Monthly Archives: March 2016

What a ‘Make in India’ driven Defence Procurement Procedure 2016 means for the Indian Defence Industry

In early January 2016, speaking after he inaugurated a new Hindustan Aeronautics Limited (HAL) helicopter unit in Tumakuru, Prime Minister Narendra Modi clearly stated that ‘If India has to be self-reliant in the area of security according to our armed forces needs’, it has to ‘make its own weapons’. This was quite in keeping with the emerging centrality of indigenous weapons’ manufacture to Modi’s ‘Make in India’ vision as evidenced by Defence Minister Manohar Parrikar’s view that ’the requirement for domestic production of defence equipment is more than for any other sector’ and that ‘achieving self-reliance and reducing dependence on foreign countries in defence is a necessity today rather than a choice, both for strategic and economic reasons’.

Naturally, such a doctrine must reflect itself in a concrete reorientation of the Ministry of Defence’s (MoD’s) Defence Procurement Procedure (DPP) towards a decided emphasis on sourcing indigenously designed, developed and manufactured systems for it to be credible. Long in the making, the contours of this re-orientation have now been unveiled and reveal an attempt to foster indigenization while balancing competing pressures and interests. For Indian industry, defence is now seen as a ‘recession proof’ business and the privileging of local manufacture with no discrimination between public and private entities has been a long standing demand by it.

Given India’s muted private investment cycle, it was only a matter time before the government would have had to focus on public spending in order to engender employ generating growth. Now one of the major ‘non-plan’ heads under the Union budget is of course the allocation for defence (excluding pensions and civil expenses by MoD), accounting for about 13-14 percent of overall   government spending annually. Forty percent of the total allocation for defence is typically reserved for capital expenditure. And of that 40 percent, a significant portion leaks to foreign lands each year, something that is now an unsustainable proposition. After all, a country also imports influence along with weapons’ purchases from abroad. Instead, the priority now is to keep much of the capital component of the defence budget ‘in country’ and use it to widen the defence industrial base (DIB) in a bid to spark a new wave of industrialization. India’s broad industrialization target is to increase the share of manufacturing output in Gross Domestic Product (GDP) from the current 15 percent to about 25 percent by 2025. Military industries, with their various techno-economic second order effects and high value nature are being seen as an important means to attain that goal. In fact, India’s ever growing domestic requirements will be used as an anchor to expand the DIB with the concurrent aim of becoming a major military systems exporter in the years ahead. Though projections vary, a 3-5 percent global market share by 2030 is certainly not outside the realm of possibility for India’s DIB.  Incidentally, MoD intends to raise Indian defence exports to the level of a billion dollars annually by 2020.

It is in the late 2020s, 2027 to be precise, that the Dhirendra Singh(DS) Committee tasked with reworking DPP- 2013 (the last version of the DPP before DPP-2016 which will be released shortly) by the Modi administration, sees India attain the long cherished goal of reaching 70 percent indigenization levels. In recent years, the ‘foreign exchange component’ has accounted for around 50 percent of MoD’s capital expenditure and this represents an outflow of $ 6-8 billion annually.

To be sure, in the period 2013-15, the Defence Acquisition Council (DAC) has accorded ‘acceptance of necessity’ (AON) primarily to proposals in the ‘Buy’ (Indian) and ‘Buy and Make’ (Indian) categories under DPP-2013, something whose impact will be felt in terms of reducing foreign outflows in the years ahead. For instance, in 2014-15, of the 56 AoNs accorded by the DAC for a total value of Rs 117829 Crores, 40 AoNs, amounting to Rs 111070 Crores were from the ‘Make’, ‘Buy’ (Indian) and ‘Buy & Make’ (Indian) categories. And in 2013-14 only 6 out of 34 AONs went to the ‘Buy’ (Global) category for a potential order value of only 371 Crores which represents just 2 percent of the total value of all AONs approved in that period.

Nevertheless, there is a fair bit of concern about the level of ‘indigenous content’ (IC) in systems that are being procured even under the ‘Make’, ‘Buy’ (Indian) and ‘Buy and Make’ (Indian) categories. In many cases, domestic value capture is less than 25 percent even under the ‘Buy’ (Indian) format. Naturally higher IC is desirable not just for operational security reasons (OPSEC) but also to generate greater employment through military procurements by increasing the number of component suppliers who’ll chiefly be micro, small and medium enterprises (MSMEs). Indeed, one of the key reasons for the ‘Make in India’ push in the defence sector is the fact that military related manufacturing is still relatively labour intensive and has the potential to generate several higher wage middle class jobs. According to some projections, an Indian DIB that can cater to 70 percent of annual needs by 2027 will lead to the creation of almost a million new domestic jobs despite an expected doubling of productivity in that period.

