CAG Report on Defence Offsets Policy Reveals Failures on All Fronts

While Parliament was in turmoil on the last day of the Monsoon session, the Comptroller & Auditor General (CAG) tabled its Report No. 20 of 2019, which is a review of the defence offsets policy since its inception in 2005 to the present day.

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. This has restricted public access to this important report.

Even the brief statement from the CAG, 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. However, the Rafale deal is not addressed in detail in the report, which carried out the performance audit of “Management of Defence Offsets.”

Financial Failure

The CAG report underlines in distinct terms what has been consistently argued in these columns from the outset of the offsets policy. Over the years, through the twists and turns of the numerous versions of the Defence Procurement Procedures (DPP), the offsets policy, as it was configured and implemented, could not deliver on the promise that India would acquire advanced military technologies or at least manufacturing capabilities.

The purpose of the offsets policy was not only to acquire advanced technologies and defence industrial capabilities, but also plough back some part of the huge amounts spent by India on acquisition of military equipment from abroad.

The policy aimed to do that by making it mandatory for the foreign original equipment manufacturers (OEM) to spend a substantial portion of the contract amount (30% or 50% depending on total contract value) in India in the form of purchase of related goods or services from Indian suppliers, or foreign direct investment (FDI) in 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, as many as 46 offsets contracts worth Rs.66,427 crore were signed. Of this, Rs.19,223 crore worth of offsets contracts should have been discharged in phases, but only Rs.11,396 crore or 59% have been discharged so far.

Worse, only Rs.5,457 crore worth of offsets, that is 48% of claims and a mere 8% of total offsets value, have been accepted by technical and internal audit authorities concerned as conforming to requirements. Even otherwise, the remaining Rs.55,031 crore is to be discharged by 2024 at an average rate of Rs.9,172 crore per year, compared with the average rate of Rs.1,300 per year. Even after discounting disputes on discharge of offsets, out of 19 offset contracts worth Rs.15,508 crore (that should have been completely discharged by 2018), only 10 offset contracts worth Rs.2,962 crore or just 19% of obligations were claimed as completed by the vendors.

The CAG 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 that there were no bank guarantees as insurance against non-performance (as in the Rafale contract), and 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 the verification of offset claims is so slow that it defeats the very rationale of the policy. For instance, the report cites (2.2a, p.7) the Boeing P8i maritime surveillance aircraft contract in which 90% of offsets have been claimed, but only 6% have been verified!

The CAG report also describes case after case of failure to ensure fulfillment of offset obligations of OEMs from different countries, such as the Mi-17 V5 helicopters from Russia’s Rosboronexport (2.9.1), unmanned aerial vehicles from Israeli Aerospace Industries (IAI) (2.9.2), the Rafale deal (2.9.3) and Boeing (2.9.4).

Many of these cases were the outcome of poor initial definition of offset projects by MoD. The detailed and repetitive nature of these failures also points to deeper problems, namely, India’s high dependence on defence imports, the country’s low bargaining power due to its tortuous procurement procedures leading finally to “emergency” requirements, and the fatally flawed system of announcing the winning or L1 bidder first and then 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 DPP, especially the offsets policy, which 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. The CAG report shows some awareness of these weaknesses, as the next section elaborates, but it does not address the underlying geo-strategic politics of military technology.

Technical-Industrial Failure

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

The report analyses the types of discharged offset projects, especially with respect to the stated goals. Till DPP 2012, there were three streams for discharging offset obligations -- direct purchase by the OEM of products/services from Indian offset partners (IOPs), FDI in Indian firms/JVs and FDI in Research & Development (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 three options.

Another finding by the report (2.3.1a) shows that an overwhelming 90% of the value of offsets was contracted through direct purchase of goods/services (of which only 36% was claimed) and only 3.5% through FDI in Indian firms/JVs (Nil claimed till 2018)!

All this despite various incentives such as the DPP revision in 2011 that included repair, maintenance, overhaul, and upgradation in offsets contracts. In the DPP 2013, transfer of technology (ToT) to offset partners, transfer of equipment/services to IOPs and high technology acquisition by Defence Research and Development Organisation (DRDO) were added to the offset avenues, with additional incentive of a 2x-multiplier if the IoP was an MSME (medium, small and micro enterprise) and a 3x-multiplier for advanced technologies to DRDO.

None of these have worked to bring in advanced technologies, and only one case has transpired in transfer of manufacturing equipment for artillery guns by Russia’s Rosboronexport to the Ordnance Factory Board (2.7).

Further, no technology transfer or investment in R&D has taken place to date (2.4)! The CAG report says that the 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, if not in so many words, severe weaknesses in the MoD or DRDO in effectively identifying offset projects (2.4), and 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 the 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 among a total of 48, just 16 IoPs had bagged five or more offset projects each and three IoPs had bagged 59% of the 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 is hardly such an entity 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%!

Rafale Deal

One cannot, of course, end this brief of the CAG report without discussing its mention of the Rafale deal in different places (mainly 2.9.3, p.17). These mentions are indeed 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 on the problems in such loading of offsets towards the end of the contract period, and on the difficulty of enforcement in the event of the OEM failing to fulfill its offsets obligations, it should be noted that the Rafale deal, too, did not have any bank guarantee--a weakness pointed out by the CAG.

The report notes the weakness of DRDO in identifying six earlier offset projects for technology acquisition (2.9.3), of which both France’s Dassault and its weapons systems partner, European missile maker 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 (ADAG) or at least of its promoter Anil Ambani who recently declared before a UK court that his “net worth is zero”, throws up in the air a large chunk of the offsets that Dassault were coerced or otherwise persuaded to discharge through a joint venture 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 France’s Safran, the manufacturer of Rafale’s engines. The DRDO is said to be extremely interested in acquiring engine technology from Safran, whether for “upgrading” the badly stuck Kaveri engine project for the Light Combat Aircraft (LCA) Mk2 or re-designing an entirely new engine for the Advanced Multi-role Combat Aircraft (AMCA) project.

The point to note is that the French aeronautical engineering industry, and Safran in particular, are among only four countries along with the US, the UK and Russia that have all-round capability in aero-engine design and manufacturing, which even China does not have (as evidenced by China’s continued Russian power plants even for its most advanced fighter aircraft).

The DRDO would do well to pro-actively rope in Safran into 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 the Narendra Modi government squandered or deliberately scuttled the earlier deal for 126 Rafale fighters, including 108 being produced in India by public sector Hindustan Aeronautics Ltd (HAL) along with manufacture of the engine in this country. Senior Safran executives include a Vice President who was once the Ambassador to India. Earlier this year, he said 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’s 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 for the motivations of foreign OEMs while transacting sales of military equipment, especially with regard to advanced technologies.

The government, too, seems blissfully unaware that merely raising FDI limits and urging foreign OEMs to invest in India are not only inadequate as an incentive but also demonstrate 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 United Arab Emirates have run fairly successful offset programmes for acquiring key technologies or industrial capabilities. Brazil’s highly successful Embraer civilian passenger airline is believed to have grown out of strategic acquisition of technologies through offsets.

India currently lacks a professional and technically competent system to identify technology and industrial gaps in the Indian ecosystem and formulate offsets projects which it should pro-actively pursue while being 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. The country should, instead, 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. Far from eliminating corruption, as bureaucrats claim it will, the procedures 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!