CURRENT STRATEGIC THINKING. Defence and security NICOLAS SARKOZY NATO VICTORIA NULAND, OLIVIER KEMPF

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1 défense nationale et sécurité collective CURRENT STRATEGIC THINKING défense nationale et sécurité collective April 2008 Defence and security NICOLAS SARKOZY NATO VICTORIA NULAND, OLIVIER KEMPF China and India HUGUES TERTRAIS, PIERRE BAUDIN, FRANÇOIS LAFARGUE, BERNARD PRÉZELIN, HARSH V. PANT, GUILLAUME ROCHARD & DHIRAJ MATHUR Technology: a strategic imperative for France JEAN-PAUL HERTEMAN April 2008 e11

2 INDIA India: a new eldorado for the European aerospace and defence sector? GUILLAUME ROCHARD AND DHIRAJ MATHUR India can reflect on a decade of significant political, economic and demographic transformation which today sees it stand as the world s fifth largest economy 1 and the second most populated nation. As an emerging market, it could be an attractive destination for European companies confronted by new challenges in their domestic markets. This is the case in the aerospace and defence (A&D) sector. While the automotive sector has already made its move to India, European A&D companies seem to be lagging behind in terms of local industrial presence, despite the significant business opportunities in the Indian defence and civil aviation sectors. This delay could be due to restrictions imposed by the specific regulations governing the A&D sector. It could also reflect some constraints faced by European SMEs when entering this emerging market; the perception of those constraints and therefore the motivation to make a move often depends on the size of the company wishing to invest in India (Prime, Tier 1 or Tier 2). 1 This is based on purchasing power parity, which uses the long-term equilibrium exchange rate of two currencies to equalise their purchasing power. The purchasing power parity exchange rate equalises the purchasing power of different currencies in their home countries for a given basket of goods. It is often used to compare the standards of living between countries, rather than a per-capita gross domestic product comparison at market exchange rates. Défense nationale et sécurité collective, April 2008

3 Guillaume Rochard and Dhiraj Mathur Why do business in India? India has become one of the most exciting emerging markets in the world for several reasons: The country has a population of over a billion and between 2000 and 2005 the population increased by circa 17 million per annum. It is also the youngest nation in the world, with approximately 50 per cent of its population under the age of 25. Both of these features are forecast to continue, with a working population forecast to reach 882 million by Although no single party has managed to gain an outright majority in Parliament since the 1990s, this has not given rise to any notable degree of instability. Indeed, the common thread linking each of the governing coalitions has been a consistent economic policy in favour of a free market, underpinned by a commitment to reform and a progressively liberal regulatory regime. India s GDP is the third largest in Asia and the second largest amongst emerging nations (based on purchasing power parity). GDP has grown at an average annual rate of 7.6 per cent, reaching 9.4 per cent in The Government is targeting an annual growth rate of 9 per cent until These factors have not gone unnoticed by foreign investors who view India as an increasingly attractive location for inward foreign investment. With over 20 million shareholders, India has the third largest investor base in the world after the United States and Japan, and over 9,000 companies are listed on the stock exchanges. Foreign direct investment (FDI) and portfolio investment amounted to US$21.2 billion in 2006 and $16.0 billion in the nine-month period to September India appears as a mature, modern and liquid market place allowing foreign investors to find local partners to safely fund and develop common businesses. For European A&D companies facing increasing constraints in their domestic market, a move to India could be a solution to some of their strategic issues. As has been widely publicised recently, the European civil aviation sector is facing one of its largest crises ever as the dollar keeps weakening against the euro. This is in a market where aircraft are sold in dol- 2

