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The Government of India introduced offsets in defence procurements in
Defence Procurement Procedure - 2005 and detailed guidelines were
issued in May 2006. The policy is applicable to all purchases where
indicative cost is over Rs 300 crores for ‘Buy’, ‘Buy and Make with
Transfer of Technology’ and ship-building cases. Offsets higher than
30 percent may be specified for specific cases. For joint ventures
where Indian firm is bidding, the foreign partner will have to
discharge-offset obligation.
Offset obligation is to be completed coterminous within main contract
and can be discharged through any of the following routes:-
| (a) |
Direct purchase of or executing export orders
for, defence products and services provided by Indian defence
industries.
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| (b) |
Foreign Direct Investment (FDI) in Indian
defence industries.
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| (c) |
FDI in Indian organisations engaged in research
in defence R&D. |
Generally, offsets are of two types - direct and indirect. In direct
offsets, the compensatory dispensation remains confined to the main
weapon system, its sub-assemblies and components. On the other hand,
indirect offsets have a much wider scope and transcend other economic
and social activities. However, India has decided to adopt a
semi-direct path and demands offsets related to the defence industry
as a whole.
Offset obligations are measured in terms of offset credits. As India
does not use offset multipliers, the value of offset credit is equal
to the monetary value of the obligation. It implies that in case a
foreign vendor carries an offset obligation of Rs 100 crore, he has to
either purchase goods/services worth Rs 100 crore or invest the amount
in Indian defence industry/defence R&D. Of course, he can have a mix
but the total value must add up to Rs 100 crore.
A Defence Offset Facilitation Agency (DOFA) has been established as a
‘single window’ under the Department of Defence Production to
facilitate implementation of offset policy, vet offset proposals
technically, provide advisory clarifications on policy and procedures
(in consultation with the Acquisition Wing, where necessary) and
assist vendors in interfacing with industry for identifying potential
offset products/projects.
For products, which contain imported components; only the value
addition in India will count towards offset obligations. Offset
contract will be signed with the main contract. A vendor cannot delay
execution of main contract on the plea of inability of Indian offset
partner to execute offset contract.
A penalty equivalent to 5 percent of unfulfilled portion of obligation
in a year will be imposed on the defaulter. Vendor failing to complete
offset obligation during the period of main contract (or during the
period extended) will be debarred by Acquisition Wing for future,
after giving him opportunity to explain.
The Indian policy has the following major distinctive provisions:
| (a) |
All proposals that meet minimum offset
requirement are to be treated at par. No weightage is allowed
for the quality or quantum of offsets. No preference is given
for extra offsets offered.
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| (b) |
It is for the vendor to select methodology
and Indian partner for the fulfillment of offset obligation.
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| (c) |
No offset multipliers are applicable.
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| (d) |
Offset banking has not been provided for. |
The US India Business Council has been spiritedly advocating a number
of policy changes. One of their recommendations relates to offset
banking. It wants the Government to permit banking of offset credits
to enable foreign vendors to accumulate them in advance.
Generation of Bankable Offset Credits
A vendor may generate potential offset credits through programmes
undertaken prior to the award of main contract for ‘banking’ purposes
for future use against likely obligations. Many vendors feel that
pre-contract offset activities make sound economic sense for the
following reasons :-
| (a) |
Vendors show their earnestness and commitment
to the host country and thereby create a favourable impression.
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| (b) |
As most contracts stipulate co-terminus
completion of offset programmes, vendors confident of winning
main contracts get early-starter advantage.
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| (c) |
Banked credits create an informal pressure on
the host country and improve a vendor’s chances of bagging the
targeted main contract, although pre-contract offset credits do
not offer any such guarantee.
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| (d) |
In case a vendor does not get the hoped-for
contract, he is at liberty to sell the accumulated offset
credits to recover his costs with profit. |
Bankable offsets can be created in the following two ways: -
| (a) |
By excess generation through ongoing offset
programmes.
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| (b) |
By executing fresh offset-centric programmes,
in anticipation of bagging future defence contracts. |
Execution in Excess of Current Obligation
A foreign vendor may decide to continue with an ongoing offset
programme even after his obligation has been fully met, provided he is
allowed to ‘bank’ extra credits earned through additional activity.
These extensions benefit the host country as well. Such arrangements
can materialise under the following circumstances:
| (a) |
An offset programme may not be financially
viable due to lack of economies of scale. A vendor may well
decide to scale-up his commitment, provided he is allowed to
‘bank’ surplus credits earned.
