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Should MoD Persist with Defence Offsets?

Mr Amit Cowshish is a former Financial Advisor (Acquisition), Ministry of Defence and former Distinguished Fellow, Manohar Parrikar Institute for Defence Studies and Analyses, New Delhi. Click here for Detailed Profile
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  • August 07, 2020

    The draft Defence Procurement Procedure (DPP) 2020, released by the Ministry of Defence (MoD) on March 20, exempted foreign vendors from discharging offset obligation in all ‘Buy (Global)’ cases exceeding Rs 2,000 crore other than those processed on the single-vendor basis under specific Inter-governmental Agreements (IGAs), including the Foreign Military Sales (FMS) programme of the US Government (USG).

    The FMS programme is administered through a standing framework devised by the USG under which individual deals are finalised between the MoD and the Defence Security Cooperation Agency (DSCA) of the USG, which in turn enters into specific contracts with the US companies for supplying the equipment to India. The offset contract in all such cases is, however, negotiated by the MoD directly with the US company supplying the equipment through FMS, as the USG does not take any responsibility for offsets as a matter of policy.

    Many thought this exemption was an oversight as the draft DPP 2020 also contained thoroughly revamped offset guidelines which seemed unnecessary if the non-exempted category of foreign contracts was to be narrowed down by excluding inter-governmental deals from its purview. It turns out that the exemption was not the result of an oversight.

    The exemption has been retained, along with the revamped guidelines, as a part of the revised draft DPP 2020, rechristened as Defence Acquisition Procedure (DAP) 2020 and released by the MoD on July 27. The changes proposed in the offset guidelines require a fresh look, both on conceptual and empirical grounds, as the new regime is likely to yield diminishing returns.

    The offset requirement was introduced in 2005 in a very rudimentary form based on the recommendations of the Kelkar Committee, but it was only in August 2012 that the objectives of the offset policy were defined for the first time. These were later incorporated in DPP 2013 and have continued unchanged since then.

    The objectives of the current policy seek “to leverage capital acquisitions to develop Indian defence industry by (i) fostering development of internationally competitive enterprises, (ii) augmenting capacity for Research, Design and Development related to defence products and services and (iii) encouraging development of synergistic sectors like civil aerospace, and internal security”.1

    These objectives have been tweaked in DAP 2020 by deleting the word ‘services’ from the second objective and the third objective altogether.2 This seems to suggest that the deleted objectives have either been met or the MoD considers it futile to pursue these objectives through offsets. Neither of these inferences is correct.

    Of 54 offset contracts signed till October 31, 2019, as many as 32 related to procurement programmes of the Indian Air Force (IAF), followed by 15 of the Indian Navy (IN) and seven of the Indian Army (IA).3 Considering that 60 per cent of the offset contracts related to the IAF, manufacturing and services at least in the civil aerospace sector should have shown considerable progress for the MoD to conclude that this sector does not need any further incentivisation. But there is no evidence of that. The only alternative explanation is that these sectors are not viewed as priority sectors any more for reasons that remain unexplained.

    The main issue, however, is not about the tweaking of the objectives of the offset policy but the need to continue with it in view of its past performance and the prospects of the Indian industry benefitting from it in future. It is unimaginable that the MoD’s sub-committee which has proposed the changes would not have considered these factors but it is possible that it did not contemplate recommending discontinuation of the policy as it was not a part of its terms of reference.

    Be that as it may, there is a case for dispensing with the policy, especially in its proposed form, before it becomes a part of DAP 2020. The main reason for suggesting this is the likely reduction in the offset business for the Indian companies, which has anyway already shrunk with the threshold for foreign contracts entailing offset obligation being raised from Rs 300 crore to Rs 2,000 crore in 2016.

    Several foreign contracts processed in the recent past have been only through the IGA/FMS route. This includes mega deals not only with the US and France but also with Russia. According to a July 2016 article, 70 per cent of the deals at that point of time were through IGAs.4 There is no denying that the MoD has been more comfortable with such deals, most of which are on a single-source basis. This has also proved to be a faster way of concluding complex contracts.

    Consequently, with the formalisation of the proposed exemption, coupled with the high threshold for effectuating the offset clause, and growing emphasis on procurement of equipment from the Indian companies which does not attract offsets, the number of foreign contracts entailing offset obligation would inevitably come down very significantly.

    It would also prompt major exporters of arms to India to formulate schemes similar to the FMS, or nudge the MoD to go in for deals through IGAs to save their defence industry from executing offset contracts in India, which has never been easy for them, not least because of the complex process of changing offset partners, rephasing offset implementation schedule, addressing audit observations on offset claims, and delay in earning offset credits. No wonder then that the pace of execution of the offset contracts has been slow.

    To put it in perspective, the cumulative value of 54 offset contracts signed till October 31, 2019 was US$ 11.80 billion with the period of performance of the longest offset contract stretching up to 2024. However, as on that date, the prime vendors were required to discharge offset obligation worth US$ 3.6 billion only, against which the value of the obligation actually discharged by them stood at US$ 1.68 billion, resulting in the imposition of penalties to the tune of US$ 38.19 million.5 This is not indicative of the success of the offset policy, which seems to be focussed more on enforcing, rather than facilitating, execution of the offset contracts.

    According to a study carried out by the Manohar Parrikar Institute for Defence Studies and Analyses (MP-IDSA) for the MoD, as on October 31, 2019, the offset obligation was being discharged by 171 Indian Offset Partners (IOPs). However, till that date, approximately 87 per cent of the total offset obligation had been discharged by only 15 IOPs, with the top five accounting for 51.76 per cent and the top 10 accounting for 76 per cent of the total business done till then.6

    Further, according to the same study, more than 90 per cent of the offset obligation was being discharged by the prime vendors through direct purchase of products and services from the IOPs.7

    Whatever be the reason – and it is arguable if the proposed changes address them - there has been no transfer of modern technology or state-of-the-art equipment to the Indian companies, or critical technologies to the Defence Research and Development Organisation (DRDO), or much foreign direct investment (FDI) in the Indian defence companies, all of which were permissible avenues for discharging the offset obligation.

    With the offset business being garnered by a handful of Indian companies and prime vendors shying away from transfer of technology and equipment or even FDI, it is hard to argue that the policy has served its stated objectives and strengthened the defence industrial base in India in the last 15 years since it was introduced. The situation is further muddied by the difficulties faced by the prime vendors in executing the offset contracts and avoidable controls exercised by the MoD on them.

    In the circumstances, it is important to reconsider the decision to continue with the policy, also keeping in mind that there is a cost attached to discharging the offset obligation which is indirectly borne by the MoD as a part of the overall value of the contract. To put it differently, the MoD is incurring extra cost without the returns being palpably commensurate with this investment.

    Policies have to be dynamic and if the offset policy has not served its purpose – or served it only to a limited extent - in the last 15 years, despite continuous modifications, it is unlikely to produce spectacular results with its applicability anyway being restricted to fewer offset contracts. It is time the need for its continuation is subjected to dispassionate cost-benefit analysis.

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