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Will Defence Industrialization Help The Technological Upgrade Of The Indian Economy?

- 24th March 2011


India’s high growth rates of well over 8% over the last five fiscals have concealed a growing merchandise trade deficit, projected at an unsustainable 13% of GDP by 2014. India imports most of its requirements in high-tech machine tools, telecommunications and IT hardware equipment, civil aerospace and armaments. This year, India expects to procure US$ 15 billion worth of armaments, rising to US $50 billion over the next few years, mostly to be imported (1). The services sector - which comprises 55% of GDP, with manufacturing at 28.8% - accounts for only one third of India’s exports and does not compensate for merchandise export deficits. Moreover, high growth in India’s services sector translates into gains mostly for foreign manufacturers.

Some Indian firms and sectors have strong technological capabilities, but this is not an economy-wide phenomenon due to the lack of a national innovation system and low R & D to GDP ratio (0.9% as estimated by Thomson Reuters research). India needs to urgently implement a national policy for technology upgrade if it is to meet the challenges and security dilemmas of the 21st century.

A unique opportunity to rectify the situation has presented itself following major reforms in defence production policy and the simultaneous easing of restrictions on high-tech transfers to India by the United States and other Western countries, reflecting changing geostrategic realities. The Defence Minister of India has emphasised that India should develop a self-reliant and diversified defence industrial base. Under reforms announced in January 2011, greater stress has been laid on the development of indigenous manufacturing capabilities and on the private sector’s involvement in the defence sector. The reforms call for indigenous manufacture of defence equipment by both the public and private sectors including SMEs, establishing synergies between indigenous players including research and academic institutions, and broadening and strengthening the defence R&D base, including Government funding support for 80% of the R & D costs of indigenously developed products.

Apart from indigenisation, the reforms also stress private sector involvement in defence production. One of the most indicative policy statements is the resolve to treat selected industrial firms in the private sector at par with public sector units, thus ending an era of discrimination against private players, a revolutionary development in the Indian context (2).

Defence offsets, mandated at a minimum of 30% of armaments imports over US$ 66 million, which can be fulfilled through export orders, joint ventures or technological collaborations with Indian partners, are also to be one of the important vehicles for technology inflows and indigenous defence manufacturing (3). The FDI cap has however been retained at 26%, raising serious questions about the possibility of large technology inflows given such restrictions.

Will the West help India Bridge the Technology Gap?

Changing geopolitical alignments have opened up further opportunities. One of the dimensions of the strategic US –India rapprochement was the easing of restrictions on transfers of high technology to India. On January 24, 2011, the US implemented commitments given in the Indo-US joint summit statement of November 8, 2010 to remove Indian companies from the U.S. “Entity List” and support India’s membership in four multilateral export control regimes – the Nuclear Suppliers Group, Missile Technology Control Regime, Australia Group, and Wassenaar Arrangement (4). The Indian entities thus removed will no longer be discriminated against, but neither will they circumvent national export controls on dual use, high-tech items maintained by advanced economies.

The policy re-orientation was consistent with the oft-quoted assurance that the US would help India become a major power in the 21st century (5), with President Obama also calling India an indispensable partner (6).

The reforms on both sides laid the ground for the announcement of a host of agreements with significant scope for technology transfers during the biennial air show Aero India (Bangalore, February 2011). The prospect of winning major defence contracts – the key one being the multi-billion dollar contract for the Multi Medium-Role Combat Aircraft (MMRCA) - was an important contributing factor. Some of the deals announced at Aero India included joint ventures between Larsen and Toubro (L & T), a major private engineering firm with EADS, between Lockheed Martin and the Tata Group, and between SAAB and several Indian firms; an offer by Boeing to transfer technology of the AESA radar, giving its bid for the MMRCA an edge over those of rival competitors (6); and the pledge of the Eurofighter consortium to make India a "significant manufacturing and engineering partner" and to "pursue an ambitious industrialisation strategy" creating 20, 000 skilled jobs in India and 100,000 jobs in Europe (8). At another venue, Ashton Carter, US Under Secretary for Defence Acquisitions even stated that the US could consider Indian participation in the Joint Strike Fighter programme, though India had just concluded an agreement with Russia to develop a fifth generation fighter.

A defence industrialisation strategy for India?

The reforms are meant to catalyse a boom in defence manufacturing and technology, employment and growth. But will they generate multiplier effects on the rest of the economy? Will real indigenisation take place, given the reluctance of Indian companies to open the “black box”? Will additional capacities be created across the production chain, in R&D institutions, vocational training establishments, and in the Indian engineering sector in general? Will the reforms ultimately lead to a reduction in India’s trade deficit and the technological upgrade of the entire economy?

Some of these goals may be achieved. There is scope for building on the successes already notched up by Indian manufacturing in the pharmaceuticals, automotive, shipbuilding and strategic weapons sectors. However some pitfalls may arise, as follows:

26% FDI is not conducive to proliferation of high-tech investments: Jane’s noted that only three joint ventures were approved since January 2009, with the FDI cap of 26% acting as a major disincentive (9). More incentives will be required to induce investments since firms jealously guard their technologies and countries continue to maintain stringent export control regimes.

