Navigating COVID-19 and beyond

Navigating COVID-19 and beyond: Policy impetus for the Aerospace and Defence sector June 2020

Navigating COVID-19 and beyond: Policy impetus for the Aerospace and Defence sector

Content Indian Defence industry

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Foreign Direct Investment (FDI) in defence manufacturing increased to 74 percent

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Self-reliance in defence production

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Other announcements

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Indian MRO industry

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India seeks to become a hub for Aircraft Maintenance, Repair, and Overhaul (MRO)

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Airport privatisation to enter Round II

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Other announcements

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Conclusive remarks

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Navigating COVID-19 and beyond: Policy impetus for the Aerospace and Defence sector

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Navigating COVID-19 and beyond: Policy impetus for the Aerospace and Defence sector

Preface Over the past 18 months, India’s aerospace and defence sector has seen a spurt of policy attention from the government. Roll-out of refreshed draft Defence Procurement Policy 2020, draft Defence Production Policy 2018, framework for Strategic Partnership and Offsets etc., have emerged as significant developments in the policy landscape for the sector, contributing to the overarching ”Make in India” programme.

Despite a growing policy focus on promoting ”Make in India” and “indigenisation” of defence imports, large-scale foreign capital has continued to elude defence manufacturing in India.

This is primarily due to the absence of policies permitting foreign majority/equity participation without the underlying need for prior government approval.

Multiple representations were made to the Ministry of Defence and Department for Promotion of Industry and Internal Trade (DPIIT) for a review of the existing Foreign Direct Investment (FDI) guidelines for defence manufacturing, which has remained in its nascent stage of evolution for a decade now. Foreign Original Equipment Manufacturers (OEMs) and strategic investors have viewed the hitherto permitted 49 percent FDI cap as a major hurdle for technology collaboration, and transfer of know-how to Indian joint ventures led by Defence Public Sector Undertakings (DPSUs) and Indian partners.

In parallel, despite 100 percent FDI permissibility, the Management, Repair, and Overhaul (MRO) service sector has had untapped potential for a fairly long time due to a variety of reasons—higher cost of setting up MRO facilities, inverted tax and duty structure, cumbersome land and labour laws, and as a result and more importantly, exodus of trained and skilled technicians/engineers leading to servicescope limitations.

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For both these sectors, the latest policy announcements by the finance minister are much awaited and welcome initiatives especially in the wake of COVID-19, where almost every sector is reeling under substantial stress due to the demand breakdown in the economy, in India as well as globally.

An increased FDI cap to 74 percent under the automatic route for defence manufacturing will prove a net accretive policy support as it will help encourage foreign OEMs to commit relatively large investments with a long-term view while also giving them the flexibility to support their supply chains under the current circumstances. Combined with a highly competitive corporate tax regime of 15 percent headline rate for manufacturing businesses, the increased FDI in defence manufacturing will help India emerge as a highly competitive investment destination within Asia. Further, the convergence of commercial and defence MRO should provide a positive impetus to the aerospace and defence sector as a whole.

The end goal is to reduce import dependency in a staggered manner, and in the process enable the development of a robust and sustainable indigenous aerospace and defence manufacturing supply chain that can not only serve the domestic demand, but also emerge as a fast-growing export segment serving the global supply chain. These policy decisions also serve to strengthen India’s positioning on the regional geopolitical stage.

With the above in context, we are pleased to share our outlook of the government announcement impacting the aerospace and defence sector.

Navigating COVID-19 and beyond: Policy impetus for the Aerospace and Defence sector

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Navigating COVID-19 and beyond: Policy impetus for the Aerospace and Defence sector

Indian Defence industry • India is the world’s third-largest country in terms of military expenditure, after the US and China. India’s military spending increased by 6.8 percent to about US$ 70 billion in 2019 and about INR 62.8 billion (~2.1 percent of its estimated GDP) was allocated to the defence budget in FY2020–21.

