Defence

Modi government’s decision to drop offset clause in defence deals with foreign governments makes no strategic sense

Print edition : December 18, 2020

The Rafale fighter jet flies past during the 88th Air Force Day parade at Hindon Air Force Station in Ghaziabad on October 8. India's decision to go in for an off-the-shelf deal for 36 aircraft will not bring in any major technology or substantial offset investments. Photo: MONEY SHARMA/AFP

The Modi government’s dilution of defence offset norms will starve the country of an opportunity to leverage technology when weapon systems are bought.

India’s much-touted defence offset policy, formally kicked off amidst much fanfare in 2005 as the crowning jewel of “Defence Procurement Procedure (DPP) 2005”, has, thanks to the Narendra Modi government’s recent decision to dilute the existing norms, gone into a tailspin. The thought process of India’s defence offsets initiative goes back to the 1960s, to the aftermath of the Chinese debacle. But owing to the vested interests that have managed to change the contours of the policy to suit themselves, India has not been able to come up with a well-thought-out plan on how to maximise defence offsets.

Listed as the world’s second largest arms importer (according to the latest data from the Stockholm International Peace Research Institute), India has, like many other countries, hoped to use its buying power to not just secure the lowest prices but force foreign vendors to plough back a certain percentage of the overall contract value into the country on terms and conditions stipulated by it. The objective has been to use these capital acquisitions as a catalyst or a bargaining chip to bring in high-end manufacturing/production technologies to the country, attract foreign direct investments, facilitate and promote defence exports so as to become part of the global chain, promote domestic R&D in defence, expose India’s workforce to and train it in cutting-edge technology, and develop a strong indigenous defence ecosystem.

New stipulation

A year later, a new stipulation was introduced in the DPP’s offset obligations. The DPP-2006’s offset clause stated that a foreign vendor who won a defence contract totalling Rs.3 billion (Rs.300 crore) or more had to perforce invest 30 per cent (later revised to 50 per cent in some defence deals) of the contract value in India, thereby ensuring that the latest technology and skills would be brought in, the indigenous industry strengthened, and employment generated. A Defence Offset Facilitation Agency was also set up. Broadly speaking, India envisaged direct offsets (wherein the ensured benefits are directly related to the supplies envisaged under the principal contract) and indirect offsets (wherein the defence contractor helps India and Indian companies in areas unrelated to the principal contract).

But none of the objectives was really met. The only success was in the limited promotion of the export of civilian aerospace parts and components. In 2016, as part of the DPP-2016, Manohar Parrikar, the then Defence Minister, was “convinced” to revise the threshold for mandatory offset from the existing Rs.3 billion to Rs.20 billion for full-import deals.
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Said Air Marshal M. Matheswaran (retd), former Deputy Chief of the Integrated Defence Staff: “No country, definitely no vendor, wants to part with technology. Offsets are one of the ways to leverage technology. But to do this effectively we need a clearly thought-out strategic map, including on what we want to develop. Instead of this we have attempted to treat offsets purely as countertrade [exchange of goods for goods], not a partnership between the buyer and the seller. Yes, the vendor will pad up costs when you ask for technology, but the extra costs are worth it. Provided we know what we want. For offsets to work, the government needs to be involved in the strategy and what technologies we are going to demand. It cannot be left to industry alone to handle it.” Experts are of the opinion that if India is to gain from offsets there has to be a highly targeted approach to industrialisation, strategic approach to sustained investment, offset joint ventures to leapfrog technology, and technology transfer.

On September 28, the Modi government unveiled DPP-2020, wherein the Ministry of Defence (MoD) removed the offset clause requirement in inter-governmental agreements (IGA)/bilateral deals and transactions involving a single (monopoly) seller. An example of an IGA is India’s controversial decision to buy 36 Rafale fighters in a deal signed between the Indian and French governments in 2016. Even deals that may start with two or three vendors when the request for proposals (RFP) are issued narrow down to just one after the RFPs are evaluated. Competitive deals with multiple vendors will continue to have a 30 per cent offset clause.

However, with most of India’s recent mega defence acquisitions having fructified through the government-to-government route—the 22 Apache attack and the 15 Chinook heavy-lift helicopters acquired for $3 billion via the United States foreign military sales (FMS) programme—defence contractors may soon begin pressing their governments into pushing IGA or FMS type schemes to bypass India’s offset policy. The Modi government has cited padded costs and protracted contractual delays as the justification for terminating offsets in some deals. This was well known even in 2005 when India decided to take the plunge to enforce offsets. So why the sudden volte-face?

