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15 September 2015

Deficit or Direction?: Prudence in Defence Expenditure

By S.N. Mishra
12 Sep , 2015

Richard Musgrave, an acknowledged authority in public finance, had said that every Finance Minister must grapple with the three issues of Allocation, Distribution and Stabilisation. Arun Jaitley, while flagging the fiscal footprints of consolidation and prudence, seems to have echoed Musgrave’s mantras. Defence expenditure cannot be relegated to cosmetic discussions on its linkage with GDP. A definitive roadmap needs to be etched by the political leadership to ensure that this sector is in sync with national concern for fiscal prudence without compromising needs for modernisation and operational preparedness.

The defence budget for 2014-2015 has raised enormous curiosity regarding the directional change that will be ushered by the new Finance Minister who doubles up as Raksha Mantri. The big news is increase in Foreign Direct Investment (FDI) cap to 49 per cent and the creation of a corpus of Rs 100 crore towards the Defence Technology Fund (DTF). The DTF concept was mooted in the Defence Production Policy 2011. Its activation is welcome as it would hopefully provide funds to universities, the private sector and institutions of repute such as the Indian Institute Science to pursue niche technology. The enhancement of the FDI ceiling with full management control has been bit of a dampener because it has to be routed through Foreign Investment Promotion Board (FIPB) and full management control would remain with India. This will deter global Original Equipment Manufacturers (OEMs) from making investments in key technologies as they would not have majority rights.


The present paper makes an effort to demystify the mystery that shrouds the defence budget and suggests a way forward to make defence expenditure in sync with concerns for fiscal prudence and bolster indigenous defence industry capability.

Trends in Allocation and Expenditure

It would be seen from the above that there was significant under spending in the Capital Budget during 2013-2014 and considerable over spending in the Revenue Budget of the same order. The overall increase envisaged for 2014-2015 is about 11.5 per cent over actuals of the previous year. If one deflates the monetary increase in the interregnum by WPI increase, the real increase will be around three per cent. Disquietingly, the Revenue Budget does not provide any increase in real terms.

Demystification of the Budget Process

While tabling the budget documents against various demands for grants, the Finance Minster makes a pitch for six demands which includes a consolidated demand for capital outlay for the three Services, Defence Research and Development Organisation (DRDO) and Ordnance Factories (OF). The defence plan is not part of Plan Document as defence expenditure is Non-Plan in nature.

The 11th Defence Plan (2007-2012) was formally mooted in 2006. It brought up for the first time a Capability Plan linking capability upgradation requirement with adversarial capability and likely acquisitions. The 12th Defence Plan (2012-2017) is yet to be approved.

The challenge is how to improve on our design capability in critical sub-systems and bring in key technologies…

Defence expenditure belongs to the trinity of interest, subsidy and defence where fiscal prudence is usually associated with reduction in subsidies. Surprisingly, there is very little informed discussion on how to bring in economy in defence expenditure. The general debate veers around share of defence in GDP and the lamentable approach of the civilian bureaucracy both in South and North Blocks to the legitimate modernisation needs of the services.

Defence budgeting like General Budget has followed an incremental concept while many advanced countries adopt the ZBB concept and correlate inputs with outputs through Outcome Budgets. The Authority Responsibility Centre concept introduced during 1994-1995 based on New Management Strategy of UK has established an excellent footprint for better budget management and monitoring. This concept introduced a three-tier budget holder concept viz. at the level of Service Headquarters, Intermediate level (Service Headquarters) and at the Unit level. As a spin-off to this, Defence Services Estimate Volume-II has been introduced. However, in practice, this has not brought in any clear accountability in terms of outcomes like desired serviceability of fleet.

An attempt has been made to highlight some of the structural and systemic changes needed to ensure greater economy and accountability in defence expenditure.

Structural Changes

Life Cycle Costing: This concept was applied for the Medium Multi-Role Combat Aircraft programme which enables users to have a clear assessment of the cost of platform and its maintenance cost over the life-time of the aircraft. This is a standard practice for major weapons systems all over the world. We are still chary of applying it to other systems. The problem is further compounded by the disconnect between Capital and Revenue Budgeting. A holistic approach of the budget requirement for both Capital and Revenue Budgets is urgently called for.

