Anand Krishna’s musings

For years, economists and politicians have waxed eloquent about the wondrous benefits of globalization. Countries like India, that had erected protective trade barriers for the first 50 years after independence, started a regime of dismantling such barriers and “integrating with the global economy”.

Western corporations had (finally) got access to emerging markets and CEOs were salivating at the prospect of selling a range of goods and services to a rapidly growing middle class in Brazil, Russia, India, China and elsewhere. All was hunky dory as long as the going was good. But now, the world is faced with a disquieting reality: when things go sour, the very economic inter-connectedness that votaries of globalization were rooting for, causes pain. And apparently, lots of it!

In the last decade, the world economy has seen the Asian melt-down of 1997-98, the dotcom bust, the US recession/slowdown of 2001 and most recently, the sub-prime crisis. In the 20+ year old film “Wall Street”, Michael Douglas epitomized the typical investment banker in his famous line “Greed is good”. And it is exactly this greed that has amplified the current global economic crisis.

In their quest to deliver “superior returns”, managers of hedge/mutual funds have created “structured products” that tend to obfuscate investors’ (and possibly the managers’ own) understanding of risk. But it is axiomatic that higher returns go hand in hand with higher risk. In their greed for higher returns, people (investors and fund managers) lost sight of the difference between “alpha risk” and “beta risk” and when the sub-prime loans started unravelling, so too did a plethora of other asset classes. In many instances, there is poor understanding of the underlying risks. Compounding the situation further is the fact that because of globalization (which facilitated cross-border investment flows), investors in country X are being exposed to risks associated with economy Y. Ergo, the global economy has begun to feel the pain.

This pain is also being felt in other quarters. The largest Wall Street financial supermarkets- the Citigroups, Merrill Lynches, Morgan Stanleys and their European peers/competitors- the UBSs and Societe Generales- are taking substantial P&L hits. To at least part-offset these losses, some are considering a trade sale of assets like their captive back-office operations in locations like India- which represent a source of competitive advantage to these companies. Such sales, if effected, will affect the equilibrium of both the outsourcing industry (which may acquire such assets) and the domestic talent market- after all, captive BPOs do employ 50K+ skilled employees in India alone.

How all this will finally play out is a trillion dollar question. But for everyone involved- and that includes average investors like you and I- the next 12 months or so will be crucial.

India’s IT industry has enjoyed an amazing run over the last two decades, with only a brief pause to catch its breath in 2001. All good things, it is said, must come to an end. Clearly, as in other industries, the scope for “super-normal profits” is a thing of the past. What does the future hold for the IT services industry? Answering this question is not simple; in fact, there are several forces at work, and the outcome will depend on their complex interplay.

1. As the US economy heads into what may be a prolonged slowdown,  domestic spnding will dry up. Companies will go into cost-cutting overdrive and hence many companies will embrace higher levels of outsourcing.
2. With the dollar continuing to weaken against the Rupee, shrinking IT budgets will be able to buy only a smaller amount of services priced in Rupees. New projects aimed at enhancing competitive advantage may be put on the back-burner, and companies will only want to “keep the lights on”.
3. It’s election year in the US and anti-outsourcing rhetoric will reach a crescendo. Companies will defer their outsourcing program, for fear of being called unpatriotic or responsible for domestic job losses.
4. As other industries start competing for talent in India, the IT industry will be forced to raise wages- but because of the margin pinch, this increase will be lower than what other sunrise industries like Retail and Construction can offer. The supply constraint thus caused will further impede India’s outsouricng companies in their abilities to deliver more projects- and thus drag revenue and possibly, margins.

The next 12 months will be critical for the entire industry, which is at an inflection point. Companies that reinvent themeselves to be able to deliver superior value in terms of newer offerings that can deliver “non-linear growth” (revenue growth graph that is not parallel to the graph showing increase in employees),  more IP-based  services (such as  true management consulting) or move into new types of knowledge-based outsourcing (such as outsourcing of marketing servcies, analytics, equity research etc.) will come out on top. For the others, well- there’s always the option of being taken over!

As recently as about 3 years ago, US $ 1 was worth almost INR 50 (ok, a few paise less, if you want to be puritanical about it!). But today, the exchange rate is closer to US$1= INR 40 (maybe INR 39 is closer to the truth). The very premise of the Indian IT services and BPO industries is being questioned. Exporters are upset- and the impact is there for all to see whether it is garments and textiles or tea or even silk and handicrafts.

