segment which is a neglected area of HAL.

It’s time for India to abdicate ostrich like approach in the area of FDI cap in defence and increase it to at least 50 per cent to bring in significant manufacturing and design capability to the country and higher self-reliance with a proper regulatory framework in place. It will also be in sync with the National Manufacturing Policy which seeks to ramp our manufacturing capability and employment generation significantly.

Table 1: Select Sector-wise FDI inflow, April 2000 to April 2011

Source: Department of Industrial Policy and Promotion, Ministry of Commerce and Industry, Government of India, Factsheet on Foreign Direct Investment from August 1991 to May 2010, http://dipp.nic.in/fdi_statistics/india_fdi_index.htm.

Table 2: Regulations in FDI Globally

Source: US Government Accountability Office, Foreign Investment: Laws and Policies Regulating Foreign Investment in 10 Countries, February 2008.

The author is a senior officer in the Ministry of Defence, Government of India.