4 A new eldorado for the European A&D sector? lars, whereas costs are incurred in euros. Louis Gallois, EADS s CEO and Charles Edelstenne, Dassault Aviation s CEO, have clearly stated their intention of moving some of their production capacity to the dollar zone in order to hedge their currency exposure. Although the exchange rate difference between the Indian national rupee (INR) and the euro is still favourable to European companies, the INR has steadily risen against the dollar, reducing the exchange rate advantage a European A&D business could find in moving some of its production capacity to India. At the same time as moving some of their production capacity to the dollar zone, European A&D companies are also trying to decrease their production costs by moving some of their capacity to low-costs countries. India, with an average monthly salary for engineers ranging from 400 for a beginner to 1,000 for an engineer with ten-year experience, looks very attractive in that respect. This could, however, be mitigated by the fact that significant pay increases are taking place, in particular in the Bangalore area, where the main A&D Indian players are located (+12 per cent to +14 per cent p.a.). Another reason for moving to a country such as India lies in the increasing difficulties faced by European A&D businesses in hiring welltrained and skilled workers in their domestic market. Germany, the United Kingdom and France together account for 37 per cent of the total European Union (EU) population of scientists and engineers (around 9 million people in total) but they also have the oldest population. For example, 39 per cent of German scientists and engineers are in the age group, whereas only 23 per cent are between 25 and 34. In that context, India, with a significant and fast-growing population of engineers and executives, could become a large source of qualified employees for European A&D players. It should be noted however that some industry sectors such as IT and Automotive are already experiencing labour shortages resulting in high staff turnovers (from 5 per cent to 20 per cent in 2007). Indian engineers have mostly graduated as IT engineers and are often experienced within service businesses but may not always be suitably experienced for the specific requirements of the European A&D industry. Although moving to India looks attractive in many ways for European A&D businesses, this should not hide the fact that some changes have started occurring in this market place and these changes are reduc- 3

5 Guillaume Rochard and Dhiraj Mathur ing some of the existing competitive advantages. India is still an emerging market where some potential constraints should also be taken into consideration before investing. One of the first constraints that have been highlighted by foreign investors as being a limit to the development of their business in India is the lack of infrastructure. The Indian government is aware of this issue and has launched a very ambitious infrastructure development plan amounting to $430 billion, primarily focused on transport ($148 billion), energy ($120 billion) and telecommunications ($53 billion). However, the development of infrastructure has not historically been consistent from one region to another. This explains why regional industry clusters have been created. The Indian A&D industry has, for example, historically been located in Bangalore, with all major public A&D companies, Hindustan Aeronautics Limited (HAL), Bharat Electronics Ltd (BEL) and Indian Space Research Organisation (ISRO), being present there. This is also where most of the collaboration with European A&D companies has taken place. The inconsistency of infrastructure across the country is not the only issue faced by foreign investors. Although India is often presented as being much closer to our European culture than China, significant cultural differences remain. People s behaviour will differ depending on their socio-economic strata, educational background, caste, religion, exposure to international businesses and several other parameters. Relationships between people in India are often governed by a constant search for balance between strong traditional values and emerging modern business and personal behaviour. This complexity has sometimes caused difficulties for European A&D players trying to develop businesses in India. The ability of Indian A&D subcontractors to meet the industry s high standards of quality seems to vary significantly between companies. It is only the few private companies that act as direct suppliers to HAL (the leading A&D public company) who appear to comply with industry standards and are therefore in a favourable position to collaborate with European businesses. The varying levels of quality should be somewhat mitigated by the fact that most of the complex systems and subsystems used in the A&D projects are still mainly imported from Russia, Europe, Israel and more recently the United States. Large private players such as Godrej, Larsen & Toubro, Tata and Mahindra, and more recently smaller Indian companies such as Autocrat, Bevel 4

6 A new eldorado for the European A&D sector? Gears and Precision Telecom Products, have been attracted by the huge opportunities of the sector and have developed A&D activities. As some of these private players are fairly new to the A&D industry, it is sometimes difficult to assess their respective levels of compliance with quality standards. Although European A&D players should carefully select their local partners, collaborating with them by clearly defining their specifications and helping with quality control will gradually improve the overall level of quality and sophistication, as has been the case for the Indian automotive component manufacturers. For example, out of 512 member companies of the Automotive Components Manufacturers Association, over 90 per cent have an ISO 9000 certification and 25 per cent have achieved ISO benchmark for certification. The development of private players in the defence industry, although strongly encouraged by the Ministry of Defence (MOD), is only recent (2002) and looks even more complicated. The MOD bureaucracy and the absence of a formalised interface between the MOD and the private sector are often perceived by foreign investors as a lack of transparency. For example, the requirements of the Armed Forces are not communicated to the private sector until late in the process, which means that they often have to reply to requests for proposal (RFP) in a very short timeframe. As a consequence, Indian state-owned companies are pre-eminent in the defence sector, leaving little opportunity for the private players to develop in the A&D sector. Characteristics of the Indian A&D sector Despite the constraints that have been highlighted, the Indian market represents a significant growth opportunity for European A&D businesses. European players in the defence sector are facing difficult situations in their domestic markets, where military budgets for new equipment are constantly under pressure. With the third largest military force in the world, military expenditure in India amounted to $23.9 billion in 2006 (source SIPRI) and has grown steadily over the past years. Considering the obsolescence of a significant part of the military equipment (70 per cent of which is of Russian origin) and with the strategic objective of remaining a significant military force in its region, the Indian government has just launched a $100 billion investment plan over the 5

