Defence ministry to dilute offsets next week

by Ajai Shukla

Business Standard, 18th June 12

The ministry of defence (MoD) is poised to sharply dilute its Defence Offset Guidelines (DoG) during the coming fortnight.

MoD and industry sources tell Business Standard that among the amendments the apex Defence Acquisition Council (DAC) is to clear on June 24 is one that would allow foreign vendors to discharge their offset obligations with minimal production and value addition in India.

While some of the likely amendments to the DoG are broadly acceptable, a controversial new proposal has set alarm bells ringing among Indian defence producers. This innocuous, but far-reaching, amendment relates to how ‘value addition’ will be calculated when an Indian Offset Partner (IOP) produces a system or a sub-system for a foreign vendor (offset credit is only given for value addition in India). Imported items have always been excluded from the ‘value add’, calculated as the IOP’s billed cost for the equipment supplied to the foreign vendor, less the cost of imported items used by the IOP. The proposed amendment would allow the IOP to buy foreign parts from Indian sub-vendors, and present that as value-add, provided the sub-vendor is paid in rupees. 

Illustration

In practice, here’s how this would work. Consider a hypothetical offset-related contract that a foreign vendor, Smith Aerospace, signs with an IOP, Jai Bhagwan Hydraulics. If Jai Bhagwan uses Rs 80 crore worth of imported components in Rs 100 crore worth of hydraulic pumps that it supplies Smith Aerospace, the existing offset policy gives Smith Aerospace offset credit for Rs 20 crore, i.e. the value the IOP has added in India (billed cost, less cost of imported components). The new proposal changes this calculation fundamentally by defining value-add as billed cost, less the import cost incurred by the IOP.

In practice, this would allow Smith Aerospace to generate Rs 100 crore worth of offset credit through the same transaction, merely by encouraging Jai Bhagwan Hydraulics to buy the imported components (worth Rs 80 crore) from an Indian sub-vendor. Though the components remain imported, they would be treated as value-add, simply because the IOP, Jai Bhagwan, has not imported these (and has, in fact, paid the sub-vendor in rupees). This would entitle Smith Aerospace to claim offset credits for the full Rs 100 crore.

This only requires a slight amendment to Para 6.4 of the current Defence Procurement Procedure of 2011 (DPP-2011). The DAC will discuss this amendment on June 24. MoD did not respond to questions on the subject.

“Instead of encouraging the Indian defence industry to produce in-country, this amendment effectively legitimises imports. Instead of the Indian Offset Partner doing the import, the Tier-2 supplier will do it. The foreign vendor will get enhanced offset credits without any extra production having taken place in India,” points out the CEO of an Indian defence company, who has requested not to be identified.

The new policy also incentivises foreign vendors to select micro, small and medium enterprises (MSMEs) as their offset partners, by introducing a multiplier of 1.5 for offsets discharged through MSMEs. That means if Jai Bhagwan Hydraulics were an MSME (according to the monetary guidelines specified by the department of micro, small and medium enterprises, the offset credit to Smith Aviation would be multiplied to Rs 150 crore (Rs 100 crore times 1.5).

Ironically the revised policy will, for the first time, explicitly state that the offset policy is aimed at developing Indian defence industry. The threefold aim it specifies is “to leverage capital acquisitions to develop the 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) encourage development of synergistic sectors like civil aerospace and internal security.”

Other changes

The proposed policy would also permit transfer of technology (ToT) as offsets; granting any foreign vendor a multiplier of three for technologies specified by the Defence R&D Organisation (DRDO). It extends by two years the period within which vendors must discharge offset obligations and extends the validity of banked offset credits to seven years (it was earlier two years). In complex procurements (like the recent medium fighter contract) where multiple sub-vendors incur offset liabilities, the new policy will permit sub-vendors to individually discharge their respective liabilities, even while holding the main vendor responsible for discharging offsets in full.

Another amendment being discussed on June 24 could resolve a six-year debate that has exercised the MoD — which agency should administer offsets? One group, supported by the army and air force, has argued the powerful Acquisitions Wing should oversee offsets, since it buys the foreign arms that create offset obligations. Other bureaucrats apprehend a conflict of interest that might foredoom offsets, since the Acquisitions Wing’s primary mandate of expeditious procurement pre-disposes it to regard strict offsets as an encumbrance. This group argues that as offsets aim at boosting indigenous defence production capability, they should be handled by the department of defence production (DDP), a separate MoD wing that is led by a secretary.

MoD sources say the proposal that the DAC will examine gives the Acquisitions Wing responsibility for concluding offset contracts alongside each procurement contract. The DDP will, thereafter, oversee the discharge of offsets.

Offsets were first made mandatory in the Defence Procurement Policy of 2006 (DPP-2006) and then revised periodically. The policy requires foreign vendors who win defence contracts worth Rs 300 crore or more to plough back at least 30 per cent of the contract value into India in the form of defence orders, technology or infrastructure.

The amendments now proposed continue the MoD’s steady dilution of this policy. Global arms vendors, backed openly or tacitly by their governments, have mounted a sustained lobbying campaign against offsets, arguing that Indian defence players do not have the capacity to absorb the offset production that will arise. Meanwhile, India’s defence producers have argued that the very aim of the offset policy is to develop production capacity and, therefore, the foreign vendors must assist in building up capacities. The MoD, by incrementally diluting the offset policy, has indicated that it supports the foreign arms vendors.