• In 2018, India was also the fourthlargest importer of defence goods and services. In FY19, defence imports accounted for ~49 percent of the total requirement (figure 1)1.

• In order to reduce import dependency, the government made changes to the Defence Procurement Procedure to support “Make in India” and promote strategic partnerships with Indian players. The draft Defence Procurement Procedure 2020 also envisages simplification of the procurement procedure while reducing costs, and seeks to incorporate leasing from both Indian and global sources amongst others. The draft Defence Production Policy also sets the reduction of dependence on imports as its key objective.

• The government has set a target to increase its current domestic defence production (figure 2) to US$ 26 billion by 2025, with an investment of US$ 10 billion in aerospace and defence goods and services. This is also to create an ecosystem for private and public sectors to develop India as a major defence manufacturing hub. India aims to achieve US$ 5 billion from exports by 2024.2

1 2

6

Source: PRS Research and Deloitte Analysis Source: PIB Press Release dated 18 Nov 2019

Figure 1: Defence procurement US$ bn 12

% share 10.5

10 8 6

11.2

10.7

11.0

9.4 48.7%

39.4%

60%

39.9%

39.4%

37.2%

40%

20%

4 2 0

FY 2015

FY 2016

FY 2017

Total (RHS)

FY 2018

FY 2019

Foreign vendors

Figure 2: Defence production US$ bn 14 12

12.1

11.4

11.6

10 8

6.9

6 4 2 0

FY 2017

FY 2018

FY 2019

FY 2020

(As on Feb 2020)

Other PSUs/JVs

Defence private companies

Ordnance Factory Board

Defence Public Sector Undertakings

Total

0%

Navigating COVID-19 and beyond: Policy impetus for the Aerospace and Defence sector

• To achieve this objective, participation from the private sector and foreign OEMs in particular is critical. Currently, the defence production in India is dominated by the public sector.

However, despite the government’s efforts on “Make in India” and frequent amendments to FDI guidelines (figure 3), the sector has not been able to attract foreign investment as anticipated. As on December 2019, India received FDI inflows of ~US$ 250 million (INR 18.34 billion) in the A&D sector under both, the government and the automatic route3.

• One major concern raised by foreign OEMs consistently was the 49 percent cap on FDI under the automatic route, which restricted majority control over their Indian joint venture and access to proprietary technology.

Figure 3

2020

2015

• FDI up to 49 percent under automatic route • Government approval route above 49 percent wherever access to modern and “state-ofart” technology likely

2001

• FDI up to 74 percent under automatic route • Government approval route above 74 percent, wherever access to modern technology likely and for other reasons to be recorded (to be confirmed from fine print)

2016

• FDI up to 49 percent under the automatic route

• Sector opened up to 100 percent for the Indian private sector

• Government approval route above 49 percent wherever access to modern technology likely and for other reasons to be recorded

• FDI up to 26 percent permitted under the government approval route

2014

• FDI up to 49 percent permitted under government approval route • Cabinet Committee on Security approval required above 49 percent on a case-to-case basis, wherever access to modern and “state-of-art” technology likely

3

7

Press Release by Ministry of Defence on March 4, 2020 (accessible at https://pib.gov.in/PressReleasePage.aspx?PRID=1605127)

Navigating COVID-19 and beyond: Policy impetus for the Aerospace and Defence sector

Foreign Direct Investment (FDI) in defence manufacturing increased to 74 percent Announcement by the finance minister • FDI limit in defence manufacturing under automatic route raised from 49 to 74 percent.

Potential implications • The increased FDI cap is an opportune policy decision to ensure the A&D supply chain developed in India is sustained and continues to grow, fulfilling the larger objectives of selfsufficiency and cost reduction.

• An increased FDI cap will unlock the large investment potential of indigenous defence manufacturing, as foreign OEMs will be encouraged to commit sizeable investments with a long view on the sector.

proprietary know-how/technology to joint ventures with Public Sector Units (PSUs)/Indian partners as financial control will offer better protection of rights.