As such the DS committee has made a strong case for increasing IC in Indian military procurements and this recommendation seems to have been accepted by the government. The DS committee has also pointed out the role played by ‘preferred categorization’ of procurement modes in DPP-2013 which privileges ‘Buy’ (Indian), ‘Buy and Make’ (Indian) and ‘Make’ over ‘Buy and Make’ and ‘Buy’ (Global), in shifting prospective procurements towards more domestic heavy categories as encapsulated in the nature of AON’s accorded. In fact, the imposition of procedural discipline in DPP-2013 at the ‘Statement of Case’ (SoC) stage, wherein a proposal to select a given category, say ‘Buy’ (Global), needs to incorporate a justification for excluding more preferred categories such as ‘Buy’ (Indian) etc. has played a major role in reducing import heavy plans from the military’s side.

In keeping with the DS committee’s view, that this process be consolidated in favour of indigenous developments and higher IC, MoD has announced the introduction of a new category in the soon to be released DPP-2016 called ‘Indian Designed, Developed and Manufactured’ (IDDM) which will be accorded precedence over all existing categories in the DPP, i.e. even over the ‘Buy’ (Indian) category. Any system that has been designed and developed in India with IC levels of at least 40 percent will be considered eligible for IDDM categorization. Interestingly, IDDM will have another mode of categorization wherein any system with over 60 percent IC levels will also be earmarked for potential preference in procurements through this category.

The introduction of IDDM underlines the importance being accorded to buying homegrown systems wherein the systems level Intellectual Property (IP) resides in India, since that is a key determinant of value capture in high end systems and the basis for a truly capable defence industry that will remain competitive in the years ahead. An Indian product built using Indian design standards and procedures will also be far easier to modify and maintain, crucial considerations when inducting major weapon systems that need to serve for decades. Now the minimum IC criteria for IDDM does indicate that while IP is very important, the product must indeed be something that relies on the Indian industrial eco-system without which the advantages of design ownership will get eroded to an extent, with OPSEC and cost concerns emerging for major sub-systems. Moreover, only higher IC serves the other aims of deepening the DIB and generating employment.

What constitutes ‘Designed and Developed’ in India will however need to be clearly specified in DPP-2016, because this is bound to lead to a lot of acrimony between various players in the Indian defence landscape. While smaller players who have mostly homegrown systems in segments such as simulators will welcome it, some of the larger players may consider themselves shortchanged, since the origin of some of their key ‘indigenous offerings’ lies elsewhere and they may still not have access to the full systems level IP. On the other hand, if ‘designed and developed’ is kept vague, yet others who have actually invested in ‘in-house’ R&D and own IP will be worried if only ‘partly Indian’ systems easily qualify for IDDM categorization. Either way, there are going to be vociferous demands for delineating what in design terms will qualify to be an IDDM category proposal.

In the case of IC however, DPP-2013 itself outlines how it is to be measured and the thrust for greater IC as we have mentioned above will continue apace. And even as higher IC requirements for most procurement categories will be mandated in DPP-2016, other steps to encourage domestic manufacturers to increase IC in their offerings are already being taken. An example of this would be the extension of exchange rate variation (ERV) protection to all Indian companies irrespective of whether they are publicly or privately owned. This is expected to nudge Indian companies towards compliance with DPP-2013 norms which explicitly rule out showing sub-vendor imports at the tier III or IV level as IC, since any incorporation of a sub-vendor’s import as IC would hurt the main vendor itself if the rupee depreciates.

Another move that is expected to support higher IC levels is the recent removal of excise and customs duty exemptions given to PSUs that’ll make sourcing components and sub-assemblies that much more expensive for them. Now given that PSUs continue to account for 90 percent of all defence manufacturing in India, this measure would be particularly effective in boosting IC levels if PSUs were simultaneously not allowed to ‘pass thru’ the resultant higher costs in the short run to their customers. Instead, key PSUs such as HAL need to be pushed to expand their domestic vendor base through greater outsourcing and India’s DIB needs to come together to create an updated database of existing vendors. These measures, which have also been recommended by the DS committee will go a long way in expanding India’s MSME defence base beyond the 6000 or so companies that currently operate in the sector and are primarily supported by the Ordnance Factory Board (OFB) and Bharat Electronics Limited (BEL). For HAL however, the share of imports in total expenditure actually rose from 80 percent in 2001 to 96 percent in 2012.

