The Hindu Business Line : The IT difference

The growing role of the IT sector in India's economy is now well established. But the implications it has for economy-wide growth and welfare are still a source of controversy. C. P. Chandrasekhar and Jayati Ghosh examine certain struct ural features of the IT sector to draw out some implications of the rapid growth of revenues from software and IT-enabled services.

IT services are now an important component of the country's total exports. - Shaju John

IN ABSOLUTE and relative terms the size of the information technology (IT) sector in India is now impressive.

Nasscom estimates the size of the industry at $22 billion, comprising $4.8 billion of domestic revenues, $12 billion of software and services export revenues and $5.2 billion of revenues from exports of IT-enabled services and business process outsourcing (BPO). Placed in the context of the economy as a whole, the sector's revenues now amount to 4.5 per cent of GDP. This makes it an important segment of the non-agricultural sector.

As Chart 1 shows, in 2003-04 the gross revenue of the IT sector was, at 3.5 per cent of GDP, more than double the contribution of value added in the textiles sector to GDP.

Needless to say, gross revenues tend to be higher than the value added (or the excess of revenue over purchases of raw materials, intermediates and power and fuel) in an industry, which determines its contribution to GDP.

However, based on a sample of software companies included in the CMIE's Prowess database, it has been estimated that value added (weighted by sales) in 2002-03 amounted to as much as 68 per cent of sales in this industry and above 90 per cent in the case of the leading firms, making gross revenues a close approximation of the value added in the IT services sector.

By way of comparison, the gross revenues from IT services was in 2004-05 about 20 per cent higher than the GDP generated by the construction sector and almost three times as much as the GDP in mining and in electricity, gas and water supply.

What is more, gross revenues from IT services exceeded 12 per cent of the GDP generated in India's services sector as a whole, which accounts for more than 50 per cent of the nation's GDP.

Thus, even though the software and IT-enabled services sector started from a small or negligible base a decade back, its rapid expansion at an annual compound rate of more than 30 per cent per annum between 1998-99 and 2004-05 has ensured it an important presence in the economy today.

The fact that the rise to maturity of this sector has been driven predominantly by external demand is also well recognised now. Exports of software and IT-enabled services have risen at a compound annual rate of 38 per cent a year since 1997-98, and overwhelmingly explain the rapid rise of the sector.

In 2004-05, exports of software and services (Chart 2), as estimated by the Reserve Bank of India, were at $16.6 billion, equal to a fifth of the country's merchandise exports and higher than one of the principal commodity exports,namely, textile and textile products (including carpets).

This has made IT services exports an important component of India's total (merchandise and non-merchandise) exports. The ratio of IT services to merchandise exports has risen from 13 per cent in 2000-01 to an estimated 20 per cent in 2004-05. Further, the ratio of net IT services export earnings to total net invisible earnings rose from 53 per cent to 59 per cent between those two years.

It is well known that private transfers or remittances from Indian residents abroad together with revenues from IT have helped India notch up a current account surplus during the three years 2001-02 to 2003-04.

While remittances are the result of the short-term migration of natural persons, IT services earnings are the result of a process of digital migration facilitated by the technology that allows for the cross-border supply from remote locations of a range of services, often in real time.

Thus, the provision of labour services through actual or digital migration have substantially strengthened India's balance of payments.

Even during 2004-05, despite the sharp increases in oil prices and India's non-oil import bill, the deficit on the current account has been held down because of flows on account of these forms of migration.

Initially, remittances were far more important than software services earnings. But partly because of a slowing of remittance inflows in 2004-05, it is estimated that the ratio of software services earnings to remittance inflows has risen from 45 per cent in 2000-01 to 60 per cent in 2002-03 and 83 per cent in 2004-05. This makes the role of the IT sector in shoring up the current account of India's balance of payments quite crucial.

However, the sector's contribution to employment does not compare with its role in the generation of income and foreign exchange.

The only available estimates here are those from Nasscom, which indicate that employment rose from around 285,000 in 1999-2000 to just above one million in 2004-05, or at a compound rate of about 28.5 per cent per annum (Chart 3).

This is indeed remarkable given the fact that rate of growth of employment during the second half of the 1990s (1993-94 to 1999-2000) as per NSS statistics amounted to just 0.67 per cent in the rural areas and 1.34 per cent in the urban areas.

But what the growth rate figures conceal is the low base from which employment has grown, making the absolute contribution of the sector to employment minimal.

As the figures in the Table indicate, in 1999-2000, relative to the current weekly status estimates of employment yielded by the NSS Survey on employment and unemployment, employment in India's IT sector amounted to just 0.21 per cent of the non-agricultural workforce in the country, 3.4 per cent of employment in the production of textile products and 0.08 per cent of the aggregate workforce.

This mismatch between the sector's contribution to GDP and its contribution to employment does suggest that from the point of view of income distribution, the growth of the sector must be resulting in a rise in income inequality.

The mismatch itself is related to certain structural features of the IT industry as it has evolved in the country. Originally, the emphasis of India's IT policy was on generating an indigenous hardware industry, with focus on domestic production of mini- and micro-computers.