• Increased capital commitment and enhanced technological collaborations will help augment indigenous research and development capabilities, ensuring greater reliability on local supplies, and in turn, will reduce dependence on imports in a phased manner.

• India also recently overhauled its corporate tax rate and introduced a reduced 15 percent base rate for new manufacturing companies 4, placing India as a competitive investment destination amongst its Asian and BRICS peers (figures 4 and 5).

• The policy shift should also allay OEMs’ apprehensions around transferring

Figure 4: Asia Pacific Tax rate 35 30 25 20 15 10 5

4

8

Companies incorporated on or after 1 October 2019 and commencing manufacturing operations on or before 31 March 2023

Vietnam

Thailand

Taiwan

Singapore

Philippines

New Zealand

Mauritius

Malaysia

Korea (ROK)

Japan

Indonesia

India (new)

India (old)

India (new manufacturing)

Source: By Deloitte India

Hong Kong

China

Australia

0

Navigating COVID-19 and beyond: Policy impetus for the Aerospace and Defence sector

Figure 5: BRICS – Base Corporate tax rates Russia

20

China

25

Brazil

34

India – Old

30

India - New

22

South Africa

28

Source: By Deloitte India

• For the OEM/Tier-I players in India, the enhanced FDI limit gives these players the flexibility to protect their supply chain and take advantage of other policy decisions to phase out the import of certain weapons and platforms, indigenisation of spares, and allocation of the domestic capital budget.

• It would, however, be imperative to evaluate whether revised FDI limits are linked to any associated conditions in the fine print.

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India - New manufacturing

15

• Further, FDI beyond 74 percent (up to 100 percent) is likely to remain under the government approval route and subject to fulfilment of the “access to modern technology or other recorded reasons” condition. Due to ambiguity on what constitutes modern technology, such conditions have and could continue to be a hurdle for 100 percent FDI in the defence sector.

Navigating COVID-19 and beyond: Policy impetus for the Aerospace and Defence sector

Self-reliance in defence production Announcement by the finance minister • The government will notify a list of weapons/platforms for an import ban with year-wise timelines.

• Separate budget provisioning to be undertaken for domestic capital procurement.

• Focus to be on indigenisation of imported spares.

• Government procurements of value of up to INR 2 billion will be reserved for the domestic industry.

Potential implications • The government’s endeavours in recent years have been to reduce import dependence in a phased manner and develop a sustainable and indigenous defence manufacturing ecosystem through policy support and supplychain growth.

• Recently announced measures are aligned with the government’s stated policy intent of reducing the defence import bill and developing capabilities for indigenous weapons/platforms.

• In tandem with what is a fairly liberalised FDI regime and a progressive Defence Procurement Procedure, these proposals hold significant potential for growth of a very competitive and integrated defence manufacturing supply chain that promises considerable export potential, both regionally and globally, besides serving India’s indigenous needs.

• As the crosshair and target are eventually falling in line, certain other reforms in recent times, including a robust framework for strategic partnership, draft Defence Production Policy 2018, and draft Defence Procurement Procedure 2020, will play a huge role in driving self-reliance in defence production and provide impetus to defence exports. For instance, the aforesaid draft policies include reforms for promotion of indigenous raw materials and software, introduction of higher multipliers for incentivising investments, and settingup of defence corridors with state-ofthe-art-infrastructure.

Other announcements • A time-bound defence procurement process and faster decision making will aid the policy goal for a more selfreliant defence manufacturing supply chain. The project management unit is to be set up to support contract management, and trial and testing procedures are to be overhauled.

• The Ordnance Factory Board is to be corporatised to improve autonomy, accountability, and efficiency. This can be a significant policy move and will encourage more private participation from both, foreign and domestic defence players.

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• The government has proposed limiting the number of public sector enterprises in strategic sectors (including defence) to four. It is likely that existing defence public sector undertakings (>4) would be privatised/merged/brought under holding companies’ framework. This will be a milestone policy shift and will bring about more market preparedness in the approach of some existing Defence PSUs and also foster competitive market behaviour in terms of timely delivery, product quality, and price sensitivity.

