Defence Offsets: Army’s Belied Expectations and Trepidations
(Global Defence Offset Review Dec 2012)
Major
General Mrinal Suman, AVSM, VSM, PhD
Although the World Trade Organisation considers
offsets to be detrimental to free trade practices and prohibits its signatory
governments from imposing, seeking or considering offsets, the world trade is being
increasingly subjected to exacting offset demands. In the case of defence contracts, offsets have
become an integral part of all deals.
India
announced its intent to demand offsets against defence procurements in early 2005.
Subsequently, India’s defence offset policy was included in the Defence
Procurement Procedure (DPP). Initially, the policy was loaded in favour of the
public sector. It allowed discharge of offset obligations either through Foreign Direct Investment (FDI) in the defence public sector or direct
purchase of products/components/services from it. Even the task of monitoring
implementation of an offset contract was to be assigned to the participating public
sector entity.
As expected, the private
sector protested vehemently. To placate it, the Ministry of Defence (MoD)
revised the policy in 2006 by enlarging the scope of direct purchase of defence
goods and services to include the whole Indian defence industry. It also
allowed FDI in Indian defence industry and defence R&D. Further, it included
‘any private defence industry manufacturing defence products under an
industrial licence’ in the definition of Indian defence industry.
It was a cosmetic change
as no significant manufacturing activity was taking place in private sector
under licence. Industry associations continued their protests. Bowing to
pressure, MoD removed the mandatory requirement of an industrial licence for
private companies in 2008. The policy has since been further refined in 2009
and 2011.
The first offset contract
was signed in 2007 and a total of 17 offset contracts worth USD 4.279 billion
had been signed till May 2012. However, MoD has not revealed if any offset
contract has been successfully completed so far. Therefore, efficacy of India’s
defence offset regime remains untested.
As
per the current policy, a vendor can fulfill his obligations through one or a
combination of the following three routes:-
a) Direct purchase of, or
execution of export orders for, eligible products and components manufactured
by, or services provided by, Indian industries, i.e. Defence Public Sector
Undertakings, the Ordnance Factory Board and private Indian industry.
b) FDI in Indian
industries for industrial infrastructure for services, co-development, joint
ventures and co-production of eligible products and components.
c) FDI in Indian
organisations engaged in R&D as certified by Defence Offset Facilitation
Agency (DOFA).
Products eligible for discharge of
offsets relate to defence, internal security and civil aerospace. ‘Services’
mean maintenance, overhaul, upgradation, life extension, engineering, design,
testing of eligible products and related software or quality assurance services
with reference to the indicated eligible products and training. Training may
include training services and training equipment but exclude civil
infrastructure.
Although
the policy welcomes FDI both in the industry and R&D, it has failed to attract
foreign investors. With an upper cap of 26 percent, the policy is considered
highly dissuasive. No foreign investor is likely to invest his resources in a
venture where he has no significant control.
Undesirably, export
of defence goods and services has been the only viable option available to
foreign vendors to fulfill their offset obligations. It amounts to compensation
trading which is considered to be the least beneficial form of offsets.
Latest
Policy Changes
Even
though official promulgation is stilt awaited, reports appearing in the press
indicate that MoD has approved a number of changes in the offset policy. The
most significant being acceptance of transfer of technology against offset
obligations. Technology has to be complete (including documentation, training
and consultancy); without any license fee; and without any restriction on
domestic production, sale or export.
Concurrently,
a system of multipliers is being introduced to offer incentive to foreign
vendors to offer technologies in the areas of India’s preference. Multipliers
are factors that are applied to the actual worth of an offset contract to
arrive at the value of offset credits earned. For example, a foreign vendor who
supplies technology worth 100 million dollars having a multiplier factor of 2,
will earn offset credits worth 200 million dollars.
Further, in case
foreign vendors select micro, small and medium enterprises as their offset
partners, they are entitled to a multiplier factor of 1.5, thereby increasing
the value of offset credits earned by them by 50 percent.