7 Guillaume Rochard and Dhiraj Mathur period in order to renew the Armed Forces equipments. This represents a major opportunity for European A&D players to further expand into India, although some other countries such as Russia (the traditional supplier of military equipment to India), the United States and Israel have already seen and started to act on this opportunity ahead of Europe. The Indian government has recently put out to tender a contract for 126 fighter aircraft, estimated to be worth more than $10 billion. EADS (Eurofighter), Saab (Gripen) and Dassault Aviation (Rafale) are reported to be considering a bid. The Indian Air Force also plans to upgrade its fleet of Mirage 2000 and MiG-29 aircraft and is considering the purchase of 15 C-130J Super Hercules aircraft. The Indian Navy has already struck a deal with France for the purchase of six Franco-Spanish Scorpene submarines. This deal consists mainly of a technology transfer, with the submarines being assembled in Mumbai. The Viraat aircraft carrier is also expected to be replaced in by the new Vikrant-class carrier, which will be developed and manufactured under a cooperation contract agreement with the Italian shipyard Fincantieri. In this context, the German motorist MAN Diesel could benefit from a significant contract with the Indian Navy, related to the supply of equipment for the Vikrant and the delivery of engines by the end of Although it seems more difficult at the moment to identify opportunities in the armoured vehicle market, the renewal of existing vehicles has already started, with the purchase of T-90 and Arjun main battle tanks, and is likely to be significant in the foreseeable future. Some European armoured vehicle companies, such as Ashok Leyland (truck manufacturer), have already started collaborating with Indian companies in order to prepare for these opportunities. On the other hand, the civil aviation market growth is fuelled by the Asian market at the end of April 2007 Asia accounted for circa 25 per cent of Airbus s cumulative orders. In that context, the Indian market is growing strongly due to the increasing number of airlines (14 companies in 2007 against 4 in ) and to the development of lowcost airlines (for example Air Deccan, created in 2003). This growth is driven by the increase in the Indian middle class s purchasing power (200 to 300 million people) and the development of international relationships. The total number of passengers amounted to approximately 6

8 A new eldorado for the European A&D sector? 75 million in , and the Government expects this number to double over the next decade. In order to meet this demand, the number of aircraft is expected to continue to increase (from 370 at the end of 2007 to 550 by the end of 2010), and significant investment will be required in airport facilities, training centres (6,000 new pilots required), ground handling personnel and maintenance facilities. To encourage foreign investment in this booming market, the Indian government has deregulated part of its economy since the 1990s. For example, customs duty has decreased from 100 per cent in 1990 to 14 per cent in Specifically in the defence sector, the Indian government has tried to promote both foreign investment and the development of local private players through its FDI policy and the implementation of offset agreements. The origin of the Indian defence industry goes back to 1801 and the creation of Gun and Shell Factory at Cossipore. Today, India has 39 ordnance factories and eight defence public sector undertakings (DPSU) that are all state-owned and are the leaders of the Indian A&D market. However, the Government has recognised the benefit of having a strong private sector and would like it to be the natural complement of the existing state-owned companies, with the aim of procuring around 70 per cent of its defence requirements from indigenous sources by This objective explains why the Indian government has progressively opened up the A&D market to local private companies and foreign investors (for example in 1991 for the manufacture of components, assemblies and sub-assemblies). In January 2002, with a view to promoting defence-industry partnerships, the MOD decided, in a major move, to open production of defence equipment to private businesses. These partnerships could be held 100 per cent by local private investors with a 26 per cent maximum FDI. Despite these regulatory changes, only a few A&D private companies such as Taneja, Triveni and Maini have managed to be involved in small-value defence contracts. The Indian private sector is not yet integrated and its potential does not yet seem to be fully harnessed to building the industrial base for defence that is viable, local and includes private companies, which is necessary to reach the objective of relative self-sufficiency set by the MOD. In this context, FDI has remained limited, opportunities for foreign investors to partner with a local com- 7

