The Indian Ministry of Finance (MoF) recently rejected a proposal of the Mahindra Defence Systems (MDS) to form a joint venture (JV) company in India with the UK's largest defence company, BAE Systems. The JV proposal, based on equity ownership of 51 per cent for MDS and 49 per cent for its British partner, was to "develop, manufacture and provide through life services support for Land Systems defence equipment" and reportedly envisaged a capital inflow of over Rs.550 million. The decision of the MoF can be termed unfortunate for several reasons.

The MoF did not specify the reasons for rejection. Apparently, the MDS-BAE's proposal was shut down on "technical grounds" that the proposed JV was not consistent with foreign direct investment (FDI) guidelines for the defence industry. Technically, the MoF's argument is logical, in the sense that a foreign investor, under the present guidelines, cannot hold more than 26 per cent equity in any of India's defence industrial infrastructure. The above logic however does not hold ground from the perspective of the Ministry of Defence (MoD) which had made it clear, on earlier occasions its intent to allow greater FDI in the defence industry on a "case-by-case" basis, and provide a level-playing field to private sector vis-a-vis the public sector. The said proposal, which was doing the rounds for several months, had the "blessings" of the MoD and was widely expected to get the final nod from the MoF. By turning down such a proposal the MoF's difference in perceptions with the MoD are evident.

Perhaps, the greatest damage from this incident is in the palpable loss of confidence of foreign companies in India's decision-makers responsible for defence production. It is to be noted that if the MDS-BAE JV had passed, it would have been the first one in India's defence industry involving a domestic private player and an international partner with near equal ownership rights. A successful passage of this JV would have paved the way for many such ventures in the future. By turning down the JV, the decision-makers at the MoF have not only silenced expectations but created a situation where foreign companies looking for greater Indian presence become more suspicious of the government's seriousness in attracting higher investment.

While the MoF's action has made MDS "comply" with the present investment norms, the issue of allowing FDI into defence production needs to be examined with renewed vigour. It is to be noted that since the opening up of the defence industry for foreign participation, very little by way of FDI has actually entered India. For instance, among the 16 FDI proposals - amounting to nearly Rs.8 billion - cleared recently by the Finance Ministry, only one was in the defence production sector, and that too without any fresh inflows. Besides, according to open sources, in the last seven or eight years, only three FDI proposals involving domestic private companies have been cleared by the MoF. The FDI inflow of those proposals is less than Rs.70 million, a fraction of the total FDI inflows to India in the same period.

The reason behind little FDI in defence production is not difficult to fathom. The policy, in the present form, can at best be described as restrictive. It does not provide foreign investors incentives with respect to capacity expansion, purchase guarantee and exports while subjecting them to purchase and price discriminations vis-a-vis public sector enterprises. Given these constraints, the major investors are reluctant to invest in Indian companies where they would have little control. That is why not a single FDI of any significance is seen in the defence industry while billions of rupees are being infused in civilian sectors with liberal FDI guidelines.

The policymakers need to factor in the very logic that led to the opening up of defence production to the private sector with an added instrument of FDI. If the logic was to recognize the private sector's potential to contribute meaningfully to the materiel cause of the armed forces, the government must ensure that the ability is not handicapped. Bear in mind that the private sector unlike the public sector does not have the luxury of state protection. Only the returns from investment can guarantee its survival. Since the defence industry is primarily single consumer-driven and highly capital-intensive, the private sector is at a greater risk. The risk is compounded in the face of its little experience with the technological know-how that goes into defence production. Arguably, the contributions from international defence majors in the form of both capital and technology can enhance the ability of the Indian private sector which in turn would contribute to India's defence industrial capability. The present policy of FDI for defence sector does not allow this to happen. The MDS case provides an opportune time to re-examine FDI policy for the defence industry.