Thursday, September 13, 2007

Free lunches in the software industry

Indian software industry is acclaimed as one of the major economic success stories of recent decades. The figures are impressive and there is surely considerable substance in the growth story. It has single-handendly lifted India to the league of a knowledge super power, and imparted a huge stimulus to the Indian economic growth engine. From being marginal a decade back, Indian software exports have surged to over $32 bn in 2006-07. But closer scrutiny reveals a few areas of concern, and they are being increasingly felt, and often with bitter consequences.

The recent strengthening of the rupee has generated much heartburn in the boardrooms of our software companies. There have been calls by all the major companies for the RBI to inervene in the foreign exchange markets to stabilize the rupee. The increasing rupee makes our exports, whose expenditures are mainly rupee denominated, costlier and thereby affects our export competitiveness. The dependence of our software companies on a weak rupee is substantial.

A recent study by First Global Securities Ltd on the Indian software industry throws up certain interesting conclusions. It brings out starkly the extent of dependence of software companies margins on a weak rupee. It shows that the 36% depreciation of the rupee in the past 11 years, has contributed atleast 40-67% to the margins of our software majors. It claims that the high profit margins of 19-27% are due to a "currency subsidy". The appreciating rupee becomes a challenge, especially since well over half the sales of the top companies (except TCS) are to the US market, leaving them with dollar denominated revenues and rupee expenditure.

The cheap labor costs or billing rates, by acting as a form of "wage subsidy", have been another major source of comparative advantage for our companies. Initially the labor costs were only a fraction of those in the developed markets, thereby contributing substantially to the profit margins of these firms. But with rapidly increasing wage rates, this advantage is fast diminishing. This wage inflation is eroding the fat profit margins and reducing our comparative advantage. In any case, the wage arbitrage which these companies took advantage of, arose due to the inherent economic inefficiencies and was bound to disappear.

Further, our software industry also benefitted by being active participants in the initial, high growth phase of the software industry. The growth rates can be very high and margins spectacular with any sector in its initial growth phase, as there exists numerous, easy to adapt opportunities for efficiency improvements at the margin. Consequently, our software firms have been doubling their revenues and profits every two to three years. But with greater competition and as the market matures, it is inevitable that the margins decline and growth rates fall to more reasonable levels. Globally, software industry is today much more competitive and efficient, and this reflects in the fast diminishing opportunities for higher profits.

It is one of the fundamental axioms of economic theory that there are no free lunches. There are costs, explicit or implicit, associated with any decision. Benefits or economic returns are always associated with costs. If the economy is not operating at the efficient frontier, it may so appear for some time atleast, that there are no costs associated with some decisions. The arbitrage opportunities presented by way of a weak rupee and low wages were free lunches. So too were the fat margins and growth opportunities available due to the initial growth phase of software sector. And as is the case with such free lunches, they cannot go on forever. As the economy becomes more competitive and efficient, these free lunches have to end.

The moral of the story is that as competition increases and the sector becomes more efficient, all free lunches in the software industry are going to end. Therefore our software companies should, instead of lobbying for keeping the rupee weak, be facing up to the reality of a competitive and efficient market. They should be on the constant look out for newer opportunities, exiting from low margin and low growth areas, and migrating to newer high growth, high margin areas.

They also need to seriously pursue developing the local software market. I am not sure about this, but it may not be off the mark to claim that there would not be too many Indian companies, among the top ten clients of each of our software majors. The story of our software industry is somewhat similar to the manufacturing sector in the East Asian economies. The local market for manufactured produce was small, and these countries relied on massive exports. As we have seen, there are limits to this type of growth.

Knowledge based industries are fertile workshops for Joseph Schumpeter's hypothesis of "creative destruction" at work. With rapidly evolving technolgies and work process innovations, software industry is especially vulnerable to this trend. Only the most adaptable and nimble firms can survive in this highly competitive environment. Therefore, instead of relying on free lunches, our software firms need to innovate or languish and perish!

Update 1
Another free lunch is the handsome tax holiday on Software Technology Parks, which extends till March 2009.

Update 2 (22/10/2010)

In this context, of relevance is the ongoing debate in India about letting the tax expemptions provided to IT companies located within the Software Technology Parks of India (STPI) expire at the end of fiscal 2010-11. The Government of India had provided a 10-year tax holiday to IT firms, which though was supposed to expire at the end of 2008-09, has been extended twice till March 2011 under pressure from the software industry who whine about competition from other "low-cost" countries.

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