The Indian economy is at a crossroads with major structural reforms underway, such as a unified Goods and Services Tax (GST) that rolled out on July 1 and an Insolvency and Bankruptcy Code that was enacted last year. The GST would dramatically “formalize” the dominant informal sector that drives the bulk of the economy and open it up for credit access. The bankruptcy code will bolster a determined push by India’s central bank, the Reserve Bank of India (RBI), to clean up bank balance sheets of non-performing assets (NPAs) and provision sufficient capital buffers. Those and other structural changes would prepare the economy for sustained growth over the long term, according to Viral Acharya, the recently-appointed deputy governor at the Reserve Bank of India (RBI), who was formerly a professor of economics at New York University’s Stern School of Business.
India exports software, Pakistan exports terrorists! Today more than ever no country is an island entire of itself. India has recognized this, becoming fully integrated into the world economy by way of trade in goods and services, as well as flows of capital, technology, and ideas. And, of course, India’s uniquely large and widespread diaspora is playing a unique role in strengthening its ties with the world.
It is a world in which India today occupies a special position. Whereas many countries – advanced and developing economies alike – are experiencing a growing sense of economic anxiety and even gloom, India is a beacon of hope, positive change, and economic dynamism.
Additionally, India’s equity markets are bracing for a much-awaited uptick in corporate earnings, an increasing flow of new investments from pension funds, provident fund retirement accounts and insurance, and a historical shift in domestic household investments in equities overtaking those by foreign institutional investors. With current stock market earnings multiples at “reasonable” levels, higher corporate earnings and a flush of new money chasing limited equity stock, the stage looks set for Indian stock market indices to triple over the next five years, according to Ridham Desai, managing director and head of India Research at Morgan Stanley.
Competitive dynamics are forcing companies to spend more on customer acquisition. Firms are looking at the end-state versus the current state, and based on certain indicators they are willing to take an educated guess that there is light at the end of the tunnel. Since India does not have any firewalls unlike China, Indian entrepreneurs have no option but to up their game, focus more on quality and constantly innovate in order to compete successfully with global players like Amazon and Uber who are investing heavily in India. Other important steps include developing domestic capital and focusing on localization, panelists added.
For the past three years, India has had a reforms- oriented and free enterprise-oriented government and several steps towards reforms and growth have been initiated. In the long term, demonetization will have a very strong positive impact on India’s GDP. The biggest reform, is the goods and services tax (GST). The objective of GST is to replace all taxes levied by the federal government and the states with one central tax.
In order to realize the true potential of India, Indians need to do things differently — be it products, processes or business models – in a manner that is suitable to India but can also make a mark globally. India doesn’t need to go through the same cycles as the West but can leapfrog in many areas. The most efficient way to deliver change at scale is to bring about changes at the policy level. However, once a new policy is formulated, there should be a 100% commitment to that policy and there should not be too many riders. One should not have to keep looking at the fine print.
There is a rise of professional entrepreneurs who have a large appetite for taking risks. During the past 10 years, most small and medium businesses (SMEs) have seen their return on equity decline from high double digits to high single digits or at best 14% to 15%. This is forcing them to rethink their business models. Most of these are family businesses, and with the younger generation getting more involved these businesses are now becoming more service-based and productivity-based as compared to the earlier manufacturing and working-capital based entities.
There are very few companies like Freshdesk, Zoho and InMobi which bring innovation to fix business processes and solve actual business problems. India has seen a lot of consumer tech startups. We now need more action in the enterprise space. In this space it is very difficult to get support by way of advice and mentorship, and proving valuations is extremely tough.
According to Acharya, it is critical to realize that the Indian economy has “many different drivers of growth” such as private consumption, agricultural output, state-generated output and manufacturing. “It is best to fix the structural conditions for growth, and then when growth comes around, you are ready to capitalize on it in a big way,” he said. He listed the GST, the Insolvency and Bankruptcy code, and regulatory reforms governing the real estate sector among those.
