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The Indian Exception Proving the Rule

The Indian Exception Proving the Rule

Author: Vivek Wadhwa
Publication: The American
Date: April 23, 2009
URL: http://american.com/archive/2009/april-2009/the-indian-exception-proving-the-rule

Filed under: Science & Technology, Big Ideas, Boardroom The Satyam scandal rocked the global business community and threatened to stifle the Indian outsourcing industry. But as the dust settles, the forces driving outsourcing are as strong as ever, with benefits for both India and the West.

On January 7, Ramalinga Raju distributed a four-and-one-half-page letter to members of the Bombay Stock Exchange and then went into hiding. In the letter, the chairman of multi-billion dollar Indian IT company Satyam told of how a small accounting discrepancy, created by a sleight of hand that artificially pumped sales numbers, turned into a gaping hole in the company's balance sheet. After Ramalinga's revelation, shares in Satyam plunged more than 80 percent and the Indian government sacked Ramalinga and Satyam's entire board of directors in a desperate bid to save the company and spare its remaining shareholders. Roughly $1 billion had gone missing and Satyam had been overstating revenues for several years at least, if not more.

Almost immediately, IT executives at U.S. insurance giant State Farm decided to cut ties with Satyam, a significant black eye for the outsourcing firm. Pundits predicted a flood of other foreign companies would abandon not only Satyam but other Indian IT companies large and small.

For critics of outsourcing in the United States, the scandal seemed to confirm something they had long suspected. The Indian outsourcing story was simply too good to be true and here was the evidence. One of the four largest Indian IT companies had resorted to booking fake revenues in order to keep shareholders happy. How many other landmines lurked in the balance sheets of other Indian companies until recently deemed the darlings of Wall Street?

Today it appears that Satyam was the exception that proves the rule. Months have passed since a chastened Raju did the perp walk. Initial concerns that Satyam was only the first scandal lurking have rapidly faded. No other major Indian IT outsourcing firm has found evidence of improprieties, even after hurried deep dives into their books by finance departments and outside auditors.

Even more important, few foreign customers have pulled up stakes based on fraud fears. To the contrary, the National Association of Software and Services Companies, the powerful Indian IT trade group which counts all the outsourcing giants among its members, came out with a bold prediction on February 4 that export revenues to Indian IT companies would reach $47 billion by the end of fiscal year 2009, an increase of 16 percent to 17 percent over the previous year. This growth comes against the backdrop of the worst global recession since the Great Depression and building nationalistic sentiments against shipping white-collar jobs from the developed to the developing world.

The forces pushing the growth of IT outsourcing and fueling the rise of Satyam, along with companies like Wipro and Infosys, did not disappear because Ramalinga shoved $1 billion down a rabbit hole. Rather, the very same forces are actually gathering steam. And these forces will fuel a new wave of outsourcing from U.S. companies that goes beyond India's legacy plain vanilla data and IT administration business and into more advanced research and product development processes. Companies such as Tata ConsultancyServices and HCL Technologies are helping develop next-generation networking services, medical equipment, avionics systems, and the interiors of luxury jets for Western companies. Both HCL and Tata got their start running drab, back office data processes for foreign firms. Now they are being trusted with the crown jewels.

A handful of key forces constitute strong winds at the back of the IT outsourcing movement and the subsequent move into outsourcing innovation. The first of these is pure, hard economics. Wages in India remain significantly below those in the West. Computer programmers on the subcontinent earn less than fourth as much as their peers in the West. For a while, it looked as if a labor shortage and demand for outsourcing would outstrip supply and push wages up sharply. But in the past year wage pressures have subsided as Indian IT companies, with impressive in-house education programs, have succeeded in training hundreds of thousands of smart young Indians to pick up the slack. At the same time, other costs affecting IT services in India have begun to rapidly abate. A real estate bubble in India had resulted in land appreciation far greater than that experienced even in tech meccas such as Silicon Valley. Now that bubble is bursting and prices are coming down hard, bringing down with them the cost of setting up a facility in India.

