India’s IT Sector Needs to Reboot

After spectacular tenfold expansion over the last decade, India’s vaunted information technology juggernaut is slowing, a victim of rising wages, an appreciating rupee, slowing exports to the US and rising taxes from a government not only trying to mop up revenues from every source but one giving in to popular perceptions that the IT sector as been pampered for too long.

It has been a long, fast ride. Earnings from the software and services sector (including domestic and exports and excluding hardware) touched nearly US$40 billion in 2006, one fourth of the country’s exports, according to India’s National Association of Software and Services Companies (NASSCOM).

But that is changing. For instance Azim Premji, who owns 84 percent of Wipro, India’s second-largest IT company, has long been touted as the richest man in India. He has now slipped to tenth, his net worth plummeting from US$17.8 billion to a still formidable $13.6 billion from the beginning of this year.

The Bombay Stock Exchange IT Index, which monitors the performance of 10 leading IT companies, has fallen by 12.35 percent over the last nine months and by 3.74 percent over the last three. By contrast, over the same span, the BSE Capital Goods Index, tracking 28 companies, has increased by 82.02 percent and 28.39 percent, respectively. This is a complete reversal of performance since India has never been acknowledged as a strong capital goods competitor.

With the IT slowdown, there are increasing questions on how the macro economy will be impacted, whether new jobs will be created and who will fill up the burgeoning commercial real estate developments, especially those in the Special Economic Zones. And finally whether the IT whiz kids will continue to rake in foreign exchange for the country even as they face competition from nimble and newly emerging IT powerhouses like Ireland and Israel.

The first concrete evidence of the slide came when major Indian IT companies announced their first quarter results at the end of June. Wipro, and the fourth largest, Satyam Computer Services, logged annual Q1 growth of 8.45 and 8.07 percent respectively a poor show when compared to the double-digit growth of previous years. Others are worse off, reporting negative growth: Hinduja TMT at minus 93.30 percent, Mastek at minus 33.57, Polaris Software minus 25.27 and Hexaware Technologies, down 9.08.

The main villain is rising wages. IT salaries, on an average, have been rising 15 percent annually for the last few years. In the process, they have been closing the gap between India and other emerging IT destinations.

“Other countries will destroy the India advantage if we do not manage the spiraling employee costs and the talent shortage issue better,” says a project leader at a Chennai-based business process outsourcing outfit.

Fresh graduates joining outsourcing companies are used to earning Rs20,000 (US$500) per month – a figure many of their fathers didn’t reach in entire careers spent in mills or offices. They were also assured of substantial and regular increments. But hefty salary increases will soon be history, if pronouncements of officials of NASSCOM are anything to go by.

Speaking at a two-day NASSCOM Quality Summit in Bangalore recently, the body’s chairman, Lakshmi Narayanan said: “It is not just the appreciating rupee that is forcing moderation in wage increases. The availability of human capital in large numbers will also impact the rate of increase."

Hefty salaries and substantial wage increases were not the only attractions for talented youngsters making a beeline towards the software sector. Incumbents get exposure to global postings and practices, the work environment is world class (including in-house food courts, recreation and banking conveniences), they enjoy flexible work schedules and, perhaps best of all, it is one of the rare industries with a flat hierarchy. This is also the only sector in India that is employee-centric. For IT companies their employees are their main assets and this results people-friendly work policies.

Apart from rising wage costs, the Indian government’s decision to roll back certain facilities under one of its schemes is also a matter of concern. In 1991, the government’s Ministry of Information Technology created the Software Technology Parks of India in order to encourage software exports. At 41 locations across the country, the STPI provides IT companies with services covering network design, system integration, installation, operations and maintenance of application networks. Various tax incentives were also available, but this scheme will expire in 2009.

"One step that will send a positive signal to the beleaguered industry is the extension of tax incentives by 10 years under the STPI scheme," NASSCOM said in a recent statement.

“This is a very wrong time to withdraw such incentives,” adds industrialist Venugopal Dhoot, president of the Associated Chambers of Commerce and Industry in India. “The government should extend the STPI scheme for another 10 years to help Indian industry maintain a competitive edge over countries like China and the Philippines, which are giving more and more tax benefits for their homegrown IT companies.”

As if this weren’t enough, the industry has also been saddled with three new levies: the Minimum Alternate Tax (MAT), a tax on employee stock option plans and a new tax on service apartments. Kiran Karnik, the normally unflappable president of NASSCOM, was recently quoted as saying, "There will be no impact in the short run, but it will be felt in the long run as these would be impediments to the growth of start-ups, though large companies would not be affected."

