Defence Offsets Proving Detrimental to the Services

Post-Kargil, Indian defence imports had been ranging between 3 to 6 billion dollars annually whereas defence exports had been stagnating at meagre 50 million dollars an year. Despite India’s best efforts very little headway was being made on the export front. As a last resort, a proposal was mooted in 2004 to coerce foreign sellers to compulsorily buy Indian defence goods in exchange. While the proposal was being debated, an article titled “Offsets in Arms Trade: Need for a National Policy” appeared in Indian Defence Review (Oct-Dec 2004). It had suggested that India should have a national offset policy and all major defence deals must carry mandatory offset obligations. Defence Public Sector Undertakings (DPSU) and the Ordnance Factory Board (OFB) were quick to grasp the significance of offsets and modified their proposal from one of counter-trade to that of offsets.

As India has no national offset policy, Ministry of Defence (MoD) took the initiative to evolve its own defence offset policy. Initially announced in early 2005, the policy was made a part of Defence Procurement Procedure – 2005. As the primary aim of the policy was to boost exports from the public sector, it allowed discharge of offsets either through FDI in Indian public sector undertaking for defence industrial infrastructure or direct purchase of products/components/services from DPSU/OFB/other industry identified by MoD. Interestingly, the task of monitoring implementation of every offset contract was to be assigned to a DPSU or OFB.

The above policy was subjective in intent. The private sector protested strongly against the unfair treatment meted out to it, forcing MoD to revise the policy in 2006. Scope for direct purchase of defence goods and services was enlarged to include the whole Indian defence industry. It also allowed FDI in Indian defence industry and defence R&D. Further, it defined Indian defence industry to include DPSU, OFB and any private defence industry manufacturing defence products under an industrial licence granted for such manufacture. As no major manufacturing activity was taking place in private sector under licence, the policy continued to favour the public sector.

As was expected, industry associations were not satisfied and appealed to MoD for a level playing field. Bowing to pressure, MoD removed the mandatory requirement of an industrial licence for private companies in 2008. Now, the only stipulation to being an offset partner is that the Indian company should not have more than 26 percent foreign holding.

Before examining the effect of offsets on the services, it is essential to understand three aspects that have a profound bearing on the modernisation plans of the armed forces, i.e. objective of seeking offsets, receipt of technology against offsets and cost of demanding offsets.

Objective of Seeking Offsets

Offsets are universally accepted as a powerful leverage to obtain compensatory benefits by asking the seller to undertake well-designated activities to satisfy vital economic necessity or fill critical technological void. Therefore, before embarking on offsets every country identifies and spells out objectives that are proposed to be achieved through offsets. Thus, the objectives are always nation-specific and in consonance with national aspirations and long-term vision. In the absence of well evolved objectives, offsets lose focus and prove highly wasteful. An aimless offset policy can neither contribute to the growth of indigenous industry nor provide long term economic benefits.

India may be the only country whose defence offset policy has no stated objectives. MoD has not considered it necessary to explain as to what it intends to achieve through offsets and the roadmap for the same. However, as offset policy is a part of Defence Procurement Procedure – 2008 (DPP-2008), it can be reasonably inferred that its objective would be in line with the objective spelt out in DPP-2008, i.e. achieving self-reliance in defence equipment. Additionally, India has been reiterating its resolve to reduce the current proportion of imports from 70 percent to 30 percent. If that be so, primary thrust of the Indian policy should be to seek infusion of technology to strengthen its indigenous defence industrial base.

However, contrary to all rationale, the Indian offset policy has been formulated to continue dependence on imports. India has not considered it necessary to direct offsets to pre-designated areas of its choice. It has abrogated the right to select methodology, areas and offset programmes in favour of the vendors, thereby rendering India’s needs inconsequential. It is natural for every foreign vendor to opt for programmes that cost the least and are easy to fulfill – Indian needs do not count at all.

Infusion of Technology against Offsets

Every country that strives to develop indigenous industry seeks technology through offsets to bridge the gap and use acquired technology as a take off platform for indigenous development of more advanced technologies. More than 35 percent of all offsets worldwide relate to technology transfer. Transfer of technology (ToT) is rightly called as the engine that drives offsets. For technology transfer, all countries adopt a two-step approach, as given below:-

(a) Identification of Critical Technologies. These are technologies that are considered essential for stimulating and expediting the growth of indigenous industrial competence. For economies of scale, sought technologies should not be product-specific but have much wider application across a large range of systems. Ability to absorb identified technology and monitor its transfer is another major consideration.

