How Strong are Our Offset Guidelines?... A User's Perspective

Abstract

The Minister of State for Defence Mr Subash Bhamre announced in Jan 17 this year, that nearly $14 billion worth of defence offset obligations would be discharged in India by foreign Original Equipment Manufacturers (OEMs) by 2028¹. This is a huge inflow of funds which hopefully will ride its way in on the workhorse of the New Offset Policy of the Ministry of Defence (MoD) which forms a part of the Defence Procurement Procedure (DPP )-2016 announced by the MoD in Mar 16. Are our Offset Guidelines strong enough to realise the kind of magnitude of inflows which the Minister has announced? This is the question that this article addresses. It does so by tracing the entire Offset story as it has evolved over time since 2005 till date, examines the current provisions in force and conveys the sense of the author on the question stated above.

The First Tangible Milestone

Though the Defence Offset provisions formed a part of DPP 2005, for many years following this, offsets essentially remained a non-starter. There were several reasons for this; lack of clarity on various provisions, general reluctance of foreign OEMs to bite, and above all, the near incapability of the Indian Defence Industry (especially the private sector) to absorb the kind of offsets in quantum and technology terms, as would become available in time. This incapability made it very difficult for the foreign OEMs to find suitable Indian Offset Partners (IOPs) to discharge their offset obligations.

Spurred by the above inertia, the MoD in 2012, constituted a Study Group under Director General Acquisition (DG Acqn) for carrying out a comprehensive revision of the Offset Guidelines The Report of the Study Group, duly approved by the MoD, found a place in DPP 2013. The author, being a Service representative on the said Study Group, recalls the following as his first-hand experience:-

The Study Group, not only read up the Offset provisions of all the leading players of the world, viz USA, UK, France, Israel, Korea and others, but also invited reps from several friendly foreign countries to tell their story of offsets so that best practices worldwide, could be adopted. Also, the members debated at great length, the introduction of new fields for offset discharge. The difference in opinion between the Acqn Wing and the Department of Defence Production (DDP) regarding the primacy position the in offset milieu came to the forefront. Ultimately, a position of duality between these two in negotiating of offsets and discharge thereof respectively, found its place in the Guidelines. Also discussed at great length was the very many contours related to the complex issues of the Transfer of Technology (ToT), multipliers, offset banking credits and more. After months of debate, the guidelines emerged.

The Non Performance Story

In spite of the above Guidelines forming a part of DPP 2013, the years that followed showed that the Offsets did not happen the way it was perceived to flow. As of Mar 16, when the new DPP was announced, some 28 Offsets contracts stood signed worth USD 6 billion and another 43 contracts worth USD 6-7 Billion were in the pipeline.²

While the statistics may put up any claims and figures may tell any story, as DG Army AD, handling several big ticket procurement cases first hand, the experience of the author has been, that the offsets in the currency of DPP 2013 were quite a hindrance and these definitely retarded the already sluggish and inert cycle of the procurement monolith, owing to protracted discussions with OEMs. On the OEM's front, there were multiple problems in the choice of IOPs and changes thereto coupled with our net capability (read incapability) to absorb the types of technologies being offered. Actually the figures indicating Offsets in the pipeline have remained in the pipeline for years on end. And as is well known, that there are no free lunches whatsoever be the costs of offsets, the same came loaded on the main product cost . As per an expert estimate, this load is about 12-18% of the Contract cost.

The First Change Happens

The first welcome change in the status quo came in Aug 15, when the MoD came out with two amendments to the Offset guidelines (MoD ID No 1(6)D/(Acq)13-Vol ii dt 05 /08/15). The driver for these amendments has been the felt need by the OEMs over the years. In that, due to the time lag between submission of technical offset offers, finalization and subsequent implementation of the offset contracts, many suppliers faced difficulties in providing upfront specific description of products, work share, yearly discharge schedule and supporting documents to establish eligibility of the IOPs. The said amendments address this issue both at pre-contract and post-contract stage.

Vide the first amendment, the vendors can now have the option, to submit detailed offset proposals at a later stage, thereby allowing them to finalize a more realistic offset offer. A vendor can finalize its IOPs and offset product details either at the time of seeking offset credits or one year prior to the intended offset discharge. The amendment also provides adequate flexibility in the post contract stage. In that, the amended provisions provide for a change in IOP/ offset component and re-phasing within the performance period. Also a standard operating procedure (for processing offset contract amendment proposals) has been introduced allowing addressing of supplier's requests to change the IOP or their offset component as per requirement during the period of the contract. The overall value of the offset obligation is however to remain the same. This amendment will apply not only to DPP 2013, but earlier DPPs as well.

