A new Dawn emerges with liberalisation in Defence sector's Foreign Direcr Investment

The Government of India on September 17, 2020 issued Press Note 4 of 2020 (PN4) and finally revised the policy governing foreign investment in the defence sector. Hopes were raised in May, 2020, when as a part of the Economic Package to counter the COVID-19 impact, the Finance Minister announced the decision to raise Foreign Direct Investment limits in the defence sector under the automatic route from 49% to 74%. However, the industry had to wait for 4 months to see the text of the proposed change. The wait is not entirely over as this change will be effective only once a notification is issued in terms of the Foreign Exchange Management Act, 1999 (FEMA).

This change would truly be landmark, bringing to fruition a decade old demand to allow foreign defence manufacturers controlling interest in Indian companies. India for a long time has had the unfortunate distinction of being a leading importer of arms and ammunition. Permitting majority foreign investment in the defence sector should generate employment, save precious foreign exchange, and most importantly, wean the country away from import dependence. The strongest argument against this liberalisation is the vague national security risk posed by foreign ownership of defence and aerospace manufacturers. Questioning how the reality of import dependence on the same foreign manufacturers is any less of a security risk immediately reveals the hollowness of that stance.

Tracing Indian regulatory experience with Defence FDI

Embracing FDI in this sector has been a cautious and gradual exercise. India tested these waters by allowing 26% investment into the defence sector, and that too, under approval route about two decades ago in 2001. Taking the next significant step in 2015, the cap was hiked to 49% under the automatic route for companies applying for fresh industrial licenses, whereas operating defence companies receiving FDI still required government approval. As expected, limiting investors’ stake effectively to 49% denied them control over their investments, stopping short of creating an attractive environment for foreign capital to be channeled in. This should change with PN4.

Press Note 4 of 2020

Coming in the wake of unprecedented economic contraction, one expected a more broad-based liberalization of defence sector FDI policy. However, in keeping with the conservative attitude the sector is historically familiar with, PN4 offers a mixed bag of changes. It permits 74% FDI only in “companies seeking new industrial licenses”, i.e. greenfield projects, yet retains the requirement of Government approval for existing defence sector entities increasing FDI from 49% to 74%. FDI above 74% continues to require Government approval. Nonetheless, PN4 should encourage global defence players to consider fresh investments in India, for now they can control and hold more than 50% equity stake in such Indian entities.

The government has also liberalized the approach for brownfield investments upto 49%, i.e., foreign investment in companies which already have industrial licenses. Unlike the erstwhile regime where such investments were subject to Government approval, the revised policy only requires submission of a post-facto declaration with the Ministry of Defence within 30 days of incoming FDI.

This should be most relevant for existing defence companies and joint ventures, since change in foreign shareholding or fresh foreign investment upto 49% will be significantly easier with no prior approval required. However, increasing foreign investment above 49% still requires approval. These changes taken together with other stimuli provided to defence investors, should make India an attractive investment destination, especially if the Government continues to focus on purchasing India-made products.

National Security Clause

With the defence sector being critical to national security and strategic interests, the Government has retained its characteristic oversight over foreign investments in this space. The introduction of a new national security clause provides plenary powers to the Government to scrutinize and review “any” investment that “affects or may affect” national security.

Defence FDI continues to be subject to security clearance by the Ministry of Home Affairs. The existing requirement that the investee entity be self-sufficient in areas of product design and development has been retained, though the import of this provision remains vague.

Unanswered Questions

Though PN4 is undoubtedly a step in the right direction, it leaves a few critical questions unanswered:

  • What would be the contents of the declaration to be submitted for change in FDI upto 49%, and how is this to be filed?
  • What compelled a new National Security clause when the Government anyway scrutinizes each investment (i) at the stage of an FDI approval (where still required), (ii) while granting Industrial License or (iii) during the security clearance procedure?
    • What would be the consequences of an adverse assessment by the Government pursuant to review under the National Security clause.
    • Hopefully, some of these questions will be answered in the notification awaited under FEMA.   

Source : https://economictimes.indiatimes.com/news/defence/view-a-new-dawn-emerges-with-liberalisation-in-defence-sectors-foreign-direct-investment/articleshow/78386078.cms

Date : Sep 29, 2020

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