It was earlier feared that the Indian software industry might witness a slow-down in the post-Y2K period, but corporate results and other industry data point to robust growth in the future.

• The net cost of hiring Indian programmers is still less than one-third the equivalent cost in either Europe or North America, though there has been a gradual bridging of the salary gap between India and developed countries. Demand for Indian software professionals is increasing rapidly in existing and new client countries. For instance, the US is likely to absorb further 50,000 software engineers every year from India once the proposed Bill to increase visa quotas for technical workers is passed by the US Congress, and both Germany and Japan are now seeking to hire as many as 30,000 yearly workers.

• Rapid growth of Internet will create a whole new category of demand in software and allied services in future, such as in internet service applications, web design, internet call centers, validations systems, yellow pages and data mining. India is well positioned to capture a significant share of global business in these areas, even with its relatively low-tech skill base.

• Domestic demand will perhaps become another key driver of future growth. Increasing penetration of IT and Internet, pro-active government support and changes in technology will all combine to lower costs in computer hardware, software, telecom and Internet access in the short term. Personal computer sales are already registering double-digit growth in segments such as Government, Insurance, Banks, Public Tax System, Education and Small Office Home Office. India is expected to cross the one million PC shipment mark in 2000 and will have a total base of over 10 million PCs by 2005. These developments will create large domestic demand over the next few years for programmers, training institutes, web designers, system administrators and network engineers. In fact, domestic IT revenue is already increasing faster than exports and currently accounts for almost 30 percent of total industry turnover. Over the next 2-3 years, exports will continue to be the main pillar of the Indian software industry but domestic sales will also attain critical mass in importance and macro-economic impact.

Based on current and future trends, we expect overall revenue growth in software and allied services to be in the region of 40-50 percent annually for the next five years.

Rapid growth of the Indian IT industry in the past few years has already stretched the current demand-supply balance of skilled manpower, and there are fears being expressed by industry leaders and market analysts that the country may soon face a severe shortage of qualified workers. India’s education system is largely a government monopoly which has been unable to cater for past growth, and the bulk of over 200,000 new software professionals who join the workforce every year are trained in private computer schools. These institutes, however, at best provide only medium-caliber training, and their graduates are often not up to Indian industry standards, leave alone international ones. Indian salaries have increased about 50 percent in the last two years as a result of people leaving for foreign jobs, and an increasing number of Indian firms are now complaining about ‘country poaching’ rather than ‘company poaching.’ What was once considered a flattery to the country’s technical strength is slowly becoming a threat to the local industry.

While the problem is real, we do not expect this problem to have a severe impact on India in the medium term. Developments in India and abroad are likely to keep the country internationally competitive, and new sources will be tapped in future that will provide adequate manpower to sustain current growth.

• Other software exporting countries are going to be even worse affected by a future shortage of skills. Salaries in some of these countries, such as Singapore or Ireland, have already risen to such high levels that an increasing number of their firms are now looking for Indian sub-contractors or partners. India will also continue to maintain an edge over new software rivals, such as China, because many of the ‘new economy’ applications require even more extensive knowledge of the English-language than did earlier software assignments.

• India has many smaller cities and towns where the general educational infrastructure offers a large pool of manpower. With just the right amount of technical training this manpower can easily be tapped and brought into the IT industry. Bangalore and Hyderabad may be the more recognized symbols of India’s IT success story, but cities like Indore, Jaipur, Coimbatore, Baroda, Chandigarh and Lucknow (all of them with major universities and technical colleges) offer immense opportunities in future.

• There are an increasing number of IT-trained people in India – housewives, college students, small businessmen – who are looking for a supplementary source of income and who can be used by firms as subcontractors for low-level tasks and applications. This may require careful targeting, proper incentives and innovative employee-partner programs, but it can be done.

• Various initiatives to attract and retain skilled workers have been set in motion by Indian IT firms and are beginning to show results. These include employee stock option plans, flexible work hours and in-house education programs. Many firms are also increasingly hiring and training graduates from liberal arts and other disciplines. Since 1992, industry-wide attrition rate has dropped from 25 percent to 14 percent.

• In the interim, till new sources of skilled manpower come on line, Indian firms could find subcontracting partners in Bangladesh or Sri Lanka where English-speaking talent is relatively abundant and cheap.