The second amendment relates to reducing the offset trigger for Indian companies participating in 'Buy (Global)' Tenders. Earlier, the Indian vendors participating in 'Buy (Global)' category procurements, were required to discharge offset obligation on the foreign exchange component of the contract if the indigenous content (by value) in the product was less than 50%.This threshold has now been reduced to 30% i.e, the offset obligations will not be attracted if the indigenous content in the product is 30% or more. If it is less than 30%, then the offset obligations are to be fulfilled to the tune of 30% less the indigenous content percentage. With the Indian vendors now at par with the foreign Original Equipment Manufacturers (OEMs) in terms of fulfilling offset obligations, this is likely to pave the way for greater participation of the Indian companies in 'Buy (Global)' tenders.

Both the above amendments are a step in the positive direction. The first one brings the earlier DPPs at par with DPP 2013 and is likely to add transparency and speed in finalisation and implementation of Offset Contracts. This will especially give a move on to the cases stuck in the offset quagmire during the period 2005-13. The amendment is also in keeping with the evolution process of the Indian Defence Industry and their changing capability to absorb/execute offsets.

It may be recalled that in the beginning of the offset process, the foreign OEMs chose IOPs as available in the field mostly based on anticipation of capabilities, as existed then. As the years unrolled while many a IOPs grew in muscle and stature and lived up to their commitment on offsets, moving steadily upwards on their individual growth ladder, several others did not grow as was visualised and showed their inability to execute and deliver what they promised to do in the time frame required. Change of IOP or rephrasing the Offset schedule was thus the fait accompli thrust upon the OEMs. In the past, both these processes used to be herculean tasks; time consuming and procedure ridden. The amendment has removed the hurdles in this path providing a way for the OEMs to come out from the above logjam and get a move on.

The second amendment also relates to another ground reality, i.e, the capability of the Indian Defence industry in realising the indigenous content in Buy Global cases. Experience had shown, that for Buy Global procurements, the capability of the supplier to put out a 50% indigenous content in the offset package was a major problem area. The effect of this always translated in endless delay in the main procurement projects owing to protracted negotiations with the IOPs. This percentage stands reduced from 50 to 30%. The same will hopefully make some stalled projects get out of their impossible positions and proceed forward.

Essentially speaking, the net effect of the above two amendments will be to correct the two bottlenecks that have been felt over time. This is especially true for procurement projects that were under the currency of the earlier DPPs. Also, since the above amendment brings the previous DPPs at par with DPP 2013, hopefully, the stalled projects under previous DPPs will also get a momentum.

Further New Changes

Moving boldly ahead of the above two small amendments, DPP 2016 has made some fundamental changes in the applicability norms of the offsets. Most important among these is the significant enhancement in the threshold of the cost at which the offsets become applicable. As per the current norm, the Offset clause will only be attracted where the indicative cost of acquisition is 2000 cr or more, as on the date of accord of the Acceptance of Necessity (AoN). This is a sea change from the earlier limit of applicability pegged at 300 Crs.

Secondly, several other fields for discharge of offsets have been identified. These include; (1) Direct purchase of, or executing purchase orders for eligible products manufactured by, or services provided by Indian enterprises; (2) Foreign Direct Investment (FDI) in joint ventures with Indian enterprises; (3) Investment in kind in terms of Transfer of Technology (ToT) to Indian enterprises; (4) Investment in kind in Indian enterprises in terms of provision of equipment through the non-equity route; (5) Provision of equipment and/or ToT to Govt institutions and establishments; and (6) Technology acquisition by the Defence Research and Development Organisation (DRDO) in areas of high technology.

Another very important provision built in the new Defence Offset Guidelines is the waiver Clause. As per this provision (Clause 2.3) the Defence Acqn Council (DAC) may consider partial or full waiver of the offset clause (for any reason whatsoever). This optionally adaptable route will provide an institutionalised exit route from the offset regime if conditions of operational expediency may so demand. In any case, offset is not attracted in cases of Fast Track Procedure (FTP) and while exercising Option Clause of a previously signed Contract if the original Contract was not having any offset stipulation (Clause 2.5) ³

Analysing the Drivers for the New Defence Offset Guidelines

Sudden increase that too by seven times in the applicability threshold of the Offset have put many a Subject Matter Experts (SMEs) looking for the rationale. Opinions on its being 'right' or 'wrong' are divided. As per this author, the basic premise of marking up the applicability threshold has been the following:

a. The earlier limit of Rs 300 Crs was set up in 2006. Since then, the general cost of acquisition has gone up many folds, requiring an upward revision of the applicability threshold. In that, it has been the general consensus that while offsets should apply to the real high value acquisitions (with indicative costs of Rs 2000 Crs or more), these need not decelerate or bog down a (presumably) large number of other contracts (implying the ones with indicative cost between 300-2000 Crs). Such cases should come out of the offset bind due to unfinished offset obligations.

b. Besides the above, a large no of Contracts should not get loaded with offset mark up (likely 12-18%) which vendors indulge in, by escalating the product cost to recover offset amounts. These cost mark ups could well be used to buy technology or be ploughed in the main procurement.

