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Strategic Defence

Advisability Of Allowing Indirect Offsets
By Major General Mrinal Suman, May 2012 [[email protected]]

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Although India’s defence offset policy was first introduced in Defence Procurement Procedure – 2005, detailed policy guidelines were issued in May 2006. Having decided to adopt an approach of gradual, incremental and phased application of offsets, India has been making changes in the policy during periodic reviews. However, the basic contours remain unchanged. Offset threshold and offset percentage have been retained at Rs 300 crores and 30 percent respectively.

Taking cognizance of the inputs received, Ministry of Defence (MoD) allowed offset banking in 2008. More importantly, the requirement of prior registration by Indian offset partners was done away with. As fulfillment of offsets was restricted to the export of defence products/services and FDI in defence industry/R&D, foreign vendors felt constrained. Acceding to their repeated requests, MoD expanded the scope of offset programmes to include civil aerospace, internal security and training fields in 2011, thereby offering vendors wider choice to fulfill their obligations. The term ‘defence products and services’ was replaced by ‘eligible products and services’. This was a major step. 

Items for internal security like arms and ammunition; protective equipment and vehicles; surveillance and night fighting devices; counter-insurgency equipment and gears; and training aids have since been added to the list of ‘eligible products’. Civil aerospace products like air frames, aero engines, aircraft components, avionics, raw material and semi-finished goods have also been included in the list. Similarly, the term ‘services’ for the purposes of discharge of offset obligations has been defined to include maintenance, overhaul, upgradation, life extension, engineering, design, testing of eligible products and related software or quality assurance services. As regards training, only training services and equipment have been made eligible for offset credits.  

Offsets and their Categorisation

Offsets are best described as formal arrangements of trade wherein a foreign supplier undertakes specified programmes with a view to compensate the buyer as regards his procurement expenditure and outflow of resources. In other words, the supplier undertakes programmes to generate benefits for the economy of the buyer country. It is a formal arrangement as it has inbuilt contractual obligations. Many consider offsets to be some sort of a leverage exploited by a buyer to obtain compensatory benefits.

Generally, offsets are categorised on the basis of their fields of activities, as follows:-

Direct Offsets. Transactions that are directly related to the primary defence items or services being contracted in the main contract. Direct offsets in their simplistic form may include buy-back or co-production or licensed production or sub-contracts of the system and its sub-systems. In this arrangement, the seller helps the buyer produce the product or a part thereof and purchases it back for incorporation in all similar systems sold by him elsewhere in the world.

Indirect Offsets. These are transactions that are not directly related to the defence items or services being exported in the main contract. Indirect offsets have a much wider scope and transcend other economic or social activities. They generally take the form of compensation trading. Reciprocal trade, counter purchase, switch trading, counter deliveries and parallel trade fall under this category. The importance of indirect offsets can be gauged from the fact that over the years a definite shift is discernible towards them. Today, indirect offsets outnumber direct offsets by two to one, as the buyer countries have realised their immense economic and social potential. 

Over a period of time, indirect offsets have been further sub-categorised to specify the areas they relate to. All indirect offsets that relate to defence goods and services are called ‘semi-direct’ or ‘indirect offsets (defence-related)’. On the other hand, all offset activities that span non-defence sectors are called ‘indirect offsets (non-defence related)’ or simply ‘indirect offsets’.     

As stated above, India allows offset programmes in defence, civil aerospace and internal security fields. Both civil aerospace and internal security are analogous to defence sector and are presently dominated by the public sector production agencies under MoD. Therefore, it will not be incorrect to state that India’s current offset policy accepts ‘semi-direct’ or ‘indirect offsets (defence-related)’. On the other hand, India does not allow indirect offsets that are not related to defence or defence-like fields.

Increasing Demand for Indirect Offsets

Reforms are an evolutionary and continuous process. MoD deserves credit for being open to receiving suggestions from the environment and incorporating changes in the policy after due consideration.

India is expected to import foreign military equipment worth USD 120 billion during the next few years. With offset percentage fixed at 30 percent, the quantum of offset obligations will be close to USD 36 billion. Foreign vendors are anxious about the capability of the Indian defence industry to absorb offset orders of such enormous magnitude.