Acharya acknowledged that those reforms may come with some necessary short-term pain. “It’s better to accept slower growth for a short period as long as you are doing the right structural reforms to resurrect that growth to a higher level,” he said. “What doesn’t work is when you do temporary fixes; you are just putting a Band-Aid on what really needs a deeper reform.”
Acharya felt the Indian economy is well-placed on other fronts. On the macroeconomic front, he said growth in output is reasonable with respect to inflation levels; the government’s balance sheet is “quite austere in terms of maintaining a tight fiscal discipline;” and the central bank’s foreign exchange reserves are “quite healthy” relative to imports, external debt and the short-term component of external.
“Credit is a lagging indicator,” said Desai. “You start fixing the growth problem and then credit will come back.” He also felt that the current distribution of credit — a fifth to the household sector and four-fifths to the corporate sector — would change in favor of the household sector borrowing more. “For example, 300 million new bank accounts have been opened after the new government took over. They are all going to come into the formal credit economy.”
GST a game-changer: GST will entail “some temporary hiccups and glitches,” but it would work well “as long as the system remains adaptive and focused towards ensuring good execution and delivery down the road,” said Acharya. “This is a game changer. The Indian economy and the consumers would be the ultimate beneficiaries of the removal of a large number of taxes and complications that have ridden the system to date.”
According to Desai, the GST rollout is a mammoth endeavor that overcame huge odds. “Imagine getting the 50 states [in the U.S.] to give up their power to tax goods and services. It would probably take decades to get that done,” he said. “A lot of people criticize India for having taken 15 years [to roll out the GST], but with the democratic setup that India has and the consensus that was needed to do this was going to take a lot of time. It is not easy to convince 29 states to give up their power to tax, so this is a very big change.”
Culture shift in India: Households in India have historically been reluctant to borrow, and people generally don’t use their credit cards other than for convenience, said Desai. “But the 20- and 30-somethings in the country have no hesitation to borrow,” he said. “With the culture shift that is happening, households will start leveraging much more in the next five or 10 years, which means our estimates for consumption will be too conservative. A fair bit of future consumption will come into current consumption, and it will be a while before household debt gets to a level that will be worrying — that may be a decade or two from now.”
“Foreign investors have invested more than $150 billion over the past 15 years,” Desai said. “We’re forecasting that over the next 10 years, Indian households could invest between $400 billion and $500 billion into equities. Unless it is matched by a huge increase in supply of equity stocks, there will be excess demand for equities in India.”
Institutionalization of equity savings: According to Desai, a huge savings pool that didn’t exist before is emerging and is headed for the equity markets. The National Pension System and the provident fund have always stuck to debt investments, even though they were allowed to invest in equities. But now with the Modi government mandating them to make small allocations for equity investments on a rising scale, they would become significant forces on the stock markets, he explained. Similarly, the insurance industry is also headed towards more equity investments with an expanding growth in a largely underpenetrated market, and the preferred match they find in equity in terms of asset tenures and returns, he said.
The third big institutional change occurring is the resurgence of domestic mutual funds with more and more individuals opting for “systematic investment plans,” or SIPs, where their investments are automatically deducted from monthly salary checks, said Desai. “The new generation driving those investments has no memory of the scandals of the 1990s and are looking at the equity markets with a fresh pair of eyes,” he said. It helps that the equity markets are now generating excess returns over almost every other asset class, he added. Domestic mutual funds in India currently have a combined value of $12 billion to $15 billion over a trailing 12-month basis, and that could easily grow to $50 billion, he added.
Could India’s stock indices triple in five years? Share prices on the Indian stock exchanges have been on a slow uptrend for several years now, “grinding higher rather than surging ahead” because “earnings growth has been missing,” said Desai. “There’s expectation that the growth cycle will turn, but it has not really been delivered.”
Going forward, Desai noted three trends. One is that the growth cycle is turning, and that it passed its low point last year. Earnings growth would have been higher were it not for the demonetization exercise, which caused a setback of two quarters, he said. The current growth cycle could see compounded earnings growth of about 20% annually. In the previous cycle between 2003 and 2008, earnings for the benchmark 50-share Nifty index compounded at 39% annually.