However, the process of liberalisation and the experience yielded during the Y2K period saw a shift in emphasis away from hardware to software services, with hardware imports being gradually liberalised to make available cheap imported equipment for the rapidly growing software and services export industry.

The transformation that ensued resulted in a situation where the share of revenues from hardware sales fell from 44.4 per cent in 1995-96 to 17.8 per cent in 2004-05 (Chart 4).

Given the dominance of exports, this relative decline in hardware does not appear to be the result of any fundamental restructuring in the domestic market, which though characterised by cyclical behaviour, reflects a long-term stability in hardware and software shares.

The decline in hardware appears to be predominantly the result of the rapid expansion in services exports.

However, a closer look suggests that there is a change occurring in the domestic market as well.

As Chart 5 shows, packaged software revenues and revenues from services grew much faster than hardware revenues in recent sub-periods, pointing to a process of restructuring in favour of services in the domestic market as well.

This has larger implications. It is now well-known that much of packaged software bought in the domestic market, with exceptions such as accounting and banking software, is imported, since the focus of the Indian industry has been on services.

Secondly, even the hardware sector is now increasingly dominated by international brands. Even as early as 2001, Dataquest had reported: "Gone are the days of PCL, DCM and ECI — the erstwhile heroes of the domestic IT market have long vanished or have been relegated to history books. Today's domestic market is run by MNCs. Look around at any of the IT segments in India and the frontrunners are likely to be MNCs.

"Think servers and you think Sun, IBM, Compaq and HP. Think printers, you have little option but to think HP, Epson and Samsung. Think networking products and who can you think of but Cisco and 3Com? Sure, there are some lone Indian rangers, for instance HCL Infosystems in desktops and TVSE in impact printers, but even their numbers are fast dwindling. This is a domestic scene that is nearly monopolised by MNCs." This trend has only intensified since then.

In sum, there are two kinds of divisions that are occurring in the Indian industry: (i) while the domestic market is increasingly being occupied by foreign providers of hardware and software, the domestic industry is increasingly focussed on the export market; and (ii) while the domestic market for hardware and software is being occupied by foreign players, Indian firms are increasingly occupying the services space both domestically and abroad.

One implication of this is that employment losses or jobless growth and an outflow of foreign exchange would characterise one segment of the industry, while employment gains and foreign exchange inflow would characterise the other. At present, clearly the latter dominates, though not to a degree where the net employment generated by the industry is adequate to match its contribution to GDP or foreign exchange earnings.

Needless to say, this two-fold division of markets among Indian and foreign firms is still unfolding. In the interim, the domestic industry has turned out to be a multi-layered, heterogeneous formation, with firms operating in different hardware, software and services segments, characterised by extremely wide margins.

At the top are the successful firms focusing on the export market for software and IT-enabled services, especially the former. At the bottom are the large numbers of independent assemblers who find their margins depressed by falling duties on imported systems and components.

According to Nasscom figures, in 2003-04 the top 20 software and IT services exporters accounted for as much as 61 per cent of total export revenues. But even within the services segment the industry is highly differentiated.

Revenues per employee are distributed extremely unequally, with the few top players obtaining high margins and a large share of the market, and the industry being overcrowded with a number of small firms with low turnovers and extremely low margins (Chart 6). This skewed distribution explains the "winner-takes-all" scenario in the industry, showcased by a few highly successful firms with skyrocketing stock values and billionaire owners, while the fact that the experience of a majority of firms in the sector does not match this scenario goes unnoticed. Extreme concentration with attendant implications for income inequality is a core feature of the industry.

This aspect is combined with a number of other features that are indeed disconcerting. The first is that while the external market is the prime driver of growth in this sector, that market is dominated by one country: the US. This makes the industry vulnerable. Any slow down in the US can have a dramatic impact on the fortunes of the industry. Second, India today dominates the global market for outsourced software and IT-enabled services. Nasscom quotes an estimate according to which India today accounts for 44 per cent of the global outsourcing market.

This ratio goes up to 55 per cent if only the ITeS-BPO segment is considered. If current growth rates are to persist, either the global outsourcing market would have to grow at that rate with a stable Indian share or the industry would have to increase its already large share of the global market over time. That is indeed a touch difficult. Third, since the ITeS-BPO sector accounts for a rising share of total revenues, India's dependence on the less skill-intensive segments of the software and IT-services sector is rising. This makes it even more difficult to maintain market share, especially without a substantial drop in revenues per employee, since competitors are more easily generated.

Finally, even if India's share of outsourcing revenues remains high, the net benefits of this are still unclear because of the dominance of a few firms and a substantial share for captive offshore outsourcing by international firms in the ITeS-BPO sector.

According to Nasscom, captive ITeS-BPO providers accounted for as much as 65 per cent of the value of ITeS contracts outsourced to India. This kind of concentration not only makes the linkage effects of the growth of the industry less significant, it also has adverse implication for the net foreign exchange earning of the sector after taking into account repatriation of profits and other payments abroad.

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