(b) Persuasion of Vendors to Offer Required Technology. To persuade vendors to part with the technology sought, a system of assigning different multiplier values to various offset programmes is put in place. Multiplier value is a factor applied to the actual value of an offset transaction to calculate the credit value earned. For example, by undertaking an offset programme worth Rs 100 crores with a multiplier value of 3.5, a foreign vendor would earn offset credits equal to Rs 350 crores. By assigning differential weigtage to offset programmes, buyer nations provide sellers with incentives to offer offsets in targeted area of buyer’s choice.

Despite repeated assertions of wanting to make India self-reliant in defence production, India does not accept technology against offsets. This aspect will be dealt with subsequently.

Offsets and Cost Penalty

One of the major misconceptions is that offsets are free add-ons. Nothing can be farther from the truth. Offsets certainly do not come for free as foreign vendors have to incur additional expenditure to fulfill them. There are a number of factors that affect offset overhead costs and it is not feasible to fix an exact yard-stick.

Value of an offset is always expressed in terms of percentage of the value of the main contract. It is generally seen that offsets up to 50 per cent inflate the cost of the main contract by close to 10 per cent. Similarly, 100 and 200 per cent offsets may result in cost escalation by 15 and 20 percent respectively.

The above graph shows the following:-

(a) Cost penalty is not directly proportional to offset percentage. Cost penalty varies with the type of programmes undertaken.

(b) Initial cost of establishing infrastructure and initiating offset programmes is considerable. Once the process becomes functional and gets streamlined, rate of increase in cost penalty drops.

(c) Cost penalty tends to plateau after offset percentage reaches 200 percent. It implies that beyond this stage, both the offset provider and the receiver remain engaged in programmes which make commercial sense to both.

It may come as a surprise to many that the US allows its defence producers to charge offset costs even for government to government Foreign Military Sales (FMS). Although the US Government considers offsets to be detrimental to free and fair trade, it appreciates the need for companies to recover offset costs as they are considerable. The Defence Federal Acquisition Regulation Supplement (DFARS) of May 1995, allowed US companies to recover full cost necessary to ‘implement an offset agreement’ in connection with FMS purchases. Subsequently, the scope was widened by using the term ‘offset costs’, thereby facilitating recovery of full expenditure incurred in fulfilling offset obligations. It proves the point that fulfillment of offset obligations costs a company considerable expenditure which it can not absorb and has to recover by factoring it in the sale price.

Offsets and the Indian Services

When the idea of demanding offsets was initially floated in official circles, most service officers thought it to be a harmless appendage to the procurement procedure. Very few were fully aware of its implications. Many welcomed it in the hope that offsets would result in giving an impetus to the Indian defence industry. Being terribly uncomfortable with the continued dependence on foreign vendors and the resultant uncertainties, the services did not grudge encumbrance of offsets in order to make India self-reliant. However, the services were in for a shock. The Indian offset policy is anything but self-reliance centric.

India allows three routes for the fulfillment of offset obligations and they are:-

(a) Direct purchase of or executing export orders for defence products or services provided by Indian defence industries. For the purpose of defence offsets, services mean maintenance, overhaul, upgradation, life extension, engineering, design, testing of defence products, defence related software or quality assurance services.

(b) FDI in Indian defence industries for industrial infrastructure for services, co-development, joint ventures and co-production of defence products and components.

(c) FDI in Indian organisations engaged in research in defence R & D.

An examination of the viability of the above three routes is very revealing. At the face of it FDI route appears highly viable but when considered in the light of upper cap of 26 percent, the dissuasiveness of the policy becomes apparent. A foreign investor is expected to invest his resources in a venture where he has no significant control, strict capacity/product constraints, no purchase guarantee and no open access to other markets including exports. The FDI policy was announced in May 2001 and has elicited no response. Therefore, options (b) and (c) above mean little.

Export of defence goods and services is thus the only possible method to fulfill offset obligations under the Indian policy. It amounts to compensation trading which is considered to be the least beneficial form of offsets. Export of goods and services provide temporary and illusory gains, as has been the experience the world over. New markets dry up soon after the offsets are fulfilled, leaving created infra-structure idle and bereft of orders. Therefore, such trading does nothing to either strengthen the defence industrial base or promote technology upgradation. In other words, a potent tool like offsets is wasted on one-time exports.

Undoubtedly, the services have been taken for a ride. Offsets have added to their disquiet and anxieties without any boost to indigenous defence industry. A look at the following major concerns of the services will reveal the intensity and magnitude of the dilemma faced by them:-

(a) Offsets impose a cost penalty on all procurements that carry offset obligation clauses. This implies that the outflow from the defence budget gets proportionately increased. For example, for a deal that mandates 50 percent offsets, the defence budget will have to pay up to 10 percent extra in costs.

(b) Simultaneous signing of offset contract can result in a loss of focus, away from the main contract. DPP-2008 lays down that at every stage of evaluation, offset proposals would be examined along with the main technical and commercial proposals to confirm compliance. A competent vendor may get eliminated by default if his offset proposal is found unsatisfactory.