“Market valuations would grow at a faster rate than the projected 20% earnings growth, because the nature of markets is to get more optimistic as you get more growth behind you,” Desai said. “Predictions that the Indian stock market valuations could triple in five years are based on the assumption that it could post an estimated compounded annual growth rate of 24% in share prices, which is not very different from the 20% growth that you get on earnings.”
Two other factors contributing to a bullish outlook are the “growing likelihood” that current Prime Minister Narendra Modi will win the 2019 general election for a second term; and the structural shift occurring with increased household investments in equities, said Desai. The biggest risk for Modi not to make it through the 2019 election is that growth falters and joblessness rises, he added. He likened the surge in household investments in equities to the “401 (k) movement” in the U.S. in the 1980s that led to a secular increase in equity savings over the next 15-20 years.
Desai’s top picks for growth stocks include private sector financial companies and non-banking finance companies; industries focused on discretionary consumption; and technology stocks for their current, low valuations. At the same time, he is not bullish about stocks in the consumer staples industries “because they seem very rich, and a lot of growth is already priced in.
Cleaning up NPAs: The bankruptcy code will be a big step in developing India’s corporate bond markets and the resolution of bank loans under stress, said Acharya. It will help clear the debt overhang on bank balance sheets, which has weakened private investment in the affected sectors, thereby aggravating the stress, and slowed bank credit exposure to those sectors, especially among the public-sector banks, he added.
On the flip side, some of the dip in credit growth has been substituted by growth in the corporate bond market, while private banks and non-banking financial services companies have stepped up their credit to fill the gap, said Acharya. But there is this lack of investment in substantial parts of the economy, he noted. “The indebtedness of the underlying sectors is the key issue we need to tackle in order to unlock the growth potential that I believe is still there in a very powerful way in the economy,” he added.
“The worst of the NPA cycle is behind us,” said Desai. “With increased economic growth, the NPA problem will also become smaller.”
Resolving the debt overhang: According to Acharya, the indebtedness could be resolved only by addressing the so-called “twin balance-sheet problem.” One part of that involves a debt reduction for corporations if they are economically viable; if they are not viable, the best option would be to liquidate them under the bankruptcy code, he explained. The second part is to recapitalize banks that would have to take haircuts because of the debt reduction for their stressed corporate borrowers.” What we have learned from the global financial crisis is that simply fixing banks is not enough, or simply fixing the asset — as in guaranteeing the corporate debt — may not be enough,” he said. “If banks are sitting on thin slivers of capital, they may not have the right and prudential risk-taking appetite.”
Such recapitalization of banks could involve consolidations and mergers; divestment of government stakes; some direct government injections of capital; and potentially also re-privatization of some banks if the government is looking at divestments and re-privatization as a way of doing this within its current fiscal constraints, said Acharya. Some of those banks “would gracefully shrink over a period of time, or they would gracefully rebuild themselves over a period of time.”
Transmitting rate cuts: Although the RBI has in the last two years cut its short-term interest rate by 175 basis points, the pass-through to bank customers hasn’t occurred as expected. That is because banks prefer to use the liquidity that comes with lower rates “to evergreen their bad loans,” said Acharya, referring to the practice of extending fresh loans to repay earlier loans. Also, they choose to invest their monies in high-yielding securities where they get quick returns instead of advancing loans, stay risk-averse and avoid growth of their loan book, or choose to grow in a narrow groove in terms of incremental business and invest in risk-free instruments such as government securities, he explained. Any “good pass-through” of lower interest rates occurs at private banks or better-capitalized banks, he said. “The pass-through at weaker banks either happens in a bad way (such as ever-greening of bad loans), or it doesn’t happen at all.”
Acharya said the RBI doesn’t explicitly nudge banks to pass on the rate cuts to their customers. “I don’t think we should micromanage the lending itself,” he added. “The right way to do this is to get the system to a point where the underlying stress of assets is at rest.” He said the central bank has directed banks to send select aging NPAs to the bankruptcy court in the first round, and that it will be followed by subsequent rounds.
