State of policy reforms and opportunities for MSMEs in defence sector

The Indian defence ecosystem involves both the government and the defence production industry. A virtuous cycle where the growth of one can drive the growth of the other is essential to a sustainable expansion of the defence sector in India. India has been among the top 5 highest military spenders in recent years and ranked 4th in 2022-23 with a defence budget of INR 5.25 lakh crores[1], behind the US, China, and Saudi Arabia. The budget has been raised to INR 5.94 lakh crores[2] for the current year, a 13.1% increase from the previous year. The budget for modernization and capital acquisitions, amounting to approximately 27% (INR 1.62 lakh crores)2 of the total defense budget, also saw a 8.4% increase. India's defense spending, which has been maintained at around 2% of the country's gross domestic product, offers a significant market opportunity for both global and domestic defense manufacturers and the wider defense industry.

The government has implemented various policies and introduced several reforms in recent years to promote the indigenous design, development, and production of defence equipment, thus fostering self-sufficiency in the defence manufacturing and technology industry in the country. The key themes behind the plethora of reforms can be summarised as below

• Prioritize domestic procurement and debottleneck procurement process

• Promote private sector participation and incentivize global OEMs to manufacture in India

• Reorganize industry structure to promote competition and indigenous design and development

• Promote export driven growth

• Reduce import dependencies

These policy changes have undergone a continuous process of improvement through extensive consultation with industry and other key stakeholders, and the positive developments in each of the themes mentioned above clearly demonstrate that these reforms are having a tangible impact.

The prioritization of domestic defence procurement has resulted in significant growth for India's domestic defence production, with the industry's revenue reaching nearly INR 1,00,000 crores[3].

The Indian government has a goal of increasing annual defence production to INR 1,75,000 crores by 2025[4]. Two Indian defence manufacturers, HAL and BEL, are among the world's top 100 defence manufacturers based on revenue[5]. The DAP 2020 and subsequent amendments have also significantly shortened the average procurement time, with the Ministry of Defence committed to reducing it to less than two years, down from the previous average of 5-6 years.

India's defence products are gaining popularity and making an impact in the global export market. The country now consistently ranks among the top 25 defence exporting nations, coming in at 23rd place. [6]India’s overall dependency on foreign sources has reduced by about 21 per cent over the previous 5-year period. The country's defence exports have rapidly increased at a CAGR of 54%, from INR 1522 crores in FY16-17 to INR 12,814 crores in FY21-22[7].

Sanctions on Russian weapons have led to increased demand for Indian-made platforms and maintenance, repair, and overhaul services in countries using Russian platforms. Notably, private sector companies account for nearly 75% of total defence exports over the last 5 years[8], indicating that the majority of defence exports are coming from private sector licensed manufacturing, components, and subsystems that have successfully entered the global defence supply chain.

Traditionally, the private sector has served as suppliers to public sector defence organizations, but recent reforms have partially leveled the playing field. Major private sector companies are now securing important contracts both domestically and for exports. Private sector companies in India reported a total annual turnover of INR 19,920 crores in FY21-22, up from around INR 14,104 crores five years earlier in FY 2016-17, which accounts for about 21% of total defence production in the country[9]. Private sector has also led the way in creating joint ventures and partnerships with foreign OEMs which has helped the private sector leapfrog some of the technology related challenges. The growth of MSMEs involved in defence manufacturing has expanded the industry's capabilities. The number of MSMEs in the supply chain of public sector defence organizations has nearly doubled over the last 5 years, reaching over 12,000.[10] Procurement by public sector defence organizations from MSMEs reached INR 5760 crores in FY 21-22.[11]