Entrenchment of a defence oligarchy: Only very big Indian firms can bid for the joint ventures set up to discharge offset obligations, since 74% equity has to be raised. The government would also like only proven Indian manufacturers to bid for projects. This will not help SMEs to participate in defence production, which is one of the stated objectives of the reforms, and the catchment area would be narrowed down to a few elite firms, reinforcing the crony capitalism exposed in recent corporate, political and media scandals in India.

Lop-sided Economic Development: The exclusive focus of the reforms on the defence sector can lead to development of a skewed economy. A competitive defence sector will thrive only if the rest of the economy is technologically sophisticated and able to satisfy the demand for specialized alloys, composites, components, precision engineering items etc. India should thus aim at broad-based industrialisation if it wants a manufacturing take -off. That is why Central and Eastern Europe have emphasised civil offsets “to foster wider economic development of emerging economies” (10). China’s example is also instructive. The leadership, observing the examples of the US and perhaps some other advanced economies, realised that a sophisticated defence manufacturing sector could not be built by firewalling it from the civilian economy. It thus adopted a civil-military integration (CMI) model encompassing the relevant production chains. Prof. Tai Ming Cheung has pointed out in his excellent book “Fortifying China” - that an evolved version of Deng Xiaoping's 16-character policy prescribed “combining the military and civil” and “letting the civil support the military”. The synergised growth of the civil and defence manufacturing sectors gave the economy its dynamism and technological capabilities.

Easing of restrictions could intensify dependence: Easing of export controls could lead to an even greater dependence on foreign technology if the opportunity to create a dynamic innovation eco-system is not seized.

Recommendations

India needs to move away from a compartmentalised paradigm focusing solely on the defence sector. Some measures India could take are as follows:

1. Raise offset obligations to 75-100% and the FDI cap to 51%. This will result in a flood of manufacturing FDI and generate the same impact on the economy that the Maruti with 51% Japanese control had on India’s automotive market. Also, smaller Indian firms may be enabled to come forward to partner foreign firms as a result.

2. Immediately institute offsets in other sectors and for all major imports (telecom, IT hardware etc.). China developed its civil aviation manufacturing sector through offsets decreeing local manufacture of civil aviation parts, and through joint ventures and reverse engineering.

3. Introduce offset obligations for setting up innovation clusters around manufacturing units such as related R & D units, tie-ups with scientific institutes etc.

4. Institute a calibrated tariff policy to protect indigenous manufacture, along with the relaxation of FDI norms, resisting pressure for tariff reductions under multilateral trading arrangements.

5. Enable faster technology assimilation and innovation – enforcing tight time-frames, imposing penalties and incentives for full local sourcing and real indigenisation, and focusing both on upstream manufacturing and end products to ensure capabilities are built up throughout the production chain.

6. Set up a dual-use manufacturing base, creating synergies and spin-on/ spin-off effects between the defence and civilian manufacturing sectors.

7. Implement holistic reforms to create a national innovation system (study other models).

Conclusion

A better geopolitical environment, a booming defence market, defence sector reforms and the easing of restrictions on high technology exports have opened up the prospect of technology inflows into India which can be used to upgrade and galvanise indigenous manufacturing.

India should seize this golden opportunity and implement the additional reforms suggested above, together with comprehensive governance reforms - to launch a high-tech, economy spanning manufacturing revolution. Some sectors, such as civil nuclear energy will continue to work behind firewalls, as mandated in the Indo-US nuclear deal, but all the other sectors should establish linkages and share the dual use technologies and benefits available. If India fails to act, the deleterious consequences will be felt in all spheres of national life.

JS (MEA) on loan to IDSA, all views are personal.

 

1. India apparently imports 70% of its defence needs.

2. Defence production had been thrown open to the private sector in May 2001, with 26% Foreign Direct Investment (FDI) also permitted. The Defence Minister, Shri A. K. Antony in his Keynote Address at the National Seminar on Defence Industry, January 23, 2009 has also expressed his support to greater private sector involvement in defence production.

3. As a concept defence offsets have been around for a long time. Offset requirements for the 126 MMRCA tender are even higher at 50%.

4. “Commerce takes steps to implement export control initiatives to facilitate high-tech trade with India”; January 24, 2011; http://www.commerce.gov/news/press-releases/2011/01/24/commerce-takes-steps-implement-export-control-initiatives-facilitat-0

5. http://www.indianembassy.org/India_media/Mar_05/TOI.htm

6. Remarks by the President to the Indian Parliament, November 08, 2010; http://www.whitehouse.gov/the-press-office/2010/11/08/remarks-president-joint-session-indian-parliament-new-delhi-india

7. “Aero India: Boeing shows off Super Hornet upgrade options” by James Hardy JDW Asia-Pacific Editor Bangalore; Gareth Jennings JDW Jane's Aviation Desk Editor Bangalore, India; 10-Feb-2011 Jane's Defence Weekly.

8. “Aero India: Eurofighter offers India key partnership role in exchange for MMRCA deal” Keri Wagstaff-Smith Jane's Industry Reporter; 11-Feb-2011 Jane's Defence Industry

9. “Defence companies face uncertainty over Indian joint ventures” by Jon Grevatt, Jane’s Industry Briefing, Jane’s 16-Feb-2011.

10. “The changing role of offset in the global defence market”, Jane’s Industry Quarterly 03-Nov-2009
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