Impact of the financial crisis

Sudhakar Ram examines the effect of the ongoing financial crisis on the Indian IT industry

The subprime crisis and the subsequent meltdown have had a mind-boggling impact across the globe. In this article, I would like to focus on their impact on the Indian IT services industry and the opportunities it is likely to throw up for companies operating in the ‘third wave’.

Three waves of evolution


When we look at globalization, specific industries in emerging economies typically go through three waves of evolution. The electronics industry, first in Japan, then in South-East Asia and now in China, are good examples of this. In the first wave, companies in emerging economies typically act as component suppliers to developed countries that manufacture the complete product. In the second wave, the local industry gains enough expertise to provide cost-effective contract manufacturing services—of either the entire product or major sub-assemblies. The third wave is when a set of firms start marketing these products under their own brand—initially within their own countries, and then going international.

We can trace the evolution of the software services industry in India using a similar paradigm.

Wave 1 (proving capability through people) started in the 70s and 80s and peaked in the mid-90s; it established the competence of the Indian software professional and the industry got results largely through staff augmentation.

Wave 2 (offshore development) established India as a destination for low-cost, high-quality programming services. The catalyst was the Y2K bug and Indian companies’ success in delivering these projects cost-effectively. Many Fortune 1000 companies discovered that moving their application maintenance and ongoing development activities to India was viable and attractive. The second wave of Indian IT started in the mid to the late 90s, and is at its mainstream phase today.

Wave 3 (strategic value delivery), which is emerging, will be characterized by Indian companies moving to high-value, IP-led services that are strategic to the customer and hence command premium, value-based pricing. The industry is already facing a severe shortage of talent, rising attrition levels and increasing salary costs. All indications are that the linear relationship between growth and headcount will not be sustainable. The future is in creating strong brands out of India that command the respect and trust of large global customers and hence the appropriate value.

Orders of short-term impact


The first order impact of the crisis is related to the banks that have either been unable to survive as stand-alone entities (like Bear Sterns and Lehman) or have taken a deep hit and are trying to recover on their own. These institutions may cancel some contracts, and downsize others. This will have an immediate impact as most of them are large customers of Indian services firms.

The second order impact will be on firms with large investment portfolios that have been exposed to subprime lending. A prime example is AIG. In such cases, the firms may get more conservative on new initiatives and discretionary projects, thereby impacting the revenues of Indian firms that service them.

The third order impact is based on fears of recession and the general conservatism that it is likely to bring in discretionary spending.

Given that 30% or 40% of Indian IT services revenues come from the BFSI segment, Nasscom has brought down its growth estimates from 30% to between 21% and 24% for the year.


The longer-term opportunities


While we can blame blind optimism and greed for the present crisis, at a more fundamental level it is a failure of systems. The quality of underwriting at the point of loan origination has failed. Systemic controls that ensure uniform and consistent application of underwriting rules would have done much to avoid bad loans. Credit scoring that took into account not just the propensity to pay but also the quantum of debt that a person had any hope of repaying would have brought these issues to light much earlier.

Better transparency and visibility of the underlying asset portfolio, and a more balanced approach while packaging a set of mortgages into bonds, would have helped monitor the health of the assets and the loans in real-time.

Better controls and risk management systems governing individual firms as well as the entire financial system would have helped to track the quantum of leverage and the risks associated with it—both from the perspective of board governance and regulatory oversight.

For too long, large institutions have been trying to get away with spending 80% of IT dollars on maintenance and only 20% on new initiatives. In a recent Information Week article, Rob Preston argues strongly against the 80-20 rule, and says that IT’s top priority is to release money for new projects.

The financial crisis is forcing mergers of huge, complex institutions that were individually ungovernable in the first place. The only possible way these institutions can be managed is with substantial investments in new IT applications that can track all the nuances of the underlying operations and provide meaningful online, real-time controls.

Implications for Indian IT


Clearly, the need is to reduce maintenance budgets and increase transformation budgets. Reduction in maintenance budgets will force companies to send more work offshore, which is good news for the Wave 2 services players in India. However, customers will force the vendors to bring in new efficiencies, and expect aggressive cost improvements year on year.
There are tremendous opportunities for the Wave 3 companies that have the expertise and intellectual property assets to bring better governability and manageability to these large enterprises. Indian companies will probably have to partner with local firms that have this expertise or hire these experts in-house (easier now). This is the time for these companies to make the investment so that they will be able to reap the benefits in the years to come.