Outcome Budget: Almost all ministries have been preparing outcome budget where there is a linkage between resource requirements and desired outcomes. The Ministry of Defence (MoD) has been resisting this assiduously. It would make eminent sense if production organisations such as OFs, Defence Public Sector Units (DPSUs) Repair and Overhaul Organisations are asked to prepare an outcome budget. It is high time that there is transparency about such input and output linkages so that they can be compared with the private sector in terms of cost and economic efficiency.

A holistic approach of the budget requirement for both Capital and Revenue Budgets is urgently called for…

A case in point is the contracts for patrolling vessels issued by the Indian Navy and the Indian Coast Guard in favour of private shipyards. This has clearly shaken up captive Defence Public Sector shipyards who were assured about the contract earlier without adequate concern towards cost control. It is also high time that the concept of Cost Centres is introduced in major defence production establishments.

Defence Technology Fund: While the initiative to create a corpus of Rs 100 crore is welcome, the kitty is too meagre and indicative of the kind of tokenism that pervades this year’s annual budget. It would be useful to recall the Big Push Growth Model of Rosenstein Rodan (1943). Unless funding is provided, substantial research in niche technology and indigenisation would be a chimera.

Renewal and Replacement Fund: There is a clamour for a Rolling Fund for Capital Acquisition. Such a system is already in vogue with the Railways. Even the OFs have such a fund since 1988 and it has helped them to replace P&M in a timely manner.

End Year Flexibility Scheme (EYFS): In the United Kingdom, there is a concept called End Year Flexibility Scheme (EYFS) for capital outlay in defence where unforeseen surrenders are allowed to be carried over to the next year. The Arum Singh Committee (1995) had recommended this for India as part of the New Management (1995) Strategy. This needs to be reviewed as it will (a) minimise March Rush and (b) preempt temptation to park funds with DPSUs.

Accrual Accounting: The CAG has been advocating a system of Accrual Accounting instead of Cash Accounting. Such a system provides for better accounting as it takes stock of end result. This will also help proper liability monitoring and better long term planning for weapons acquisition.

Teeth to Tail Ratio: Globally, the ratio is 80:20 whereas in India it is still 60:40 clearly demonstrating that there is considerable room for economy in support services and inventory management. Furthermore, during the 9th Plan, the Revenue to Capital ratio was 75:25 which has come down to 60:40 during the 11th Plan. The present budget shows the same trend. Ideally, the ratio should 40:60 so that the requirement for the tail and maintenance is minimal and most of the budget is utilised for modernisation.

Expenditure on Spares: Spares are a costly proposition, more so when they imported from OEMs. This can derail fleet availability if not supplied in time. It is of utmost importance that we build indigenous capability and have assured cost effective supply. Programmes such as those for the Scorpene submarine and SU-30 combat aircraft, are cases in point where the OEM can take undue advantage unless build indigenous capability is developed in a time-bound manner.

Resource Crunch: The defence services are uniquely perched with no resource crunch which is not the case with many other social sector ministries. Accordingly, cost control/reduction has never been a thrust area.

In the Acquisition wing, the thrust is how to avoid surrender of funds. It may be seen from Table 2 that we have the curious phenomenon of consistent surrender of funds of around Rs 8,000 crore per year while parking huge advances with defence PSUs like Hindustan Aeronautics Limited (HAL) has been endemic.

Several committees have given extremely pertinent and workable suggestions to contain defence expenditure. They are basically for better inventory management, realistic spares management and outsourcing for support services. The Mishra Committee (2009) is an excellent in-depth study in this regard and effective follow-up action is called for.

Growth of Acquisition Budget & CGE: Military Malthusian

It would be seen that year to year, increase in defence acquisition far outgrows growth in CGE. Therefore, the FM/RM should seriously look at possible diversion of around Rs 5,000 crore from the capital budget to social sector programmes and for funding needs of SMEs who employ 108 million, contribute 50 per cent of the GDP and yet receive only 11 per cent of the institutional finance. The Economist rightly observes that, “institutional finance to informal sector will be the best way to formalise them.”

ERV vs Futures: The volume of imports by the services and the DPSUs is of the order of $5 to $6 billion. Presently, an ERV formulae governs the reimbursement of additional rupee outgo when the rupee depreciates. A committee under the Chairmanship of the Director General, National Council of Applied Economic Research had suggested that the MoD should opt for futures as it will be significantly benefit the MoD compared to ERV. This recommendation needs to be relooked at.

