Rupee fall jacks up India's arms purchase bill

Defence factories had budgeted Rs 20,000 crore in forex payout for foreign components in "made-in-India" systems like this corvette, INS Kadmatt, pictured at its launch in Kolkata in October. The rupee's fall has raised that by 20%

by Ajai Shukla

Business Standard, 25th Dec 11

The falling rupee and the defence ministry’s (MoD’s) tardiness could cost India an extra Rs 15,000 crore for its planned purchase of 126 medium multi-role combat aircraft (MMRCA). On 31st Oct 2010, three months after the Indian Air Force submitted its flight trial report to the MoD (i.e. roughly the time needed for evaluating the price bids; negotiating a final cost; and awarding the contract) the rupee reached its high-water mark of Rs 43.71 to the dollar. Had the MoD signed the MMRCA contract then, the anticipated bid price of $15 billion would have amounted to Rs 65,565 crore. An extra Rs 1,311 crore for the 2% cost of hedging the forex risk would have taken the tab to Rs 66,876 crore.

Today, at about Rs 53 to the dollar, that $15 billion bid translates into Rs 79,500 crore. The 2% cost of forex hedging is Rs 1,590 crore, taking the bill to Rs 81,090 crore, Rs 15,525 crore more than last October. The MoD is set to pay almost twice the Rs 42,000 crore that was budgeted for the MMRCA.

If the MoD does not hedge the forex risk, and the dollar hits Rs 58, the MMRCA cost would rise further to a mind-boggling Rs 87,000 crore.

This disastrous exposure to the rupee’s diminishing fortunes is the MoD’s own failure. In 2003 a committee, headed by Shashanka Bhide of the National Council of Applied Economic Research (NCAER), examined a proposal to hedge forex risk in defence contracts. The committee’s unequivocal recommendation --- that the forex component of defence contracts be invariably hedged against fluctuation --- remains ignored to this day.

The Bhide Committee found that the cost of hedging forex risk would increase the cost of a contract by 2%, but not doing so risked an Exchange Rate Variation (ERV) that averaged 4-5% over the duration of a defence contract. This ERV is naturally larger during strongly negative periods for the rupee, like the present.

An illustrative example is provided by the MoD’s forex outgo this year of about Rs 50,000 crore. Hedging forex risk could cost 3% today (a high premium due to the rupee’s volatility); while ERV losses seem very likely to exceed 5%. The extra 2% lost on a Rs 50,000 crore forex payout amounts to a whopping Rs 1,000 crores.

MoD’s forex outgo

The MoD’s capital budget (Rs 69,199 crore in 2011-12), which buys new arms and equipment, is not all disbursed in foreign exchange. Institute of Defence Studies and Analysis (IDSA) expert, G Balachandran, says that barely Rs 25,000 crore of that amount would be disbursed in foreign exchange; the rest would be paid in rupees to Indian vendors. The bulk of this goes to the 8 defence public sector undertakings (DPSUs) like Hindustan Aeronautics Ltd and Bharat Electricals Ltd; and the 41 factories of the Ordnance Factory Board (OFB).

But DPSUs and the OFB --- which incorporate many foreign components in the equipment that they build --- will disburse another Rs 20,000 crore to foreign vendors this year, says Balachandran. That would raise the forex outgo to Rs 45,000 crore.

Additionally, a portion of the revenue budget (which is Rs 95,216 crore this fiscal) would be paid out in foreign exchange. The revenue budget is earmarked for running expenses like pay and allowances; maintenance and spare parts; housing and storage; food and fuel; all the day-to-day running of the military. Of this, about Rs 5,000 crore worth of ammunition, and aircraft spares and engines, are purchased from abroad.

That takes the MoD’s budgeted forex spend to approximately Rs 50,000 crore this year. Going by the exchange rate of Rs 44.43 at the start of this fiscal, the budget catered for about $11.25 billion in overseas payments.

Lopsided spending boosts loss

Only a small percentage of this was paid out in the first six months of this fiscal year, when the rupee was relatively stable. MoD sources say that, by October-end (the latest figures available), just 37% of the capital budget had been expended, i.e. the equivalent of $4.15 billion, with procurement worth $7.1 billion still pending.

Skewing spending towards the end of the financial year, is standard MoD malpractice; in the last fiscal year, the MoD did 33% of its capital procurement in the last month, i.e. March 2011.

Since the dollar was relatively stable then the damage was limited. Over the last three months, the dollar’s sprint to Rs 53 levels means that the remaining outgo of $7.1 billion will cost Rs 37,630 crore, Rs 6,000 crore more than the budgeted amount.

In contrast to the under spent capital budget, the revenue budget is overspent: 62% of the revenue budget was spent by end-October, say sources. At this stage last fiscal, just 56% of the revenue budget had been spent.

With the Ministry of Finance (MoF) grappling with the national fiscal deficit, MoD officials do not realistically expect assistance from that quarter. By end-October the fiscal deficit was already 74.4% of the budgeted figure (compared to 42.6% last year). The MoF has issued a note requesting all ministries to prune expenditure.

“The writing is on the wall. It seems we will have to cross-subsidise our revenue budget from our capital budget this year”, says a senior MoD official.