FDI In Defence Sector

Since liberalisation of the Indian economy for FDI in 1991, the defence sector was kept out of bounds for foreign investors (even for private sector in India) citing strategic reasons. However, considering the ever increasing demand of Indian forces and resultant outflow of foreign exchange due to imports, the Government of India (“GOI”) opened up this sector in a very limited way in 2001. However, due to the ultra-restrictive stipulations in FDI guidelines for defence, the policy did not elicit much response. In the meanwhile, the demand for defence equipment as well as foreign exchange bill on imports shot up stupendously.

In view of this, thereafter, GOI has been slowly relaxing FDI norms for defence sector and recently announced up to 100% FDI, subject to certain conditions.

Let us hope the latest policy changes have the desired effects of FDI inflows, employment generation, access to modern technology, thrust to Make in India, less reliance on imports, saving of precious foreign exchange, to name a few.

The present note narrates evolution of GOI policy on FDI in defence sector.

1. First step

In 2001, through Press Note 4, FDI in defence sector was opened up to 26% permitted through the Government approval route subject to industrial license under the Industries (Development & Regulation) Act, 1951. Further, the defence sector was opened up to 100% for Indian private sector participation, subject to licensing. Apart from the FDI cap, the guidelines, inter alia, also stipulated the following:

  1. The transfer of modern and state of the art technology;
  2. A 3 year lock-in period for all defence equity inflows;
  3. No purchase guarantee from the Ministry of Defence;
  4. Detailed particulars of the management to be furnished to the government;
  5. Strict adherence to export norms as applicable to the government-owned enterprises.

The consequences of these guidelines were that till 2009, the defence sector attracted a minimal investment. In the meantime, India’s defence expenditure had shot up by 231%.

The reasons for the failure to attract any meaningful investment under the said policy were too evident :

  1. Only 26% FDI was open through the Government approval route – it was a major turn off for any foreign investor as they had no control over the management and control of the Indian company.
  2. The requirement for the transfer of “state of the art technology” was another roadblock which hindered the foreign players. Such technology to be transferred for a paltry stake of 26% was a no-go for serious players.
  3. There were no procurement guarantee from the Government regarding purchase of products, putting question marks over the return on investment.

The meagre investment saw various stakeholders and Ministries recommend various changes to the FDI policy pertaining to the defence sector.

2. Moving further

In Press Note 7 of 2014, the GOI raised the FDI cap in defence to 49% through the Government approval route. For any investment above 49%, the application would be sent before the Cabinet Committee on Security (CCS) on a case-to-case basis with a condition of access to modern and state of the art technology. Few more conditions were as follows:

  1. The applicant company to be an Indian company owned and controlled by resident Indian citizens, the management of the company to be in Indian hands with majority of the Board being resident Indian citizens.
  2. No purchase guarantee for the products to be manufactured.
  3. Import of equipment for pre-production activity including development of prototype by the applicant company permitted.
  4. For applications of 49% FDI with inflows in excess of Rs. 12 billion, Cabinet Committee on Economic Affairs (CCEA) approval would be required.

These policy changes too did not have any visible impact on the FDI inflows in the defence sector. In all by 2015, investments worth $15.3 million were attracted with only 2 proposals involving investment up to 49%.

3. A quantum leap

The FDI policy of 2016 initially envisaged a cap of 49% through the automatic route. For investment beyond 49%, the Government approval was required. This was subject to a case-to-case basis look at the application with the important condition being access to modern and state of the art technology. Other conditions included:

  1. Infusion of fresh foreign investment within the permitted automatic route level, in a company not seeking industrial license, resulting in change in the ownership pattern or transfer of stake by existing investor to new foreign investor, will require Government approval.
  2. Licence applications will be considered and licences given by the Department of Industrial Policy & Promotion, Ministry of Commerce & Industry, in consultation  with Ministry of Defence and Ministry of External Affairs.
  3. Foreign investment in the sector is subject to security clearance and guidelines of the Ministry of Defence.
  4. 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.

Press Note 5 of 2016 however again changed the equity caps and allowed for 100% FDI in the defence sector. Up to 49% investment was allowed in the automatic route while investment above 49% was to be approved under the Government approval route when it was likely to result in the access to modern technology. The condition of “state of the art technology” has been done away with.

The FDI limit for the defence sector has also been made applicable to manufacturing of small arms and ammunitions covered under Arms Act, 1959. Other conditions remain the same.

Likely benefits of the New FDI Policy for Defence Sector

Allowing 100% FDI in defence is seen as a game changer for the following reasons:

  1. Foreign investors will now have the confidence to invest into the defence sector as the ease of guidelines is beneficial to original equipment manufacturers (OEMs) as returns will be assured. This will create a situation whereby the defence forces and local industries benefit for this increased investment.
  2. The move will also enhance overall R&D to develop and deploy solutions catering specifically to the country’s security needs. Further, the domestic defence undertakings also stand to benefit from the entry of foreign players and there are already various joint ventures in place for production of defence equipment.
  3. The removal of the requirement to transfer “state of the art technology” will see production facilities of foreign OEMs shift to India.
  4. The procedure of investing for any foreign OEM has been eased drastically and it will lower the compliance costs.

This is the first article in the three part series on Foreign Direct Investment in India.

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