Three long-pending
demands of the foreign vendors are also likely to be met – an increase in the
validity period of banked offset credits from the current two years to seven
years; allowing completion of offset contracts to overshoot completion of main
contract by two years; and capping penalties for default at 25 percent.
Additionally, without diluting the responsibility of the prime vendor, MoD is
likely to allow sub-vendors in complex cases to fulfill offset liabilities
incurred by them individually.
MoD appears to have
settled the issue of management of offsets in favour of the Department of
Defence Production (DDP). An empowered Defence Offsets Management Agency (DOMA)
will be created under it with sufficient decision making powers for efficient
management of the complete gamut of implementation activities.
However, evaluation
of offset proposals and signing of offset contracts are likely to continue to
be under the aegis of the Acquisition Wing, as hitherto fore.
Belied
Expectations and Trepidations
When
the idea of demanding offsets with defence deals was initially floated in
official circles, most service officers got taken in by the euphoria created by
the government and the industry. They thought it to be a harmless appendage to
the procurement procedure. Very few were fully aware of its implications. They
were told that India’s huge bargaining power would be
exploited to channelise offset inflows into well-designated activities to usher
in an era of technological excellence and kick-start indigenous defence
industry.
However,
experience of the past few years has been highly discouraging. There has been
no progress whatsoever towards the development of a vibrant defence industrial
base. On the contrary, dependence on imported defence systems seems to be on an
increase. There has been no technology infusion and no discernible increase in
the participation of Indian private sector. Defence production continues to
remain an exclusive domain of a highly inefficient public sector.
Some
of the key issues that have been causing concern to the army have been
discussed below:-
a)
Cost
Penalty on Defence Budget
Offsets
do not come for free as foreign vendors have to incur additional expenditure to
fulfill their obligations. There are a number of variables that affect offset
overhead costs, depending on the type of programmes undertaken. Although cost
penalty is not directly proportional to offset percentage, 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.
Offset
cost penalty increases the outflow of defence funds. For example, for a deal
that mandates 50 percent offsets, the defence budget will have to pay up to 10
percent extra in costs. In other words, unless the allotment of defence budget
is proportionally increased, the army will suffer a decrease in the net worth
of its purchasing power. In case the cost of 100 artillery guns is 10,000 crore
rupees, the army will have to pay 10 percent more (11,000 crore) for 50 percent
offsets. In case no offsets are demanded, the army can purchase 110 guns with
11,000 crore rupees. Thus the army is the net loser. It has started realising
that a part of defence budget is being cleverly misused to obtain export orders
for the public sector, that too for low-tech components.
b)
Wasteful
Offset Programmes
All
nations seek offsets that are in consonance with their national needs – either
to meet an urgent economic need or to fill a critical technology void. It is
not the type of offset but its relevance that matters. Therefore, offsets must
be need-based and not availability-based. Irrationally, India has abrogated the right to select methodology, areas
and offset programmes in favour of the vendors, thereby rendering India’s needs
inconsequential. As is expected, foreign vendors opt for programmes that cost
the least and are easy to fulfill – India’s needs do not count at all.
Inappropriately selected and
ill-planned programmes invariably prove to be uneconomical and wasteful. Almost
all offset contracts signed so far have been pure counter-trade deals or entail
outsourcing of low-tech components from Indian companies. Thus offsets have
neither upgraded indigenous technological prowess nor helped improve
self-reliance in defence production.
c)
Monitoring
Concerns
It
is rightly said that ‘unmonitored offsets are unimplemented offsets’. Lax
monitoring is an open invitation to unscrupulous foreign vendors and their
dishonest Indian partners to collude and cheat the country by presenting
exaggerated claims. In the absence of a credible verification mechanism, MoD
has to accept their claims at their face value.
Close
monitoring is essential not only to initiate timely mid-course corrections but also
to ensure that every offset programme achieves designated objectives. Feedback
received from all stakeholders assists decision makers in incorporating
suitable changes in policy provisions.
