Monday, November 14, 2011

Defense offsets in India

In a recent conversation I was introduced to Defense offsets in India when I met a person who was organizing a conference on the subject. Within 15 minutes I made a suggestion based on a number of reasons that I - who knew nothing about defense offsets - believed were wrong with Defense Offsets and needed to be fixed.

Defense Offsets require all firms bidding for Indian Defense contracts to either source a certain percentage (30%) of the product from manufacturers in India and/or set aside a certain amount of money to make a investment of not more than 26% share of an Indian firm. The expected Defense Offset through 2020 is considered to be up to USD 30 billion!

Broadly speaking my view was that with its Defense Procurement policy, the government is back to its “Be Indian, Buy Indian” stance albeit with the major difference that they are trying to encourage private enterprise. Their fundamental notion itself can be questioned since we all know where the “be Indian / Buy Indian” stance took us. I should also add that the planned conference is to discuss how the policy can be improved.

Opinions I shared (questions I asked) within minutes of hearing about Defense Offsets (and one I did not) were as follows.
1)      What I did not say, but feel, is that in stipulating the offset, there is a good chance that the contracts will be priced somewhere between a 100 and a 130 rupees. Rather than question the practice, my interest is to see if the practice can be made more palatable to all sides. Opinions I did state were as follows (there may be mechanisms built into the Defense process that address the concerns – I do not know).
2)      Stipulating certain sectors narrows the choice. Further, within those sectors there may only be limited opportunities that are attractive.
3)      Those limited investment targets are likely to know their position and use it to their advantage given the acquirer’s choices are limited.
4)      It is not inconceivable that target firms may also try to influence the selection process to increase the chances of receiving equity funding.
5)      It is possible that the Defense Department makes a choice of supplier because they agree with that particular bidder’s  investment choice.
6)      The government is using its buyer power to force FDI to occur – and does not get any benefit (other than hopefully the best product their money can buy!). The benefit goes directly to the private enterprise. A good thing with the above caveat that only select sectors get the benefit.
7)      The bidding firms presumably do not have the wherewithal to evaluate all opportunities in all sectors.

The next morning I read up about defense offsets. What struck me forcefully is that many of the negatives I had raised turn out to be the very points being made against the program. How is it that a person with average intelligence can so quickly see so many negatives and the people who run the program cannot?

While the solution I proposed did not appear to have been suggested earlier (cannot be sure since my internet search was just for a couple of hours) it does seem to address the concerns raised by others. This is not to say that the suggestion is palatable – just different to the ones that essentially call for a lifting or broadening of the range of FDI (foreign direct investment) equity ownership. Some concerns I had raised have tried to be mitigated by the Defense Dept broadening the scope of offsets (increases the investment choice) to include internal security and civil aerospace and training.

It also appears to me that there a whole range of interests arrayed for and against – a lot of vested interests that stand to gain from policies being maintained and those on the other side.

Insofar as the increased efficiency of the related value chain, attempts have been made: a few clusters already exist; there are groups whose stated interest is to foster innovation and commercialization of technology etc.; and there are think tanks set up (at least one of) whose major interests is to look at issues related to Defense Finance and Defense Budgeting.

In my limited search I could find no mention of studies or suggestions regarding the improved financing of the firms in the above noted value chain. 

Part of my goals once I have a better grasp and better network is to apply my mind to such work. The basic notion here is to use a pool of capital that is hidden in plain sight and to leverage capital for greater effect. The two areas we ought to study and find solutions in are: the financial efficiency of the Defense procurement value chain and the creation of a pool of investment capital sourced from Defense Offsets but investible in any type of industry that FDI is currently allowed in. It would be split into a defined number of smaller pools and each would be managed by experienced investors and cover specific groups of industries. 

Advantages of I can think of (of creating an investment pool) are as follows.
1)      If bidders had a specific target investment in mind they could still pursue that – all that would have done is outsource the due diligence
2)      It opens up the opportunity to all sectors and leverages the available capital in the sense that the funds are now more likely to be directed to the best opportunities.
3)      The bidders do not have the hassle of negotiating the stake, accounting for it, managing the relationship etc. They could simply state the sector they want to be invested in or leave it open.
4)      In return for their role in sourcing capital for the funds they can charge say half a percent (USD 150 MM over 8 years) and use the proceeds to encourage technology commercialization, R&D etc. (though not through the same stodgy mechanisms/vehicles that have proven they do not work).

Needless to say framing the intermediary role and appointment criteria will be key. 

I look forward to your views and suggestions.

With my best wishes, Vishnu.