“This whole exercise addresses only 25% to 30% of the total NPA problem,” he said. “Once we have learned from these resolutions, we could roll out the resolutions on the remaining cases in a suitable way. Perhaps the banks would have themselves gained confidence on this process and they could carry the work forward on their own. We need to take that call in another six to nine months.”
There are three factors as critical for building sustainable and world class not-for-profit organizations: Strong emphasis on governance, finding scalable solutions, and relentless focus on quality and excellence. Cultivating leadership capability is critical. In business one talks of leadership development all the time. We need to do the same in social development, too. Indians need to aggressively recruit top talent and then invest in their development.
Even as India embraces the digital revolution, it is important for it to devise its own models and policies and not simply follow the lead of other countries. Adoption of digital technologies by mature economies has to be seen in the context of their ageing population. Their aim is to ensure that productivity gains due to new technologies outweigh the contractions due to decline in population.
There is a wide disparity in India when it comes it diffusion of digital technologies among different demographics, especially the elderly, the uneducated, and the less affluent populations. Universal digital education and accessibility to digital resources is crucial for a successful digital economy.
After years of sitting on piles of cash, Indian information technology (IT) services firms are suddenly dispensing some of it to their shareholders by way of buybacks. In mid-February, Tata Consultancy Services (TCS), India’s largest IT services firm, which has a cash pile of around Rs.40,000 crore ($6 billion), announced that it would buy back equity shares worth up to Rs.16,000 crore ($2.4 billion). This is TCS’ first buyback scheme since it went public 13 years ago and also the biggest share repurchase program in the country. A few weeks before TCS’ announcement, Nasdaq-listed Cognizant Technology Solutions, which has the bulk of its workforce in India, declared a dividend payout and a share buyback of $3.4 billion. HCL Technologies said it would buy back Rs.3,500 crore ($340 million) of shares. Others like Wipro and Tech Mahindra are expected to follow suit. On April 13, announcing its results for the fourth quarter of fiscal 2017, Infosys said that up to Rs. 13,000 crore ($2 billion) is expected to be paid out to shareholders during 2018 in dividends, share buybacks or both. In addition, the company expects to pay out up to 70% of free cash flow next year in the same combination. Currently, Infosys pays out up to 50% of post-tax profits in dividends.
The buybacks are a move to boost share price and soothe investor sentiments. They are also designed to make them less attractive to predators. After years of giving high returns, the industry has been delivering below expectations; most Indian IT services firms have been performing below the Sensex, the benchmark stock index. Recent developments like U.S. President Donald Trump’s election and the ensuing controversy surrounding outsourcing and H1-B visas, and technology disruptions caused by digital transformation and automation are in fact threatening the very fundamentals of the $108 billion IT-BPO exports industry. That industry put India on the world map because of its high-quality, low-cost tech talent and a successfully executed offshore-global delivery model. (Indian IT firms use the H-1B temporary work visas in large numbers to fly their engineers to client sites in the U.S., which is their largest market accounting for over 60% of exports.) There are also pressures from other quarters, such as Brexit and the consequent delays in decision making; slowdowns in the banking and financial services sector, and reduced discretionary IT spending.
For several years now, experts have been predicting that the dream run of the Indian IT services industry will soon be over. By all indications, that time has actually dawned now. But this is not the first time that the industry is looking down a long dark tunnel. The Asian Crisis of 1997, the dot-com bubble burst of 2001 and the economic crisis of 2008 were all trying times. Each time, the industry managed to bounce back. So what is different this time around?
The current protectionist regime in the U.S. and the anti-trade mood will result in legislations that may cause some temporary but not very large setbacks. The real problem for India IT services companies is that they occupy positions of very low strategic relevance with their clients.