IT software exporters have been most alarmed at rise of the rupee, which recently touched a nine-year high of less than 40 to the US dollar, gaining 11 percent this year alone. Exporters are now asking the Reserve Bank of India, the country’s central bank, to intervene.

“The IT sector has become a victim of its own success,” says IT analyst Pramod Sachdeva, who works with a New Delhi-based brokerage. In 1996, the sector accounted for a mere 5 percent of Indian exports but today it has leapfrogged to 25 percent. At this compounded annual growth of 35 percent over the last decade, IT was the country’s fastest growing export.

“Clearly then, if the rupee is getting steadily stronger, the Indian IT sector has had a strong hand in making it so. IT exports rode on a historically weak rupee. It is only natural that in due course, the forces of international markets will bring about a correction,” Sachdeva said.

Rising Currency Woes

Even Indian Finance Minister P. Chidambaram acknowledges the rising rupee problem. "The depreciation in the value of the dollar versus the rupee has thrown up unexpected downside risks," he said at the Peterson Institute for International Economics in Washington last week. “It has challenged our exports and our tax revenue, and we may find ourselves in a situation where we need to provide for the consequences of an appreciating currency."

News of a US slowdown is also adding to the woes of software exporters. US GDP growth in the first quarter of 2007 was 1.3 percent, down from 2.3 percent in the previous quarter, its lowest quarterly growth in the last four years. The US is the largest buyer of Indian software and services, mopping up 67 percent of all Indian exports.

“With the slowdown, US firms are becoming conservative in their IT budgets and this could impact future earnings of Indian IT firms,” says Suresh Srinivasan, who started a software firm in his living room along with his brother and now employs 150 people. “A crisis is hovering over our head for real and it is high time we started searching for some workable solutions.”

Fortunately, the solutions he hopes for are now being discussed in boardrooms across the country and some of them are already at the implementation stage:

  • Reduce US dependence

    There is a big need to reduce dependence on the US consumer. Several companies have started marketing their services to untapped and potentially large markets like Eastern Europe and Germany. Infosys, started by six professionals in 1981 and which has grown into India’s third largest software firm, has seen its European revenues increase from 18 to 27 percent in five years. In July, the company also announced that it would buy Royal Philips Electronics' back-office services units in Thailand and Poland to expand its market presence.

  • Diversify manufacturing

    A few large Indian companies like TCS, Wipro, Satyam, HCL and Genpact have set up shop in China. India’s largest IT company, TCS, has two centers in China employing 1000 people. The third is slated to open in March 2008. By 2010, TCS expects its Chinese head count to shoot up to 5000. The back-office services unit of Wipro also plans to set up two facilities in China.

    Most Indian software companies cut their teeth in banking, financial services and insurance. Now there is a conscious effort to tapping new verticals like healthcare, telecom, defense and cars.

  • Shift operations to smaller cities

    Firms dabbling in information technology-enabled services, which earned $6 billion in exports last year, are cutting costs by around 15 percent by shifting to smaller Tier II and Tier III cities.

  • Look for domestic opportunities

    Buoyed by a near-monopolistic position, Indian firms have largely ignored the Indian market, but that is changing. They are now considering the domestic market as a research laboratory. “How long can the IT industry be in its US-visa mindset? Seventy-five percent of our software industry is exports, unlike China, where the domestic market consumes 75 percent of the business,” India’s Minister of State for Commerce, Jairam Ramesh, an IT alumnus, told the NASSCOM executive board in September. “We have had the computerization of land records in a couple of states and the computerization of railway reservations. We need to take up many more national initiatives where IT can bring about a transformation.”

  • Move up the value chain

    Uninterrupted growth and a weak rupee made companies complacent. They just did not feel the need to innovate. But the slowdown in IT exports is making them think more about moving up in the value chain by innovating and sharing business risk with their customers.

    But it is not going to be easy. “Going forward we will have to compete against the likes of IBM, EDS and Accenture. They offer the full range of services to their clients. It is going to take a while before Indian companies reach that league. We claim that we are a software superpower, yet our software industry is barely four percent of global IT spending,” says the exports manager of a middle level software firm.

But much more may need to be done. The IT firms could negotiate their contracts in rupee rather than dollars. They could also draw their work force from smaller, poorer states to reduce their wage bills. At stake is not only the future of IT firms but of the country as well.

There are no easy answers, and much will depend on whether the IT players will be able to benefit from the solutions listed above — and how fast.