Defence industry staggers under rising dollar, seeks MoD protection

By Ajai Shukla

Business Standard, 26th May 12

With the dollar hardening almost 25 per cent from Rs 45 a year ago, to Rs 56 on Wednesday, our import-dependent defence is obviously taking a hit. The 13.15 per cent rise in the latest defence budget --- from Rs 1,70,937 crore last year, to Rs 1,93,407 crore for 2012-13 --- has been wiped out and more. The picture is even bleaker when inflation is factored in, which runs at about 15 per cent annually for defence equipment.

The damage extends to the Indian defence industry, which even in “indigenous” weaponry uses a substantial share of foreign components and systems, ranging from 30-70 per cent. Until last year, the Defence Ministry (MoD) sheltered the defence public sector --- which includes 8 defence public sector undertakings (DPSUs) and 39 Ordnance Factories (OFs) --- through a mechanism called foreign exchange rate variation (FERV), which adjusted their income to cover forex fluctuations. In contrast, the private sector has stood exposed to foreign exchange (forex) risk.

Consequently, many private players stare at unexpected losses. Take Larsen & Toubro, which won a Rs 1,000 crore contract in March 2010 to build 36 fast interceptor craft for the Indian Coast Guard. These are 110-tonne patrol and rescue vessels that are propelled by water jets at a scorching 44 knots (81 kilometres per hour). L&T says that about 40 per cent of the vessel is imported, including the engine and the water jets. Given a profit margin of 10 per cent, the L&T quote catered for a forex component of Rs 360 crore. Given the rupee’s fall, that forex component has risen to Rs 445 crore today. L&T says it is struggling to break even on this contract.

Or take Bangalore-based Alpha Design Technologies Ltd, which won a Rs 48 crore contract last September to build target designators for the air force, laser beams that “light up” a target, allowing a laser-detecting aircraft bomb to ride the reflected beam to the target for a pinpoint strike. When Alpha submitted its bid in Nov 2010, the dollar was worth Rs 44.37; today it is 25 per cent higher. Given that 70 per cent of the target designator is imported, Alpha faces a substantial loss.

“We were competing against DPSUs like Bharat Electronics Ltd, which the MoD covered against FERV risks. With profit margins in defence electronics barely 5 per cent, how could we afford forex hedging?” asks Colonel HS Shankar, CMD of Alpha.

Industry sources tell Business Standard that forex hedging costs were about 6% per cent annually, when the rupee was stable. A three-year hedge, essential given the time taken for discharging defence contracts, would have cost 17-18 per cent. With the rupee in freefall today, a three-year hedge will cost a vendor 30 per cent.

“With the rupee nose-diving, quoting for fixed price contracts has become extremely risky without hedging at high cost. Imagine the plight of Indian bidders when competing for Indian defence contracts against foreign companies who are anyway automatically protected,” says MV Kotwal, President (Heavy Engineering), L&T.

Now the private sector has asked industry bodies, CII and Ficci, to approach the MoD for protection. Business Standard has learnt that Ficci will be considering the issue at its National Executive meeting on May 29^th.

So far, the MoD has been entirely unsympathetic. L&T’s Kotwal says that private sector companies had asked the MoD to treat them at par with the DPSUs, which enjoyed FERV protection. The government acceded to that request in the latest Defence Procurement Procedure of 2011 (DPP-2011), but not in the manner requested.

“Instead of allowing FERV for the private sector, DPP-2011 denied it to both the public and the private sector!” says Kotwal.

In fact, DPP-2011 shelters Indian vendors from FERV in global contracts, i.e. when an Indian company competes and wins in an international tender. However, FERV shelter is disallowed in the contract categories of “Buy (Indian)”; “Buy & Make (Indian)”; and “Make” categories, which are open to Indian companies alone. The only exception is for DPSUs, when the MoD nominates them as the source for procurement or production.

CEOs of defence manufacturers point out that they already absorb significant risks, including potential fluctuations in commodity prices, especially aluminium and steel. But they say it is unfair to expect them to cater for rupee fluctuations that stem from the government’s macro-economic policies.

“When the government buys from a foreign arms vendor it absorbs the forex risk, but it wants fledgling Indian defence manufacturers to absorb that risk themselves. The private defence industry is just learning how to walk; it cannot yet carry the forex risk. If the MoD is serious about building a private defence industry, it should not transfer forex risk to us,” says Rahul Chaudhary, CEO of Tata Power (Strategic Electronics Division).

Across the defence sector, there is recognition that the ongoing forex-related turmoil is rooted substantially in the MoD’s inability to develop manufacturing capabilities in the materials, components and sub-systems that that go into modern weapons systems.

“India has successfully integrated high-tech weaponry like the Tejas Light Combat Aircraft; the Arjun tank; even a nuclear submarine. But as long as the MoD does not build capability in basic components that we continue to import --- such as Very Large Scale Integrated (VLSI) chips and image intensifier tubes and thermal imaging detectors for night vision devices --- even these indigenous programmes carry extensive forex risk,” says Major Karun Khanna, Advisor to Alpha Design Technologies.

The rupee depreciation has also affected capital procurement from overseas vendors. Says KPMG’s defence analyst, Neelu Khatri: “The capital budget allocation of Rs 79,579 crore in April was worth US $15.6 billion then; today it is worth just $14.22 billion. An effective cut of $1.42 billion means a 9 per cent procurement cut for a nation that is heavily dependent on imports and already suffering alarming rate of equipment obsolescence.”