‘Offsets’ set off political fireworks
The row over Rafale deal also centres around selection of Reliance Defence as an offset partner. Here is all that you need to know about defence contracts

What is Offset?

*Offset in defence procurement is exploiting the buying power (import) of a country to get world leading companies to invest in the importing country in terms of FDI, transfer of technology and most important by generating industrial capability to produce eligible products and services

*Most countries in the world, especially the developing countries, use offset route to gain economic benefits when buying defence equipment from foreign suppliers

*The offsets are expressed in terms of percentage (per cent) of the main supply contract value. For example, if we say that offsets are 30 per cent, it means that if the main supply contract values $100m, the offsets will be to the tune of $30m

*Different countries have different offset policy. Offsets could range from 30 per cent to even more than 100 per cent of the main contract value. South Korea and Saudi Arabia are amongst the most benefitted countries of the world through offsets

*As per DPP 2016, the extent of offset obligation is limited to 30 per cent of the contract value

*It is expected that nearly $14b worth of defence offset obligations would be discharged by foreign vendors in India over next 10 years

*Broadly, offsets are of two types – Direct Offsets and Indirect Offsets

(a) Direct Offsets:             Direct offsets are those obligations which are to be fulfilled by a vendor supplying goods in the same industry, which such goods characterise. These are related to the system being procured and are typically in the form of co-production, subcontracting, licenced production and technology transfer

(b) Indirect Offsets: Indirect offsets are unrelated to the items imported by the buyer. These include supplying goods in industries other than those represented by the items contracted. The rationale behind indirect offsets is to promote growth and development of not just a specific industry but all other local industries with assured revenues. Such offsets usually include counter trade transactions, investment, financing activities, export related assistance, and technology transfer

*Globally, during the period 1993-2011, direct offsets accounted for 40.8 per cent of all offset transactions as compared to 58.8 per cent for indirect offsets. In the early years of offsets implementation in Indian defence procurements, DPP-2006 permitted only direct offsets. However, with passage of time the offset policy changed and allowed indirect offsets. Presently, civil aerospace and internal security products are also eligible

*In India, concept of defence offsets was introduced based on the Kelkar committee (2005) recommendations, to bolster indigenous manufacturing capability. This policy, which is in vogue in nearly 130 countries, aims at leveraging big ticket acquisition in defence to inveigle the OEMs to:-

(a) Outsource orders to the importing country

(b) Prop up their export

(c) Encourage FDI inflow and

(d) Transfer key technologies

 

Indian Offset Policy

*Since introduction in 2005, the offset policy has undergone substantial changes. The details of the offset policy guidelines are captured in the Defence Procurement Procedure (DPP)

*The important aspects of the Indian defence offsets policy are:

(i) It is applicable only on two out of the five procurement categories that is ‘Buy and Make’ and ‘Buy (Global)’

(ii) Offsets are applicable in contracts where the procurement value is ₹2000 crore or more

(iii) Offset contract is separate from the main contract and is always signed between the Indian MoD and the foreign vendor

(iv) The duration of the offset contract is same as that of the main supply contract including the warranty period i.e. the offset contract is coterminous with the main contract

(v) Even if the main contract happens to be an Inter-Governmental Agreement (IGA) between Indian and foreign Government, the offset contract has to be signed between the Indian government (MoD) and foreign vendor

(vi) The prime vendor of the equipment under the main procurement contract is responsible for the fulfilment of offset obligations. However, the prime vendor may allow his Tier-1 sub-vendors under the main procurement contract to discharge offset obligations, to the extent of their work share (by value) in the main contract. However, prime vendor will remain overall responsible and liable for the full discharge of offset obligations

(vii) The foreign vendor is allowed to bank his offset credits for use in a future supply contract, subject to a maximum of 50 per cent of the total offset obligation in each procurement contract. For example, if a vendor has $10m offset credits banked from earlier contracts and in a future contract he has offset obligation of $50m, he can use $10m banked offset credit. That means he will need to look for new offset contracts worth $40m

(viii) The banked offset credits remain valid for a period of seven years from the date of acceptance by Defence Offsets Management Wing (DOMW) at MoD

Indian Offset Partners (IOP)