However, MSMEs have to face with a lot of challenges in order to succeed in this sector. Access to capital has been one of the major roadblock for MSMEs, particularly for product development and working capital. In a recent survey of aerospace and defence companies, 86% reported difficulties in obtaining funding and relying on bank credit as the only financing option available to them. Even getting a bank loan is challenging due to the lack of collateral. To address the working capital challenges faced by MSMEs, the government has set a maximum credit period of 45 days. They have also established MSME SAMADHAAN, a delayed payment monitoring system, to resolve disputes quickly. The Reserve Bank of India has introduced the Trade Receivables Discounting System (TReDS), a platform for invoice discounting and working capital financing at lower costs. After initial difficulties, the number of invoices uploaded and financed through TReDS more than doubled in the 2021-22 financial year, and the success rate improved to 94.7% from 91.3% the previous year.[12] All DPSUs are registered on the TReDS system, and MSMEs can access invoice discounting for invoices to these companies. Private sector OEMs and Tier-1s also offer reverse factoring programs for their suppliers, and if not, there are many NBFCs that offer invoice discounting services to aerospace and defence MSMEs.

The government has also instituted initiatives such as the Technology Development Fund (TDF) and iDEX. TDF provides funding of up to INR 50 crore for innovation, research, and development in defence and aerospace technology. As of December 2022, 66 projects worth INR 283.4 crore by 54 companies[13] have received support from TDF, with 31 of these companies being MSMEs (57.4%) and 18 (33.3%) being start-ups.[14]

Further, over 150 innovation contracts have been signed under the iDEX scheme. Due to the success of these initiatives, iDEX and DTIS were allocated INR 116 crore and INR 45 crore respectively in the latest budget for FY2023-24, an increase of 93% and 95% respectively[15]. Even significant streamlining in the Make procedure has been brought in, especially related to testing and trials. Investment by private equity investors and venture capitalists is another avenue that can be explored by MSMEs and start-ups. However, in order to tap into the private equity/ venture capital market, companies will have to invest in research and development and create intellectual property. A stake in the Intellectual Property would be an attractive proposition for PE/VC.

Registering on the Government e-Marketplace is a good starting point to access this market. In 2022, the Ministry of Defence was the top procuring ministry for goods and services from MSMEs, procuring over Rs 15,047.98 crore worth of goods and services, a 250% increase from the previous year. The procurement levels for April to December 2022 have already surpassed the entire FY22 procurement level, with a gross merchandise value of Rs 15,039 crore achieved in eight months.[16]

Further, to explore market opportunities, companies need to be aware of changing user requirements and plan accordingly. The Armed Forces are getting lean. 'Teeth to tail' ratios are being enhanced by focusing on core military functions and using technology as a force multiplier. The Chief of Army Staff (COAS) has emphasized that advancements in technology, such as AI and cyber, will play a crucial role in future combat. In line with this, the Defence Communication Network has been established. The Mission DefSpace[17] was launched by the Prime Minister in October 2022 to address 75 Defence Space Challenges relevant to end users. The DRDO has issued guidelines and a framework for AI projects, and an AI roadmap has been established for each DPSU, identifying 70 defence-specific AI projects for development.[18] The Raksha Mantri also launched the "Integrated Unmanned Road Map for the Indian Navy," outlining unmanned aerial and underwater platforms[19]. The DRDO is planning to develop UGVs and the Combat Air Teaming System[20]. A framework for the shared use of simulators by the three services and the ICG has been established, and the Indian Air Force has contracted with the private sector for simulators[21].

These trends and RFPs for ground and combat simulators indicate an increasing adoption of force multipliers, such as Network Centric Operations, Space, AI, unmanned systems, simulators, and electro-optics. This creates new opportunities for the Indian defence industry that are in line with global requirements.

The demand from the Indian Armed Forces is strong enough to support a mature defence production industry, but the large demand does not often result in a steady stream of orders for vendors and is instead affected by factors such as operational needs, funding availability, geopolitical concerns, and administrative delays. As a result, early profits similar to those in the commercial sector may not be realized, and the conversion of R&D into serial orders may not be guaranteed. There may be periods of low demand and at other times, suppliers may need to quickly respond to a significant increase in demand in case of a national crisis. This makes achieving economies of scale difficult and thus often results in idle production lines due to a lack of orders or delays in anticipated orders. This ultimately causes valuable production capacity and manpower to go to waste. While Indian DPSUs and large OEMs are looking at expanding exports to diversify their customer base and maintain steady order flow, MSMEs can explore dual-use options for some items or align their capabilities with adjacent industries to mitigate risks.