Navigating COVID-19 and beyond: Policy impetus for the Aerospace and Defence sector

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Navigating COVID-19 and beyond: Policy impetus for the Aerospace and Defence sector

Indian MRO industry • In the pre-COVID-19 world, the global commercial MRO market was estimated at US$ 80 billion in 2019. It was expected to reach US$ 110 billion by 2029. APAC was likely to outpace the global MRO demand.5 • Aircraft maintenance accounts for 10– 15 percent of the total operating cost for airlines, with engine overhaul being the largest segment and generating approximately 40 percent of the total MRO demand.

• India’s commercial MRO sector was around US$ 0.9 billion (around 1 percent of the global MRO market) and was expected to grow at a CAGR of 7.7 percent in the pre-COVID environment.

Indian airlines spend ~12–15 percent of their revenues on maintenance, the second-argest expense after fuel, with engine maintenance being the largest MRO expense (figure 6).6

• Despite the increased domestic demand and a healthy global MRO market growth, both for commercial and defence MRO, for years, India has remained uncompetitive compared to its Asian peers, mainly due to a regressive tax regime, and some uninviting policies, including land and labour regulations.

• Indian domestic and international airlines have been outsourcing ~90 percent of their MRO work to other countries.

• India is also poised to become a large defence aircraft market. As military expenditure increases, the necessity for military MRO capabilities will also increase.

Figure 6: India MRO market share (% of value by activities in 2019)

5 6

Engine maintenance

Component maintenance

Line maintenance

46%

21%

17%

Source: Industry Sources and Deloitte Analysis Source: MRO Association and Deloitte Analysis

12

Airframe heavy maintenance & modification

16%

Navigating COVID-19 and beyond: Policy impetus for the Aerospace and Defence sector

India seeks to become a hub for Aircraft Maintenance, Repair, and Overhaul (MRO) Announcement by the finance minister • Major global engine manufacturers are likely to set up engine repair facilities in India.

• Aircraft component repairs and airframe maintenance targeted to increase from INR 8 billion to INR 20 billion in three years.

• Defence and Civil MRO to converge.

• GST regime for MRO ecosystem was recently rationalised.

• Cost for airlines to substantially reduce.

Potential implications • On the back of enhanced FDI norms in the A&D sector, where large aerospace players are also significant defence OEMs, and considering the potentially fast-growing aviation and defence sector, India has articulated its

aspiration and potential of emerging as a regional and global hub for MRO services, both for civilian as well as military applicability.

• Earlier this year, through GST rationalisation for MRO services, the government sought to restore balance by introducing a zero rating status to MRO services rendered by Indian MRO units to customers outside India.

Further, the supply of MRO services to Indian customers is now subject to a concessional rate of 5 percent (earlier 18 percent), which further supplements the domestic MRO market. Lastly, the continuation of applicability of Integrated-GST on the import of overhauled parts by Indian customers provides a better footing to Indian MRO players (Domestic Tariff Area) in contrast to the ones offshore for service provision to Indian customers (figure 7).

Figure 7 GST notifications issued effective 1 April 2020 • GST rate on MRO services reduced from 18 percent to 5 percent.

• Place of supply changed from “place of performance” to “location of service recipient” in case of cross-border supplies (recipient or supplier outside India) • Wide coverage in amendments for aircrafts, aircraft engines, parts, and components MRO • No distinction drawn for MRO of civil and military aircrafts

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Navigating COVID-19 and beyond: Policy impetus for the Aerospace and Defence sector

• The latest policy move to allow convergence across civil and defence MRO will aid in creating a larger market place for private MRO players and provide economies of scale.

Currently, defence MRO in India is dominated by the public sector and this announcement is expected to open up opportunities for private players in the defence MRO market.

• Besides engine MRO, government focus on component and airframe maintenance will provide OEMs and investors a long-term investment horizon while committing large investment plans.