Monitoring
should culminate in a detailed performance audit of an offset programme to
ascertain whether the accruing benefits justify the cost penalty suffered. In
other words, MoD must undertake value-for-money appraisal.
The
army is understandably concerned that unless corrective steps are taken
immediately and a suitable monitoring mechanism is put in place, India is bound
to rue its apathy and indifference. Unmonitored offset programmes will
inevitably degenerate into cesspools of inefficiency and corruption, thereby
affecting execution of the main contracts adversely.
d)
Default
and Probity Issues
According
to Transparency International, offsets are ‘very open to corruption’ as they
remain on periphery and are subjected to less scrutiny. In India’s case, the
problem gets compounded as India
has abrogated the right to select offset programmes to the vendors. India is
thus totally dependent on the diligence, sincerity and truthfulness of the
foreign vendors.
Such vulnerability increases multifold
in case of offset banking where the programmes are formulated in broad and
indefinite terms. Moreover, as these programmes do not pertain to any specific
acquisition proposal, monitoring is casual and slack, rendering them open to
manipulation and disproportionate claims.
Offset obligations have to be
fulfilled during the contracted period. Any
vendor failing to fulfill his offset obligations is liable to be penalised and
even disqualified for participation in future defence contracts. With such punitive
provisions in place, the army is understandably worried that any
default in offset programmes can delay the main contract and even jeopardise
it.
Further, allegations of malpractices
in offsets can put a foreign vendor under cloud, forcing MoD to suspend all
ongoing contracts and blacklist him for future procurements. As it is, there
are a handful of major arms producers in the world. Further, strict export
legislations of many nations make the vendor base highly restricted. With MoD’s penchant for banning vendors for
even minor misdemeanours, the vendor base can shrink further. It is an issue of
genuine anxiety for the army.
The Way Forward
It will not be incorrect to state that
India’s defence offset regime is in a total mess. Piecemeal changes have become
an annual ritual. The policy is bereft of any clearly articulated objectives
and detailed planning. Worse, oversight mechanism is totally absent. The whole
process has been left to the honesty and diligence of vendors. Such a regime can
neither contribute to the growth of indigenous industry nor provide long term
economic benefits.
As
stated above, the army has serious apprehensions about the ability of the
defence offset policy to deliver. Continuing directionless drift does not
inspire any confidence and creates doubts about MoD’s ability to manage offsets.
The army is worried about the wastage of its budget for bagging export orders
for sundry items. It also fears that undue importance being accorded to offsets
may dilute focus on defence procurements and even endanger them.
Unfortunately, the procurement
procedure mandates that offset proposals should be evaluated 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 to be
deficient in any aspect. Resultantly, the army may be deprived of an excellent
piece of equipment.
As is well known, every major defence
contract is being subjected to close scrutiny for probity related issues. Fear
of subsequent enquiries is dissuading expeditious decision making. It will be a
terrible setback in case mismanaged offset programmes add to the existing woe
and despair.
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 be obtained through the leverage of
offsets. In other words, offsets must contribute to the upgradation of
indigenous technological base.
Now
that India has decided to accept transfer of technology against offsets, a proper
institutionalised arrangement should be put in place to identify needed
technologies, carry out a detailed appraisal of its usefulness, estimate its
true value and ensure its earnest transfer.
Concurrently,
India should adopt a flexible FDI policy that is technology-centric. FDI cap
should be decided with respect to nature, level, depth and exclusivity of
technology being transferred – 26 percent for low-tech proposals; 49 percent
for high-tech cases; 74 percent for the latest genre
of technologies; and 100 percent for cutting-edge technologies.
Finally,
excessive euphoria about offsets has been disconcerting to the army leadership.
Many experts feel that the primary objective of defence procurements must never
be lost sight of. Defence equipment is bought to equip its armed forces and not
for obtaining offsets. Offsets are incidental to defence procurements and
cannot be accorded primacy in decision making. Therefore, apprehensions are
being voiced by many soldiers about the defence acquisitions losing the
necessary focus and thrust. The army is also worried that inefficiently
handled offset programmes may derail the complete procurement process.