But is it all just gloom and doom? Foreign travel has become cheaper (in Rupee terms)- so more people are holidaying overseas and getting exposed to the global environment; each Rupee goes farther in terms of paying for our imports. Hiring foreign talent will be less of a burden (whether we are talking pilots or CEOs)- especially when a large chunk of the company’s revenues are denominated in INR, giving it a natural hedge (of course, when the contract is renegotiated, the expats may demand to be paid in GBP or some fancy basket of currencies!).
In the long run, a strong Rupee can only be good for the nation as a whole. Yes, certain industries will be adversely impacted- and they will need to focus on enhancing productivity, providing higher-value services that will command higher price points, and simultaneously, expand to locations that are still cost competitive. For instance, if India’s outsoucing industry is benefiting from the country’s colonial past in that English is widely spoken and is often the medium of instruction, then why should he industry not leverage the same historical English connection that African countries like Kenya and Botswana also possess? Or for that matter, tap into Francophone Algeria to service the outsourcing needs of French speaking companies/markets? If companies were to do this, I believe the true benefits of globalization would percolate far quicker across the world.

India continues to reign supreme as the pre-eminent outsourcing destination for IT and BPO services. This in spite of emerging destinations around the world- countries in Eastern Europe, South East Asia, Latin America, and of course, China.

The large talent pool and knowledge of English scale are clearly key reasons for the industry to have thrived thus far in India. But to hope that these will forever remain a competitive advantage is naive at best and foolish at worst. India’s expected GDP growth rate will be in the 9-10% p.a. for at least the next 5 years- driven partly by rising exports and partly by the demand expansion within the country. New industries will emerge, new foreign companies will set up shop in India and existing Indian companies will continue to grow rapidly. All this will require new talent- and this talent too will have to come from the same pool that today serves the IT and ITES industries. Wage costs will spiral, talent quality will decline and the magnificent edifice of the Indian IT & ITES industry as we know it today will start to crumble.

So what is the solution? Apart from the obvious resonse of establishing new delivery centers in other cost-effective locations (in the initial years, these savings will be offset by the investment required for infrsatructure, training etc.), what is needed is for India to explore new frontiers in outsourcing. If clinical research, equity research and legal research can be done from India, why not large-scale outsourcing of advertising processes such as creative & copy or indeed, even design and analysis of market research? Let the brief be developed “in-market” and passed on to a team of bright designers and copy writers in India. Why should “product design” and “services” be separated? Why not outsource engineering design- as well as manufacturing- to India?

The key is to expand the scope of what can be outsourced to a remote location such as India. The really smart western MNCs will look to use their outsourcing centers in India to develop products for local markets as well- so that they don’t lose out on the burgeoning demand in India.

If we can do all this right, it will surely be another case of chak de India.

The obvious short term impact of the rising default among “subprime” borrowers on the outsourcing industry will be in the form of lost revenues and profits. And while subprime mortgages are perhaps the most visible manifestation of the “subprime” problem, the issue of unaceptable quality of risk (relative to the pricing of that risk) is just as prevalent in the credit card and consumer loan segments of the industry. Thus, the impact will be felt not just by outsourcing companies that work with mortgage customers, but also by those that derive a significant portion of revenues from the BFSI sector- which is arguably the largest spender on outsourcing (BPO + IT services- captive units included).

The flip side is that the crisis can be expected to drive industry consolidation- which in turn, opens up new opportunities to rationalize prcesses, systems and infrastructure. And clearly, outsourcing these tasks can save the client company anything from 25-40% in costs. Existing players will want to run more rigorous analytics on their lending portfolios to assess and manage credit risk. There will also be more resources allocated to enabling lending institutions to take a customer-centric, rather than a product-centric view of their relatonship with customers. The pressure on margins might force even more BFSI players to embrace outsourcing as a strategy to regain at least a part of their financial health.

Do not assume that the impact of the subprime crisis is limited to the BFSI industry. The overall credit squeeze in the US economy will have a direct effect on spending in the retail, leisure, travel, media & entertainment and healthcare sectors. And much of the logic above in support of an increasing trend towards outsourcing will play out in these other industries as well.

Thus, in the medium term, I think the outsourcing industry will actually emerge stronger.