India’s defence outlay cut: Is it a setback for Modernisation?

New Delhi. The reported cut of INR 10,000 crore (approx US$ 1.8 billion) in the defence acquisition budget by the Ministry of Finance (MOF) has triggered the fear of a major slowdown in the ongoing acquisition programmes, including that of the much-talked-about Medium Multi Role Combat Aircraft (MMRCA) for the Indian Air Force (IAF). This cut is being viewed with disappointment against the backdrop of a statement made by the Defence Minister AK Antony just a few months back that he would seek a hike in the defence budget because of the new challenges to the defence and security of the country. At a time when the three Services are desperately trying to modernize themselves and the Army, in particular, is grappling with its operational voids, such reactions to the reported reduction in the allocation are understandable.

The question, however, is whether this cut would actually cause a setback to the modernization programme.

It is true that the allocation made for defence for the current fiscal was less than the requirement projected by the Ministry of Defence (MOD). But this was neither unprecedented nor unexpected. Allocation of resources is a zero-sum game.

To put it simply, the government can distribute among various ministries and departments only what it expects to generate by way of direct and indirect taxes and other non-tax revenue. If the demand for budgetary support exceeds the anticipated receipts, which is generally the case, the Ministry of Finance has no option but to fix the budgetary allocations for various ministries and departments in a manner that its sum total does not exceed the total receipts.

Consequently, the allocations are normally less than the projected requirements. It is because of this that the allocation for defence, and for many other ministries and departments for that matter, fall short of the projected requirements.

Any notion that allocation for defence is accorded low priority vis-à-vis other sectors is misplaced.

The gap between the projection by the MOD and the final budgetary allocation for the current year was approximately INR 35,000 crore (approx $ 6.3 billion).

It is difficult to imagine from which other sector(s) could the MOF pinch this amount to meet in full the requirement projected by the MOD. Additional resources can indeed be generated through taxation, but this is always a difficult choice.

The other option is to curtail the expenditure. This is what the government tried to do when it imposed a cut on non-plan revenue expenditure, excluding the salaries, in the very first quarter of the current financial year.

And significantly, that cut did not also apply to the capital budget.

However, with the receipts falling behind the target and the economy passing through a sluggish phase, MOF was evidently left with no option but to take stringent steps to contain the fiscal deficit. The reported reduction in MOD’s capital budget has to be seen in this context.

Does the reduction in budgetary allocation at this stage slow down the process of acquiring crucial weapons and systems?

Defence budget comprises the revenue (salary etc.) and the capital segments, with the latter being notionally divided into capital (equipment and weapons) acquisition and other-than-capital-acquisition segments.

The capital acquisition budget, which is a notional category within the overall capital outlay for the defence Services, accounts for 83 per cent of the total capital budget for the current year.

In absolute terms, the capital acquisition and other-than-capital acquisition budget for the current year was INR 66,032.24 crore (approx $ 12 billion) and INR 13,546.39 crore (approx $ 2.46 billion) respectively.

As of now, the cumulative expenditure figures for the third quarter are not available but the expenditure incurred till the end of November 2012 was 49.90 per cent of the total capital budget of 79,578.63 crore ($ 14.46 billion).

Under the capital acquisition and other-than-capital acquisition segments, the expenditure was 50.55 per cent and 46.76 per cent respectively.

Going by the average expenditure till the month of November 2012, the MOD would probably have been able to utilize only about 75 per cent of the total allocation by the end of the financial year, that is, by March 2013.

That would have left a balance of about INR 20,000 (approx $ 3.6 billion) unutilized.

Therefore, a realistic assessment was indeed required to be made by both the ministries. That the allocation has been reduced by INR 10,000 crore (approx $ 1.8 billion) and not INR 20,000 crore (approx US$ 3.6 billion) is a clear indication that such an assessment was indeed carried out.

It has to be taken into account that the expenditure in the last quarter of a financial year does not follow the average of the first three quarters. This is a notable thumb rule.

While it is up to the MOD to decide the proportion in which the reduction would be borne by the capital acquisition and other-than-capital acquisition budgets, it is also a fact that a sizeable proportion of the cut would have to be borne by the capital acquisition budget.

This brings us back to the question whether the recently mentioned cut would adversely impact the ongoing acquisition programmes that are so crucial for modernization of the armed forces.

To answer this question, it is necessary to understand the linkage between the availability of funds and the progress of the acquisition process and programmes. In a general sense, the expenditure from the capital acquisition budget is incurred on liquidating the committed liabilities related to the on-going contracts and the payments that become due after signing of the fresh contracts during the year.

The cash outgo in respect of the latter category of cases is restricted to payment of advance (generally 15 per cent of the contract value).

There is no doubt that the cash outgo on these accounts would have been taken into account by the MOF while fixing the revised ceiling after consultation with the MOD.

It is possible however that there indeed was a difference in the assessment of the two ministries. But there is also no question that a part of the cut would be restored if the assessment of the MOD goes awry and the need arises for funds over and above the reduced ceiling to liquidate the committed liabilities or make contractual payments against the new contracts. There are precedents to that effect.

Notably, the question of availability of funds in a particular year does not come in the way of initiating a proposal, steering it through various committees, obtaining the approval for the proposal, releasing a Request for Proposal (RfP), processing the responses, holding commercial negotiations and firming up the proposal for sanction by the competent financial authority, which happens to be the Cabinet Committee on Security (CCS) for proposals exceeding INR 1,000 crore (approx $ 181 million).

After a proposal has been approved it takes some time for finalizing the contract and the first payment may not become due immediately on signing of the contract.

Two examples are relevant:

There is no break on the acquisition process of six midair refueling aircraft in which European Aeronautics Defence and Space (EADS) company has emerged as the lowest bidder on the basis of life-cycle costing. The process is not being withheld by the MOD in the wake of the cut on budget. It takes several months to complete commercial negotiations anyway.

Then there is the MMRCA programme. In this, despite steady discussions, commercial negotiations are yet to be completed. Once this is done, CCS approval would be needed and that would take some time.

There is, accordingly, no requirement of funds for these or other ongoing programmes which are at various stages of processing during the current fiscal year (April 2012- March 2013).

(Conversion Rate US$ 1 = INR 55 as of Jan 2013)

The author dealt with India’s defence acquisition programmse till his recent retirement as Financial Advisor (Acquisition), Additional Secretary and Member Defence Procurement Board in the Ministry of Defence.

India Strategic