The outsourcing push to domestic MSMEs is also reflected in the removal of licensing requirements in June 2014 for most parts, components, sub-systems, testing and production equipment. Worldwide, 80 percent of any major weapon system is typically outsourced to sub-vendors who are chiefly MSMEs and it is time that the Indian defence industrial eco-system began to exhibit such features as well. According to MoD, the idea is to make MSMEs beneficiaries of about 30 percent of the total capital expenditure on defence.

Beyond acting as sub-vendors, it is primarily in the realm of some of the relatively smaller value Indian Army (IA) procurements both in low and high technology areas where MSMEs can hope to become even suppliers of whole systems. IA’s ever growing equipment pool requires a vast range of systems, some of which though low volume in nature will entail rapid innovation, an area where agile MSMEs can actually succeed. In any case, Indian private sector players whether big or small do seem to have their eye on prospective IA related requirements to grow their defence practice, as it were. A large fraction of the 307 Letters of Intents (LOIs)/Industrial Licenses (ILs) issued by the Department of Industrial Policy and Promotion (DIPP) to some 182 companies till October 2015 have been for land warfare systems or for electronics items that can easily have land warfare applications among other uses. Till date, 50 licensed companies covering 79 ILs have reported commencement of production and even partial commencement is now enough to stave of withdrawal of license. Importantly, the initial validity of ILs granted under the IDR Act have been increased from 7 years to 15 years with a provision to further extend an IL by another 3 years on a case-to-case basis. These relaxed regulations are naturally intended to attract greater private interest in a number of ‘Make’ programs that are now at the planning stage.

Indeed, as the DS committee report emphasizes, the focus of military procurement must see a shift towards ‘Make’ programs with high IC in tune with the requirements outlined in Long Term Integrated Perspective Plans (LTIPPs) as well as a more detailed Technology Perspective Capability Roadmap (TPCR). In order to defray the risk associated with these technology intensive programs under the ‘Make’ category, MoD has also announced modifications that will change the way in which ‘Make’ programs will be executed. DPP-2016 will modify the existing ‘Make’ rules to include three types of programs.

In the first type, termed ‘Make I’, the government will fund 90 per cent of the prototype development cost, i.e. 10 percent more than the current outlay of 80 percent as specified by DPP-2013. Moreover, if a successful prototype fails to get an order within 24 months of completion of development, the concerned vendor will be refunded its share of expenditure (i.e. 10 percent) incurred in developing the prototype. This rule is expected to make it easier for vendors to incur expenses in a risky, high cost of capital environment, reassured that a significant portion of their cost is likely to be recovered even if orders are not placed. The second type deemed ‘Make II’ will involve industry funding for prototype development and if a tender is not issued within two years of successful prototype development, MoD would refund the entire development cost to the duly selected vendor. The third mode called ‘Make III’, is reserved for MSMEs and involves industry funded projects with a development cost of less than Rs 3 crore, with the development cost once again being refunded to the chosen vendor if a tender is not issued within 24 months of successful prototype development.

Now while the two big ‘Make’ projects currently seeing deployment, the Integrated Materiel Management Online System (IMMOLS) and the Integrated Air Defence Command and Control system (IACCS) have been Indian Air Force programmes, in the near future it is IA which is going to drive some of the bigger ‘Make’ schemes such as the Tactical Communication System (TCS), Battlefield Management Systems (BMS) and Futuristic Infantry Combat Vehicle (FICV) programmes. These programs will of course be governed by DPP versions older than DPP-2016, but some of their specific features point to the shape of things to come. While all ‘Make’ programs till DPP-2013 pertain to ‘high technology complex systems or critical components/equipment for any weapon system to be designed, developed and produced indigenously’, the TCS program was considered particularly dependent on being able to leverage cutting edge technology, which is why a 45 percent weightage had been given to the ‘access to critical technologies’ criteria. Even in the case of the FICV project, this head has 31.37 percent weightage. But in the case of both TCS and BMS, commercial assessment of a vendor’s turnover, profit, net worth and physical assets have weightages of only zero and 10 percent respectively. In the case of the FICV project the weightage given to commercial assessment is 26.08 percent however.

