US recession may hit Indian tech sector hard

When the US sneezes, the world catches a cold, or so the adage goes.

That saying could prove particularly true for India's IT and IT-enabled services (IT-ITES) industry, where the US accounts for the largest share — at over 50 percent — of the Indian software and outsourcing market.

"The US slowdown will impact the smaller IT-ITES firms more," Hari Rajagopalachari, executive director at PricewaterhouseCoopers India, told ZDNet Asia in an email interview. In fact, he added, it may lead to increased consolidation in the small and medium-sized industry segment.

According to Milan Sheth, an Ernst & Young India partner in business advisory services, the economic slowdown will mostly affect medium-sized IT-ITES companies.

"Most small firms have very strong niches. It's the mid-size firms that will be badly hit in the event of a portfolio rationalisation by the American clients," Sheth told ZDNetAsia in a phone interview.

The economic slowdown in the US has already had some impact on the Indian market. The rupee has been strengthening against the dollar for over a year now, causing worries for Indian exporters.

The Indian stock markets have also crashed due to the downturn, with the Bombay Stock Exchange Sensitive Index, or BSE Sensex, dipping by nearly 13 percent in just two trading sessions in January this year. It bounced back after the US Federal Reserve cut interest rates. The BSE Sensex comprises 30 of BSE's largest and most actively traded stocks.

"The US slowdown is a long and protracted one," Rajagopalachari said. He explained that the US slowdown is due to structural readjustments in the country, while the global economic scenario is caused by changing fundamentals in the currency, energy and financial markets.

"The implications for all of India's externally linked sectors are significant," Rajagopalachari said. "The strongest and most immediate impact will be on the IT-ITES sector."

The weak will fall first
Sheth noted that, while the budgets of US-based companies will undoubtedly be cut, the services of Indian companies that are adding value will be retained.

"Those companies that haven't performed may lose out," he said. "For instance, if an American telecoms company today has 18 vendors, out of which 12 are in India, it may want to reduce that number to 14 or 16. So, the less efficient ones may be weeded out first."

And, while the US economic slowdown will perhaps add pressure to cut costs through further offshoring — good news for Indian service providers — that extra offshoring could take some time to materialise.

Rajagopalachari said: "In the long term, the low-cost offshoring trend will increase. But, in the short term, between 12 and 18 months, there will be a demand contraction due to management changes and a paralysis in decision-making in the US corporate sector."

During a recent media briefing, Kemal Dervis, administrator at the UN Development Programme (UNDP), said the US slowdown might make it difficult for India to sustain its economic growth rate of eight percent.

Rajagopalachari concurred: "The US economic crisis is structural and hence long-term. It is not a cyclical phenomenon alone. India will be impacted significantly," he said. "About 50 percent of India's economic growth is structural and the rest is affected by cyclical factors."

"Over the next three to five years, it is difficult to see Indian growth rates outside the five to eight percent range. The US contraction in consumption will hit exports across sectors, not just in the IT-ITES sectors," he said.

India's way out of the downturn cycle, Rajagopalachari said, is to step up domestic consumption in the face of rising inflation.

According to Sheth, the challenge Indian companies face is to demonstrate their ability to add value.

Over the last 12 months, Indian companies have been diversifying their risks by increasing their focus on non-US markets, such as Europe.

However, Rajagopalachari said, given the preponderance of US revenues in the portfolios of India's IT-ITES sector, the positive impact on revenues and margins as a result of revenue diversification away from the US market is "marginal".

Indian IT-ITES companies have also undertaken labour-cost rationalisation by getting rid of poor-performing workforces and tightening recruitment policies.

Companies have also reduced the average age of their workforce in order to reduce cost and improve overall profitability. Sheth said: "Companies may not be adding the kind of people that they were last year, but they are definitely getting better yield from existing employees."

There is, however, a silver lining amid the gloom. For instance, the pressure on American companies to increase offshoring activities, in order to combat cost pressures, will increase in due course.

Reports also indicate that, despite the US slowdown, the number of acquisitions by Indian IT-ITES companies in the US during the first two months of 2008 increased by nearly 75 percent.

Sheth added: "One must not forget that India's domestic demand is booming."

In addition, the slowdown has accelerated the desire of India-born professionals based in the US to return to their home soil. While such IT professionals previously returned in hopes of being part of the Indian growth story, today the sub-prime crisis, slowing economy and fear of layoffs in the US are prompting these workers to look for opportunities in India.

As a result, India's talent pool is getting richer and it could be only a matter of time before the Indian IT-ITES industry overcomes the problems posed by a US slowdown.

Swati Prasad is a freelance IT writer based in India.