An analysis of the basic premise, as stated above reveals that the first basic presumption about raising the offset threshold so as to free from the offset shackles, a large number of procurement cases in lower cost brackets (300-2000 Crs), seems to have a factual contradiction.

As per the open source data of the time when DPP-16 got promulgated , i.e. Mar/ Apr 16, out of the total 71 contracts in the offset pipeline (amounting to 48,3443.93 cr) as much as 45 (461848.70 cr) belonged to the bracket of above 2000 cr while the 300-2000 cr bracket had balance 26 cases ( 21595.27 cr).In terms of percentages, the above translated to some 63% cases above 2000 cr and the balance 37% in 300-2000 cr bracket. Given the above figures, the purpose of freeing a 'large number' of procurement cases does not come good simply because a much larger number belongs to the >2000 cr bracket.

Notwithstanding the statistics above, it is the sense of the author borne by his first-hand experience that while the quantum of 26 Contracts may look dwarfed as compared to 45, in these 26, reside a large number of Army related procurements, which though, may not be as high-value as the aircrafts and ships (save the fewer high ticket cases of Army Air Defence, Artillery and Mechanised forces) but these are of critical operational importance. Many such cases are badly stuck owing to the offset shackles. These will hopefully get a move on spurred by the new guidelines. This is of great importance to the Army since in many of its procurement cases, while the individual cost of each unit/piece may be less but the same is required in such large numbers by the bulk of field army at the cutting edge, that the case becomes huge in its own standing and importance.

Another point relates to the capability of absorbing the offsets as evaluated from the cost perspective. 30% offsets of 2000 Crs. will amount to a minimum of 600 Crs. Some Experts have opined that absorbing offsets of this magnitude will effectively put the MSMEs out of the ring. The author's opinion is to the contrary.

While, it is agreed that 600 cr is an issue but so is the fact that the face of MSMEs itself is fast evolving, duly propelled by the opening of the overall eco system, as well as, the push effect of opportunities emerging from the big players, both domestic and foreign, who are currently bathing in the sunshine of the Make-in-India wave. This has recently got a shot in the arm with the announcement of new Policy of the MoD for boosting Private Sector Defence manufacturing through the route of strategic partnership.⁴ If one MSME unit falls short of absorbing the offset in range and depth, what about joining of hands of a few MSMEs under a common banner for a product specific vertical? What about multiple subsidiaries of one big banner? While 600 cr will be a tough call, it is not impossible, since there are options to make that happen.

To facilitate the above, it is the sense of the author that there is a need to build adequate remedies/tools to let MSMEs partake fully in the offset theory. Many new initiatives are already a reality. For instance in the Make Procedure, Projects with estimated cost of prototype development not exceeding 10 cr for ‘Make I’ and 3 cr for ‘Make II’ categories already stand earmarked for MSMEs. If some facilitation by way of tweaking of guidelines is called for to further facilitate, the MoD shold go for it.

In addition to the above, very many issues relating to Offsets like, multipliers, banking of credits, multiple offset field including new additions, formats for vendor identification through internet, format for case specific advertisement on internet and above all, the detailed and clear procedure for implementing the offset provisions now stand stated in the new Offset Guidelines. It is to be hoped that the executors on ground will walk the talk when it comes to implementing the guidelines in a spirit of 'passing and not 'failing'. Open sources inform us that the MoD is also working on a new Defence Procurement Organisation (DPO). It is to be hoped that the most prominent lacuna in the Offset regime, that is of split responsibility between the DG Acqn and DDP wherein the former finalises the Contract and the later manages its implementation will be corrected and the entire process will be vested in one body.

It can thus be stated as a bottom-line that with the coming in of the New Defence Offset Guidelines while there has been considerable move forward in the policy domain, it is now the take of the executors of this Policy to actually make it happen what was envisaged by the policy makers. And finally, the author's take on the main question: Will the Minister's prediction on the likely offset inflow of 14 Billion USD by 2028 going to become a reality? It will, if the guidelines now in force are implemented in a positive and enabling spirit by the stakeholders on ground; at least the factuals’ in the Guidelines will not fail us in delivering what is expected out them.

Refrences

1. http://economictimes.indiatimes.com/articleshow/56359688 [3].
2. Ritika Behal, "Revising Defence Offset Policy" Defence ProAc Biz News Vol IV issue 2 Mar-Apr 2016.
3. https://www.ddp.gov.in>defence-offset-guidelines
4. https://www.m.economictimes.com>defence-procurement-policy