MSMEs In Defence Production: A Neglected Sector

By Air Marshal Dhiraj Kukreja

Mission “Make in India” was launched a year ago, to transform the country’s economy by taking the focus away from the services sector and convert the nation into a manufacturing hub.

To achieve success in the initiative, an ecosystem was planned to be put in place with simplified licensing procedures, lesser bureaucratic hurdles and red tape, with an easy inflow of investments; the initiation of the process was to begin with defence manufacturing.

New policies have been released in the recent past, more are in the pipeline, and are supposed to provide a thrust to India’s pursuit for self-reliance in defence production; the policies have clauses to support indigenisation and upgrading of technology. But, has this not been the thrust since Independence? Sadly, defence imports continue, even in indigenous products.

The defence industry, more so the aviation sector has been in a state of excitement ever since the announcement was made of “Make in India” with policies to support the slogan.

The Foreign Direct Investment (FDI) limits were increased; a list of items requiring an industrial licence was published in June 2014, and a security manual for the licensed defence industries was notified; projects were cleared by the Defence Acquisition Council (DAC) worth hundreds of crore, but the manufacturing process just did not gather momentum.

The policies, the clearances, the increase in FDI, all seemed to favour large private corporates and the Defence Public Sector Undertakings (DPSUs); one sector seems to have been either totally neglected or paid mere lip service – that is of the Micro-Small-Medium Enterprises, the MSMEs.

What is an MSME?

The MSME Development (MSMED) Act, 2006 defines MSMEs based on their investment in plant and machinery, for a manufacturing enterprise, and on equipment for enterprises providing or rendering services. The present ceilings on investment for enterprises to be classified as Micro, Small and Medium Enterprises are as follows:The Micro, Small and Medium Enterprises (MSME) sector has emerged as a highly vibrant and dynamic sector of the Indian economy over the last five decades.

MSMEs not only play a crucial role in providing significant employment opportunities at comparatively lower capital cost than large industries, but also help in industrialisation of rural and backward areas, thereby, reducing regional imbalances, assuring more equitable distribution of national income and wealth.

MSMEs are complementary to large industries as ancillary units and this sector contributes enormously to the socio-economic development of the nation. Some of the known sectors are the Coir Board and the Khadi and Village Industries Commission (KVIC).

The primary responsibility of promotion and development of MSMEs is that of the State Governments, however, the Government of India (GoI) supplements the efforts of the State Governments through various initiatives.

MSMEs are the key drivers of long-term sustainable growth. Empirical evidences also show a positive relationship between R&D investments, skilled labour and knowledge spill-over on the one hand, and economic growth on the other. Further, globalisation has also radically changed the geography of innovation, with new players, markets, and opportunities emerging over the last two decades.

MSMEs may have more impact on innovation than it would appear from their contribution to R&D activity. In sectors like the aerospace and defence industry, MSMEs contribute most to innovation because of low scale of economies and the high importance of knowledge.

Collective learning networks encourage innovation, especially for the enterprises that lack the assets and resources to invest directly in R&D. In the current economic context, the ability to innovate and build entrepreneurial societies is even more compelling than before.

The aerospace and defence industry is of strategic importance to any nation. It is an acknowledged fact that India needs to increase self-reliance in its own national interest. On the other hand, the international defence industry today is universal in nature with a complex network of global supply chains.

It, therefore, is imperative for MSMEs to integrate themselves into the supply chains of national and international defence majors, in order to reduce dependence on foreign supplies and also to gain a foothold in the international aerospace and defence market.

In India, many MSMEs have served as suppliers to DPSUs and played a significant role in the Indian defence-manufacturing sector, but their contribution has largely remained unnoticed. In order to achieve self-reliance in defence production and subsequently emerge as a significant defence player, India needs to improve the competitiveness of its MSMEs and enhance their role in the Indian defence industry.

Enhance MSME Participation

India ranks among the top ten countries in the world in terms of military expenditure. The country’s cumulative defence budget, capital plus revenue expenditure have grown over the years. However, around 70 percent of defence procurements continue to be through imports.

In case of indigenous manufacture, a substantial portion of production continues to be under government’s jurisdiction because of the critical and sensitive nature of the sector and a belief that the private sector does not have the requisite capability.

Notwithstanding the policies aimed towards encouraging manufacture in the private sector, the potential of both the large companies, and MSME contribution in defence, remains to be fully realised.

To enhance productivity, competitiveness, and employment generation in the manufacturing sector, the GoI set up the National Manufacturing Competitiveness Council (NMCC) in October 2004, to serve as a forum for coherent policy initiatives.

After studying the policies of eight countries, including China, the NMCC, in its report submitted in 2008, made a special recommendation in favour of small and medium-scale manufacturing industries; most of the recommendations made by the NMCC were accepted.