They consider inclusion of civil aerospace and internal security to be of peripheral importance as all items mentioned under internal security already appear in the list of defence products. Most of these items are produced by ordnance factories. As regards the civil aerospace sector, HAL (a MoD undertaking) occupies a monopolistic position in the Indian aerospace industry with a few private sector companies being fringe players.

Therefore, foreign vendors are pressurising MoD to widen the scope of offset activities to include fields that are unrelated to defence. In other words, foreign vendors are demanding introduction of offsets covering other social, industrial, infrastructural and economic sectors. For the sake of brevity, all non-defence related offsets will be referred to as indirect offsets for further discussion.  

Introduction of Indirect Offsets
Offsets do not come for free and entail considerable cost penalty. As can be seen in Illustration 1, cost penalty increases with an increase in the offset percentage demanded, albeit not in direct proportion. An offset requirement of up to 50 percent inflates the cost of the main contract by close to 10 per cent. It is an empirical estimate as the actual cost penalty depends on the type of offset programmes undertaken.

Illustration 1: Relationship between Offset Percentage and Cost Penalty

Indian policy has pegged offset percentage at 30 percent, with the sole exception of MMRCA deal where it has been raised to 50 percent. It implies that India would be incurring an additional expenditure on account of offsets to the tune of USD 12 billion (10 percent of the proposed USD 120 billion shopping list).  It is a colossal sum by all accounts. To ensure that commensurate benefits are obtained by the country and the funds are not frittered away, the complete gamut of offset process has to be duly streamlined.  

Before accepting indirect offsets, India must pay attention to the following five facets (See Illustration 2): -

Formulation of Policy. Offsets should form a part of an overall national endeavour with well-specified aims. A national policy needs to be formulated with the objectives that are sought to be achieved through offsets duly spelt out. The policy statement should also lay down offset thresholds and indicate the areas in which offsets are preferred. This is by far the most critical aspect as it is not the quantum of offsets but the relevance of the areas in which they operate that determines their usefulness.

Creation of Required Structures and Organisation. An overarching authority is required to be set up under a nominated nodal ministry at the national level to oversee the complete gamut of offset activities. It should give ‘in principle approval’ to offset packages for all high value import deals and should consist of members from various ministries dealing with commerce and industry. It should also have representatives of Indian industry – both public and private sectors. Other experts from different fields should be co-opted as and when required. It should issue necessary directions for apportioning required weightage to direct and indirect offsets; prioritise areas/fields in which offsets should be sought; fix offset thresholds for different types of procurements; and issue guidelines to all concerned ministries for fixing offset percentages.

Finalisation of Offset Programmes. This process starts with the issuance of tender documents in which requirement of offsets is specified. Once bids are received from the vendors, they are evaluated along with their offset packages. Discussions are carried out for seeking clarifications from the bidders, if required. Once the successful bidder is identified, a detailed dialogue is initiated with him to draw out a mutually acceptable offset plan, which is flexible, realistic, realisable and practical. The plan should spell out proportion of direct and indirect offsets, and identify fields for offset programmes with their multiplier values with inter set priorities.

Illustration 2: Facets of a Well-evolved Offset System

Negotiation of Offset Contracts. Negotiations are carried out with the vendor to discuss specific projects in each field to have an optimally balanced mix. Thereafter, expert groups are constituted for different projects and their reports included in the offset contract document. All aspects including levels of technology, value addition, penalty clauses, measurement methodology and time frame for implementation are spelt out in clear and unambiguous terms. To cater for unforeseen contingencies, offset contracts should have adequate inbuilt flexibility.

Monitoring of Offset Programmes and Award of Credits. As offset contracts remain on the periphery, it is rightly said that an unmonitored offset programme never delivers. Therefore, it is essential that their implementation is closely and regularly monitored by a properly constituted oversight authority that can apply timely corrections to put a non-performing programme on track.  Offset credits should be awarded to a vendor only after ascertaining successful completion of a programme. Feedback is also collated to recommend changes in the policy provisions to improve efficiency of the offset regime. 