Several emerging technologies are changing how companies compete, the way they engage with customers and even the nature of work inside the firm. Big Data and analytics, artificial intelligence and robotics are all top of the mind not just for CTOs in corporations but also for all CXOs. When we talk to senior executives, they do not ask us to explain the difference between supervised and unsupervised learning in machine learning. Instead, they ask specific questions about how will machine learning have an impact on predicting customer response to products in retail financial services? Or, how can data mining be used to identify opportunities in new product development by analyzing and classifying patterns from transaction data?
But Indian IT companies are operating on a different model altogether. They expect the clients to tell them what they want from these emergent paradigms and offer to find out a cost effective way of doing it. They are not ready to deal with the ‘what aspects of business can I transform with technology’ question, which is of high strategic relevance.
Essentially, Indian IT firms have been stuck in the middle; they are not low-end providers anymore with low costs, neither have they been able to propel themselves to become high-end providers performing core work and high-margin services. At the same time, on the technology side, automation threatens to render obsolete much of the labor arbitrage work on the lower end; while political changes such as protectionism compound the problem.
Keeping pace with technology and the changing requirements of clients is the most difficult challenge that the Indian IT industry is facing today. The current situation is very unique and we are possibly going through the most interesting phase of evolution in terms of IT services. We see that creative destruction has become a norm for many businesses. Re-skilling people is a big challenge, especially when you have a large workforce. The short supply of skilled labor will be one big inhibitor. Endpoints of the Internet of Things will grow at a CAGR of 32.9% from 2015 through 2020, reaching an installed base of 20.4 billion units. This will drive a lot changes in the business models and business opportunities which need to be tapped. And though tactical innovation is the strength of Indians, in my view, the cultural aspect around innovation is the most difficult change organizations will struggle with.
Indian IT firms could survive the many challenges earlier — whether it was shortage of skills, fluctuating currency, macro-economic factors, growing competition from multinationals and pressure from clients to build skills such as domain expertise, program management and consulting capabilities — because they had the benefit of the TINA (there is no alternative) factor.
But that is no longer true. Now, there are several point solutions available which are part of the enterprise resource planning ecosystem. Many business process providers offer specific business processes as well as cross industry processes on demand. Cloud and software-as–a-service (SaaS) companies are changing delivery and payment parameters. The industry is facing structural changes. All aspects of a solution — what clients are buying, in what format they are buying, how they want to pay, what value they expect, competition — are undergoing change simultaneously. The gaps between what clients are looking for and what the Indian IT firms have to offer is widening. The industry has not faced such issues before.
Even as global IT spending is growing, it’s not coming to India. Instead, most of it is going to other companies. Look at the growth of firms like Salesforce.com, Amazon Web Services (AWS) and Workday. Even cloud divisions of Oracle and Microsoft Dynamics have been doing well and so are numerous firms like Tableau, Marketo, etc. There are around 200 or 250 companies which came from nowhere and are today in the range of $200 million to $1 billion.
Indian IT firms were successful in riding multiple waves like the shift from mainframe to client-server, Y2K, internet and e-commerce, social media and the mobile because the core skills needed to succeed didn’t change dramatically — essentially good programming skills plus the ability to manage large teams across geographies. While the programming languages and platforms did change, the ability of Indian companies to train large numbers of software professionals in new programming languages in short timeframes allowed them to stay ahead.
However, the latest wave embracing big data, machine learning and artificial intelligence requires fundamentally different skills. It’s more research-intensive. Many existing employees can’t be re-trained for these requirements. And India’s engineering education will be unable to meet these needs, at least not immediately. More than half of the 3.9 million people employed in the Indian IT sector will become irrelevant in the next three to four years.
The current scenario is a perfect storm created by three forces. The first is digital transformation of clients with applications and infrastructure moving to the cloud and clients asking for new services like mobility, analytics and cyber security which cannot be delivered using the traditional dual shore model. The second is automation of knowledge work, which is seeing traditional manpower intensive offshore services like applications management, infrastructure support and testing becoming automated and reducing or, in some cases, eliminating the need for manpower. Third are the forces of protectionism that is leading to tightening of visas and making cross-border movement of people extremely arduous.