Said Air Marshal Ravi Kanth Sharma (retd), a former Vice Chief of the Air Staff: “We need to tighten the scope of offsets. It may not be wise to throw out the policy. And to make offsets work we need to quantify the approximate amount of offset that we want to load, both in the main contract and in the offset contract. The problem today is most OEMs [original equipment manufacturers] aren’t complete entities. Not even Russian OEMs. They are integrators. So they may not be even possessing all the technology that we want transferred. Also, handholding being a time-consuming affair, OEMs get frustrated. Not to mention the 20 windows and three Ministries they have to wade through. We need to identify and address shortcomings.”

An example of OEMs rarely being in total control of all technology that operates the equipment being sold is the Rafale deal. The offset is to be discharged in the Rafale contract by the four French partners—Dassault Aviation, MBDA, Safran and Thales—each of which steadfastly guards its respective know-hows.
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Did India set its eyes too high when asking for technology to be transferred via offset obligations? Technology that its establishments—R&D or manufacturing—was in no position to absorb? A case in point is the single-crystal turbine blade technology India badly wants. Hindustan Aeronautics Limited (HAL) and the Defence Research and Development Organisation (DRDO) have over the past two decades had discussions with the French engine manufacturer Snecma regarding this, but nothing has come out of them. Informed sources point out that Snecma at one point suggested a 15-year programme for the absorption of the technology by HAL. But HAL wanted the technology to be assimilated in seven years. The French refused. Likewise, the erstwhile Soviet Union’s Antonov Design Bureau (now in the Ukrainian SSR) had suggested an 18-year programme for Indian entities to go from licence production of their aircraft, to technical absorption to innovation.

CAG’s observations

In September, replying to a parliamentary question, the government stated that as of November 2019, the Defence Ministry had entered into 52 offset contracts worth $12 billion (since 2007, when the first offset contract was signed) via Indian offset partners, the duration of these contracts extending up to 2022. A recent Comptroller and Auditor General of India (CAG) report stated that between 2007 and 2018, the government had signed 46 offset contracts worth Rs.664.27 billion ($9 billion), of which contracts worth Rs.192.330 billion should have been completed by 2018. But, as of December 2018, the approved and completed offset contracts amounted to only Rs.54.57 billion or 8 per cent of the Rs.664.27 billion.

The CAG’s “Performance Audit Report on Management of Defence Offsets” implicitly highlighted the fact that the stated policy objectives were not achieved, with “technology transfer agreements in the offsets not (being) implemented”. The report also castigated the government for not putting in place an automatic monitoring system for offset contracts as it had initially promised.

This was not the first CAG report to criticise India’s defence offsets policy. The CAG report No. 17 of 2012-13 states: “Acceptance of DFI (direct foreign investment) in kind with no value addition through the IOP (Indian offset partner) was also not in consonance with the offset provisions as prescribed in the DPPs. There were also instances of selection of ineligible IOPs. The overall monitoring mechanism for directing offset activity towards desired objectives was ineffective as it was created without a clear definition of its objectives and role. It thus remained only a paper exercise. [The] MoD needs to ensure clarity in the offset provision and procedures so as to leave little room for ambiguity in its interpretation. The monitoring mechanism also needs to be reviewed to ensure effective implementation of the offset contracts.” But successive governments have not acted upon the CAG’s key findings.

Effectiveness of offsets

It may be true that India’s offset policy has failed to achieve its stated goals and that even after 15 years of offset obligations the Indian defence industry can fulfil hardly 30 per cent of the armed forces’ equipment needs. But is it time to jettison the offset policy? Would it not be akin to throwing the baby out with the bath water? Will this not hurt domestic capabilities? Does this move not fly in the face of “Atmanirbhar Bharat”, the self-reliant India policy proposed by the Prime Minister?
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Critics of offsets are quick to cite Jurgen Brauer and John Paul Dunne (eds.), who, in their book Arms Trade and Economic Development: Theory, Policy, and Cases in Arms Trade Offsets (London, Routledge: 2004, p. 1), categorically state that “neither economic theory nor extant empirical evidence suggests that offset arrangements yield net benefits”. Brauer and Dunne, in a separate work on the effectiveness of offsets, state: “Offsets do not result in arms acquisition cost reductions, do not stimulate broad-based civilian economic development, (do not result in) substantial (nor) sustained job creation not even within the military sector, that almost no successful technology transfer into the civilian sector is observed, and that only limited technology transfer into the military sector occurs, often over decades and at high cost. Moreover, whatever technology is transferred is quickly outpaced by continuous technology advances in the main developed countries.”

