TOWARDS AN INDIAN ‘MILITARY-INDUSTRIAL COMPLEX’?

As of 2021, India has the second largest armed forces and the third largest defence budget in the world....

As of 2021, India has the second largest armed forces and the third largest defence budget in the world. However, historically, the defence sector in India has been a monopoly for public sector companies. In 2001, the defence sector was unlocked for domestic private businesses subject to certain licensing requirements. This was also the same time foreign investors were permitted to invest in the defence sector. Initially, foreign direct investment (FDI) was permitted up to a maximum of 26%. Over the years, the FDI cap has been substantially increased and currently stands at 100%, subject to certain conditions. More recently, due to external aggression from neighbouring states, the Government has been keen to further develop the Indian defence manufacturing sector. The thrust has been to encourage the development of indigenous solutions for its defence requirements and reduce its external dependency. In this article, we will discuss the opportunities for foreign and domestic investors in the Indian defence industry.

Recent Developments

India seems to be in a hurry to reduce its massive defence import bill and has been making steady progress to achieve this by introducing various reforms in its policies. To increase demand and encourage defence production, the Government has made efforts to modernize the Indian armed forces. The Government has already spent USD 37 billion in the last three years on modernization and equipment in the defence sector.

In a big push towards self-reliance, the Government has announced an import embargo on 101 defence items in the last year and 108 defence items this year; to be progressively implemented over the next few years. The recently released draft Defence Production and Export Promotion Policy 2020’s aim is to fulfil the twin objective of self-reliance and achieve USD 5 billion in value of exports by 2025. The Government has also been in touch with friendly countries like France and UAE, to enhance defence co-operation through joint production and mutual trade.

Regulatory regime

The regulatory framework for defence is covered across laws framed by the parliament and policies for procurement framed by the executive arm of the Government. The extent of foreign investment in the defence sector is governed by the FDI policy which is amended from time to time by the executive arm of the Government.

Manufacturing in the defence sector is governed through: (i) Industries (Development and Regulation) Act, 1951 (IDRA); and (ii) Arms Act, 1959 (Arms Act). Before manufacturing an item, the manufacturer is required to examine the list of defence items as provided under IDRA and the list of arms and ammunitions as provided under the Arms Act. In theory, if the manufacturer’s products are not mentioned in either of the lists, they are free to manufacture them without taking any defence related licenses. However, in practice, almost any item related to defence could require a license since the lists cover most defence items.

With respect to foreign investment in the defence sector, Ministry of Commerce and Industry has gradually increased the FDI cap from 26% in 2001 (which was subject to licensing) to 100% by 2016. 49% was allowed under the automatic route and beyond 49% through the Government route. The 49% cap under automatic route was further increased to 74% in the year 2020 for companies seeking new industrial licenses. This was done to encourage foreign players to transfer critical and proprietary technologies to Indian entities. A foreign investor planning to hold more than 74% stake should take the Government route; if the investment is likely to result in access to modern technology. Among other conditions, the Government has also introduced a national security clause which provides that any investments in the defence sector could be reviewed on grounds of national security.

Another critical regulatory framework in this sector has been the Defence Procurement Procedure of the GOI, which is amended from time to time and has undergone several positive changes over the years. The Government had introduced ‘Make Type’ of procurement in the Defence Procurement Procedure, 2006 to push the industry to design, develop and produce advanced defence equipment domestically. Thereafter, the Government in its Defence Procurement Policy of 2013 accorded primacy to buying defence equipment from both private and public Indian manufacturers. The recently introduced Defence Acquisition Procedure, 2020 by Ministry of Defence (MoD) also seems to be aligned with the Government’s vision of making India self-reliant by empowering Indian domestic industry through the ‘Make in India’ initiative.

Private players who set up manufacturing of defence products in India can also avail the opportunity of using India as an international export hub. All manufacturers can export defence items while keeping in mind the restrictions imposed under the SCOMET (Special Chemicals, Organisms, Materials, Equipment, and Technologies) list. The SCOMET list is prepared keeping in mind India’s obligations under the various international treaties that it is a signatory to. Export of items mentioned in the SCOMET list are either prohibited or permitted via an express authorisation to ensure that such sensitive items do not fall into the wrong hands. Accordingly, manufacturers of defence items seeking to export them need to carefully review the SCOMET list. If the concerned defence item is not mentioned in the SCOMET list, the item can be freely exported.

According to some estimates, more than 460 licenses have been issued to private players for production of defence equipment. In 2015, the Government extended the validity of the license granted under IDRA to 15 years from a relatively short period of 7 years.

Growth opportunity

Considering the various initiatives launched by the Government and the geopolitical conflicts of India, it seems like the defence expenditure is bound to increase. To put things into perspective, according to a report titled – ‘The Indian Defense Market - Attractiveness, Competitive Landscape and Forecasts to 2025’, the Indian defence market is expected to grow at a compound annual growth rate of 10.46% between 2021 and 2025.

Keeping in mind the MoD’s continued efforts to put an embargo on imports, both foreign and domestic players can apply for licenses to manufacture the items in the negative lists. These items could thereafter be supplied to the armed forces to fulfil their internal demand or exported to other countries. India has recently allowed exports of 156 different types of equipment which include armaments, combat systems, missile systems etc. These items are at present being exported to more than 84 countries. Further, the Government’s efforts to promote exports can be witnessed by the extraordinary 700% growth in defence related exports between 2016-17 and 2018-19.

The Indian defence sector seems to be on an upward trend, with a special focus on indigenization and self-reliance. The Government is also acting in a swift manner to bring about the necessary changes in policies to promote ease of doing business. To that extent both foreign and domestic players could consider exploring the Indian defence sector’s untapped potential.

Authors: Ajay Joseph, Partner and Nicolas Seizou, Director | Veyrah Law

The team can be reached at ajay.joseph@veyrahlaw.com and nicolas.seizou@veyrahlaw.com.

Views expressed above are for general information purposes only and should not be considered as a formal legal opinion or advice on any subject matter therein.