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| (b) |
In the case of export of goods and services,
a vendor may find the business financially lucrative. After
having invested in the development of new markets and having
acquired related experience, it may make economic sense to carry
on as long as the market conditions remain conducive.
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| (c) |
In case a vendor has invested in the
indigenous defence industry against partial/full fulfillment of
his offset obligation, he may decide to have a more intimate
partnership and invest additional funds. Presently, the
Government has put a cap of 26 per cent for Foreign Direct
Investment (FDI) in the defence industry. There are three
scenarios in which investment of additional funds is possible:
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| (i) |
In case earlier investment was less than 26
percent, a vendor can increase it to the permissible limit.
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| (ii) |
In case the capital base of the Indian company
is increased, vendor can pick up additional equity up to the
allowed cap.
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| (iii) |
The Government may revise its policy and
increase/remove FDI ceiling.
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| (d) |
Investment in defence R&D has to be flexible
as cost and time overruns are fairly common. R&D programmes
cannot have rigid financial funding. A foreign vendor has to
remain invested and committed till the fructification of the
project. At times, he may be forced to invest additional capital
to protect his earlier investment |
Execution of Anticipatory Pre-contract Offset Programmers
In some countries, vendors are permitted to undertake approved
programmes which would fetch them offset credits, in anticipation of
getting major defence contracts. The UAE permits anticipatory offset
credits in designated areas, provided it is convinced that the
proposed activity would create new economic wealth and will be in the
interest of the UAE.
A vendor who is confident of bagging a major defence contract may seek
permission of the host country to commence offset programmes in
advance. Offset credits thus earned are ‘banked’ to defray subsequent
offset obligations. In case the vendor fails to get the anticipated
contract, he is at liberty to trade his offset credits.
Functional Complexities and Need for Caution
Management of offset banking is a highly intricate and complex task.
If banking is allowed, trade in offsets has to be accepted. Both are
intrinsically and mutually contingent. Experienced vendors know how to
exploit ambiguities in policies and lacunae in implementation to their
advantage. Unless competently handled the whole exercise can prove in
fructuous and even counter-productive.
Given the option, every vendor would choose the easiest and most
remunerative alternative. For example, many vendors will find it
profitable to outsource defence software from India to earn offset
credits. But gains to India may be illusory as India’s IT exports are
already robust and thriving.
As offset banking may entail economic activities worth thousands of
crores of rupees, it is absolutely essential that the Indian
Government take a well-considered decision. Offset banking should not
be viewed in isolation, but as an important and integral element of
long-term national policy. The Government must weigh all issues
involved to evolve a comprehensive and explicit policy directive.
Need for Pre-Approval of ‘Bankable’ Offset Programmers
India allows direct offsets (related to the main system under
procurement) and semi direct offsets (connected to defence industry).
As all pre-contract activities are anticipatory in nature, they have
to relate to semi-indirect offsets. It implies that under pre-contract
activities, a vendor can export defence goods/services or invest in
the Indian defence sector (including defence R&D) without reference to
any specific acquisition proposal of the Indian Government.
As seen above, a vendor may earn offset credits simply by buying any
product from Indian defence industry. It becomes a pure counter-trade
arrangement. But, export of goods/services is considered to be the
least beneficial form of offsets. As value of an offset programme
depends primarily on its appropriate selection, the policy should also
indicate the areas in which offsets are preferred and also offer
suitable incentives for the same.
To ensure that routine commercial investments and trading activities
are not shown as offset programmes to earn credits, it must be
ascertained that all pre-contract activities relate to new
products/services or new markets or conspicuously enhanced scale of
existing operations. DOFA should be the designated authority to
approve all proposals against which offset credits would be permitted.
DOFA has to make sure that the additional economic activity generated
through offsets is in consonance with national policy imperatives. It
will prevent misuse of the facility by knowledgeable vendors.
All countries that allow offset banking have an elaborate procedure in
place to estimate anticipated immediate, short term and long-term
benefits to their national economy. Expert groups are constituted for
different projects and their reports included in the contract
document. Therefore, programmes should be selected on the basis of
their viability, estimated offset credit value, ease of monitoring and
demonstrability of accruing benefits.
Application of Multipliers
As noted earlier, it is not the type of offset but its relevance to
own needs that should guide the selection. It is imperative that all
pre-contract offset activities be intelligently directed towards
programmes involving investment and/or transfer of technology. For
this purpose, offsets are commonly assigned ‘multiplier value’. It is
a factor applied to the actual value of an offset activity to
calculate the credit value earned. It is a methodology of assigning
differential weightage to various offset programmes to provide vendors
with irresistible incentives to offer offsets in targeted area of
their choice.