Although all facets are distinct, a certain degree of overlapping is natural. As can be seen, management of offsets requires multi-disciplinary expertise. This requirement becomes more pronounced in the case of indirect offsets wherein their functioning falls under the superintendence of multiple ministries. Therefore, it has to be a well coordinated effort at the national level. No single ministry by itself can identify and monitor offset programmes covering the entire spectrum of economic and industrial fields.

Limitations of Indian Defence Offset Policy

India has no national offset policy. Indian defence policy is a stand-alone and an exclusive endeavor of MoD. No other ministry is involved. In case MoD decides to accept indirect offsets, it will be faced with the following predicaments:-
• Who will identify non-military fields in which indirect offsets should be sought?
• Who will prioritise the identified fields and assign inter se weightage to them?
• How will multiplier values be determined for each offset programme?
• Who will provide necessary skills to negotiate offset deals pertaining to different sectors and sign contracts?
• Who will monitor and validate successful implementation of offset programmes for the grant of credits?  

Needless to say, all the above mentioned issues are beyond the competence of MoD. It will have to depend on the expertise of the concerned ministries who are unlikely to respond at the behest of MoD. Therefore, an empowered coordinating authority at the national level is an inescapable prerequisite before considering acceptance of indirect offsets.

It must also be borne in mind that there are four major risks involved with indirect offsets. One, indirect offsets can result in a loss of focus, away from the main contract under MoD as inter-ministry coordination can be quite vexing and exasperating.

Two, as offset contracts have to be completed co-terminus with the main contract, any delay in offset programmes can adversely affect completion of the main contract. Worse, MoD cannot expedite indirect offset programmes as these would be functioning under the superintendence of other ministries. Imposition of penalty for default and its recovery by way of deduction from the bank guarantee of the main contract or the amount payable to the vendor under the main contract can vitiate the working environment.

Three, whereas offset cost penalty will be borne by the defence budget, benefits will not accrue exclusively to the indigenous defence industry. Finally and most worrisomely, indirect offsets are highly vulnerable to corrupt practices as they span multiple ministries and remain under peripheral supervision.   Allegations of malpractice in offsets can even endanger the main contract as MoD will be hard pressed to initiate punitive action against the delinquent vendors.

The Way Forward

Howsoever desirable indirect offsets may be India is not yet ready to accept them, as seen above. As indirect offsets would overlap all ministries, it will well nigh be impossible for MoD to interact with other ministries and obtain their enthusiastic participation. Therefore, to start with, India should evolve a National Offset Policy (NOP) with clearly spelt out aims and objectives. Policies applicable to different ministries should flow from it.

NOP should be pragmatic with long term applicability and sufficient inbuilt flexibility to cater for changing situations. It should contain directions for apportioning weightage to direct and indirect offsets along with norms for fixing offset threshold and offset percentages. It should also lay down guidelines for approving, validating, discharging and measuring offset contracts.

Union Commerce Ministry should be tasked to act as the nodal ministry for offsets in all fields. Necessary structures and organisations will need to be set up both at the Commerce Ministry and other concerned ministries. All high value offset packages of Rs 1,000 crores and above should be handled by the Commerce Ministry whereas powers to manage packages of lesser value should be delegated to respective ministries.

Offsets should not be viewed in isolation as one-time agreements, but as an important and integral element of long-term national policy. To derive full benefit from offsets, it is absolutely necessary to understand the dynamics of offsets.  Inappropriately selected and poorly monitored offset programmes invariably prove to be highly wasteful in national resources and uneconomical for their value.   

Finally, India possesses enormous leverage with its huge shopping list. This power should ideally be used to fill a critical technological void or fulfill an important economic need. Offset policy should be in consonance with the national economic objectives and the immense potential of offsets should be exploited as engines of national economic growth and technological upgradation of the indigenous defence industry.

First published in Defence and Security Alert May 2012

About Author – Major Gen Mrinal Suman is India’s foremost expert in defence procurement and procedures and offsets. He heads Defense Technical Assessment and Advisory Services Group of CII.

Also read
Defence Offsets and Transfer of Technology
Defence Procurements: Time for Radical Reforms

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