Defence ministry comes to private firms’ aid

By Ajai Shukla

Business Standard, 18th May 13

Private sector companies in defence have been asking the ministry of defence (MoD) for protection against foreign exchange risk variation (ERV), a benefit that defence public sector undertakings (DPSUs) have always enjoyed. Accepting the plea, MoD has approached the finance ministry to approve ERV protection for the private sector.

Defence Minister A K Antony told Business Standard on the sidelines of a defence function, “We have taken up a case with the finance ministry for private-sector defence companies to be protected from ERV. Now the ball is in the finance ministry’s court.”

India’s private-sector defence companies have stepped up the campaign for ERV protection after being seriously hit by the rupee’s fall from Rs 44 a dollar in October 2010 to below Rs 56 just a few months later. Even “indigenous” defence systems contain many imported components and sub-systems, so any depreciation in the rupee’s value raises production costs in India and hits profitability.

Private-sector companies say, given that defence contracts run 5-10 years from signing to conclusion, a significant degree of ERV volatility is almost inevitable.

In MoD tenders, private Indian companies are expected to compete against foreign vendors, which are not affected by ERV; and against DPSUs, which already enjoy MoD protection. Earlier this year, industry body Ficci had sent a detailed paper to MoD, seeking a level playing field for the private sector.

Ficci had suggested that all bidders, including DPSUs, submit their commercial bids on a multi-currency format, with imported components quoted in foreign exchange (forex), and components sourced in India quoted in rupees. Since 2006, foreign vendors and private Indian companies have been submitting multi-currency bids. But DPSUs bid entirely in rupees, while separately indicating the forex component of the bid.

The winner of a contract, i.e. the L-1 (lowest-cost) vendor, is selected by reducing all quotes to their rupee value on the day of opening of the bids. For this, the forex component in the bids of foreign vendors and private Indian companies are converted to Indian rupees at the selling rate of State Bank of India, Parliament Street, New Delhi.

The Defence Procurement Procedure of 2006 (DPP-2006) and subsequent revisions mandate that a DPSU winning a contract would enjoy ERV protection on the forex content that it had indicated in its bid.

DPP-2011 provided similar ERV protection to private Indian companies, but only for global tenders, i.e. acquisitions categorised as ‘Buy (Global)’. In acquisitions that are confined to domestic vendors, i.e. ‘Buy (Indian)’ category, no ERV protection is provided to anyone. But DPSUs get ERV protection in single-vendor cases, or when they are nominated for production. According to Ficci, “it needs to be seen how this will be interpreted in case of private companies”.

Ficci also points out that DPSUs can gain a bidding advantage by converting their forex component into Indian rupees at an arbitrary lower rate, thus submitting a lower rupee bid. Ficci has requested that the exchange rate used be the one prevailing on the day bids are opened.

MoD has grappled for long with ERV issues. In 2003, a committee headed by Shashanka Bhide of the National Council of Applied Economic Research (NCAER) had recommended that MoD must invariably hedge the forex component of defence contracts against fluctuation. That recommendation remains ignored to this day.

The Bhide committee determined that hedging forex risk would add two per cent to the cost of a defence contract, but not hedging was likely to cost an extra 4-5 per cent. This loss would naturally be larger during markedly negative periods for the rupee, like in the past three years.

DPP-2013, which has been revealed only in outline so far, was expected to address ERV issues, but the highlights that MoD has announced so far are silent on ERV.

If the finance ministry accepts the MoD proposals on ERV reform, it is likely these would be promulgated as an amendment to the soon-to-be-announced DPP-2013.