What this reveals is that in times to come, ‘Make’ projects in the C4ISR category requiring a ‘network of networks’ approach will give the utmost weightage to a vendor’s in-house R&D capabilities and/or ability to secure access to IP from elsewhere. For more traditional systems, such as armoured vehicles and other platforms, more traditional parameters that take into account commercial assessments will matter considerably in addition to considerations of technology and IC levels, the latter being specified at a minimum of 30 percent for ‘Make’ projects under DPP-2013.

The DS committee in turn has recommended that for platforms of ‘strategic importance’, the L-1 competitive bidding route can be junked altogether in favour of inviting a ‘strategic partner’ (SP) from the private sector for the creation of long term capacity in a particular segment. Since the primary focus of SPs would be to support sustainability and bring forth incremental improvements in platform capability through technology insertions over their lifetimes, they would need to have competence in system engineering, supply chain management to manage life cycle support, and should be companies that are looking for assured revenue streams based on long term partnerships, rather than those who would prefer one-off contracts from time to time.

The DS committee’s SP model recommendation is based on the view that markets for major weapons platforms typically do not lend themselves to competitive models owing to a variety of factors including their inability to support more than a handful of players. The SP model recommendation has been accepted by the government and the V.K Atre Committee set up to give it detailed shape has decided that it will be pursued for large projects worth over Rs 10,000 crore in two categories. The first category would include partnerships in the fixed wing aircraft, helicopter, submarine, armoured fighting vehicles, aero-engines, guns and warship segments. Each of these segments will see the selection of only one SP based on a minimum qualifying criteria which will include at least 51 percent Indian ownership, a minimum annual turnover of Rs 4000 crores for the past 3 years, a CRISIL ‘A’ rating, revenue growth of at least 5 percent in the past 5 years and a Debt/EBITDA ratio of 3:1. A second category under the SP model that will look at metallic materials and alloys, non-metallic materials and ammunition will however see the selection of up to two partners from private industry.  Final evaluation will give 50 per cent weightage to technical parameters, 30 per cent to financial parameters and 20 per cent to platform specific criteria.

Clearly, the emerging details of the SP concept indicate that the government undeniably intends to distribute very large programs amongst groups with established industrial capability. The limiting of the number of SPs to only one in key platform segments is an indication that it wishes to avoid the bidding related acrimony that has been seen in the past, for say the FICV program, where a company like Tata Motors could narrowly miss out being selected based on slightly ad hoc financial criteria. Instead, in the SP model, the government will undertake a rigorous audit of interested firms who will have to allow inspection of their books for this end.

It is worth noting that each SP in the designated segments will be chosen over and above the capacities that exist in the public sector. So it must be kept in mind that while the government may be leveling the playing field by issuing longer term licenses, extending ERV protection to all Indian companies and subjecting public firms to the same tax structure, it will not let existing public capacity wither away. With over 120,000 employees and 41 factories spread out across India, OFB will continue to be a recipient of massive orders. Even in the case of the FICV program, MoD has duly nominated OFB to be one of the contending ‘Development Agencies’ for this ‘Make’ program. OFB has also been of course receiving ammunition orders under the revenue head of the defence budget.

Among the eligible private players for any program, technical competency and IC levels in their wares will obviously be key considerations for successful selection in the years ahead. Given the emphasis being placed on indigenous IP, as epitomized by IDDM, companies that have had long associations with DRDO, whatever their size, and have a R&D practice, will find themselves in an advantageous position. Long term involvement in DRDO projects has also given private sector primes such as L&T and Tata Power SED access to a potentially larger domestic vendor base that will be important to meet IC requirements.

The SP concept is a clear indication that the government wants private sector primes to focus on one or two areas of core competency and legacy capability. This means that new companies incorporated in various segments, irrespective of whether they are backed by very large conglomerates are unlikely to make much headway in securing key orders from the Indian military. Moreover, given that the new offset guidelines indicated by MoD say that only tenders worth over Rs 2000 crore will require offset packages instead of the current Rs 300 crore, the scope to build a defence practice through creating new capacity by leveraging foreign tie-ups is also not precisely the same as before. This is on account of the fact that future offsets though of a higher value on the average will mostly be of a ‘direct or directed’ nature wherein they’ll be used to source key technology in lieu of large orders placed with foreign majors. In any case, the number of offset opportunities themselves will reduce greatly on account of far fewer ‘Buy’ (Global) tender. In the years ahead, success in the Indian defence market will come to those companies that invest in R&D, are able to work closely with the public sector and are in the game for the long haul.

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