• Clearly, recent announcements place India in a pole position to capture the multi-billion dollar aviation services market and build high-quality infrastructure facilities, wider and deeper precision manufacturing capability, and a spare-part supply chain, alongside creating skilled employment opportunities

• To achieve the end goals set out by the government in recent announcements, certain other aspects, which have historically impeded the growth of the Indian MRO sector, would require to be addressed, including high set-up costs, multiple levels of certification, skill building, service quality and breadth of services, and tax regime (figure 8).

• While a significant cost driver in the form of revised tax regime has been set, the return to normalcy for the aviation sector post the global lockdown will determine the Indian MRO sector’s speed of growth. The government has made its intentions very clear, and every effort will be made to ensure sustainability and growth of this sector.

Figure 8

Service Quality The services offered by existing MROs are limited and lack the infrastructure and technology of their global counterparts, resulting in a major part of MRO work being outsourced to Singapore, Sri Lanka, UAE, Europe, and others.

High set-up costs Establishing an MRO facility involves huge initial costs (infrastructure, machines, and equipment), along with high operating costs.

Global certification Very few Indian MROs provide heavy maintenance services as it requires approvals from several global OEM’s and regulators.

Airlines steer abroad due to the availability of globally certified standard of quality.

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Skill building MRO facilities require ancillary industries and services. There is a large requirement for superspecialised training facilities.

Tax nuances/costs Inverted duty structure and lack of full credit adds to overall costs, customs classification issues, and inconsistent tax classification visa-vis civil and defence MRO

Navigating COVID-19 and beyond: Policy impetus for the Aerospace and Defence sector

Airport privatisation to enter Round II Announcement by the finance minister • Bid processes for private participation in six airports in the second round to commence immediately. Private investment of around INR 130 billion is expected in the first two rounds.

• Another six airports to be identified and put out for development through private participation in the third round.

Potential implications • After a successful first round of bidding for six airports, where concession for three airports have already been awarded, the commencement of the second round of bidding is anticipated by infrastructure players/investors.

With the latest announcement,

intending bidders will look to review the modalities, particularly the much talked about cap of two airports per bidder.

• Private participation is expected to help increase efficiency of airports, augment revenue for the government, and provide better quality infrastructure to the public.

• A lot has changed since the first round where a number of players had participated in the development of six airports. Besides the impact of COVID-19 on passenger traffic and the aviation sector in general, there are differences in the scale and nature of business at airports that are likely to be included in rounds 2 and 3. This would need to be considered from a privatesector perspective.

Other announcements India gets to utilise more airspace • Restrictions on utilisation of the Indian airspace to be eased. Presently only 60 percent of Indian airspace is freely available.

• The proposed relaxation will make civilian flying more time and fuel efficient, and facilitate optimal utilisation of airspace.

• Overall benefit of INR 10 billion per year is likely to be captured by the Indian aviation sector.

Encouraging private participation in space • In order to spur private sector participation in the space sector, the government has now provided a level-playing field to the private sector with the use of ISRO facilities towards improving capacities.

• This is an important policy step to encourage private-sector investment in India’s space sector development.

Conclusive remarks India is poised at cross-roads for consolidation and growth in the aerospace and defence sector.

• The Indian government has taken the opportunity of the COVID-19 pandemic to look at the aerospace and defence sectors comprehensively, and to initiate 15

policy measures that might go a long way in resetting the sector on a more pronounced growth trajectory.

• It is now on the industry to reciprocate and take advantage of the emerging playing field in the aerospace and defence sector in India.

Navigating COVID-19 and beyond: Policy impetus for the Aerospace and Defence sector

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Navigating COVID-19 and beyond: Policy impetus for the Aerospace and Defence sector

SMEs

Alaric Diniz

Sumit Singhania

Acknowledgements Shivam Saigal Tushar Aggarwal

Contact us Alaric Diniz adiniz@deloitte.com

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Peeyush Naidu

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