The Financial Crisis - Impact on the Indian IT industry

The subprime crisis and the subsequent meltdown has been the subject of much discussion in the recent past. The magnitude of the crisis, the impact it has had on what we thought were rock-solid institutions and the ripple effect across the globe have been mind-boggling. What I’d like to focus on, in this article, is the impact this will have on the Indian IT services industry and the opportunities it is likely to throw up for companies operating in the Third Wave. Before getting into the impact of the crisis, let’s look at the Three Waves of Indian IT.

The Three Waves of the Indian IT Industry

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 very 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 in a cost-effective manner. Many Fortune 1000 companies discovered that moving their application maintenance and on-going 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. Like all mainstream markets, this is characterized by the emergence of a few leaders, namely the Tier 1 IT companies, who demonstrate high rates of growth and profitability and increasing market share.

Wave 3 (Strategic Value Delivery), which is emerging, will be characterized by Indian companies moving up to high-value, IP-led services that are strategic to the customer and hence command premium, value-based pricing. As we have seen, the industry is already facing a severe shortage of talent (as opposed to mere numbers), rising attrition levels and increasing salary costs. There are enough indications to suggest that the linear relationship between growth and headcount will not be sustainable for much longer. The future is in creating strong brands out of India – whether in services, products or solutions -- that command the respect and trust of large global customers and hence the appropriate value.

Orders of Short-Term Impact

Moving on to the impact of the crisis, the first order impact is obviously 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. Since most of these institutions have been large customers of Indian services firms, some of the contracts may be cancelled while others will probably be downsized, with a view to keeping costs under check. This will have an immediate impact on the Indian firms serving these customers.

The second order impact will be on other firms with large investment portfolios that have directly or indirectly been exposed to subprime lending. As an example, some of the insurance companies may be impacted by this – the prime example being AIG. In such cases, the firms may tend to 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 with respect to any discretionary spending.

Given that 30% or 40% of Indian IT services revenues emanate 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

When we dig into the reasons for the crisis, while we can blame blind optimism and greed, at a more fundamental level it is a failure of systems.

The quality of underwriting at the point of loan origination had failed. Systemic controls that ensure uniform and consistent application of underwriting rules could 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 on a real-time basis.

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.

All these point to a desperate need for a massive overhaul of systems – and a substantial investment in new IT initiatives. For too long, large institutions have been trying to get away with spending 80% of IT dollars just on maintenance – keeping the lights on – and only 20% on new initiatives. In fact in a recent Information Week article, Rob Preston says that IT’s Number One priority is to release money for new projects. He says: “If you think you can lay low under the corporate radar or continue to argue that the 80-20 rule is an immutable law of IT physics, then you're due for a wake-up call.”

Today’s financial institutions have become too large and complex, while the core enterprise systems are still a decade or so behind. A plethora of point solutions, Excel spreadsheets and people’s ingenuity are what keeps these places running. To make matters worse, sophisticated financial products devised by quant wizards continued to hit the market. These products -- being derivatives of derivates – are far removed from the physical reality they try to hedge against. So much so that the underlying financial control systems and risk management systems are unable to provide adequate governance and oversight.

To top it all, 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 keep track of all the nuances of the underlying operations and provide online, real-time controls that are meaningful.

Implications for Indian IT

Clearly the need in future is to reduce maintenance budgets and increase transformation budgets. Reduction in maintenance budgets will force more work going offshore – which is good news for the Wave 2 services players in India. However, customers will force the vendors to bring new efficiencies – which would mean that the current ‘Lift and Shift’ model of moving headcount to India will no longer work. They will also expect aggressive cost improvements year on year.

New initiatives will throw up tremendous opportunities for Wave 3 companies that have the depth of expertise as well as the intellectual property assets to bring better governability and manageability to these large enterprises. Indian companies will probably have to partner with local firms that bring 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.

These are interesting times and hence throw up planeloads of challenges and opportunities. It is up to the courageous to go beyond the known and explore new horizons.