Offsets are the Achilles Heel of defence procurements and should be done away with
Maj. Gen. Mrinal Suman (retd)
No other facet of the Indian procurement policy has been subjected to as intense a scrutiny as the concept of offsets. India announced its intent to demand offsets against defence procurements in 2005. The first offset contract was signed in 2007. Dozens of offset agreements have since been signed and many offset programmes are currently under execution. The policy has been subjected to several major revisions. However, the debate about the cost-effectiveness and expediency of offsets continues unabated.
Recently, while addressing an international conference on ‘Energising the Indian Aerospace Industry’, Pratyush Kumar, President Boeing India, counselled, “Abolish offsets. It hasn’t delivered. It costs money”. He was not alone in faulting offsets. Nikhil Khanna, Managing Director, BAE Systems, termed offsets as the ‘Achilles Heel’ of procurement. Both were doing some plain speaking. Their advice must be given due consideration as they have had first-hand experience of navigating their companies through the morass of India’s convoluted offset policy. Both the distinguished speakers were alluding to the failure of offsets to boost local production. Their observations raise fundamental questions regarding the efficacy of offsets in ushering in an era of technological excellence and energising the indigenous defence industry.
Offsets can generally be termed as formal arrangements of trade with inbuilt contractual obligations wherein a foreign supplier undertakes specified programmes with a view to compensating the buyer regarding his procurement expenditure and outflow of resources. In other words, the supplier undertakes measures to generate benefits for the economy of the buyer country. Offsets can also be called as trade arrangements with reciprocity clauses to provide some sort of relief to the buyer to help him pay for the purchases. The negotiated package consists of the primary contract and the compensatory offset contract.
The World Trade Organisation (WTO) considers offsets to be market-distorting and contrary to ‘free and fair’ trade practices. Yet, offsets have become such an integral part of the international arms trade environment that over 130 countries are demanding them. Offsets do not come for free as foreign vendors have to incur additional expenditure to fulfil them. Hence, they mark up their commercial bids to absorb offset overhead costs. It is estimated that offsets up to 50 per cent inflate the cost of the main contract by close to 10 per cent. Similarly, 100 and 200 per cent offsets may result in cost escalation by 15 and 20 per cent respectively.
The Indian Conundrum
Despite repeated assertions in quest of self-reliance, India’s dependence on imported defence equipment continues to be above 70 per cent. India’s defence industry is in a pitiable state and the country has acquired the dubious distinction of being the largest buyer of conventional weapons in the world. Self-reliance continues to be a pipe dream.
The present government has declared ‘Make in India’ mission to be the cornerstone of its nation-building initiative and defence manufacturing has rightly been identified as one of the key sectors. Along with many other initiatives, the government expected offsets to provide the necessary stimulus to the indigenous defence industry. Unfortunately, all hopes have been belied. Experience of the past few years has been highly discouraging. There has been no progress whatsoever towards the development of a vibrant defence industrial base and there has been no technology infusion at all.
According to the reports submitted by the Comptroller and Auditor General (CAG), ‘benefits of offsets could not be reaped to the extent envisaged due to the lack of uniformity in interpretation of the extant offset provisions; acceptance of foreign investment in kind with no value addition; selection of ineligible Indian offset partners; and an ineffective monitoring mechanism’. In other words, India’s offset regime is in an utter mess.
India has made offsets mandatory for all capital acquisitions categorised as ‘Buy and Make’ and ‘Buy (Global)’ where the estimated cost of the acquisition proposal is more than the offset threshold of Rs 2,000 crore. In ‘Buy and Make’ procurements, offset obligations have been fixed at 30 per cent of the foreign exchange component. Regarding ‘Buy (Global)’ cases, offset obligations have been pegged at 30 per cent of the estimated cost of the acquisition. However, the Defence Acquisition Council (DAC) has been empowered to consider a partial or full waiver of the offset clause on a case to case basis.
As per the current Indian policy, offset obligations may be discharged with reference to eligible products and eligible services through any one or a combination of the six prescribed routes: direct purchase of or executing export orders for products and/or services; FDI in joint ventures with Indian enterprises (equity investment); investment in ‘kind’ in terms of Transfer of Technology (ToT) to Indian enterprises; investment in ‘kind’ in Indian enterprises in terms of provision of equipment through the non-equity route; provision of equipment and/or ToT to government institutions and establishments, including DRDO (as distinct from Indian enterprises); and technology acquisition by DRDO.
Products eligible for discharge of offsets relate to defence, internal security and civil aerospace. ‘Services’ mean maintenance, overhaul, upgradation, life extension, engineering, design, testing of eligible products and related software or quality assurance services with reference to the indicated eligible products and training. Training may include training services and training equipment but exclude civil infrastructure. Further discussion will, however, focus on the effectiveness of offsets in infusing technology.
Offsets make sound business sense only if the trade-off results in extraordinary economic or technological gains. Technologies that industrially-advanced countries are reluctant to sell can be obtained through the leverage of offsets. In other words, offsets must contribute to the upgradation of indigenous technological base. Unfortunately, India has abrogated the right to select methodology, areas and offset programmes in favour of the vendors, thereby rendering India’s needs inconsequential. It does not consider it necessary to direct offsets to pre-designated areas of its own choice. Needless to say, every foreign vendor opts for programmes that cost him the least and are easy to fulfil.