The MSMED Act was notified in 2006 to address policy issues affecting MSMEs as well as the coverage and investment ceiling of the sector. The Act seeks to facilitate the development of these enterprises as also enhance their competitiveness. It provides the first-ever legal framework for recognition of the concept of “enterprise” which comprises both manufacturing and service entities.

Establishment of specific funds for the promotion, development and enhancing competitiveness of these enterprises, progressive credit policies and practices, preference in Government procurements to products and services of these enterprises, more effective mechanisms for mitigating the problems of delayed payments to MSMEs, are some of the salient features of the Act.

Both, the recommendations of the NMCC and the provisions in the MSMED Act, have borne fruit as in recent years, the MSME sector has consistently registered a higher growth rate as compared to the manufacturing and industrial sector. However, the contribution in the defence manufacturing is minimal.

Challenges Faced by the Sector

In the current global financial crisis not only the MSMEs, but all stakeholders in the economy have been impacted adversely. In this process, all MSMEs, more so in the defence-manufacturing sector, are facing an uphill task to manage operating profitability, access to adequate risk or debt capital and availability of professional help or advisory services to deal with the crisis-situation.

Some of the challenges faced by the MSMEs in the defence-manufacturing are:

Access to markets.

Access to information and business development services.

Non-recovery of dues/payments from large-scale buyers.

Increased Competition.

Financing challenges due to low credit penetration.

Rigidity in implementation of the Offset Policy.

High Transaction Costs.

MSME promotional framework.

The Road Ahead

The MSME sector is a pulsating and energetic sector; there is only the need to harness its potential. There are certain distinctive characteristics of MSMEs – flexibility, great diversity, low cost inputs – that make them highly competitive as production units. The present global trends, knowledge, innovation, downsizing, networking, have reduced the gap that once separated a large enterprise and an MSME.

To sustain the growth of a largely agriculture-based Indian economy, the growth of other sectors such as industry, services, and manufacturing is imperative. An inter-sector shift from agriculture to the industry and services sectors, is part of the natural growth of any economy.

The share of the services sector in India’s GDP has risen from 40 per cent in 1980 to 53 per cent in 2008. However, during the same period, the share of the manufacturing sector has only risen from 26 percent to 29 percent. Thus, the role of manufacturing sector and MSMEs, in particular, is significant for the country’s transition from a predominantly agricultural economy to becoming manufacturing oriented.

India has not grown as per its potential; the psyche of Indians being to work as per one’s own choice rather than go into collaboration, or join hands to work and produce collectively. There has to be a course correction and the MSMEs must learn to venture out jointly, or with partnership, be it with an Indian associate or a foreign business enterprise.

As was mentioned by a speaker at the Seminar on the subject that this writer was invited to, “it is a huge pie out there to be shared…. so huge that one cannot consume it alone….so all should join hands.” The sector lacks the requisite knowledge of how to enter into defence manufacturing, or even the basic requirements of the defence sector, in general and the Armed Forces in particular.

Technology is fast changing in today’s world and defence related technology is no exception. To keep the Armed Forces in a state of readiness and equipped with the latest technology, timely updating is necessary and it is easier to upgrade the smaller private production units, as compared to the larger DPSUs.

Some years ago, the MSMEs were not so technologically qualified, with poor managerial skills, little knowledge of IT, hardly any specialised skills and little or no design capability.

Today, the same MSME sector possesses domain knowledge, is agile and dynamic in its thinking, is focussed and quality conscious, and has a high level of specialisation with professionally managed and trained manpower; almost the entire sector is IT savvy and aware of global developments.

With the defence industry in India being ‘de-monopolized’, it was expected that private participation in the defence sector would help in transforming India with a sound defence industrial base, capable of producing world-standard products at highly competitive prices.

MSMEs can play a significant role in this as they have the capability to produce sub-systems and components of primary equipment; however, the defence and aerospace sector MSMEs are restricted to providing only low value services. The private sector is chary of investing large amounts into production or R&D.

Technology partnerships should be the new strategy of cooperation, which could also help in tapping the potential of MSMEs, which should be viewed as strategic partners and not as competitors by the larger corporate. The MSMEs are led by technocrats and can absorb new technology with comparative ease.

The sector may be limited by capital funding but it is definitely not limited by innovation and is willing to take on more challenges. Training, support and nurturing by DPSUs and DRDO would go a long way in providing the necessary impetus.

The users, as well as those who wish to join hands with MSMEs, should have the knowledge of the capabilities of the sector, knowing who makes what and where. Towards this end, the MSMEs must have frequent interactions, with the users and amongst themselves too.

The GoI/State Governments should be able to provide a database to facilitate contact between the manufacturer and the user. Despite a common format, the various procurement agencies such as OFB, DPSUs, DRDO and DG Ordnance Services, follow their own vendor registration process. There is no single source database available. Even within organisations, some MSMEs are registered with more than one agency.

