Recognizing this gap, on May 16, 2020, in an unprecedented move to spur the post COVID-19 Indian economy, the Finance Minister announced that the automatic route limit for foreign investment in the defence sector will be raised from 49% to 74%

by Anuj Prasad and Anandita Kaushik

Up until recently, the Government’s strong stance on foreign investment in the defence sector has always been that for reasons of national security, defence sector companies cannot be controlled by foreign players. To this end, a 49% cap on foreign investment in the defence sector is prescribed under Indian foreign investment regulations as well as existing defence procurement norms (currently, the Defence Procurement Procedure-2016 (DPP-2016)). The DPP-2016 lays immense emphasis on priority being given to indigenous procurement and most procurement avenues impose conditions of Indian ownership (i.e., FDI capped at 49%) and Indian control to qualify as an eligible vendor.

The effect of this hard policy stance is that joint ventures (JVs) formed in the sector so far have been licensed low-end technology or produce simple parts and components. Foreign original equipment manufacturers (OEMs) have been hesitant, and understandably so, in licensing state-of-the-art, sophisticated technologies to JVs they cannot control and accordingly, such JVs are by and large far from the vision of becoming manufacturers of complete defence platforms. As a result, these JVs merely function as part of the foreign OEM’s global supply chain, adding to Indian exports in the defence sector, but have not been in a position to participate in Indian defence procurement as prime vendors and contribute to the development of the ecosystem in any significant way.

Recognizing this gap, on May 16, 2020, in an unprecedented move to spur the post COVID-19 Indian economy, the Finance Minister announced that the automatic route limit for foreign investment in the defence sector will be raised from 49% to 74%. This is a major policy change and would mean that going forward, foreigners can set up Indian JVs with a controlling stake. Since lack of control was the single most significant roadblock to licensing of proprietary technology, this move should overcome that obstacle. Ideally, the outcome should be that in the years to come, we see Indian JVs producing fighter aircraft, submarines, land systems and other proprietary OEM platforms in India, realising the dream of making India self-reliant in defence production.

However, the exact contours of the amendment to exchange control regulations are unclear for the time being, as the notification to bring about such change has not yet been released. More importantly, so far the Government has not announced any intention to make consequent changes to the eligibility conditions under extant procurement procedures. Without a consequent amendment to procurement procedures, the only incentive for OEMs to increase their stake in Indian JVs and licence sophisticated technology to them would be offset compliance, which has historically not proven to be a strong enough catalyst.

Prior to the announcement of May 16, the Defence Ministry had released a draft of the Defence Procurement Procedure-2020 (DPP-2020), for public comments, which would eventually replace the DPP-2016. The DPP-2020 of does not reflect the 74% FDI position, and imposes eligibility conditions of Indian ownership and control. Since the DPP-2020 remains in draft form today, the Government has a golden opportunity to realise the dream of Atmanirbhar Bharat in defence production by aligning the procedures to the Finance Minister’s announcement on changes to foreign investment regulations in the sector.

In our view, the best way of ensuring this without compromising on the ideal of reducing imports, would be to shift focus from Indian ownership and control to indigenous content (IC) aspects. Under defence procurement procedures, IC is broadly calculated by reducing costs of imported components and services (including royalties) from the overall equipment cost. The higher the IC in a product, the greater is its procurement priority. Now that the foreign investment regulations permit FDI beyond 49% in defence sector companies, going forward, the quantum of IC in a product should be the sole determinant of qualification, and conditions on Indian ownership and control should be removed.

To this end, the most important change would be to the definition of ‘Indian Vendor’ under the DPP-2020. At present, the definition stipulates that while the ownership of the entity may be as per extant norms, control of the entity should be with resident Indian citizens. Since JVs with more than 50% foreign ownership will automatically be foreign “controlled”, this definition should be amended to stipulate that control should be with resident Indian citizens only where the FDI is 49% or below. A similar change should also be made to the eligibility criteria under the Make procedures, which today limit FDI in an eligible vendor to 49%. Since foreign investment in the defence sector will continue to be subject to security conditionalities, including a security clearance of the investor by the Ministry of Home Affairs, such a change should not impact national security considerations. Further, as the indigenous ecosystem develops and gains sophistication, the Government could consider a proportionate increase in the IC requirements in future iterations of the procurement procedure.

With the Finance Minister’s announcement, we are poised to hit the inflection point in India’s journey towards self-reliance in defence. But for this decision to truly alter the reality of the Indian defence ecosystem, the Government will have to reflect its changed policy stance in the procurement procedures in an expeditious manner. Continued lack of clarity on the above aspects will only derail the development process.