India must adopt application of multipliers if it wants to derive full
benefits. For example, no vendor is going to invest in India’s defence
R&D where the risks and uncertainties due to time and cost overruns
are enormous. It is only through the application of multipliers that
the foreign vendors can be persuaded to invest in the pre-selected
areas.
Efficient Monitoring Mechanism
Inadequately monitored offset activities have always proved wasteful.
Monitoring not only helps in achieving the objectives of the programme,
but also provides invaluable feedback for data storage and further
fine-tuning of the policy. Monitoring is a multifaceted and complex
task for the following reasons:-
| (a) |
There are no well-developed tools for
measurement and evaluation of cost-benefit equation.
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| (b) |
As limited data is made public in respect of
defence offset activities, no standard monitoring mechanism has
been evolved so far.
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Offset banking needs regular and close oversight. Many host nations
have found to their dismay that old and routine activities were
presented to them under the garb of offset programmes by smart
vendors. India must take due precautions before permitting ‘banking’
and have a properly constituted monitoring system in place to carry
out periodic reviews of the process and apply corrections, where
necessary. DOFA, duly strengthened by experts, could be assigned this
task.
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Regulation and Penalties for Default
All nations have in built safeguards in the form of penalty clauses.
The Indian policy also has clauses for penalties for default. But
these are applicable to offset obligations emerging from defence
contracts and not pre-contract activities. In case India decides to
introduce offset banking, it has to have systems and procedures in
place to ensure that vendors fulfill their commitments diligently.
Vendors should not be permitted to treat pre-contract programmes in a
casual and slapdash manner. Though anticipatory in nature, all
pre-contract activities consume considerable indigenous resources as
well. In case a vendor loses interest (may be due to market dynamics)
and wants to exit before completion, he must be penalised. He should
not be permitted to renege on his commitments just because his initial
offer was voluntary in nature and not due to any contractual
obligations.
Transparency and Close Oversight for Probity
According to Transparency International, offsets are ‘very open to
corruption’ as they remain on periphery and are subjected to less
scrutiny. Moreover, they are formulated in broad and unspecific terms.
Not all details of offsets are duly published. Security concerns of
the host countries and the vendors’ reluctance to share data (terming
it as commercially sensitive) render the whole programme open to
manipulations. The problem of vulnerability gets further aggravated in
case of offset banking.
Regular probity check is required in respect of the following aspects:
| (a) |
Grant of approval to only those programmes,
which bring in new economic gains to the country.
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| (b) |
Correct evaluation of credits, especially in
cases of transfer of technology.
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| (c) |
Regular monitoring for adherence to agreed
terms and conditions
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| (d) |
Imposition of penalties for default.
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Concerned functionaries have to ensure that no aspersions are ever
cast as regards probity, and this can only be done by maximum
transparency and laying down detailed instructions with no
discretionary powers. Over-sensitivity to security should be avoided
as it breeds unnecessary suspicions.
Conclusion
Offsets have come to stay. More than 130 countries are demanding
offsets in one form or the other. The current market for offsets is
estimated to be close to USD 50 billion and has given rise to a
flourishing worldwide trade in offset credits. These are bought from
companies having surplus credits and sold at a profit to defence
vendors who need them to fulfill their offset obligations. It is a
highly cost-effective option in cases where a vendor has to execute
offsets programmes in areas totally unrelated to his business. Growth
of offset banking is a natural corollary of offset trade.
Australia found its Defence Offsets Credit Scheme to be too
complicated and unwieldy, and replaced it with Defence Industry
Investment Recognition (DIIREC) Scheme in 1995. Instead of granting
‘bankable credits’, Australia decided to introduce a
recognition-centric scheme. DIIREC recognises investments made by
overseas companies in Australia’s indigenous Defence capability and
grants them favourable consideration in new Australian defence
contracts.
As regards India, it has just introduced offsets in its defence
procurement procedure and is yet to acquire the necessary skills. It
has rightly decided to follow a graduated and phased approach. That is
the reason why it has kept offset threshold at a high of Rs 300 crores
and fixed offset value at a meagre 30 percent. Provisions will be
reviewed as India gains better understanding of dynamics of offsets.
As seen above, offset banking is a highly complex affair needing
elaborate organisational setup with a dedicated expert agency. Unless
handled with due care and caution, there is a likelihood of the
country being taken in by clued-up vendors. Instead of economic gains,
India may get saddled with infructuous and wasteful activities.
Besides, it may give rise to unscrupulous dealings with consequent
trading of charges. India must, therefore, tread warily and exercise
due caution while considering introduction of offset banking.
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