Mumbai: India’s defence spend is expected to hit $620 billion between fiscal years 2014 and 2022, with half of it going into capital expenditure (capex), potentially turning a leading buyer of expensive arms into an arms supplier to rich nations.

Driven by both domestic and external demand, the annual opportunity for Indian companies—both public and private sector—is expected to reach $41 billion by fiscal year 2022 and $168 billion between fiscal 2014-2022, according to a report by industry association Federation of Indian Chambers of Commerce and Industry and financial services firm Centrum Capital Ltd.

The report, released earlier this month, noted that the government has consistently underspent vis-à-vis budgets set for the domestic defence sector, mainly due to procedural delays.

Majority of the spends were for maintenance and paying salaries of the Armed Forces rather than for buying new equipment.

“This anomaly is being taken very seriously by the government, which is planning to shift the current operating expenditure :capital expenditure ratio of 60:40 to 50:50 and eventually take it to 40:60 in the long term. Policy level changes in the past 2-3 years are considered positive by industry players," the report noted.

“Realisation of the importance of private sector for upgradation of arms is a major positive. We expect the domestic demand to be the primary force to drive industry growth," it said.

The report said fiscal strains on the balance sheets of developed countries will lead to global firms starting to look for cheaper sourcing of products and services from other countries.

“We believe India has the key ingredients (large and relatively low cost engineering talent pool along with comfort of Western nations with India from a geo-political perspective) to deliver on the opportunity," the report said.

“However, India will have to significantly improve on some other factors (technology, lack of a defence manufacturing ecosystem, etc.)," the report added.

Besides, the nature of warfare becoming more software intensive plays to the strengths of India, with its IT sector growth and its diversified presence.

Post a 10-15 year learning curve, some Indian companies are expected to move up the value chain and become independent system integrators across the technology-design-system integration value chain, either by themselves or as part of significant consortia, the report noted.

This will in turn drive growth in the defence sector, as Indian companies ramp up their capacities to cater to growing domestic demand.

Sandeep Upadhyay, senior vice-president and head infrastructure solutions group at Centrum Capital, said he believes the Indian defence sector is at an inflexion point and poised to grow at a sustainable high rate in the next decade.

“The prolific growth opportunities highlighted in the report, backed by a renewed focus from the government on streamlining policies and cultivating a conducive investment climate, potential investors should consider it as a strategic investment alternative," he said.

India’s defence spend is large when compared with spends on other parts of the economy, but is under-represented in terms of market capitalization on listed stock exchanges. The defence spend has been in the range of 2-2.5% of the nominal gross domestic product (GDP) in the past decade, while market capitalization of Indian defence companies has never been above 0.7% of GDP at any given point in time.

There are several reasons for this. A large part of the spend (60% currently) is revenue expenditure—which is internal in nature. Unlike in the US, where some non-core functions are outsourced, the Indian Armed Forces have always relied on doing these functions internally.

“We see these functions changing over the next 5-10 years though we believe this area is unlikely to grow as fast as the capex," the report said.

Also, of this capex (40% of the budgeted spend), about 70% is imported—India is among the largest importers of weapon systems globally. This is reflected in the lower revenues of Indian corporate entities.

The main public sector units in defence are Hindustan Aeronautics Ltd, Bharat Electronics Ltd (BEL), Bharat Earth Movers Ltd (BEML), Mazagon Docks Ltd and Bharat Dynamics Ltd. Of these, BEL and BEML are listed on Indian stock exchanges BSE and NSE.

The large private sector companies are all part of listed entities—such as Larsen & Toubro Ltd (L&T), Tata Power Ltd, Tata Motors Ltd, Mahindra and Mahindra Ltd, Bharat Forge Ltd—or unlisted holding firms such as Tata Sons Ltd.

“We believe indigenization will take center stage and gather pace going forward. Government took a number of steps in this direction, by opening up defence production to the private sector and allowing 26% FDI (foreign direct investment) in 2001 and defined categorization hierarchy in favour of indigenous procurement in 2013," the report said.

Recently, the FDI limit was further raised from 26% to a composite cap of 49% (FDI and FII) through the Foreign Investment Promotion Board route with full Indian management and control.

The report hopes that the government’s Make in India initiative will also help Indian defence firms step up manufacturing.

The initiative, launched by Prime Minister Narendra Modi, includes simplification of the “Make" procedure, financial incentives such as tax holidays, and incentivizing research and development.

The government has also streamlined its offset policy with innovative components, giving a thrust to medium and micro, small and medium enterprises sector, and simplifying export rules.

The offset clause stipulates that 30-50% of the armament purchase value should be spent on buying Indian components, sub-systems and products.

As part of capital purchase agreements with foreign defence firms, it is aimed at building an ecosystem of domestic suppliers.

“It has also been decided to promote defence and aerospace exports through an export promotion body," the report said. “We believe that this initiative will incentivize private players to invest more into Aerospace and Defence sector and help exports grow."

“In the next 5-10 years we expect Indian players to become systems integrators. We believe this process could be hastened by inorganic initiatives by groups with deep pockets (L&T, Tata, Mahindra & Mahindra, Reliance Industries, Bharat Forge, etc.) who may pick up assets divested by foreign defence players as they restructure and become trimmer," the report added.

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