Pause or halt?

Pause or halt?

Abit of recent history can help us understand what a strong rupee will mean for India’s outsourcing industry, in terms of both growth and profits.

In 1998, the rupee was trading at around 40 to a dollar and India was exporting a little less than $2 billion of software and other business services. The Indian currency has since then dropped and jumped up against the US dollar—but these gyrations have not prevented the local software and business process outsourcing (BPO) companies growing at a frenetic pace over the past nine years.

Now, in 2007, the rupee is once again at around 40 to a dollar (its 1998 level), while outsourcing exports are close to $32 billion. What this means is that our outsourcing exports have grown 16-fold over the past nine years, and this despite the fact that the rupee has not depreciated in line with domestic inflation.

What this little sojourn into the past shows is that the overall growth of outsourcing has been quite independent of currency vagaries, and has in fact been more dependent on other factors such as the growth in the world economy, IT spends in global companies, the politics of visas, and the supply of local engineers. This flies in the face of the current obsessive belief that a strong rupee is all that matters for the outsourcing industry.

In fact, all this suggests that it is very likely that the great Indian outsourcing juggernaut will not be stopped in its tracks because of a strong rupee. The basic business model —of using India and a few other similar countries to cut costs—is still robust, even though growth rates may be slightly slower in case the US drops into a recession.

It is very likely that global outsourcing will keep growing at around 20% a year over the next decade, which is a bit faster than the growth rate of the rest of the economy in nominal terms (taking inflation into account, that is).

This is far slower than what the industry has been used to since the Y2K fear gripped the world. But it is not exactly a case of severe inertia.

The question is how profitable this activity will be in the future. And it is here that the real troubles lie. There was a time when net margins of the large software companies were close to 50%. These are now down to around 23%. The halving of profit margins is not inexplicable, given rising wage costs and a weak dollar. This margin compression is likely to continue in the future as well, as incomes rise and software elves in places such as Bangalore, Hyderabad and Pune get higher salaries.

Stock market investors are justified in being less enamoured of technology companies than before. For example, as pointed out in a research report by a foreign brokerage, Infosys Technologies’ price-earnings ratio in October 2006 was 80% higher than the comparable number for global peer Accenture. By August 2007, this premium was whittled down to around 15%—an indication that investors expect Indian technology services companies to grow at the same rate as their global competitors in the future. They will not be growth leaders.

Should we be surprised by all this? No. There is no instance in economic history when the profit margins of companies in a commodity business have not been beaten down eventually, as costs rise and competition gets stiffer. And—like it or not—labour arbitrage is a commodity business. Most Indian software and BPO firms are well managed. So they will respond to these challenges. We already see moves to hike prices, do more onsite work, set up centres abroad and play the merger and acquisition game. Consulting and product development beckon. But these are transitions that would have happened even if the rupee had not soared.

Despite this, we would not be surprised if profit margins of the large software and BPO firms halve once again over the next decade.

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