9 Guillaume Rochard and Dhiraj Mathur pany being reduced to collaboration (JVs, transfer of technology, licensing, subcontracting of simple parts, etc.) with state-owned businesses (for example BAE Systems and HAL for manufacturing of 42 AJT Hawk). As a result, India continues to depend on imports for a lot of systems, subsystems and even parts, with local production remaining limited to the low end of the technology spectrum. For example, this is the case with the IJT 36 programme (intermediary training aircraft) where most of the equipment is imported in order to shorten the development cycle. Faced with this situation and in order to promote local businesses, the Indian government updated its 2005 offset policy in April The new defence procurement procedure states that all contracts over INR 3,000 million (approx. 53 million) must have an offset obligation amounting to a minimum of 30 per cent of the contract value. Considering the prevalence of Indian A&D state-owned companies, as already described, it is almost impossible for a foreign A&D company to fulfil its offset obligation with a private player. This explains why most collaboration happens with European A&D prime contractors (BAE Systems, EADS, Safran, Thales, Fincantieri, Man, etc.), Tier 1 and Tier 2 not having the critical size to partner the large Indian stateowned companies. In addition, it will be very difficult to find Indian private partners who, in the case of JVs with foreign partners, are able to put up 74 per cent of the capital. Therefore, even though the new offset policy seems attractive, the cap on FDI remains a constraint for its implementation. Cooperation with Indian companies Since 1953, European A&D prime contractors have been industrial partners to Indian companies through cooperation agreements with state-owned companies (mainly HAL). With sales amounting to $1.2 billion in 2006, HAL, which has its headquarters in Bangalore, is the clear leader in the Indian A&D market. This company has an impressive product track record, with 12 types of aircraft designed and manufactured in-house and 14 types of aircraft produced under licence. As a result of its strong competitive positioning, HAL has always been considered by European players as a 8

10 A new eldorado for the European A&D sector? credible partner and has therefore been targeted by them for a long time. For example, Safran, through some of its subsidiaries such as Snecma, Turbomeca, Messier Dowty, Messier Bugatti and Sagem Défense & Sécurité, has regularly provided engines and equipment for aircraft and helicopters deployed by the Indian Air Force and Navy. This equipment has been used by HAL to manufacture under a Eurocopter licence circa 600 Cheetah (Lama) and Chetak (Alouette III) and to assemble more than 200 Adour Jet engines for Jaguar aircraft. As mentioned earlier, FDI in defence businesses is limited by law to 26 per cent and this has historically constrained investment by foreign defence players in India. However, the definition of defence equipment in the Indian regulations remains fairly vague, thereby opening the way to some degree of interpretation. This has resulted in foreign companies setting up operations related to, but not necessarily purely related to, defence equipment. For example, BAe Systems owns 40 per cent of BAeHAL Software Limited, its joint venture company with HAL, which is dedicated, amongst other solutions, to avionics embedded software and simulation software. This company has activities that are on the fringe of the defence sector, but takes advantage of the fact that up to 100 per cent FDI is allowed when providing software services. Similarly, Safran Aerospace India Pvt Ltd, Snecma s R&D centre in India which develops engine components and embedded software, is a 100 per cent subsidiary of Safran (100 per cent FDI being allowed for R&D companies as the Indian government highly encourages setting up such businesses). Having started to set up operations in India, and taking into account the significant business opportunity represented by the Indian A&D market, prime contractors are encouraging their suppliers/subcontractors to accompany their development in this region. A move to India by European A&D Tier 1 and Tier 2 would compensate for the present lack of maturity of the Indian A&D private sector, and in the medium term would help the development of local players. Two European A&D SMEs that seem to have anticipated the demand from prime contractors for moving some of their production to India are Recaero and Machaero, although not many other European A&D SMEs have followed suit yet. 9

