Defence Offsets: CAG Review and Govt’s Latest Changes

VIRTUALLY on the last day of the budget session of parliament while it was in turmoil, the Comptroller & Auditor General (CAG) tabled its Report No.20 of 2019, which is a review of the defence offsets policy all the way from its inception in 2005 till the present time. While a summary statement was released by CAG to the press, the detailed report has unfortunately not been posted on either the CAG website or on the websites of either house, restricting access of the public to this important report and the information contained in it. Even this brief statement, on which most media reports have been based, reveals the rotten state of affairs in the conceptualisation and implementation of the offsets policy, including in the controversial Rafale deal which, however, is not dealt with in detail in the report on the performance audit of “Management of Defence Offsets.”

The CAG report underlines in stark terms what has been consistently argued in these columns from the outset of the offsets policy, through the various twists and turns of the numerous different versions of the Defence Procurement Procedures (DPP) over the years, namely that the offsets policy as it was configured and implemented would not, indeed could not, deliver on the premise that India would acquire advanced military technologies or at least manufacturing capabilities. The purpose of the offsets policy was to acquire advanced technologies and defence industrial capabilities by ploughing back at least some part of the huge amounts spent by India on acquisition of military equipment from abroad, by making it mandatory for the foreign original equipment manufacturer (OEM) to spend a substantial portion of the contract amount (30 per cent or 50 per cent depending on total contract value) in India in the form of purchase of related goods or services from Indian suppliers, or FDI in related Indian defence industries, or transfer of advanced technologies.

The CAG report shows (para 2.2a) that from 2007 when the first offset contract fructified till 2018, 46 offsets contracts worth Rs 66,427 crores were signed. Of this, Rs 19,223 crores worth of offsets contracts should have been discharged in phases, but only Rs 11,396 crores or 59 per cent have been discharged so far. Worse, only Rs 5,457 crores worth of offsets, that is 48 per cent of claims and a mere 8 per cent of total offsets value, have been accepted by concerned technical and internal audit authorities as conforming to requirements. Even otherwise, the remaining Rs 55,031 crores are to be discharged by 2024 at an average rate of Rs 9,172 crores per year, compared to the average rate of Rs 1,300 per year. Even discounting disputes on discharge of offsets, out of 19 offset contracts worth Rs 15,508 crores that should have been completely discharged by 2018, only 10 offset contracts worth Rs 2,962 crores or just 19 per cent of obligations were even claimed as completed by the vendors.

The Report raises many questions about why such slippages were allowed or tolerated and why damages for non-delivery were not collected.   In some cases, it points out, there were no bank guarantees as insurance against non-performance (as in the Rafale contract), and in other cases where the amount of bank guarantee was less than the offset amount promised! The report is also sharply critical of the administrative system in the ministry of defence (MoD) where verification of offset claims is so slow as to defeat the very rationale of the policy. For instance, the report cites (2.2a, p7) the Boeing P8i maritime surveillance aircraft contract in which 90 per cent of offsets have been claimed, but only 6 per cent have been verified!

The report also describes case after case of failure in enforcing or ensuring fulfillment of offset obligations with OEMs from different countries, such as the Mi-17 V5 helicopters from Russia’s Rosboronexport (2.9.1), UAVs from Israeli Aerospace Industries (2.9.2), the Rafale deal about which more later (2.9.3) and Boeing (2.9.4), many due to poor initial definition of offset projects by MoD.  While technical aspects are dealt with in the next section, the detailed and repetitive nature of these failures also points to a deeper problem, namely the high Indian dependence on imports, the low bargaining power of India due to its tortuous procurement procedures leading finally to “emergency” requirements and the fatally flawed system of announcing the winning or L1 bidder and thereafter engaging in negotiations on price and offsets, and above all the full knowledge and exploitation of these weaknesses by foreign OEMs.

The financial failure is, however, only reflective of a much larger failure in the entire defence procurement procedure, especially the offsets policy,  which are riddled with procedural red-tape, shortage of technical and industrial knowledge, and an utter lack of appreciation of the motivations of foreign OEMs while transacting sales of military equipment, especially with regard to advanced technologies.  The CAG report shows some awareness of these weaknesses, as the next section shows, although not of the underlying geo-strategic politics of military technology.

The CAG report reveals that, along with the financial failures and perhaps more seriously, the offset policy has also totally failed in acquiring advanced technologies or even in significantly enhancing industrial or manufacturing capabilities, both the explicitly stated objectives of the offsets policy and the Kelkar Committee recommendations on which it is based.

The report analyses the types of offset projects discharged, especially with respect to the stated goals. Till DPP 2012 there were three streams for discharging offset obligations viz., direct purchase by the OEM of products/services from Indian offset partners (IOPs), FDI in Indian firms/JVs and FDI in R&D outfits. Clearly, acquisition of advanced technologies in terms of know-how or industrial capability would increase from the first to the third of these options.

The report finds (2.3.1a) that an overwhelming 90 per cent of the value of offsets were contracted through direct purchase of goods/services (of which only 36 per cent were claimed) and only 3.5 per cent through FDI in Indian firms/JVs (nil claimed till 2018)! All this despite various incentives such as the DPP revision in 2011 to include repair, maintenance, overhaul, upgradation in offsets contracts. In the 2013 DPP, transfer of technology (ToT) to offset partners, transfer of equipment/services to IOPs and high technology acquisition by DRDO were added to the offset avenues, with additional incentive of a 2x-multiplier if the IoP was an MSME and a 3x-multiplier for advanced technologies to DRDO. None of these have worked to being in advanced technologies, and only one case has transpired of transfer of manufacturing equipment for artillery guns by Rosboronexport of Russia to the Ordnance Factory Board (2.7). And no technology transfer or investment in R&D has taken place to date (2.4)! The CAG report says MoD while accepting this fact, has tried to shift the blame on to OEMs choosing its own offset projects, even though this was an option given to OEMs under the DPP itself!

