OnAsia

MOST foreigners visit Mysore to see its many palaces, testaments to bygone royal splendour. But the city, south of Bangalore, is also a good place to observe monuments to India's modern might. One of its suburbs contains a lush campus with a collection of futuristic buildings: the Global Education Centre, one of the world's largest corporate-training facilities, operated by Infosys, a leading Indian information-technology (IT) services firm.

Visiting the centre, you would think that for India's IT businesses, the sky is the limit. Rarely has an industry grown so rapidly for so long. It has boasted annual growth rates of nearly 30% in the past ten years, with revenues now nearing $50 billion, about 5.4% of India's GDP. But some in India are starting to worry that the industry is heading for a fall. At the very least, analysts say, the industry's leading firms—Tata Consultancy Services (TCS), Infosys and Wipro, to name only the three largest—need to do more to adapt their business models as the industry matures.

The “IT” in India's IT industry has always been something of a misnomer. True, most of its more than 1.6m employees sit in front of computers, writing software for Western firms, remotely maintaining their computers and electronically handling some of their operations. But the business is mostly about people and processes. The very essence of India's IT firms is their ability to marshal huge local workforces to supply high-quality services.

One of their biggest innovations has been to borrow ideas from manufacturing and apply them to services, by building a sophisticated human supply-chain, for instance. They have also focused on certification and continuous improvement—a result of having to be, at least initially, better than their Western rivals in order to win business, says Girish Paranjpe, the boss of Wipro's consulting arm. Today more Indian than American firms meet the highest internationally recognised standards for software development.

All this has enabled Indian firms to take advantage of a rare, if not unique, set of market conditions. On the demand side, Western companies needed to cut costs, but their computer systems still required a lot of human labour. On the supply side, there was an army of well trained, English-speaking engineers demanding only a fraction of a Western salary. Fast fibre-optic links brought both sides together and a favourable exchange rate made this global connection even more attractive: customers paid in dollars, and employees were paid in rupees. The result was a “low-risk, high-margin business”, says Kiran Karnik, the outgoing president of Nasscom, the industry's trade group. To increase sales, firms could hire more people without caring too much about productivity, with the result that growth in revenue correlated closely with growth in headcount.

So why the concern? Indian IT faces a host of threats, says Sudin Apte of Forrester Research, a consultancy, who argues that the industry needs to reinvent itself. The most immediate difficulty is the rapid appreciation of the rupee against the dollar in recent months (see article). Since its low in mid-2006, it has gained 16%. This has made a liability out of what had been a big asset for Indian IT firms—making most of their sales in America. The strong rupee has also thrown other structural problems into relief. These fall into three categories.

What goes up...

First come the familiar problems. One is India's clogged and insufficient infrastructure: workers in Bangalore can spend four hours a day in traffic. Then there are the tax breaks that subsidise the industry, some of which expire in 2009. There is also a growing talent shortage. Indian engineering schools award around 200,000 diplomas each year, and produce around 250,000 graduates, but only half are employable by the IT industry. Employees have learnt to switch jobs for better pay, and salaries are going up by 10-15% a year. For senior staff, they will soon reach Western levels.

Second, competitors are starting to emerge. IT industries in other parts of the world, such as Central Europe, may never match India's in size, but they can still pick off valuable contracts. Meanwhile, foreign IT firms have been beefing up their Indian subsidiaries. In 2002 the six biggest—including Accenture, IBM and HP—had fewer than 10,000 employees in total in the country. Their combined Indian workforce now exceeds 150,000. This enables them to rival the Indian firms in scale and cost, while exploiting their stronger brands and international scope.

The third category concerns future threats. In the short term a slowdown in IT spending looms as America's economy weakens. In the longer term Indian firms must keep abreast of technological changes. Many of the services they now provide will eventually be automated; this is already starting to happen, for example, in software testing. Western firms, meanwhile, increasingly want Indian providers to do more than just keep systems running; they want help in developing new solutions to business problems—something few Indian firms are set up to do.

The question is whether the industry's business model can cope with these threats even as the potential for growth in its established markets declines. According to calculations by CLSA, a French-Asian investment bank, Indian IT firms will soon have a share of nearly 20% of their addressable market's value and almost 40% of its volume. They will also struggle to make their existing business more efficient: most fat has already been cut.

Many think that Indian IT firms need to move into new, higher-margin services and to cut the link between revenues and headcount, for instance by offering more consulting, developing more intellectual property and making acquisitions abroad. To be fair, the leading firms are already doing this. Infosys now generates nearly a quarter of its revenues from consulting, says its new boss, S. Gopalakrishnan; and Wipro recently paid $600m for Infocrossing, an American firm, the largest in a series of acquisitions by Indian firms.

But is the industry moving fast enough? Nasscom's Mr Karnik says no, but he thinks there is still time to change things. Partha Iyengar of Gartner, another consultancy, sees more urgency. He expects slower growth and lower margins if the big firms are not making most of their money in consulting and other high-margin areas within three or four years. This will be hard, he says: today's focus on people, processes and profits may keep many firms from reaching the next level. But, he says, India's IT firms have shown before that they can change if they really need to.

Even if the heavyweights stumble, smaller firms are ready to take up the baton. For example, MindTree Consulting was founded 1999 in anticipation of the very threats that have now materialised. However potent these threats prove, they have already demonstrated that for all the talk of the world being flat, economic gravity still applies.