NEW POLICY ON DEFENCE CONTRACTS OFFSETS

Not Just About Money

Raghu

 

INDIA'S policies on defence-related acquisitions from abroad and production within India are believed to have been directed not only at ensuring India's security interests but also at promoting self-reliance and indigenous capability in this vital sector often involving advanced technologies. Whatever one's opinions about intentions, questions have often been raised, including in these columns, as to whether these goals have actually been achieved. Again, while the point may be debated, clearly there are major problems going by the evidence in the past two decades.

 

India has been buying ever larger quantities of increasingly sophisticated military hardware from foreign suppliers, while its defence forces have not been able to acquire necessary comparable equipment from Indian state-sector manufacturers due to inadequate performance, inordinate time delays and massive cost overruns. Fighter aircraft such as the Light Combat Aircraft (LCA), jet trainers, helicopters, main battle tanks, submarines are all military equipment in which India has had active indigenous or collaborative R&D or manufacturing programmes over several decades. But, as inventories have reached the end of their life cycles calling for replacements, India has repeatedly been forced to go in for costly foreign acquisitions while requisite indigenous capability has continued to languish even for the next generation of technology. This has not only increased India's dependence on imports, and vulnerability to technology denial regimes, in such a vital sector, it has also meant huge lost opportunities for enhancing science and technology capabilities, and downstream spread effects, in important sectors of national industry.

 

Very belatedly, India had set in place over the past two years a policy of "offsets" in major defence contracts worth over Rs 300 crore in value. Under this clause, a party securing such a contract was obligated to plough back to Indian parties at least 30 per cent of the contract value by way of buy-back of products and services, with a provision for a higher percentage in special cases. Of course, there still remained the danger that even such offsets may amount to little more than some sub-contracts or assembly-line operations, not resulting in any upgradation or absorption of know-how or capability, but it least it was a beginning.

Unfortunately, under pressure from major manufacturers in the US and some other Western countries, there are moves to dilute even this offset clause in important ways to the detriment of the long-term Indian interests. As we go to press, Defence Ministry officials have confirmed that a modified DPP will be notified by April 2008.

 

OFFSET

POLICY

 

The policy on offsets, first enunciated in 2005, was further elaborated along with rules and procedures in the Defence Purchase Policy (DPP) of 2006 under which a new Defence Offset Facilitation Agency (DOFA) was also set up to work with vendors on implementation and monitoring. Offsets could include buy-back of products or services, foreign direct investment (FDI) in Indian public or private companies for such products or services or co-development and infrastructure, or even FDI in Indian entities engaged in defence R&D. All these were envisaged to be "direct offsets" that is directly related to the contract, the procurement of items under it, and their cost.

 

In the short period DPP-2006 had been in operation, two major contracts had been concluded with offset clauses. Israeli firm ELTA System had been awarded a contract worth Rs 900 crore for supplying radars. Under the offset provision, ELTA signed contracts with two Indian firms for purchase of components, with Astra Microwave securing a contract worth Rs 100 crore. Similarly, in the $1 billion (Rs 4000 crore) contract awarded to the Russian manufacturers of the Mig-29 for upgrades of the IAF's fleet, the vendor has agreed to offsets of $300 million. Several other pending deals such as for refueling tankers also contain offset clauses.

 

Interestingly, even the controversially cancelled deal to purchase 196 military helicopters from the French-led European conglomerate Eurocopter (most probably cancelled under pressure from its US rivals Bell Helicopters as revealed in these columns a few months ahead of the cancellation) had contained offset provisions with Eurocopter having agreed to 30 per cent offsets as required.

 

Two points must be noted here.

 

First, such offset clauses are not unique to India nor are they some archaic leftovers of an earlier "socialistic" self-reliance policy incommensurate with the contemporary realities of globalisation. Many countries have, and continue to successfully enforce, such offset clauses in the interests of their economies and in order to boost their knowledge base and industrial capabilities. Israel, Malaysia, Thailand to name a few are among many other countries in Asia and South America having even more stringent offset conditionalities than India.

 

Take for instance Israel's $2.5 billion order for 50 F-16 fighter aircraft from the US giant Lockheed Martin which had lost out to its American rival Boeing (both now pushing aggressively for the Indian 126-aircraft deal). Israel secured an offset package of $850 million or about 35 per cent of the contract value spread over 10 years. Within 3 years of signing the deal, Lockheed Martin had already invested over $250 million in 12 Israeli firms for sourcing various components, assembly and post-production services. Israel not only enhanced their capabilities in these sectors it also ensured that it acquired new knowledge in advanced areas. Lockheed Martin was made to invest and participate in co-development of flight simulators and helmet-mounted display systems, as well as other technologies relating to space applications and electronics. Israel also made full use of its option clause for acquisition of a further 50 F-16s to add pressure on the US vendor.

 

OFFSETS

FOR WHAT?

 

Second, as also brought out by the above example, offsets should not be seen merely as commercial propositions by which India could earn additional money thus reducing capital outflows in defence contracts. Merely obtaining orders for some components, or securing servicing and overhaul contracts, or even assembly and license- production is not sufficient to ensure absorption of know-how and building up the capacity to independently develop and manufacture equipment using the next generation technology. Indeed, India's own experience of serial license-production agreements clearly reveals the yawning gap between certain types of licensed manufacture and development of indigenous capability.