Critics also point out that in terms of costs, offsets could, given the protracted negotiations and contract-drafting process, hike up the cost of procurement by 20 to 30 per cent. Also, with technical offsets being difficult to define, and the vendor highly reluctant to pass on any meaningful technology, offset negotiations take years to complete, delaying procurement in the process. This is not a comforting thought to the end user, such as the Indian Air Force, whose technical evaluation team is under intense pressure from the Air Headquarters to evaluate and quickly procure much-needed equipment.

Global practice

Offsets, a form of protectionism, are a globally accepted practice. Defence contractors do not enthusiastically embrace them, but certainly tolerate them as a predominating feature of the international arms trade. Studies have shown that before 2001, as many as 46 countries had offset requirements in some form or the other. The figure is now closer to 140, every one of these countries looking for high-technology solutions as they undertake re-capitalisation and modernisation of domains across air, land, and maritime systems. Estimates by boutique consulting firms indicate that offsets worth $35 billion are generated every year. China has used offsets most effectively, even using civilian contracts to garner technology in the defence sector.

Even when purchasing commercial civilian aircraft, China has insisted, obtained and fully utilised offsets from companies such as Boeing and Airbus. With self-sufficiency in defence needs and industrial capabilities as their goal, the Chinese have forced foreign bidders to set up joint ventures with local Chinese companies in order to meet RFP requirements. Even companies that had steadfastly refused to set up production facilities outside of their territories were forced to yield. Besides insisting that top-of-the-line technology flowed to Chinese companies, China has also made sure that within a period of time these OEMs deployed Chinese nationals in at least in the second rung of leadership. China’s participation in the European Union’s Galileo project is cited as an example of how China was able to gain technology that allowed it to manufacture navigational satellites that also have a military application.

Even countries such as the United States, which do not have a formal offset policy, have offset obligations in other forms. The “Buy American Act” of 1933 necessitates the U.S. federal government to prefer “substantially all” of its acquisitions from domestic entities. In fact, countertrade in defence was first initiated by Dwight Eisenhower in the 1950s when he insisted that West Germany buy U.S.-built defence equipment to reimburse the cost of stationing U.S. troops in Europe. European countries themselves have hugely benefited from high offsets, often exceeding 100 per cent of the contract value.
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A 2007 European Defence Agency (EDA)-sponsored study found an average offset percentage of 135 among the European countries during 2000-06. The study says that countries such as Finland, Greece, Poland and Spain demanded an average of 145 per cent. Another instance of high offset demand is the United Kingdom’s contract with Boeing in which the U.S. company was asked to provide an offset of 130 per cent.

Countries such as Brazil, Malaysia, Poland and South Korea have progressively increased the percentage of offsets. Brazil, during negotiations with Sweden’s SAAB for the purchase of 36 Gripen fighters, a deal valued at $4.1 billion, received an industrial offset/trade compensation package worth $9 billion. (The first aircraft was delivered in 2019.) SAAB has to invest in manufacturing facilities in Brazil, train Brazilian engineers and pilots in Sweden, besides overseeing a technology-transfer programme aimed at the Brazilian Air Force and specific Brazilian companies.

In 2003, in a deal called “Peace Sky”, the U.S. firm Lockheed Martin sold 48 F-16 fighters to Poland for $3.5 billion via the foreign military sales (FMS) route. The deal was not only financed to the tune of $3.8 billion through U.S. foreign military financing for 15 years, but Lockheed Martin also offered Poland an offset package of $6 billion by way of business investments. No wonder Polish officials called it “the deal of the century”. Contrast this with India’s own Rafale purchase for 36 aircraft off the shelf, a deal which makes no long-term strategic sense. And offsets which are minor.