It is estimated that there are more than 6,000 vendors, of which around 95 per cent being from the MSME sector. As a result, the outsourcing is minimal; a few years ago, only about two per cent was being outsourced to the MSME sector.

The GoI wishes to increase the outsourcing to 20 percent, but very few DPSUs/PSUs have touched that figure; there are a few which are in double digits, but the majority is below 10 per cent. The gap needs to be filled; the direction has been there for some time; there is a need of handholding.

The Armed Forces have set in motion a strategy of enhancing their deterrence and operational capabilities by upgrading existing equipment in a planned and phased manner. It is imperative that perspective programmes (Long Term Perspective Plan and the Five Year and Annual Plans) cater for upgrading of existing equipment and acquisitions.

The Indian defence industry needs to cover the shortfall between existing and desired levels of state-of-the-art equipment, which should give a boost to India’s defence industrial base.

Recommendations

The Defence MSME sector units are engaged in design, development, product engineering, manufacturing, undertaking Offset Obligation, providing services like installation, commissioning, in-country repair, training, document preparation and a host of other activities that are so particular to a defence activity, on behalf of the foreign OEM. The financial survival of these units is dependent on production orders. They face a ‘non-level playing field’ due to the following:

Rigidity in implementation of ‘Offset policy’,

lack of funding from the financial institutions,

high transaction cost, and

MSME promotional framework.

Keeping in mind the above issues that the defence MSME sector faces, there are some recommendations for consideration:

•   Widen the base of Industry participation by including all “MSME defence licensees” as automatic Indian Offset Partners (IOPs). Therefore, change in IOP by a Foreign OEM (FOEM) should be deemed approved if the new IOP is a MSME and has an existing defence production license. Apart from easing the problems of the foreign OEM to find offset partners, it would also result in a huge supplier base.

• The entire supply chain of the FOEM be allowed to participate in the Offset obligation and their interactions with the Indian counterparts must be facilitated. This would result in a more free transfer of technology, while not reducing or diluting the Offset obligation conditions/ commitment of the FOEM.

•   All post-contract services such as installation, commissioning, maintenance, in-country repair, life-cycle support, documentation and training be permitted as part of Offset obligation discharge, when undertaken by a “defence licensee”. The abeyance notification of May 2013 should be withdrawn with the above provision to prohibit the misuse by ‘fly-by-night’ operators.

• A “Defence MSME Fund” should be created that is dedicated towards the requirements of the Defence MSMEs. Lending at low interest rate by financial institutions, be addressed by designating the defence MSME Sector as a “priority sector”, on the same lines as applicable for the Agricultural sector.

• An 80:20 risk sharing formula, in ‘development contracts’, as applicable under the “Make” programme be institutionalised, where 20 per cent would be the contribution of the MSME.

• Late Delivery (LD) penalty should be applicable on the ‘net value’ of the contract i.e. without taxes and duties, to ease the financial burden on the MSME.

• Orders/follow on orders to be placed on vendors in cases wherein:

Product developed upon user request and accepted technically.

Products designed and engineered for the User and successfully deployed.

Private companies should be issued Proprietary Article Certificate (PAC).

• The Defence Export Policy needs to be simplified. The mandatory requirement of the present NOC and End-User certificates should be removed, if the export is to the published list of countries, where exports are permissible.

•   The MSMED Act, which is being amended and is likely to be published by the end of the year, be expedited.

Conclusion

The current geo-political situation is volatile. We have challenges from both within the country and outside. India is becoming a significant player on the global stage and now attracts worldwide attention.

In view of these and many other considerations, it is imperative that we build our indigenous capability by manufacturing and maintaining our defence equipment in the country. Being “defence prepared” will not only give us a strategic and economic edge, but is also in the interest of national security.

Amendments to the Defence Procurement Policy have provided a new thrust for indigenisation; more favourable changes are expected if the recommendations of the ‘Dhirendra Singh Committee’ are accepted. Introduction of major programmes in the ‘Make’ category, allowing participation of Indian public and private industry, is a big step in the right direction towards developing or acquiring cutting-edge technology.

Defence offsets and the proposed liberalisation of FDI in the defence sector must be leveraged judiciously to enhance indigenous capabilities.The defence industry is capital intensive, with a long gestation period – from conceptualisation, to development and the final manufacturing – and characterised by a cyclical nature in order placement for domestic needs.

It, therefore, typically needs a large customer base to be competitive and to sustain business. This can be achieved only when both domestic and export markets are opened for the industry. There is a need to create a comprehensive vendor database indicating the capabilities of all MSMEs and other companies active in the aerospace and defence sector for the benefit of OEMs and prime contractors.

The increasing role of MSMEs in the emerging aerospace and defence environment will augment India’s indigenous defence production substantially. For too long, this sector has been neglected. Now is the time to make amends.

This article was first published in Indian Defence Review.