Whatever be the future scenario in manpower availability, it is very unlikely that major Indian software firms will simply stop growing in the short to medium term. Many of them have already carved a successful international brand equity for themselves and have moved on to the higher-end of IT skills. In the worst case scenario, low-margin firms may get crowded out and there may well be some internal re-structuring and re-positioning of the software industry. But in the end, overall industry growth is unlikely to be seriously affected.

While Internet is clearly going to be a success story in India, the potential for profit from e-commerce is very limited in the medium term. This is particularly true for Indian portals and ‘pure-play’ web businesses who will face incredible odds in building a successful niche in a cluttered environment, especially given the difference in social, legal and business practices in India from those in the West. Some key factors affecting Indian e-commerce are:

2) Lack of Critical Mass: Domestic telecom and PC penetration levels in India are rising faster than ever before, but the total numbers are still very low by international standards and will stay so over the medium term. A personal computer currently costs several times the average salary of a middle class Indian, whereas in the United States a PC may cost no more than a quarter of the average monthly salary. Industry spokesmen are fond of repeating that the total installed base of PCs in India has now crossed 3.8 million, but more than 1.4 million of these machines are not Internet-capable since they have 80386 chips and below.

Based on our best guess regarding telecom growth (given below), there will be less than 27 million land-based telephone lines in the country in the next 2 years, less than half of what China already has today.

India does however have a large base of cable TV-connected homes, approximately 37 million strong, out of which at least 20 percent are expected to become e-connected in the next few years once the cost and technology of set-top boxes is rationalized. But even if this were to happen, and also assuming that the Indian economy grows at 7 percent annually over the long term, India will have an active e-buying population (people who are net-connected and with a comfortable income level) of only about 15 million after ten years. According to international industry reports, the equivalent figure for China is 85 million.

So no matter how you look at it, the conclusions are the same: the total e-commerce audience in India will be limited in the medium term, and will be smaller than many other countries in the Asia-Pacific region.

3) Indian Cultural & Business Practices Are E-Unfriendly: The bulk of future domestic growth in IT and Internet will mainly come from middle income groups and small manufacturing enterprises, particularly those in small cities and towns. But these groups are slow adapters to the global economy, and their personal habits and business customs may not support growth in e-commerce. For instance:

• The number of credit card users has climbed rapidly in India in recent years but the average per-card spending is very low, in fact less than $ 20/month. The existing culture and legal system neither encourage people to buy goods on debt nor provide merchants with a convenient insurance against default. Currently, over 80 percent of e-commerce in India is by cheque, and where delivery of the product is done only after credit into the merchant’s account. This process negates the whole idea of Internet as a fast and hassle-free shopping medium. The new cyber law recently passed by the parliament goes some way in providing E-customers with a verifiable digital identity and penalty against fraud on either side, but it is still too early to tell if it will actually work in both letter and spirit.

• Most of India’s private sector companies have large internal bureaucracies, and their purchase departments are particularly inefficient, opaque and often corrupt. For instance, the period of float gained by holding on to vendor payments is a favorite ploy, and there is economy-wide inertia in settling accounts. There is no effective electronic data interchange (EDI) between large manufacturers, vendors, banks and government customs, and even simple inter-bank transactions take up to 7 days. Clearly, the basic building blocks of B2B are missing.

• Also, given the huge needs of Indian industry to upgrade their technology via imported capital equipment, it is very likely that a major chunk of B2B will take place not between Indian-Indian firms but between Indian-foreign firms. Many firms have in recent years launched some form of cost cutting measures in an effort to stay competitive in the global economy but attitudinal and systemic changes are indeed very slow. There is a lot of hope and money invested by Indian B2B entrepreneurs and their venture capital investors, but many of these dotcoms may at best end up playing a subsidiary role to international B2B majors.