11 Guillaume Rochard and Dhiraj Mathur In November 2006, Recaero, a 21 million turnover French aeronautical spare parts manufacturer, created Recaero India, a company based in Bidadi (30 km from Bangalore) and held 75 per cent by the French parent company and 25 per cent by local individuals. This 65,000 sq. ft facility will primarily supply engine parts for Snecma (a Safran company) and Airbus (an EADS company). An initial investment of INR10 million (approx. 0.2 million) is planned over a threeyear period ( ) and could be scaled up to INR30 million (approx. 0.6 million) in a second phase. The plant in Bangalore forms part of Recaero s corporate strategy to address the expectations of its main customers Safran and Airbus, who account for 35 per cent and 30 per cent of Recaero s 2006 turnover respectively. These primes look for subcontractors able to provide highquality products, in short lead times, at prices that are competitive when compared with the euro zone. Recaero has reduced its operating costs with the acquisition of four new machine tools in May Activities such as drilling, truing, turning, and countersinking which previously required a lot of handling are now performed by one unique machine tool. The production process was validated in France before the installation and commissioning of two of these machine tools at the Bangalore plant. Considering both the expected higher output rate and the lower labour costs in India than in France, Recaero could soon benefit from its investment in India. To fund its investments, both in India and France, Recaero increased its share capital by 5 million at the end of This money was raised from the French private equity houses ACE Management, ICSO Private Equity and Multicroissance. Similarly, Machaero, a 13 million turnover French company specialising in the design and manufacturing of bearing equipment for the aeronautical sector, created a business unit near Bangalore in February The 2,500 sq. ft facility, inaugurated by the Executive Vice President of SAFRAN, is initially producing high-tech parts for the SAFRAN CFM56 and GE90 engines. In addition, Machaero has acquired two new driving machines enabling higher output and better quality, resulting in increased productivity. Machaero will primarily use these machines for the production of spare parts for the SAFRAN CFM56 engine. 10

12 A new eldorado for the European A&D sector? Recaero and Machaero have similarities: a long-term relationship with European primes in their domestic market, the acquisition of new technology at the same time as their development in India, the location in Bangalore of their Indian branch close to the major players of the A&D Indian sector and the use of European funding to support their foreign investment. These two companies are good examples of what Tier 1 and Tier 2 suppliers could do in India. They nevertheless remain exceptions at the moment. Conclusion Despite the fact that India represents a great opportunity for European A&D companies, both for the potential of its internal market and for the cost advantage resulting from offshoring, only prime contractors have really started to make a move to this country. India remains for several reasons a difficult market to get into, especially for SMEs. The various constraints that are currently experienced in entering the Indian market are much more significant for SMEs that have limited resources, both in terms of management time and investment capacity. Several avenues are worth exploring in order to facilitate the move of SMEs to India. The first one perhaps lies in the hands of the prime contractors, who will have to give some clarity to their subcontractors in terms of business they would be ready to give them if they were to make this move. As this has worked well in the automotive sector, primes should also be ready to provide advice and support to them in order to facilitate their development. The presence of SME s will also become increasingly important for primes in order for them to be able to meet their offset obligations. European industry associations also have a role to play by representing SMEs, giving them critical mass and promoting their know-how. For example, GIFAS, the French aeronautical industries association, was one of the 500 exhibitors at Aero India 2007 (the fourth largest air show in the world), organised by the Indian MOD. It is only through the support of such organisations that the majority of SMEs currently have the opportunity to present themselves abroad. It is likely to be down to the governments to put in place a win-win strategy. Europe should clearly define a development plan in India for 11

13 Guillaume Rochard and Dhiraj Mathur its A&D sector and promote co-development programmes (for example the cooperation between Safran and HAL in developing the Shakti engine), in order to provide access to a fast-growing market and hence ensure the future of its A&D industrial base. India, on its side, probably has to attract European A&D players of all sizes if it wants to be successful in developing its A&D private sector. It therefore has to continue its efforts towards the liberalisation of its A&D market, involving, in particular changes in the FDI policy and more clarity on the Armed Forces needs. These changes should improve longer-term prospects and give more confidence to European A&D companies to invest in India. 12