In 2007, the Indian rupee dramatically appreciated against the U.S. dollar. This squeezed many outsourcers locked into long-term contracts and reduced profit margins (ironically, it also induced many of them to hire heavily in the United States and the West to expand operations and hedge against currency risk). As the U.S. mortgage and financial crisis unfolded and economists theorized that the general indebtedness of the United States would result in a weak currency, it appeared that the strong rupee was a permanent reality. But when the U.S. banking crisis grew more serious in 2008, stock markets in the developing world plunged even faster than the U.S. exchanges, and fears that these economies, too, would swing into deep recessions exerted strong downward pressure on the rupee. The world fled to the safety of the U.S. dollar. Trading at roughly 39 to the dollar in the fall of 2007, the rupee has fallen sharply in early 2009 to an exchange rate of 50 to the dollar.

True, the dollar may well plunge again if deficit spending runs amok. And the ongoing deep recession in the United States has alleviated some of the economics that spurred outsourcing. Real estate prices have dropped and wage growth among IT professionals has slowed. But U.S. companies have grown used to the flexibility that outsourcing allows, with the ability to easily upsize or downsize departments or headcount without worrying about paying unemployment or severance, or receiving bad publicity. And the difference in costs between comparable employees based in the United States or India remains stark.

Beyond economics, other forces are at play. Over the past decade, the very same Indian IT companies handling mundane data-centric tasks have watched with interest as U.S. companies such as General Electric, Cisco Systems, Microsoft, Adobe, Motorola, and Google have set up engineering and development centers in the Indian subcontinent. These U.S. companies have placed these advanced and high value added processes in India not only to take advantage of cheap labor but also to put product development closer to fast growing markets. Since the bulk of sales growth for most U.S. multi-nationals is expected to take place in developing Asia, it makes perfect sense to put product development closer to customers. Another key reason for locating R&D in India is to take advantage of the time zone difference and build a 24-hour product development and research cycle.

Not surprisingly, Indian IT and outsourcing companies began developing advanced R&D capabilities that would allow them to compete for this type of work (albeit on an outsourced basis) for foreign multi-nationals. After all, helping to design and plan manufacturing of actual products would surely be a more profitable service than running server farms or tending corporate computing networks.

These types of R&D outsourcing arrangements are rapidly growing in number. In addition to Boeing's avionics contracts with HCL, the aerospace giant in January 2008 entered into agreements with the Indian Institute of Science and software firms Wipro Technologies and HCL Technologies to create and develop wireless and networking technologies. HCL also has an agreement with General Electric aerospace subsidiary Smiths to set up and operate an R&D center in India. Wipro, MindTree, and other Indian companies are now offering semiconductor chip design services, a high value added activity formerly dominated by outsourced chip design firms in the developed world and in Taiwan. Indian pharmaceutical company Ranbaxy has an agreement with Merck to perform early stage drug development in exchange for downstream royalties. The arrangements listed here are merely the tip of the iceberg. In a study conducted by California management consultancy firm Zinnov, outsourcing of R&D to India (either to regional subsidiaries of multinational corporations or to Indian IT outsourcing firms) should hit $22 billion by 2012. This is a shocking figure considering that dollar value of Indian R&D outsourcing 20 years ago was a tiny fraction of that large sum.

Spurring this rapid rise of R&D is restrictive U.S. immigration policies that have forced many of the talented top-level science and engineering researchers to leave the United States after completing graduate educations and, sometimes, brief stints of employment on H-1B visas. Combined with India's own efforts to build a strong talent pool in science and engineering specialties, the result has been a deep and relatively inexpensive high-tech work force that rivals that of the best U.S. technology regions such as the Bay Area of California. Aside from disliking the restrictive immigration policies, many Indians studying in the United States now feel that better opportunities lie at home than in America, all things being equal. These opportunities are both professional-with the rapidly developing R&D and science and engineering research complex-and cultural. Family, closeness to friends, and care of aging parents are often cited by Indian students as strong factors behind their decision to return home. The shift of talent to India has made it far easier for multinational corporations to make the decision to relocate research activities there.

- Vivek Wadhwa is executive in residence at Duke University's Pratt School of Engineering and a senior research associate at Harvard Law School's Labor and Worklife Program. He earlier wrote for The American about "America's Other Immigration Crisis."

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