• Indian customers like to bargain, and they want to touch and feel a product before buying. These have by now become second nature and a part of the larger shopping experience, which itself is often a substitute for an outing in tradition-bound Indian families where the wife has little social release of her own. This is one reason why catalogue shopping has failed miserably in India, and why e-commerce will be limited in the medium term to low margin items that are commodity-like in nature. Music and books are perhaps more e-retailable than any other product, but their total sales in India is still less than US $ 500 million. Taking into account average profit margins in music/book sales and assuming that 20 percent of this market shifts to the Internet (and international trends indicate that even this is on the higher side), the net profit streams of all B2C dotcoms taken together do not exceed US $ 20 million. This may be a simple, back-of-the-envelope calculation but it correctly indicates the low potential of e-retailing in India, at least for some time.

• Most studies of internet usage in India – and this is still an evolving field – indicate trends which are not favorable to e-commerce. Food items comprise over 60 percent of the average household budget in India, as against only 15 percent in Western countries. Furthermore, Indian eating habits rely largely upon a daily cycle of grocery purchase, that too in small in small quantities and mostly of perishable items. In contrast, Internet is perhaps best for bulk buying of manufactured food products that can be frozen or otherwise stored. Current studies in India also indicate that an overwhelming amount of Internet time is spent on non-commerce activities and mostly by the male head of family or by teenage children, but the main decision maker on household purchases is still the wife or the mother. These and many other contradictions exist, and B2C businesses are very unlikely to be successful unless there are some dramatic social and behavioral changes among Indian consumers.

It is increasingly clear that e-commerce and net-based business opportunity have been over-sold by promoters, and over-evaluated by venture funds. We expect that many of these dotcom ideas will fail in the next year, and some are quite likely to be merged or acquired by other net entities.

The early level of excitement over Internet has been dampened to some degree by the recent worldwide fall in technology and dotcom stocks, and even previously gung-ho foreign venture capitalists have become more cautious and withdrawn. These funds were expected to bring in greater maturity and insight, but this has clearly not happened. They have not only ignored local conditions and factors but many have teamed up with, or invested in, local collaborators whose competence, quality of management or commitment is in serious doubt. Some of the biggest recipients of dotcom venture financing so far have been either children of traditional Indian business families or other well-connected society people.

This brings up an old issue once again, the problem of evaluating business opportunity in India. The local corporate environment is opaque and shrouded in unnecessary secrecy, firms are not subject to stringent disclosure rules, and the media is careless (sometimes even in league) about checking tall claims. It is very easy for local industry chambers, promoters or consultants to dish out misleading data or self-serving advice. The myth of the 300 million Indian middle-class (which simply did not exist, but which many consumer multinationals found out rather late in the day) is a perfect case in point. Similarly, there are now many misleading figures and deceptive claims in the local net community:

• There exist a very wide range of forecasts on Internet users and e-commerce revenues in India. For instance, a recognized international market research firm has predicted 7 million Internet users in India by 2004, while an equally reputable international bank has predicted 30 million. We tend to believe the lower figure, and in fact if some of the technology improvements do not happen at the required speed due to political uncertainty or any other reasons, it is likely that that this figure may not even cross 6 million.

• According to an industry report issued by a leading IT apex body in India, the actual number of users who have "ready to access to Internet in India is more than 3 million (as on 31 March, 2000)." This is more than 3 times the number of actual Internet connections, and it includes just about anyone who has access to an Internet cafe. The use of this type of proxy and exaggerated data is routinely done by Indian industry, and goes largely unquestioned.

• Many Indian dotcoms are claiming more eyeballs and viewership than is either true, likely or even available amongst all Indian net users, both in India and abroad. For instance, the online version of an Indian newspaper claims more monthly pageviews than either the New York Times or Wall Street Journal.

• Last year, industry sources and major research institutes were predicting that more than 40 private Internet Service Providers (ISP) would be operational by the end of 1999. This has not happened despite the government granting permits liberally, and less than 10 of them are operational. In fact, many of them, such as ETH Dishnet, Mantra Online and Satyam Infoway, are facing pressure on margins due to limited web traffic, and have been forced to offer discounts or other value-added services just to build up a loyal customer base. The point is not that ISPs have failed, or will fail, in India – on the contrary, we are relatively optimistic about some of them – but that exaggerated predictions are common in India.

• A recent survey of Initial Public Offerings (IPOs) in the Indian IT sector revealed that many bogus companies have in past few months raised money simply by changing their name to include a dotcom tag, even though their operations or past expertise have little to do with IT.