Companies thus have various options to choose from in terms of categories of defence acquisition, and they can adopt business models that align with their capabilities and objectives. Start-ups and MSMEs can consider partnering with foreign original equipment manufacturers to fulfil indigenization requirements and offset obligations, or collaborate with well-established Indian entities such as DPSUs, DRDO, or private industry for the production and provision of subsystems or components. Several Indian Aerospace & Defence firms are now established and thriving as participants in the global supply chain of multinational companies. However, one of the key worries of original equipment manufacturers (OEMs) when it comes to incorporating MSMEs into their supply chain is the lack of sophisticated and technologically advanced internal systems for efficient production and quality management. MSMEs should embrace digital tools such as ERP, PLM, and Industry 4.0 to alleviate these concerns. Further, security and confidentiality are major concerns in the defence supply chain that require extra attention, as the loss of plans for a new missile or ship could have serious consequences. With rising incidents of ransomware and other types of hacking, having a robust IT security system is becoming essential for sustained growth in the defence supply chain. A well-established internal supply chain management, including materials sourcing and access to well-developed and demonstrable industrial support system for capabilities not available in-house goes a long way in proving reliability to global OEMs.

To summarize, the defence supply chain provides various chances for all types of industries and increased private involvement would benefit everyone involved. Finding specific military needs and focusing on niche areas will be crucial for newcomers to succeed. However, the ultimate tests will be reliability and quality control.

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Author Abhranil Chatterjee - An Indian School of Business and IIT Guwahati graduate, Abhranil has more than 10 years of experience in strategy formulation and manufacturing primarily in Aerospace and Defence sector. He has been a key member of prominent business houses and global consulting firms in the Aerospace and Defence practice. He has closely worked with Ministry of Defence, Defence Public Sector Enterprises and leading business houses and global OEMs. Abhranil is the founder of &-Ventures, India, which is a market intelligence and consulting company aligned to fostering growth in Aerospace and Defence sector.

This article was published by MCCIA (Mahratta Chamber of Commerce, Industry and Agriculture for CPSE Level Vendor Development Programme Cum Exhibition of Products organised by MSME Development and Facilitation Office, Mumbai on 7th and 8th February 2023.

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[1] Annual budget, Ministry of Finance, Government of India 2022 [2] Annual budget, Ministry of Finance, Government of India 2023 [3] DDP Dashboard, Ministry of Defence, Government of India 2023 [4] Defence Production and Export Promotion Policy – 2020, Ministry of Defence, Government of India [5] The SIPRI Top 100 Arms-producing and Military Services Companies, Stockholm International Peace Research Institute [6] Stockholm International Peace Research Institute factsheet – March 2022 [7] DDP Dashboard, Ministry of Defence, Government of India 2023 [8] &Ventures Research [9] DDP Dashboard, Ministry of Defence, Government of India 2023 [10] Raksha Mantri Shri Rajnath Singh attends MSME Conclave, Press Information Bureau, Dec 2021 [11] Mandatory Procurement from MSMEs for Defence Establishments, Press Information Bureau, Aug 2022 [12] Report on Trend and Progress of Banking in India for FY22, Reserve Bank of India, Dec 2022 [13] industries supported under the Technology Development fund, Press Information Bureau, Dec 2022 [14] &Venture Research [15] Tweet by Rakhsa Mantri Shri Rajnath Singh, https://twitter.com/rajnathsingh/status/, Feb 2023 [16] Defence ministry top buyer of MSME goods in 2022: GeM, Financial Express, Jan 2023 [17] Prime Minister Shri Narendra Modi inaugurates DefExpo22 in Gandhinagar, Gujarat, Press Information Bureau, Oct 2022 [18] AIDef, Ministry of Defence, Government of India, July 2022 [19] Ministry Of Defence - Year End Review 2022, Press Information Bureau, Dec 2022 [20] &Ventures Research [21] &Venture Research