Systemic Changes

Long Term Planning: With the formation of the Acquisition Wing (2001) and Integrated Defence Services, it was hoped that the acquisition process would be faster. The Government’s intent to provide a level playing field to the private sector particularly in Ship Building and their association in the formulation of a capability plan, are eminently welcome moves. Such association by the private sector and DPSU/Ordnance Factories would help them to plan long term investments. In practice, however, the synergy between the CISC and Industry associations is still tepid and the private sector is rarely considered a partner.

Defence Industry Base: In recent years, several major policy initiatives have been taken up such as the Offset Policy, Make Policy and Defence Production Policy to improve the Self Reliance Index (SRI). During 1995, it was assessed as 0.3 which was to be enhanced to 0.7 by 2005 as recommended by a Committee headed by Dr. Abdul Kalam, the then Scientific Advisor to the Raksha Mantri. The SRI shows no signs of moving on an upward trajectory. The challenge is how to improve on our design capability in critical sub-systems and bring in key technologies through the Transfer of Technology (ToT)/Offsets policy.

The MoD also needs to bring in greater professionalism in terms of maintaining a proper database for the large number of contracts by different services ; mso-ascii-theme-font:minor-latin; mso-fareast-font-family:”Times New Roman”; mso-fareast-theme-font:minor-fareast; mso-hansi-font-family:Calibri; mso-hansi-theme-font:minor-latin;}

A holistic approach of the budget requirement for both Capital and Revenue Budgets is urgently called for…

India is a potential destination for foreign investment due to its huge pool of skilled personnel, labour arbitrage and democratic institutions. Technological transfer to defence PSUs such as Bharat Dynamics Limited (BDL) has brought in significant cost reduction in various missiles systems. A liberal FDI policy and ease of doing business should be of paramount importance.

The New Manufacturing Policy mentored by the Krishna Murthi Committee is expected to galvanise manufacturing in India with the support of industrial corridors and freight corridors. This will generate additional employment of around 10 million per year and is going to be a game changer for India. The Defence Manufacturing Policy has to be a part of National Manufacturing Policy so that there is complete synergy between systems having both civil and military bearing (Dual Use Technology) like Aircraft, Ships and Electronics/Radars.

Delegation of Powers: There has been significant delegation of powers on the revenue side. This is a follow up to the Arun Singh Committee recommendations. While making a huge delegation in 2007 there was a clear understanding with SHQrs that higher delegation should lead to improved serviceability. However, there appears to be no attempt to assess the efficacy of such delegation.

Conclusion

In conclusion, it may be mentioned that better synergy between the MoD, defence services, defence production units, the DRDO, OEMs and reputed design houses is the way forward to bolster our defence industry base. Credible Public Private Partnerships (PPPs), viable Joint Ventures and Joint Design programmes will foster this process. The present dissonance between the Services, production agencies and the DRDO needs to be sorted out through strong political will and direction.

The MoD also needs to bring in greater professionalism in terms of maintaining a proper database for the large number of contracts by different services; monitor contract liabilities as per milestones and share data between budget holders within the service and intra service. This is all the more important for systems having both civil and military applications in aircraft, ship and electronics. Given the sizable IT budget proper coordination by the acquisition wing will ensure huge economy and much better delivery and budget monitoring. Defence budget provides enough room for the economy and must not be way-laid by cosmetic discussions on GDP percentage.

The FM has suggested constitution of an Expenditure Management Commission to take a holistic view of subsidies and urea pricing with a view to contain non-plan expenditure and fiscal deficit. It strongly suggested that possible economies in defence expenditure be made a part of this commission’s study.

Richard Musgrave, an acknowledged authority in public finance, had said that every Finance Minister must grapple with the three issues of Allocation, Distribution and Stabilisation. Arun Jaitley, while flagging the fiscal footprints of consolidation and prudence, seems to have echoed Musgrave’s mantras. Defence expenditure cannot be relegated to cosmetic discussions on its linkage with GDP. A definitive roadmap needs to be etched by the political leadership to ensure that this sector is in sync with national concern for fiscal prudence without compromising needs for modernisation and operational preparedness.
© Copyright 2015 Indian Defence Review

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