Some foreign venture capital firms have learnt these lessons, and we expect the smaller ones to slowly but selectively start exiting from current dotcom investments by Q1 2001, or at least to dilute their current levels of exposure. This however does not mean the end of venture financing for Indian net start-ups. The pool of total venture capital available is still quite large, and despite all the problems we have mentioned so far India still remains a more natural place to invest in content-related or software-related firms than most Asian countries. In fact, India is really the only viable choice in Asian software stocks since the IT industries in Korea and Taiwan, the two other large IT players, are dominated by hardware firms.

We expect that India will continue to receive upwards of US $ 500 million per year of venture capital and Greenfield investments in the IT sector over the next 3 years. But future deals will be more cautious, better targeted, and also linked to specific milestones in local software, telecom, broadcasting or consumer trends.

Software and IT stocks in India have been on a roller-coaster ride in the past few months. The IT-index of the Bombay Stock Exchange climbed to its all-time high in the early part of 2000 when many firms in India doubled their paper-wealth in just a few trading sessions. At one point, Infosys (India’s most reputed software firm) rose almost 8 percent daily for a week. The founder-CEO of Wipro, India’s largest IT company, was even declared the world’s 3^rd richest man in January 2000 by a Forbes magazine survey. This was when the boom on the Bombay Stock exchange was stoked both by a sustained rally on NASDAQ as well as the initial wave of tremendous excitement over Internet. However, most IT stocks have lost almost 60 percent or more of their value since then amidst wild gyrations from week to week. Most of them are currently trading at PE multiples of around 70, which is still high if compared with pharma stocks (PE of about 40) or food processing (PE of 35) but in line with IT indices in international bourses.

The rapid enlargement of the Indian IT industry and the uncertain nature of Internet-related revenues are creating a lack of clear direction or sustainable sentiment on local bourses. Indian IT stocks behaved almost completely as a mirror image of NASDAQ in the early part of 2000, but in the past two months local market sentiment has displayed more bearish gloom. This is partly because Indian stocks had risen faster than US tech stocks, and hence they were set to fall more sharply when the market direction reversed. In the near term, local factors will continue to play a key role in determining IT indices, especially since India and the US appear to be moving in different directions over inflation and consumer spending. However, over a longer period, there will be much greater convergence of IT stock movement between the US and India, largely due to growing investment and contractual links between firms on either side. Meanwhile, we expect further volatility in Indian IT stocks, but within a narrower band, and especially in second-tier software scrips with a small equity base. These scrips are likely to face high selling pressure even during a minor bear cycle.

We recommend that potential investors adopt a segmented and calibrated approach to stock picking in the Indian IT industry, and distinguish between pure e-businesses, software developers and firms who provide other back-office services. We advise against taking large positions in pure net-based firms until some of the smoke and dust over Internet settles down, or to wait till next year when we expect some good deals to emerge as a result of expected mergers, acquisitions and re-structuring of venture fund portfolios. On the other hand, select software stocks are good buys at current levels and especially on further declines. Many have lost enough flab in the market correction of recent weeks (though some are still clearly overvalued), and the whole software sector remains a favorite with most foreign fund managers. We recommend looking at fundamentally strong software stocks with a large market capitalization and a diversified customer base.

From a macro perspective, the Internet revolution in India is quite real. With a whole array of knowledge-based skills and legacy to draw upon, India is very well suited to integrate Internet into its industry, public institutions and education system. Perhaps more so than any other country in Asia, Internet will have a profound impact on India’s progress towards a more open and accessible business environment. However, the potential of Internet in the corporate sense of profit making has being overstated, and many pure web-based Indian businesses are likely to fail. But even though Indian society is not yet ready to adapt to the ‘new economy’ in a consumer sense, the increasing ubiquity of Internet technology will create new global opportunities for India on the supply side, and especially in software. There will very likely be an acceleration in the pace of domestic IT penetration, and this will help in increasing productivity and efficiency in the larger economy. At a minimum, continued growth in software exports and inbound investments will provide a comfortable source of hard currency, which in turn will act as a hedge against any adverse changes in India’s balance of merchandise trade. Even more, the direct and indirect impact of all Internet-related benefits could be as high as an extra 1 to 1.5 percentage point GDP growth over the medium term.