NEW DELHI – India plans to increase its defense spending by 12.5% over the previous year and further open its domestic weapons industry to foreign investments.

Finance Minister Arun Jaitley, who is also the defense minister in the new government, has earmarked 2.29 trillion rupees ($38 billion) in defense spending for 2014-15, compared to 2.03 trillion rupees allocated in 2013-2014.

The new budget spending proposal also represents an increase of 2% from the 2.24 trillion rupees set aside in the interim budget by the previous government presented in February.

The additional 50 billion rupees will be for acquisition purposes. "I have increased the capital outlay by 50 billion rupees, over and above the 895.88 billion rupees allocated for the same purpose in the interim budget," Jaitley says.

India has been the world’s top arms importer for the last three years.

"Modernization of the armed forces is critical to enable them to play their role effectively in the defense of India’s strategic interests," the minister says. An increase in the defense capital budget is encouraging, considering the number of contracts that are pending with the defense ministry. India is thought to be close to finalizing the long-delayed $20 billion contract with Dassault Aviation for the sale of 126 Rafale fighters.

The defense ministry also is waiting to sign an estimated $3 billion deal to purchase Boeing’s Apache attack and Chinook military transport helicopters.

Rahul Gangal, a principal at Roland Berger Strategy Consultants, which focuses on the aerospace and defense sector, says, "An expansion in the defense budget is a necessity to address serious capital equipment shortage. A higher expansion would have served the armed forces better. It will be critical to note how the entire amount is utilized in the corresponding time period considering the historical issues of non-utilization of the entire outlay."

India’s annual defense budget is just one-third that of neighboring China despite the tensions that remain along their shared border, according to a recent Pentagon report.

China’s official annual defense budget in 2013 was $119.5 billion against India’s $39.2 billion. For comparison, Russia’s national defense budget in 2013 was $69.5 billion, followed by Japan at $56.9 billion.

The biggest policy change announcement in the proposed budget was the increase of the ceiling on Foreign Direct Investment in India’s defense sector from the current 26% to 49%, in a bid to boost the economy’s manufacturing sector. The full management control of such joint ventures will stay with Indian companies, Jaitley says.

"We will retain the Indian control in defense Foreign Direct Investment [FDI]," Jaitley said. "We need to revive growth in manufacturing."

The government’s decision to increase the investment limits for foreign firms in the defense sector has evoked mixed responses.

Dhiraj Mathur, aerospace and defense lead for PwC India, says, "Ultimately, this does not make any material change and may not be enough incentive for foreign firms to bring in investments and proprietary technology. However, on a more positive note, allowing investment by [foreign investors] is a pragmatic step which will remove uncertainty and provide added flexibility and opportunities for raising finances to listed Indian companies."

However, the government’s own investment promotion department, the Department of Industrial Policy and Promotion (DIPP), which initiated the proposal, was not in favor of a limit of anything under 51%. It argued that no foreign investor will transfer technology without majority control over the Indian venture.

Earlier, the DIPP’s draft cabinet note had suggested that 49% FDI should be allowed in ventures without any transfer of technology. In companies where the foreign partner is willing to transfer the know-how, it proposed to allow overseas players to hold up to 74%, while 100% was suggested for companies engaged in manufacturing state-of-the art equipment and machinery, or those involved in modernization projects.

"The decision to increase the FDI limit to 49% will be viewed by most foreign OEMs and some Indian companies as a very limited step and for a real change, this limit should have been enhanced to 51%," says Ganesh Raj, policy analyst at Ernst and Young.