(c) Offset obligations have to be fulfilled co-terminus with the main contract. The policy allows imposition of penalty and its recovery by way of deduction from the bank guarantee of the main contract or the amount payable to the vendor under the main contract. Further, failure to implement full offset obligations during the period of the main contract makes the vendor liable to be disqualified for participation in future defence contracts. With such punitive provisions in place, any default in offset programmes can delay the main contract and even jeopardise it.

(d) Offsets are notorious for corruption as they are often formulated in broad and imprecise terms, leaving enough leeway for multiple interpretations and manipulations. Furthermore, offset contracts are never monitored as closely as the main contract. Allegations of malpractice in offsets can put a foreign vendor under cloud and affect his commitment to timely completion of the main contract. Additionally, MoD may be forced to debar the vendor to exhibit its zero tolerance for dishonest activities, thereby endangering the main contract as well.

Indian Services are the Net Losers

As per the figures released by Defence Offset Facilitation Agency (DOFA), offset agreements worth Rs 8125 crores had been signed by the end of 2009. The share of aero systems is 94 percent at Rs 7645 crores and that of naval systems 6 percent at Rs 480 crores. While bulk of the export orders have gone to the public sector (mostly HAL Ltd), some orders have been placed on the private sector companies for the supply of goods and services.

To generate offset contracts worth Rs 8125 crores, the value of main contracts would be close to Rs 17000 crores (assuming offset percentage to be mere 30 percent). Again, considering the standard cost penalty of 10 percent, the Indian defence budget has already suffered an extra outflow of close to Rs 1550 crores on account of offsets – only to facilitate export orders of sundry items for some select Indian companies. It will not be incorrect to state that the Indian offset policy is designed to obtain export orders for the public sector at the cost of the defence budget. Take the case of 126 fighter aircraft that India proposes to buy at an indicative cost of 11 billion dollars. The proposal carries an offset liability of 50 percent, resulting in a likely cost penalty of 10 percent. It implies that India could save one billion dollars if no offset obligations are imposed or buy up to 15 additional aircraft with the same budget. It is certain that extra outflow of one billion dollars will finance export orders for HAL. Worse, HAL would manufacture and supply low-tech items like doors and windows of aircraft and not systems/sub-systems that may boost its technological prowess.

On the whole, offsets are not contributing to the upgradation of indigenous technological base but adding to the woes of the services and taxing the defence budget. Indian policy makers have failed to appreciate the full potential of offsets and trivialised a powerful instrument of industrial growth for transitory gains for DPSU and other entities.

The Way Forward

As seen above, offsets cost a country considerable extra expenditure. The question therefore arises whether they are desirable. It is universally accepted that offsets make sound business sense only if the trade-off results in extraordinary economic or technological gains. Technologies that industrially-advanced countries are reluctant to sell can only be obtained through the leverage of offsets. Over 130 nations are demanding offsets in defence purchases today. Despite knowing that the seller is bound to amortise the offset expenditure by suitably factoring it in his price quote, the countries find the proposition appealing.

India has an unusual knack of inserting provisions in a policy that are totally contrary to the stated objectives of the policy itself. Self reliance is a stated aim of DPP-2008. Yet, India does not accept technology under offsets. It is a dichotomy that the services fail to understand. The common reason given by the Government functionaries is that they are unable to price technology. It is a totally specious and hollow excuse. India purchases technology as a part of ‘Buy and Make’ deals – either contracted as a part of the main deal itself or negotiated separately at a later stage. Apparently, no ToT contract can be entered into without pricing the technology involved.

There is no standard price of technology in the world market. It is purely need-based and determined by the degree of desperation of the technology seeker. DRDO can be asked to identify technologies that it needs. Normally, DRDO should seek technologies in which it has made considerable headway but not mastered – commonly referred to as lacking ‘last mile connectivity’. Thereafter, DRDO can work out the anticipated expenditure on indigenous effort to master the said technology as also urgency of its application. These two factors help decide fair, reasonable and acceptable price of technology.

Many knowledgeable observers are of the opinion that MoD has been pressurised by the public sector to disallow ToT against offsets as the public sector wants to perpetuate its monopoly on receipted technology through the current system of ‘Buy and Make’ deals. The public sector fears that acceptance of ToT against offsets would make the private sector preferred partner of foreign vendors. Therefore, opposition of the public sector is purely to safeguard its exclusive turf. It is time MoD rises above extraneous considerations to ensure that the benefits accruing from offsets do not get outweighed by the cost penalty. Transfer of technology should be made the preferred form of offsets. Through a well-evolved system of application of multipliers, irresistible incentives should be provided to foreign vendors to offer technologies that India needs the most.