Do Offsets Make Sense?
Proponents of offsets claim that technologies that industrially-advanced countries are reluctant to sell can only be obtained through the leverage of offsets. However, Prof. Keith Hartley of Centre for Defence Economics (University of York) observes, “Offsets have their limitations.
Questions arise about the extent to which they involve any valuable technology transfer. For example, US firms are unlikely to offer ‘free gifts’ to their UK rivals.” It is a well-known fact that to safeguard his own financial interests, no vendor will ever part with his exclusive and cutting-edge technology. His endeavour will always be to offer low-end technology that the recipient nation has still not mastered – it may well be close to getting obsolescent in advanced countries.
Monitoring of offsets is a multi-dimensional and laborious task. It requires special skills and capabilities. Every offset programme needs a unique matrix, assigning values to different criteria for collation. India’s lax monitoring regime extends an open invitation to a wily foreign vendor and his unscrupulous Indian partner to connive to short-change the country. They can easily enter into an unholy nexus to submit inflated progress reports and claim offset credits. In the absence of a credible verification mechanism, MoD must accept their reports at their face value. Resultantly, instead of drawing benefits, India would end up suffering an additional outflow of resources.
Further, it is very difficult to measure the real impact and effectiveness of technology transfer against offsets. As costing of technology poses severe problems, it is well-nigh impossible to quantify the benefits accruing from offsets to ascertain their cost-effectiveness. Many countries have realised that offsets result in elusive gains unless effective negotiation, implementation and monitoring systems are put in place. Many countries have burnt their fingers due to lack of in-depth understanding of the interplay of clashing interests and prevailing insincere practices. Belgium has decided to do away with defence offsets.
The Way Forward for India
With a view to retain focus on mission ‘Make in India’, there is a need to create an enabling and supportive environment for attaining self-reliance in design, development and manufacturing of the defence systems. In that quest, offsets can certainly play a critical role, provided offset programmes are diligently selected, planned, supervised and monitored. Sadly, India’s track record has been dismal in all aspects. As stated above, reports submitted by CAG reveal total lack of any worthwhile value-addition in India due to the flawed policy and indifferent implementation.
Most importantly, every country that seeks to develop an indigenous industry must try to bridge the technology gap through offsets and subsequently use the acquired technology as a take-off platform for indigenous development of more advanced technologies. Therefore, India should make technology transfer to be the preferred route for discharging offset obligations.
To ascertain cost-effectiveness of offsets, every major procurement proposal must include details of offsets sought. Instead of leaving it to the vendors to choose the offset programme to discharge their obligations, detailed contours of the required programme should be included in the Request for Proposal (RFP) upfront. Every vendor must know at the very outset as to what the offset requirement entails and should be able to work out associated economics.
Vendors should be asked to submit two commercial quotes – one with the stipulated offset package and the other without any offset obligation. Such an approach will have twin advantages. First, vendors will be forced to reveal the actual offset cost being charged by them, thereby facilitating value for money evaluation. Secondly, with the cost of the indicated offset programmes spelt out by all vendors, inter-se cost appraisal would become easy. Additionally, being aware of the fact that offset costs would be subjected to comparison, vendors are likely to exercise due care in their quotes. Incidentally, Transparency International also recommends dual quotes for enhanced transparency in defence deals.
Once technically acceptable vendors are short-listed, and their commercial quotes are opened, lowest fully compliant vendor should be identified as the ‘lowest bidder’ based on quotes without offset package. Thereafter, a reality check should be carried out to determine whether seeking a specified offset package makes economic sense or not. As offset costs would have been indicated by multiple vendors, Commercial Negotiation Committee (CNC) can work out a reasonable range to ensure their cost-effectiveness. A counter offer as regards offset costs can be made to the ‘lowest bidder’. In case he declines to accept it, CNC should recommend procurement without offsets. This would imply that the demanded cost penalty does not justify the advantages likely to accrue from offsets.
Till now, offsets have neither upgraded indigenous industrial prowess nor helped improve self-reliance in defence production. They have been totally wasteful. On the contrary, India has suffered considerable financial outflow due to offsets without commensurate benefits. According to former defence minister Manohar Parrikar, the cost increase due to offsets had been between 14 to 18 per cent.
Raising of offset threshold from Rs 300 crore to Rs 2,000 crore has been by far the most significant change in the new offset policy and the government deserves to be applauded for the same. Carrying the reforms further, application of offsets to ‘Buy and Make’ cases should be done away with, thereby making them free of the convolutions and vagaries of offsets. The suggested process of dual commercial quotes must be followed to discover actual offset cost penalty and carry out a thorough cost-benefit analysis thereof.
Offsets should not be demanded as a matter of routine. They make sound business sense only if the trade-off results in commensurate economic or technological gains. As the economics of offsets have never been subjected to systematic studies, there is growing scepticism about the efficacy of offsets the world over.
The current euphoria in India about the benefits of offsets is highly misplaced and detrimental to national interests. Due heed should be paid to the sane voices of eminent people like Pratyush Kumar and Nikhil Khanna. They are sounding cautionary notes. It is time to pause and reflect, lest India continues to waste precious time and resources in pursuit of illusionary gains.