India in a class of its own

While India's IT prowess is indisputable today, the country is also a victim of its own success as it faces wage inflation and competition from Eastern Europe and China.

According to a recent industry report by India's National Association of Software and Service Companies (Nasscom), maturing socio-political attitudes and an appreciation of the proactive efforts by key stakeholders to further strengthen India's value proposition are helping to reinforce its position as the IT outsourcing destination of choice.

Nasscom is confident that India will remain an integral part of any major global sourcing strategy even as businesses around the world are exploring alternate destinations such as Eastern Europe to enhance their multi-country delivery capability.

The reasons for Nasscom's optimism: the growing impact of technology-led innovation, and the increasing demand for global sourcing as more companies choose to focus on their core competencies. And it is confident that India will achieve its target of US$60 billion in IT exports by 2010.

While India is uniquely advantaged to best address these opportunities, they are not lost to others. Timely, coherent and continued action is needed to ensure that India makes the most of these opportunities and maintains its lead, Nasscom noted.

In an interview with ZDNet Asia, Kiran Karnik, president of Nasscom, noted that the availability of well-educated engineers has been instrumental to India's IT success. "The large number of smart people educated in the right discipline has been the single most critical factor."

Nasscom estimates that about 19 million students are currently enrolled in high schools and 10 million students in pre-graduate degree courses across India. While nearly 3 percent of them find jobs in other fields, the rest opt for employment in the IT industry. By 2008, there will be an estimated 17 million people available to the IT industry.

More importantly, India's high level of English proficiency has helped the country open doors to outsourcing deals from English-speaking countries. In addition, Karnik said in the 1990s, the Indian diaspora in the United States and the United Kingdom has also "acted as a very good bridge between those countries' markets and India".

Strong government support in the form of policies that encourage the growth of the Indian IT sector has also been a key push driver, Karnik said. This includes easing foreign ownership restrictions for local companies, a move that has helped India attract key IT investments.

"The government also had a good long-term vision by putting in place a 10-year plan in 1999, where tax relief is given to export profits," Karnik added. "This gives companies assurances in planning their cash flow and business models."

Eroding cost advantage?
India has always enjoyed a strong track record of delivering a significant cost advantage, with clients regularly reporting savings of between 25 percent and 50 percent over the original cost base.

Kiran Karnik, president of Nasscom

Nasscom's Karnik believes this cost advantage--achievable by outsourcing to India--is unlikely to go away for a long time, and he cited several reasons.

First, the absolute cost advantage vis-à-vis other key markets is actually increasing. According to Nasscom, the current 10 percent to 15 percent wage inflation in India amounts to a lower dollar-value increase in the wage bill, compared to the 3 percent to 4 percent average wage inflation in the developed countries.

Secondly, there is still scope to further lower infrastructure and overhead costs among Indian IT companies. "Despite the reduction in telecoms costs by 30 to 40 percent in the last two years, depending on how much bandwidth you consume, we still have higher costs for telecoms than other countries," Karnik explained. "So, there is still scope for further reduction there."

Also, Karnik said because of India's inefficient infrastructure, Indian IT companies are incurring at least a few percent more in extra cost. "This can't get worse, and will only get better, so there's some scope there for further savings," he said.

Finally, there is scope for further leveraging operational levers to drive efficiencies in the Indian IT organization.

According to an industry benchmarking exercise conducted by Nasscom since 2005, the adoption of internal practices varies across the industry. This suggests that the adoption of industry best practices can further enhance operational excellence in Indian IT companies.

Contrary to concerns of rising wage inflation eroding the sustainability of India's cost-advantage, especially over the past two years, leading players such as Mumbai-based Tata Consultancy Services (TCS) have managed to grow at an above average rate--while sustaining their high levels of profitability, Karnik noted.

"Clearly, this indicates that they have been able to manage their internal resources, including human resources, very efficiently," Karnik said. "They're spending less time on projects and getting more out of their human resources for higher productivity."

TCS' revenues crossed US$4 billion for the first time, for its latest financial year ended Mar. 31, 2007. The company reported a 41 percent year-on-year revenue increase to US$4.3 billion on net income of US$950 million.

S. Mahalingam, chief financial officer of TCS, attributed the sterling performance to "several levers in terms of pricing, offshore leverage and cost controls" to boost its profit margins against the fluctuating Indian rupee.

Currency fluctuations are often not within the control of any company, and this will naturally affect bottom lines.

As Infosys' president, COO and joint managing director Kris Gopalakrishnan alluded, the company's profitability is impacted "not by wage inflation per se, but by wage inflation coupled with an appreciating rupee".

Michael Guilbault, senior analyst at research company Technology Business Research (TBR), agreed. He noted that a 1 percent increase in the value of the Indian rupee versus the U.S. dollar or sterling pound, socks some Indian firms' gross margins with a 5 percent hit because they pay most of their staff in rupees.

But as India's IT industry moves toward providing higher-end services, including consultancy and industry-specific applications, Nasscom's Karnik said, cost becomes a lesser concern.

"I would say that cost is always important, but it becomes far less important, for example, especially during R&D (research and development), where you're more worried about intellectual property (IP) protection," he explained.

Karnik added: "As you move to higher-value work, you want to make sure that you have the kind of quality and people who can provide high-end expertise."

Infosys has already moved from providing development and maintenance services, to higher-end work such as consulting services and implementing large IT transformation projects. And right from the start, the company believes it cannot sustain its business, if it were to hire only computer engineers.

