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FDI in Defence: Lessons for Developing Countries

The author holds an LLM with highest honours, having specialised in Government Procurement Law from The George Washington University Law School, Washington DC. In 2009, he established, a website dedicated to the advancement of public procurement law in India. The author has been a member of IDSA since 2011.
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  • May 07, 2013

    Most developing countries hear persistent demands from foreign manufacturers and advocacy groups for raising foreign investment caps in high-tech industries, particularly in the defence sector1, usually laced with suggestions that increased foreign investments would result in rapid technological upgradation of the domestic defence industrial base. Some demands for foreign direct investment (FDI) levels have been as high as 74%, numbers that could be particularly problematic once the fragile behavior of foreign institutional investments (FIIs) has been fully factored-in.

    On a closer enquiry, some of these proposed arguments could be rather simplistic, particularly when most MNCs are increasingly using tax havens for locating their IPRs, rendering their operations opaque to any meaningful enquiry or oversight by other countries2. Most developed economies are already feeling threatened by increasing equity investments sponsored by foreign government-owned and/ or foreign government-controlled entities3 in the defence and high-tech industries, and particularly in the context of the EU, it is likely that a strong, coordinated government response for supervision and oversight of foreign investments will emerge on the horizon sooner than later.

    Typical concerns that make foreign investments in the defence sector important from a national security perspective are: (i) foreign owners could eventually restrict defence supplies to host governments; (ii) foreign owners could use acquired technologies to harm host government’s security interests; (iii) foreign-acquired domestic firms could be used for surveillance, infiltration and sabotage against the host governments4; and (iv) particularly from a developing country perspective, foreign ownership could result in widespread infusion of low-end technologies that could wipe out nascent defence industrial bases in the host countries.

    The last prospect can be particularly problematic for developing countries, in the absence of credible evidence that higher FDIs necessarily result in transfer of high-end technologies. In fact, energising defence manufacturing in emerging economies has usually been the result of well-designed offset policies as in South Korea5, and/ or smart leveraging of defence procurements that incentivise joint manufacturing and co-development—a path that Indonesia appears to have focused on recently6. At the bare minimum, developing countries may first need to provide a level-playing field to their own domestic manufacturers, as many of them force their own nascent industries to compete with established global manufacturers7.

    Conceptually, strategies for controlling foreign investments in the defence sector, as practiced in established arms-manufacturing countries, can broadly be categorised into two levels of control and supervision—sector-wise controls and company-wise controls, in addition to a third level of actual practices, as explained below.

    Company-wise controls take the form of specific caps on foreign investments: the UK, for instance, does not allow any foreign shareholder to own more than 15% in BAE and in Rolls Royce through the UK Government’s golden shareholdings8. In addition, both companies’ terms of association require the chairmen and certain board members to be UK nationals. France’s golden share in Thales gives the French Government the right to oppose any outsider investor acquiring more than 10% of shares, in addition to a government observer on the firm’s Board of Directors. Similarly, Italy has golden shares in various defence companies, including Finmeccanica and Fincantieri, where in the latter case, the Italian Government needs to approve any investments of over 3%9.

    For the purpose of sector-wise controls, European and US systems can be broadly classified into four models that are used to protect their industrial base against foreign threats10. As an example of the first “Prohibition” Model, Finland, Lithuania and Slovenia place an outright prohibition of all non-EU and non-NATO FDI in defence, aerospace and security sectors. Under the second “Approval” Model, as occurs in Austria, Denmark, Poland, Spain and Sweden, any foreign investors, including those from the EU, must first receive government and ministerial approval for any acquisition deal. A third “Review” Model, as occurring in France, Germany and the UK, acquisitions by foreign firms may be subject to review by competent ministries. Finally, under the fourth “Supervision” Model, as occurs in the US, proxy boards comprising of US nationals run and monitor all defence firms, whether domestically- or foreign-owned. In the US, of course, the sectors where FDI could be restricted need not be limited to defence alone: the government exercises its authority to supervise, prohibit and/ or require changes to foreign holdings in any industry, in case FDI in that industry is assessed to be a potential threat to its national security. And in both the US and in some EU countries practicing the supervision model, government reviews can be triggered by foreign shareholdings as small as 3 or 5%.

    Further, as a matter of actual practice, governments can easily make it impossible for a foreign-owned firm to operate, given the peculiar monopsonic nature of defence markets. For example, a government could refuse to grant export licenses to the company or to buy the military equipment being produced11, thus making a foreign-owned firm financially unviable—a real possibility because of subjective methods of public procurement such as competitive negotiations, and on account of ad-hoc criteria and assessments made while permitting or prohibiting exports of defence items and technologies. An additional complexity in this regard has arisen on account of the recent passage of the lop-sided Arms Trade Treaty by the UN General Assembly: an arrangement with significantly adverse implications for the development of defence industries in developing countries12.

    Based on a preliminary study of prevailing international practices, it appears that policy choices for developing countries with regard to foreign investments in defence need to address a number of inter-related components. In fact, some of these policy issues could be equally relevant in the context of public listing of previously government-owned defence enterprises, a situation being increasingly witnessed in those countries facing persistent revenue deficits.

    Firstly, there may perhaps be a strong need to specifically exclude FIIs in defence industries, given the high volatility with, and higher possibilities of indirect foreign government ownership through the FII route. Secondly, on a related note, there may be a need to consider restricting foreign direct investments to those made by original equipment manufacturers alone, as FDI even by manufacturers through tax havens tends to be stubbornly resistant to any meaningful oversight.

    Thirdly, given the relative lack of effectiveness in their legal and administrative systems, developing countries may need to work out administrative strategies for providing an effective deterrence to de facto foreign control of domestic arms-manufacturing capabilities, which may include mechanisms to keep a close watch on equity movements (i) in domestic companies where foreign investments take place; and (ii) in foreign investing entities themselves, in order to avoid the kind of problems that EU countries are now beginning to face. In addition, some of this may need to be supported by a strong legal framework for government rights to receive prior information on and block any foreign investments above certain specified limits through golden shares as against a mere retention of affirmative rights, as the latter may not measure up to strict legal enforcement in certain jurisdictions.

    Fourthly, control and senior management functions in defence industries may need to be vested only in full-fledged domestic citizens—a requirement that should necessarily cover chairmen and members of the board of directors of such companies. And lastly, a calibrated, reciprocity-based approach must be an integral element of national policy-making, in order that equivalent benefits are obtained by investors from developing countries who may be interested in picking up equity stakes in the investing countries.

    None of these policy elements should face any serious challenges, given that established arms-manufacturing countries themselves practice most of these restrictions. Even the first two policy elements should not witness any real contests, given the absolute need for clarity on the equity structure of a foreign investing entity, both before and after an investment has been permitted, in sectors as strategically sensitive and important as defence. The need for reliable sources of defence supplies in times of war is a non-negotiable requirement for preserving national security; and that by itself, is a sufficient reason for developing countries to keep this objective firmly in focus while formulating their policy responses to foreign investments in the defence sector.

    Views expressed are of the author and do not necessarily reflect the views of the IDSA or of the Government of India.