Strategic Partnership model for Defence - Modi govt's SEZ moment?

After a long and tortuous journey, the Ministry of Defence (MoD) recently finalised the Strategic Partnership (SP) model for defence manufacturing. The salient points of the new policy are as follows:

1. Four key systems - Single engine fighter aircraft, helicopters, submarines and Main Battle Tank/Armoured Fighting Vehicles - have been opened up for private sector manufacturing. While the first two have been opened up exclusively for private sector manufacturing, the last two are open for PSU/OFB to bid for as well.

2. There will be ONE SP per project selected.

3. The SP will require tie-ups with foreign Original Equipment Manufacturers (OEM), to cover manufacturing, transfer of technology (ToT), assistance in training skilled human resources and other support.

The putative objectives of the policy are clear and have been discussed for years. Create a Military Industrial Complex (MIC) in India, provide competition to an inefficient PSU eco-system, and prmote indigenous solutions to our large defence requirements. The question is, does the policy do so?

Shorn of the hype and hyperbole, not only does the policy not seem to achieve any of the stated objectives, it in fact lends itself to massive rent-seeking opportunities (or at least motivations for the same). At its core, the policy seems geared to simply replace a public sector license-manufacturing monopoly into a private sector license manufacturing monopoly. 

Lets look at the structural elements. 

First, the defence industry, by its very nature, is a monopsony (a market that has only one buyer, and multiple sellers). Typical other examples of monopsony markets are Railway engines, British National Health Service. In such a market, the buyer can maximise value from this market by promoting a high level of competition among many sellers. The issue though is, military technologies, by their very nature, are available with few companies/entities. Ergo, in the best of times, it is difficult to find enough competing sellers to foster genuine competition. Governments around the world therefore try various incentives to foster competition. The new SP policy however, reverses the logic, by creating monopolies in key areas. In short, now the monopsony buyer (the government) creates a monopoly seller to buy from, instead of fostering wide competition to derive maximum value for itself!

Second, the structure envisaged in the new policy is exactly what has prevailed for many decades in India. Typically, the government (and the military) ask a bunch of foreign OEMs to bid for a contract, select one from those who respond (or remain left in the fray after many years of dilly dallying), and then designate a PSU (or OFB) to license produce the product in India. From Mig21s to Su30s, T55s to T90s - this has been the model adopted. The new policy simply replaces the PSU license producer with a selected PRivate Sector SP. The process remains the same - a foreign OEM provides the know-how, a partner Indian SP sets up the manufacturing facilities to license produce the system in India. In other words, convert a public sector monopoly into a private sector monopoly!

Third, the policy supposes that somehow private ownership is the panacea of all ills plaguing the defence industry. Problem is, private sector operates on principles of profit maximisation (as it should). When a policy seems geared to award monopoly status around license manufacturing of a major system owned by a foreign OEM, there is little incentive for the SP to invest in large R&D and achieve true self sufficiency. Long years of license production of Mig21 didnt enable HAL to design a new fighter (or fighter engine) on its own, because it knew when the time comes, it will license manufacture the next generation (which it did, with the Su30). Similarly, a monopoly private company license producing the F16 (say) has no incentive to set up capabilities to design and manufacture the next generation of single engine fighter. It would rather focus on maximising profits for the assembly line by "working the system".

Many years ago, the UPA government unveiled an ambitious SEZ policy, to emulate China's success with SEZ. But thanks to the design of the same, the policy became a tool for tax avoidance and real estate - related land grabbing. Very quickly, the entire process got embroiled in litigations, allegations of corruption and controversies. It was a design defect with the policy itself. The defence SP policy portends to a similar fate