"We've recruited English and science graduates, and converted them into software engineers by training them," Gopalakrishnan said. "We're also recruiting from outside India, including the U.S. and Europe."

He added: "For certain roles like infrastructure management and services like business process outsourcing, you don't require engineers. This gives us an additional pool to recruit from."

TBR's Guilbault noted that Infosys already shells out US$147 million to prepare fresh graduates to work in the business world.

"The situation gets worse going forward as the IT companies are forced to cast a wider net to locate trainable candidates," he added. "A major problem facing Infosys is the precipitous drop in the quality of education between the best and second-best schools in the country."

However, Guilbault noted that the Indian government has finally started responding to the IT lobby's complaints about the school system. "But it's unclear where the government will find the funds to make any material improvements in the situation."

Wages to level off
With over half the population of India aged below 25 years, Nasscom's Karnik said, India's young demographic profile has given the country an edge over competing outsourcing destinations.

He said: "As more young people graduate from college, there will be a big supply in the marketplace. While the supply-demand gap now is a cause for concern, in the medium term--within three to five years--you'll get a correction in the supply-demand equation.

"While wage rates are not expected to fall, you'll find them leveling off very rapidly," Karnik added.

Karnik said fewer people in China and Eastern Europe will enter the workforce due to their aging populations. "This is bound to create serious pressure on their demand-supply gaps," he said. "Their demand [for IT labor] will grow and supply will begin to decrease as the young people population drops off."

He added: "You can see this happening five to six years later even in a large country like China: their internal demand for growth is going to be such that there is no way their wage rates are going to be held down--their wage rates are going to escalate far more rapidly than Indian wages."

Still, Karnik acknowledged that India's shrinking IT talent pool has been putting upward pressure on wages. "Only 30 percent of engineering graduates have the skills that the IT industry needs," he said.

Companies such as TCS and Infosys are tackling the issue by setting up training institutions on their own. "This enables them to take people, who would otherwise be rejected, on a six-month training program to expand their workforce," Karnik said.

In addition, Nasscom is also working with universities to ensure that skills required by the IT industry are imparted to graduates, he added.

While public-private partnerships are springing up to address the challenges facing the educational system, TBR's Guilbault said, the "private sector can't continue to keep footing the majority of the bill, while maintaining industry-leading margins".

Stacking up against rivals
As India strives to move up the value-chain, it is also facing competition from emerging outsourcing locations such as Russia, widely known for its superior engineering competency.

Karnik said: "I have great respect for Russian capability in engineering and innovation, and I do think they are as good as us.

"However, their problems in human resource scalability are tremendous. They have a population that's decreasing, and the number of engineers available in five to six years will deplete very rapidly, thanks to a combination of smaller population growth and the emigration of bright Russians to the U.S. and Israel.

"In India, we have the same situation of people moving out, but we have enough people staying behind. And in the last two to three years, there has been a reversal of that trend where those who've gone abroad are coming back to India," he added.

Karnik acknowledged that Russia will continue to be a good place for innovation, "but not for being able to provide any scale to that innovation".

"So, if you want a small thing done by a dozen of engineers, Russia is very, very good," he added. "But if you are looking at getting a few hundred people, then you'll have great difficulty getting that human resource in Russia, especially in five to 10 years' time."

To Infosys' Gopalakrishnan, the emerging outsourcing locations of China, Russia and Eastern Europe allow the company to target new geographies and niche markets. "I see Russia participating in high-end graphics and mathematical modeling; China is used to provide services to the Chinese market; Poland is used to support Europe and Mexico is used for support Spanish-speaking clients," he said.

On Indian innovation, Gopalakrishnan noted that Indian companies have mainly been engaged in short- and medium-term R&D activities such as process and service innovation. "And as you move up the value-chain, the amount of IP increases, but what is probably not happening in India is long-term R&D in basic research and completely new techniques and technologies."

Still, he added that global companies such as Microsoft, Intel and Motorola are already beginning to shift some core research activities to India. These include chip design, as well as product and software development. "If you include multinationals and Indian companies, you'll find the complete ecosystem being replicated in India," he said.

Maturing socio-political attitudes
At the height of the outsourcing wave around 2002, there was socio-political apprehension about IT jobs moving from Western countries to India. But since then, Karnik said, there is now widespread recognition in countries like the United States about the mutual benefits of outsourcing.

"There is definitely some pain and readjustment required in the case of individuals who lose jobs temporarily and have to be retrained and redeployed elsewhere," he said. "But, I think there is academic research which shows that the savings accrued from outsourcing are reinvested for further growth of the U.S economy."

"This makes sure that U.S. companies stay competitive," he said. "The reason why large companies cut off jobs is because they are not able to keep up with the competition," he added.

He noted that companies now realize that they can be competitive by moving some work offshore to lower costs, and in turn become more efficient, increase sales and retain more jobs.

However, Karnik said, the Indian IT industry continues to be concerned with tariff barriers such as visa restrictions and excessively tight controls on data movements.

Earlier in April, the United States stopped accepting H1B visa applications after it received more than double the quota set aside for such visas, affecting IT giants like Microsoft and Intel who hire many Indians. Microsoft Chairman Bill Gates and other tech leaders have for years have pressed the U.S. Congress to raise the H1B visa limit.

Karnik said: "We don't really see those problems inhibiting growth, but we'll continue to talk to U.S. policymakers to ensure problems are minimized and spread wider understanding of the true benefits of a global economy."