As rupee falls against dollar, defence firms seek shield on rate variation - Broadsword by Ajai Shukla - Strategy. Economics. Defence.

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Tuesday 19 July 2022

As rupee falls against dollar, defence firms seek shield on rate variation

The dollar has appreciated against the rupee, while the Euro and the pound have remained largely flat vis-à-vis the rupee

By Ajai Shukla

Business Standard, 20th July 22


The exchange rate of US dollar vis-à-vis Indian Rupee has fallen to Rs 79.74 to the dollar, down from Rs 74.55 a year ago. This 6.96 per cent fall in rupee against dollar in just one year is making private Indian defence companies consider petitioning the Ministry of Defence (MoD) for protection against exchange rate variation (ERV).


The non-manpower allocations to the three services in 2022-23 adds up to Rs 222,511 crore. 50 per cent of that, or Rs 111,255 crore, can be conservatively assumed to be going to foreign original equipment manufacturers (OEMs). ERV accounts for another 6.96 per cent of that, or Rs 7,743 crore. If the rupee falls further, that figure will increase.


It is mainly the dollar that has appreciated against the rupee, while the Euro and the United Kingdom pound have remained largely flat vis-à-vis the rupee in recent years.


India’s private defence firms had last campaigned for ERV protection after being bruised by the rupee’s fall from Rs 44 a dollar in October 2010 to below Rs 56 just a few months later. Even “indigenous” defence systems contain many imported components and sub-systems, so any depreciation in the rupee’s value raises India’s production costs and hits profitability.


Foreign OEMs bid for MoD contracts in foreign currency. If they emerge as the lowest bidder (L1), the MoD pays them in foreign currency. Indian OEMs say that the concept of “equal treatment” and a “level playing field” demands that the same payment methodology should be extended to Indian firms who emerge as L1 in a tender.


Indian companies compete in international contracts under significant disadvantages. They must look for risk cover at significant cost, especially for projects that run over three-to-five year periods or longer. This whittles away the principles of level playing field and promoting indigenous defence capability. 


In MoD tenders, private Indian companies are expected to compete against foreign vendors, which are not affected by ERV; and against DPSUs, which already enjoy MoD protection.


In 2013, industry body Ficci had sent a detailed paper to MoD, seeking a level playing field for the private sector against foreign OEMs and defence public sector undertakings (DPSUs).


Ficci had suggested that all bidders, including DPSUs, submit their commercial bids on a multi-currency format, with imported components quoted in foreign exchange (forex), and components sourced in India quoted in rupees. Since 2006, foreign vendors and private Indian companies have been submitting multi-currency bids. But DPSUs bid entirely in rupees, while separately indicating the forex component of the bid.


The winner of a contract, i.e. the L-1 (lowest-cost) vendor, is selected by reducing all quotes to their rupee value on the day of opening of the bids. For this, the forex component in the bids of foreign vendors and private Indian companies are converted to Indian rupees at the selling rate of State Bank of India, Parliament Street, New Delhi.


The Defence Procurement Procedure of 2006 (DPP-2006) and subsequent revisions mandate that a DPSU winning a contract would enjoy ERV protection on the forex content that it had indicated in its bid.


DPP-2011 provided similar ERV protection to private Indian companies, but only for global tenders, i.e. acquisitions categorised as ‘Buy (Global)’. In acquisitions that are confined to domestic vendors, i.e. ‘Buy (Indian)’ category, no ERV protection is provided to anyone. But DPSUs get ERV protection in single-vendor cases, or when they are nominated for production. According to Ficci, “it needs to be seen how this will be interpreted in case of private companies”.


MoD has grappled for long with ERV issues. In 2003, a committee headed by Shashanka Bhide of the National Council of Applied Economic Research (NCAER) had recommended that MoD must hedge the forex component of defence contracts against fluctuation. That recommendation remains ignored to this day.


The Bhide committee determined that hedging forex risk would add two per cent to the cost of a defence contract, but not hedging was likely to cost an extra 4-5 per cent. This loss would naturally be larger during markedly negative periods for the rupee, like in the past year.


In 1993, as a part of the liberalisation and deregulation reforms initiated by the Narasimha Rao government, the Indian rupee (INR) has officially been following a market-determined exchange rate for foreign exchange. In this, the price is determined by demand for and supply of foreign exchange – with intervention by the Reserve Bank of India from time-to-time. 


The MoD provides foreign exchange for direct import of defence equipment, as well as for nominated procurements from DPSUs, thus bearing almost 95 per cent of the foreign currency risk in defence procurement contracts. 

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