Last week, India's defense ministry awarded initial operating clearance to the air force's indigenous light combat aircraft, a multirole fighter called Tejas. To the outside observer, this seems to show that the Indian military is on the march, utilizing the greater resources that India's expanding economy has laid at its disposal.
The reality is quite different. Indigenous material comprises only about 30% of military equipment, and a lot of it takes decades to become effective; the Indian air force first conceived Tejas, for instance, in 1969. That means a good chunk of the Indian military's weaponry acquisitions must be satisfied from abroad. And New Delhi is still failing to address the underlying reasons for this dependence on imports.
Self-reliance in manufacturing used to be the avowed goal of all Indian planning, and defense was no different. Early on, India invested in government-owned arms manufacturing units, backed up by a network of state-funded research and development laboratories. But to little avail. Indigenous tanks, for instance, didn't work well, and more complex armaments were simply out of New Delhi's reach.
So India relied on foreign arms, particularly from Moscow. Over the last two decades since the Soviet Union fell, New Delhi has diversified its supplier base to include Western powers. The intent was not only to give the armed services the weapons they wanted, but also to establish a local defense industry with foreign help.
In 2001, India permitted up to 26% foreign direct investment in the defense sector, hoping to attract the likes of Boeing into joint ventures with Indian firms. This was followed by India's first-ever Defense Procurement Policy in 2005.
The highlight of this DPP was the concept of offsets. These are binding arrangements written into commercial defense contracts that oblige the foreign vendor to invest a certain portion of their contract back into the home country. So when New Delhi pays Boeing billions of dollars for C-130 transport planes, it expects Boeing to "offset" that cash outgo by pouring money back into India—to either buy Indian parts or give an Indian contractor capital for research and development. Indeed, the policy's official purpose was "to promote defense industrial capability through transfer of technology, increased investment in R&D and licensed production." DPP 2005 proposed a minimum offset of 30% of the contract value for every deal greater than three billion rupees ($70 million).
Later DPPs refined the policy, but the idea remained the same. Under DPP 2008, for example, a foreign vendor couldn't spend its mandated 30% offset in civil infrastructure such as roads. The Indian government was focused on using this policy to deliver on its long-term goal of creating a local defense-industrial base.
DPP 2011, announced earlier this month, suddenly dilutes this focus. It widens the scope of offsets to "include civil aerospace, internal security, training within the ambit of the eligible products and services for discharge of offsets obligations."
The defense ministry in New Delhi won't admit it, but the turn-around is not just a tacit acknowledgment of India's limited capacity to absorb offsets, but also an indictment of the offsets policy itself. If the policy is to succeed, the foreign vendor should want to operate in a country where it actually derives commercial benefits from partnering with locals. But in India, the poor quality of the state-run defense units and ordnance factories rules them out as partners. The country simply does not also have a large enough private defense manufacturing sector that a Boeing or Lockheed could buy parts from or invest in.
The final nail in the offset coffin is India's FDI policy. Which among the decrepit public-sector companies or near-absent private ones would Boeing choose from to invest in? Or, rather, which local manufacturer does it trust enough to share its proprietary technology with? A joint venture could be trustworthy, but because of the FDI cap, a local firm will have to put up 74% equity—no small potatoes in an industry where contracts easily total $100 million and upward. This is why over 10 years the 26% FDI regime brought in only $150,000 of investment.
If the Indian government wants to use offsets as an interim measure to bring in foreign manufacturers, it should do away with the FDI cap. Higher stakes in companies could help add value to the offsets policy: Boeing's purchase of 34% of Aero Vodochody, a Czech firm, as an offset deal in 1998 is a good example.
The FDI regime has wrecked such opportunities. A proposal last year by India's Ministry of Commerce to increase the FDI cap in defense manufacturing was rejected outright by the defense ministry. By both sheltering local firms from real competition and yet requiring foreigners to invest in them with offsets, the government wants the best of the old socialist way of nurturing its infant industries and the new capitalist way of acquiring foreign know-how. So far it has failed to secure either.
India should scrap offsets altogether and remove the FDI cap to provide a better investment climate and attract foreign manufacturers. As defense production becomes a part of larger industrial growth in India, the world's largest democracy will become a stronger power.
Mr. Singh heads the national security program at the Takshashila Institution.