The report also brings out, although again not in so many words, severe weaknesses in MoD or DRDO in effectively identifying offset projects (2.4), keeping in mind requirements of the R&D and industrial ecosystems in India. Not pro-actively identifying technology or industrial projects is perhaps the biggest failure of the offsets policy, and needs to be identified as such.

A related failure of MoD is not pro-actively upgrading the industrial infrastructure and capability to absorb technology inflows through offsets. The CAG report shows that, out of a sample of 28 offset contracts studied in a total of 48, just 16 IoPs had bagged five or more offset projects each and three IoPs had bagged 59 per cent of offset projects, revealing the narrow base of the Indian defence industry (2.2b).

This also underlines the futility of the government’s efforts to promote private players in the defence ecosystem while the reality is that there are hardly any with the requisite capability. The same applies to the failure of the offsets policy to incentivise FDI in the Indian defence industry, despite desperate attempts by the government to progressively raise the FDI ceiling in defence to 74 per cent!

One cannot of course end this necessary brief of the CAG report without discussing the mention it makes of the Rafale deal in different places (mainly 2.9.3, p17). These mentions are of course cursory given that the offsets are to commence three years after the signing of the deal in 2016 and are to be completed over seven years till 2023, with the offsets loaded in the final two years. Since the report has commented about the problems in such loading of offsets towards the end of the contract period, and the difficulty of enforcement in the event of failure by the OEM in fulfilling its offsets obligations, it should be noted that in the Rafale deal too there is no bank guarantee, a weakness pointed out by CAG.

The report notes the weakness of DRDO in earlier identifying six  offset projects for technology acquisition (2.9.3) of which both Dassault and its weapons systems partner MBDA ruled out five as being outside their core competence!

Regrettably the CAG report does not deal with other foreseeable problems in the Rafale deal offsets as well as the potentialities that require to be pro-actively pursued.

The complete collapse of the Anil Dhirubhai Ambani Group, or at least of its promoter Anil Ambani who has declared before a court that he is essentially broke, throws up in the air a large chunk of the offsets that M/S Dassault were coerced or otherwise persuaded to discharge through a JV with ADAG.

MBDA should be able to discharge their offsets obligations by sub-contracting missile assembly or other weapons systems to Indian firms to be discharged by M/S Safran, the manufacturer of Rafale’s engines. DRDO is said to be extremely interested in acquiring engine technology from Safran, whether for “upgrading” the badly stuck Kaveri engine project for the LCA Mk2 or re-designing an entirely new engine, probably in collaboration with Safran, for the Advanced Multi-role Combat Aircraft (AMCA) project.

Point to note is that the French aeronautical engineering industry, and Safran in particular, are among only four countries along with the US, UK and Russia, to have all-round capability in aero-engine design and manufacturing, which even China does not have, as evidenced by its continued Russian power plants even for its most advanced fighter aircraft. DRDO would do well to pro-actively rope in Safran into an R&D collaboration for an engine design or upgradation project.

This would be at least one technology absorption project that India could finally salvage out of the Rafale deal, after this government squandered or deliberately scuttled the earlier deal for 126 Rafale fighters with 108 being produced in India by HAL including manufacture of the engine in this country. Senior Safran executives including a vice president who was once ambassador to India, said early this year that Safran would be happy to collaborate with DRDO on this and that discussions are underway. It is to be hoped that the government does not find a way to scupper this as well!

In conclusion, the CAG report on offsets is welcome but does not go far enough. Maybe it is too much to expect an audit to address the more complex issues involved. The problem is that the MoD system for offsets, and indeed for defence procurement in general, is riddled with procedural red-tape, shortage of technical and industrial knowledge, and an utter lack of appreciation of the motivations of foreign OEMs while transacting sales of military equipment, especially with regard to advanced technologies.  Government too seems blissfully unaware that merely raising FDI limits and urging foreign OEMs to invest in India is not only inadequate as an incentive, it betrays a complete ignorance of the small and monopolistic world of advanced military technologies. If India wants to leverage its huge imports of advanced military platforms for gradually obtaining and building advanced technologies, know-how and manufacturing capabilities, it has to do it in a very purposeful, mission-oriented and targeted manner.

More than 130 countries have offset programmes. Spain, Brazil, Turkey, Malaysia and even the UAE have run fairly successful offsets programs for acquiring key technologies or industrial capabilities. Brazil’s highly successful Embraer civilian passenger airliner is believed to have grown out of strategic acquisition of technologies through offsets. India currently lacks a professional, technically competent system to identify technology and industrial gaps in the Indian ecosystem and systematically formulate offsets projects which it should pro-actively pursue, organically linked with defence acquisitions. India also needs to abandon the primitive system of declaring a single L1 winner, and then negotiate with this one party with no bargaining power and, instead, should identify at least two potential winners and negotiate simultaneously with both covering all aspects including offsets and select the best deal. Long-winded procedures with all sorts of detailed steps only serve to tie India’s decision-making system in knots and, far from eliminating corruption as bureaucrats claim it will, only provide more loopholes and scope for subjective interpretation and incentives for some people to find a way out of the maze. Or maybe that is the point!