Dawn of a new era in the Indian defence industry

The government's reforms can be attributed to its intent to change the status quo that was existing till 2014 and to support the Make in India campaign

EY
By EY
Published: 19, Jul 2017

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Indian air force Jaguar aircraft fly during the inauguration ceremony of the "Aero India 2009" at Yelahanka air force station on the outskirts of the southern Indian city of Bangalore February 11, 2009. The 7th Aero India, organised by the ministry of defence, showcases the latest in the field of military and civil aircrafts. The show runs from February 11 to 15. REUTERS/Vijay Mathur (INDIA) - RTXBHEP
There is significant curiosity and interest among foreign OEMs and the private sector toward the defence industry. Image by: Vijay Mathur / Reuters

India’s defence industry continues to gain traction with the Government’s recent policy changes and reforms such as the Defence Procurement Procedure (DPP 2016) and changes in foreign direct investment (FDI) regulations. The Government has a clear vision for an indigenous defence industry, and these reforms can be attributed to its intent to change the status quo that was existing till 2014 and to support the Make in India campaign. These reforms coupled with the country’s attractiveness to global defence companies and the tremendous export potential in engineering services and components sourcing seem to steer the nation in the right direction.

As a result, there is significant curiosity and interest among foreign OEMs and the private sector toward the defence industry.

A glimpse into some of the reforms announced since 2014:

Changes in FDI regulations
In 2014, FDI in the industry was increased from erstwhile 26% to 49%, with approval from the Foreign Investment Promotion Board (FIPB), to woo foreign investments. However, the foreign investment inflows for 2015–16 were a meagre INR 56 lakh. In order to improve the situation, FDI regulations were further tweaked in 2016 by allowing up to 49% through the automatic route and up to 100% through the government approval route in cases where the country could get access to modern technology. FIPB has also been abolished, thus further streamlining the procedure and reducing regulatory blocks to facilitate greater foreign participation in the defence space.

The DPP 2016
The DPP 2016 introduced a new category for equipment “Buy (Indian - IDDM),” where IDDM stands for “Indigenously Designed, Developed and Manufactured,” to provide a greater thrust to Make in India in defence production. Under the new IDDM category, a product will be required to have at least 40% indigenous content if it is designed in India or at least 60% indigenous content if the design is not indigenous, making it the most preferred category.

One long-awaited reform that has seen the light of day is the Strategic Partnership Policy (SPP), recently rolled out as Chapter 7 of the DPP 2016. Unlike the global scenario where the defence production model majorly lies with the private sector, in India a concentrated production model lies with the Defence Public Sector Undertakings (DPSUs). The SP model was designed with a vision to create capacity in the private sector on a long-term basis over and above the capacity already existing in the public sector. The policy will be implemented in four segments in the initial phase (fighter aircraft, helicopters, submarines and armored vehicles/main battle tanks), with more segments added to it as it matures.

Another important reform part of the DPP 2016 is the freedom to foreign OEMs to choose an Indian Offset Partner (IOP) over the course of the contract, with an option to change the IOP if required, bringing in more competition and efficiency.

Regulatory reforms
In order to improve indigenization in the defence space, the Ministry of Home Affairs (MHA), which earlier had the authority to issue licenses for a list of defence items, has now delegated the Secretary, Department of Industrial Policy and Promotion (DIPP), to issue licenses. This will be done under the strict supervision and control of the MHA. However, there is still no clarity regarding the approving authority for those items that were there in Press Note 3 (2014 series) but have not been included in the schedule to the MHA notification.

An area of concern in the sector is increasing the share of export of defence goods in India, where 70% of the defence goods are imported. To improve this situation and also to enhance the role of Indian companies in the global supply chain, the Directorate General of Foreign Trade (DGFT) recently released an amendment to the SCOMET list, which covers dual use goods, services and technology for exports. The amended list includes the earlier “empty but reserved” and now populated Category 6 of “Munitions List.” This makes India compliant with global norms such as the Wassenaar Agreement.

Performance of some Indian defence companies in the past three years
An interesting aspect of the introduction of these reforms and policies is how the market capitalization of some of the defence companies in the last three years increased at a CAGR of ~34%, outperforming that of the Nifty (9.4%) during the same period. The strengthened financials of these companies along with the potential order book in the coming decade have clearly had an incremental effect on the growth of the market capitalization of these companies.

The Government’s Make in India program to indigenize the manufacture of defence equipment and its decision to allow private companies’ participation in this segment have allowed some of these companies to strategically enter the defence segment and strengthened the long association of certain other companies with the Ministry of Defence (MoD).

cagr
001Calculated from market capitalization between May 2014 and May 2017
Market capitalization values from screener.in

India has a great opportunity to change the status quo and become a key player in the global defence industry. The implementation of the announced policy changes coupled with a mind-set shift toward the private sector from only DPSUs will go a long way in setting the tone for the growth trajectory. To make this happen, it is important that there is close collaboration between the Government, defence forces, DPSUs and the industry. The time to start is now.

 

 

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