 

India manufactured the French Alouette helicopter (Cheetah) and its engine at HAL, Bangalore, in the '70s and '80s but, not having absorbed the technology, was forced to go for imports of the next generation helicopters such as the Eurocopter. HAL's bottom line was certainly boosted, its turnover substantially increased for several years, but this does not appear to have translated into capability to develop and make its own helicopters, forcing the government to go in for another sequence of imports and license arrangements. Similarly, India is now in the market reportedly for 200 howitzer artillery guns building up through licensed manufacture towards an inventory of 1500 guns worth an estimated $2.5 billion (Rs 10,000 crore), and even had to buy howitzers on an emergency basis during the Kargil conflict, despite having had full access to the Bofors technology since the '80s.

 

Therefore, in working out offsets, quite apart from the commercial angle, it is very important to see that offset arrangements are properly planned and channelised to projects and institutions with a clear vision of what is required in the short and medium term in terms of developing independent indigenous capability and know-how.

 

NEW POLICY

 

Despite this past experience, and in spite of some success in pressurising vendors into more meaningful collaboration through the policy of direct offsets under DPP-2005/6, the defence ministry is in the process of modifying the DPP particularly is respect of offsets. It is no coincidence that this process has been initiated at a time when major Western military hardware vendors are salivating at the $30 billion Indian acquisition budget, and especially the massive $10 billion deal for multi-role combat aircraft, in the tender for which India has specified a 50 per cent offset condition, much to the open displeasure of US aviation majors Lockheed Martin and Boeing. It is also no surprise that defence ministry spokesmen confirmed the advent of a new offsets policy just prior to the opening of the large arms expo in Delhi on February 18.

 

The revised policy proposes three major departures all leading to a framework of "indirect" offsets in contrast to the earlier system of direct offsets.

 

The first allows for "banking" of offsets wherein offsets accumulated under one project can be shown against any subsequent project too.

 

The second, although apparently an extension of the first, allows companies engaged in civilian contracts to "bank" such offsets and show them against offset requirements in military contracts. Clearly, this is purely a commercial consideration and makes no allowance for the fact that the main purpose of offsets is, or ought to be, building capability and know-how in the defence technology sector albeit with spin-offs in the civilian sector. It is also a measure that will clearly favour Boeing which can show offsets and "bank" its sub-contracts to Indian parties making fuselage parts for the passenger jets being bought by Air India and Indian Airlines while tendering for the combat aircraft order.

 

The third modification and perhaps the most dangerous is to allow vendors to charge for technology transfer, show these charges as part of the offsets and deduct these charges from the actual offset payments. This is a specious provision and opens the door to all sorts of underhand manipulations, will render the entire offsets mechanism useless and make its processes completely non-transparent.

 

Who is to define what constitutes transfer of technology and what price to attach to it? In any sub-contracting or license production, there is some technology transfer involved. Under the direct offset clause operational hitherto in India, and practiced elsewhere in the world, licensed production includes technology transfer for manufacture. Under the modified provision, it can be charged separately, and an arbitrarily determined technology fee can be subtracted from any buy-back arrangement! With a 50 per cent offset provision for the fighter deal, about Rs 20,000 crore worth of business was expected to come to Indian firms but, with the new technology transfer clause, this could easily be reduced to half or even less!

 

VESTED INTERESTS Vs

NATIONAL INTERESTS

It is significant that pressure has been brought on India to change its offsets provisions particularly by US companies especially in the aviation sector.

 

The US Defense Department has always opposed offset clauses, but has not stood in the way of contracts including such clauses when it serves US policy or when US companies push for them, as with the Israeli case cited above. In the case of India, the US India Business Council (USIBC) constituted and empowered under the US-India Strategic Partnership has been pushing hard for precisely such modifications in offsets policy as are now being made in the soon-to-be-revised DPP.

At the Bangalore air show in 2007 when US aviation companies made a big show of their various offerings, Nikhil Khanna, Director of Policy Advocacy at USIBC in Washington said: "We have encouraged the broadening of the definition of offsets to include indirect offsets, so other areas of India's economy may gain from the massive investments that are sure to flow from aerospace and defense contracts…" and added that this would credit for technology transfer, limitation of liability, and the ability to "bank" the value of current projects as offsets for future defense contracts. At that time Khanna stated that new Delhi was "considering the suggestions". Defence minister A K Antony stated that "if there is scope for improvement, we will adjust and make minor changes to the policy." It now seems that he has! Only thing is, the changes are not minor!

 

Indian industry has reason to feel deeply aggrieved. The Confederation of Indian Industry (CII), through a Committee chairmanship of Rahul Bajaj had advocated an aggressive offsets policy as far back as 1999. CII had strongly recommended that "direct offsets be implemented as a matter of National Policy for Defence Procurement… [so as to] get state-of-the-art technologies for both Public and Private Sectors [and] give major thrust to Self Reliance."

 

The proposed modified offsets policies, being instituted at the instigation of US companies backed by political pressure, will negate these aims. It is therefore imperative that pressure be brought upon the UPA government to abandon these changes, stay the course with direct offsets and ensure that the offsets are properly directed and monitored so as to reduce India's dependence on imports and consequent vulnerability to technology denial regimes while simultaneously leading to significant enhancement in science and technology capabilities, as well as a spread effect in important industrial and research sectors of the national economy.