Business Standard, 21st Jun 13
The Federation of Indian Chambers of Commerce and Industry (Ficci) has written to Defence Minister AK Antony, complaining that the Defence Procurement Procedure of 2013 (DPP-2013) is “failing to address the critical survival issue before the private sector today of risk cover against Exchange Rate Variation (ERV).”
Battered by the rising dollar that is testing the Rs 60 mark, the Indian private sector firms that made bold to enter defence production say they are losing the fight. Private firms must buy costly insurance against exchange rate variation (ERV), an added annual cost of about 6 per cent. Their overseas competitors bear no such risk.
“This effectively means that the private sector will continue to reel under the effects of a depreciating value of rupee and high cost of inflation losing on competitiveness vis a vis foreign OEMs [original equipment manufacturers] especially with the DCF [discounted cash flow] methodology (of calculating the lowest cost bidder) favouring foreign OEMs given the currency stability in the western world,” wrote Ficci Secretary General, A Didar Singh, to Mr Antony.
In comparing bids under the DCF process (which involves discounting all payments to be made in the future and reducing them to their present value) the DPP has inexplicably mandated a flat 9.5 per cent cost of capital, both for Indian and global companies. Indian CEOs point out that the real cost of money for a foreign vendor is far lower (about 3 per cent annually, given today’s one-year LIBOR rate of 0.7) than the 10-15 per cent that Indian firms borrow money at. This allows foreign vendors to bid significantly lower.
Ficci has also expressed deep concern that DPP-2013 has not implemented the defence minister’s oft-stated promise to end the “nomination” of DPSU’s in major defence programs.
“The retention of ‘Nomination of DPSU’s/OFB’ in DPP 2013… compromises MoD’s stated intent to make private sector a key player in defence production,” says Ficci’s letter.
Ficci points out that DPSUs/OFB get ERV protection in nominated tenders, which currently amount to some Rs 30,000 crore. This, say private sector CEOs, entirely changes the public sector’s perception of financial risk, providing greater assurance.
Also affecting DPSUs/OFB perception of risk positively, is the Progressive Payment Schedule, which governs MoD payments to the public sector for nominated tenders. This allows DPSUs/OFB to build up enormous cash balances. In contracts with private sector firms, the MoD pays 15 per cent advance; 75 per cent at the time of delivery of the equipment; and the balance 10 per cent linked with the warranty.
But the public sector enjoys a preferential schedule. According to a MoU, which the MoD has with all DPSUs/OFB, these companies get 15 per cent advance; and the final 10 per cent is also linked with warranty. But 75 per cent is paid incrementally, at different stages of manufacture, linked with milestones like placement of order, receipt of material, production of prototype, etc. This ensures a steady cash flow that is more reassuring than the “on delivery” payment implemented with the private sector.
Ficci’s letter raises another key private sector complaint: the MoD’s failure to rationalize taxes and duties on offsets. A telling case is that of electronics company, Astra Microwave, which builds radar components in an offset-linked contract with Israeli company Elta. The tax and duty regime at the factory gate of Indian companies makes it cheaper for Astra Microwave to export its components to Israel and then import them back to India, than supplying them directly from its factory.
Without rationalizing the tax structure, “the Indian defence sector will remain at sub-component level and not move up the value chain to achieve System Integration capabilities,” says Ficci.
But it is the falling rupee that has most affected the Indian defence industry, which has a 30-70 per cent share of foreign components even in “indigenous” weaponry. Defence industry sources say hedging costs were 6 per cent annually when the rupee was stable. A three-year hedge, the bare minimum given that defence contracts are typically discharged over 5-7 years, added 17-18 per cent to the forex component. Today, given the tumbling rupee, a three-year hedge adds 30 per cent to the forex cost.