The foreign vendor discharges his offset obligations through his Indian Offset Partner (IOP), which can be from private or public sector or even Govt agency such as DRDO and Ordnance Factory Board (OFB) or a mix of these. The selection of the IOP is left entirely to the foreign vendor and Indian government does not have any role to play in the IOP selection process. This policy has been consistent since 2005

*Under the offset guidelines, it is not mandatory for the foreign vendors to even mention the names of their IOPs in the offset contract as they are at liberty to make a choice based on business requirements. The names of the IOPs can be officially communicated to the MoD either at the time of seeking offset credits or one year prior to discharge of offset obligations through that IOP

Avenues for Discharge of Offset Obligations

*DPP-2016 permits six avenues for discharge of offset obligations, which are:

(i) Direct purchase of, or executing export orders for, eligible products manufactured by, or services provided by Indian enterprises

(ii) Foreign Direct Investment in joint ventures with Indian enterprises (equity

investment)

(iii) Investment in “kind‟ in terms of ToT to Indian enterprises for the manufacture and/or maintenance of eligible products

(iv) Investment in “kind‟ in Indian enterprises in terms of provision of equipment through the non-equity route

(v) Provision of equipment and/or ToT to Government institutions and establishments engaged in the manufacture and/or maintenance of eligible products

(vi) Technology Acquisition by the DRDO in areas of high technology

It may be noted that:-

(a) A minimum of 70 per cent offsets should be executed through combination of avenues (i) to (iv)

(b) Offsets under (vi) is restricted to 30 per cent of the total offset obligations

Organisation at MoD for Management of Offsets

*Acquisition Wing: The Acquisition Wing under DG (Acquisition) in the MoD is responsible for:-

(a) Technical and commercial evaluation of offset proposals received in response to RFPs

(b) Conclusion of offset contracts

*Defence Offsets Management Wing (DOMW): The DOMW in the MoD under Secretary Defence Production is inter-alia responsible for:

(a) Formulation of offset policy guidelines

(b) Interfacing between foreign vendors and Indian industry

(c) Management of offset contracts

Benefits of Offsets for the Importing Government

*Why do governments pay 8-10 per cent extra for offsets? The offsets act as catalysts for the defence manufacturing eco-system of the country. The important benefits of offsets are:

(i) It brings critical and key technologies to India from the foreign OEMs for manufacturing of defence/civil aerospace/dual use products

(ii) It reduces the country’s dependence on foreign vendors for future imports. For example, when South Korea purchased F-16 fighters from Lockheed Martin of USA, it learnt how to manufacture basic trainers as part of offsets. The KT-1 basic trainer aircraft manufactured by Korea Aerospace Industries was co-designed and co-developed with Lockheed Martin as part of offset obligations of the US firm. Subsequently, South Korea not only manufactured KT-1 for Korean Air Force but also exported it to many countries.

(iii) It creates large number of skilled jobs in the country. The discharge of offsets include training, technical assistance of workers by the foreign vendors and their subsequent employment in the manufacturing setup being established as part of offsets

(iv) Offsets bring in Foreign Direct Investments (FDI) in Joint Venture companies with an Indian partner. At present, the Indian Government has allowed 49 per cent FDI under automatic route in defence manufacturing sector. Special case to case approval of competent authority will be required for FDI more than this cap.

(v) Foreign vendors tend to shift their operations to India to take benefits of cheap skilled labour and earn offset credits at the same time. This would result in creation of credible defence manufacturing ecosystem in the country and boost exports resulting in earning of FOREX

Global Offset Trend

*Based on 2 report by Frost & Sullivan:

(i) The total forecasted global offset market size is pegged at $ 113 Bn in the ten year period 2012-21 at a Compounded Annual Growth rate (CAGR) of 3.5 per cent

(ii) Saudi Arabia and India are expected to be the largest offsets markets and primary growth drivers in offset market

(iii) The top five countries by offset market size in this period are:

1st:       Saudi Arabia

2nd:      India

3rd:      Brazil

4th:       South Korea

5th :      UAE

(iv) The top five countries by CAGR  per cent in offset market in this period are:

1st:             Indonesia (7.5 per cent)

2nd:      Poland (6.1 per cent)

3rd:      South Korea & Taiwan (5 percent)

4th:            Singapore (4.5 per cent)

5th:       UAE (4.3 per cent)

*India, at a CAGR of 3 per cent, stands at 14th out of top 20 offset markets in this respect