Said P.M. Soundar Rajan, who served the DRDO for over 40 years and superannuated as the Director of the Defence Avionics Research Establishment: “No country, read original equipment manufacturer [OEM], wants to part with cutting-edge technology. Offsets are a platform to force OEMs to part with technology. Yes, offset negotiations are protracted, result in a tenfold increase in the contract document paperwork, is complicated, [involves] a lot of hard work, and eventually delays the procurement of badly needed equipment. But we should not give up our offset route. Doing away with offsets will only make it comfortable for foreign and domestic vendors. It’s a done deal for them, they will dictate. The armed services will also support dismantling of the offset protocol because they will get what they want faster. But DPSUs [defence public sector undertakings] and the DRDO will continue to be starved of an opportunity to leverage some technology. The country will get weapon systems but lose an opportunity to get technology.”

Even Soundar Rajan agrees that the DRDO and the PSUs have been slow in absorbing technology. Said Soundar Rajan, who is now a visiting professor at the National Institute of Advanced Studies: “Technology, more than being transferred, has to be absorbed. India lost the fifth-generation fighter aircraft programme because the Russians were not prepared to wait. Offset should come as part of the contract. Not just as a paragraph added on. When an R&D proposal is given, costs go up and finance gets involved. But the higher costs are justified if the offsets are worked out correctly. No point in getting technology like we did in the case of the Sukhoi-30 deal with Russia. The technology wasn’t (even) used in the development of the indigenous light combat aircraft Tejas programme.”
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Said Colonel H.S. Shankar (retd), chairman and managing director, Alpha Design Technologies: “Lots of technologies have flowed in from OEMs to Indian companies through direct offsets and also the export market. On the basis of offsets, other upgrade projects have been undertaken by Indian industries through their own R&D. So it is a misnomer to denigrate offsets. Offsets are not at all difficult to implement as compared to the difficulties due to some OEMs expressing their reluctance to part with the details of software.”

While it is true that foreign defence vendors are reluctant to share and transfer top-of-the-line technology to Indian entities, it is equally true that Indian companies are incapable of meaningfully absorbing much of this technology. Many scientists, technocrats and veterans who have made a beeline for the private sector post their superannuation from either the DRDO or the armed forces speak in unison when they say that the Indian private sector is only interested in immediate financial windfalls and is unprepared to accept the fact that the defence sector needs both deep pockets and staying power.

Explained a former DRDO scientist: “The DNA of the private sector entrepreneur is, ‘money can buy anything’. What they don’t realise is, even if lucrative commercial interests lure a vendor, you can’t buy his government’s policies.”

But it is not all doom and gloom. Many vendors and Indian entities have struck beneficial partnerships. Even the most hardened critics talk of the success that TAL Manufacturing Solutions Ltd (TAL), a 100 per cent subsidiary of Tata Advanced Systems Limited, has had with Boeing at their state-of-the-art aerospace manufacturing facility at the Mihan Special Economic Zone in Nagpur, Maharashtra. Over a year ago TAL celebrated the delivery of the 25,000th Advanced Composite Floor Beam to Boeing for all of their Dreamliner airplane variants—the 787-8, 787-9 and 787-10.

But this achievement did not come easily. TAL was awarded the first contract to manufacture floor beams for the Dreamliner family of airplanes in 2011, and the first set of floor beams was shipped in 2014. Sources at TAL say that it took TAL five years before it could even meet Boeing’s quality standards. Do Indian entities have the wherewithal, or are even willing to persevere until the OEM’s exacting standards are met, is a valid question.

Added Air Marshal Subramanyam Sukumar (retd), a former Air Officer-in-Charge Personnel: “Offset, in principle, is a very good concept. But, our bureaucratic systems made it a cumbersome process. Every vendor increases his cost by a few per cent to cater to offsets. Offsets should be at a strategic level in terms of major technological benefits to the country, defence industry, DRDO, etc. And, not for the export of small items, which needs an organisation to keep account of and haggling with the foreign OEMs. Since OEMs will not be willing to transfer cutting-edge technologies to anyone, our requirements should be clearly defined in the RFP itself. And only if the OEM meets those criteria should it be allowed to participate. We should also be realistic on what technology any OEM will be willing to part with. This should be an iterative process during the RFI [request for information] stage. I strongly believe that we are absolutely capable of absorbing and mastering any technology. We need an offset policy that is more realistic and process and procedures that are practically implementable.”

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