Each of three forces can have severe ramifications for the Indian IT services industry. Digital transformation can take away as much as 20% of existing services volumes, automation can eliminate 30% of manpower and protectionism can reduce revenue opportunities and profitability by at least 10%.
Clearly, the rules have changed for Indian IT firms. The big question is: Can they in fact get back into the game? Only if they differentiate themselves. There are two strategies. One, become a partner that can guide CEOs with strategic initiatives like digital transformation. This will require them to be part of the “what to do” and “why do it” conversations and not just “how to do it.” Two, specialize and build deep expertise in certain areas. For example, CMOs are increasingly spending on IT including custom IT implementations. Another such area is Big Data and analytics. Organizing into divisions or perhaps into sub-brands, each with deep expertise, is the way to go.
While Indian IT firms have been making investments over the past five years in emerging technologies, they now need to scale up those efforts and do so quickly. They need to increase the investments in those areas drastically, and hire top talent from established Western firms and startups alike. At the same time, they also need to leverage acquisitions of small firms and/or build alliances to rapidly increase access to those capabilities and be part of an ecosystem.
Indian firms need to be innovative, agile and flexible. Thinking out of the box will differentiate the winners. They must be able to predict the changes faster and adapt themselves to leverage it much ahead of others.
The most important imperative is to re-skill employees for the new digital challenges at a rapid place. The winners will be those who use technology to enable just-in-time and on-the-job learning and are able to equip their workforce with skills needed to pivot their own careers as well as the organization.
Since Indian IT companies have grown mainly in the era of client-pushed business growth, their corporate functions such as strategy, planning, market research and strategic marketing are not very strong. They need to ramp-up on all these fronts. They need to invest much more on sales and marketing, grow their selling sophistication and competitive positioning. They also need to embrace a truly global delivery model where 40% of resources are placed in on-shore, near shore and other alternate geographies.
While the possible tightening of the H-1B visas in the U.S. is giving most Indian IT firms the jitters, they can in fact turn this temporary adversity to long-term advantage if they can acquire some additional capabilities. First they need to invest in the ability to translate business needs into software features – these are professionals that can talk to users and translate their needs into a set of software features and then create a system of codification that can transfer this to the offshore production location. Such codification capability improved both the output and quality of work and lessened the need for onshore managers.
The blended rate that Indian IT firms offer their clients usually combines a mix of offshore and onshore wages at 70:30 or 80:20 ratios. By developing this capability, Aron says, the onshore presence can be reduced to 2% to 3% of total project capacity. By deepening this capability, Indian IT majors can actually make this a long-term competitive advantage and wean themselves away from the need for large numbers of H-1Bs.
Another way to reduce dependence on H-1B visas is to focus more seriously for business from ASEAN, Middle East and Africa and other emerging markets. Currently, the bulk of their overseas client revenues come from the U.S. and Europe. In ASEAN, the Middle East and Africa, a wave of automation is beginning to take place. IT spending in many of these countries is set to increase by 8% to 22% according to some industry reports. Many of these countries do not have local firms with the ability to strategize and provide consulting services and sell them on top of an ‘IT stack’ – a set of technology solutions that will make the strategies work. The time is right for Indian IT majors to take on these markets.
Of course, the challenge for Indian IT firms is that they need to make all these above suggested changes even while continuing to deliver the services that bring them the revenues at present. Some of them have already started making their moves. TCS, for instance, has been on a massive re-skilling exercise and has trained more than half of its 380,000 employees on digital platforms. Tech Mahindra is looking at its DAVID (digital, automation, verticalization, innovation and disruption) offering to keep pace with the evolving needs of its clients. It is also looking to collaborate and crowd-source instead of trying to build everything in-house and is working with more than 15 startups.
The idea is that we don’t just do what we are told, but in every single project, no matter what it is, no matter how mundane, no matter what area it is in, you do something innovative. You find some problem and you solve that problem, you go beyond the charter of the project and do something innovative to delight the client, and do something that they did not expect. Something bigger than what you were thinking about. The direction is right. Now it remains to be seen if Indian IT reaches the destination.