After This Week's Victory, Will the Congress Government Press Ahead with Reforms?
Published: July 24, 2008 in India Knowledge@Wharton

On Tuesday, the United Progressive Alliance (UPA) led by Prime Minister Manmohan Singh won a trust vote in Parliament by a surprisingly large margin, beating out the combined opposition by 19 votes. The UPA received 275 votes while the combined opposition of the extreme Right and the extreme Left mustered 256. It wasn't as close as in 1999, when the Rightist Atal Bihari Vajpayee government lost by just one vote. But the debate -- centering in part on the government's insistence on going ahead with a nuclear deal with the U.S. --was far more acrimonious.

The crisis has been long in the making, and time was running out for both Singh and U.S. President George Bush. The latter has just a few months left in office; Singh has to call for elections to be held before May 2009.

When the Indian government took the step of approaching the International Atomic Energy Agency (IAEA) with the draft India-IAEA safeguards agreement for approval by its board of governors, the Left parties cried foul. They have been supporting the UPA from the outside. Without their backing, the government was reduced to a minority. The Left has been opposed to the nuclear deal on ideological grounds. Prakash Karat, general secretary of the Communist Party of India (Marxist) has often criticized it for being too pro-U.S. and undermining Indian sovereignty. As for the Right -- principally the Bharatiya Janata Party (BJP) led by Vajpayee and shadow PM L.K. Advani -- the nuclear deal was conceived when the BJP was in power. Consequently, its arguments against it now sound opportunistic.

Opportunism is actually the order of the day. Filling in for the Left (which has 59 members of Parliament -- MPs) is the Samajwadi Party (SP), which has 39. Other parties -- several of which have just one MP in the House -- moved into horse-trading mode. "The price of an MP is Rs25 crore ($5.8 million). No one has principles anymore," Communist Party of India (CPI) general secretary A.B. Bardhan said at a meeting to launch the Left campaign against the government. A few days later, rebel Congress MP Kuldeep Bishnoi told a rally that he had been offered $23 million for his vote.

The House descended into chaos when three BJP members took out bundles of currency notes (a total of Rs1 crore -- $234,000) and alleged they had been paid that amount as an advance to abstain from the trust vote. The total promised payoff, they claimed, was $2 million. The Speaker has ordered an investigation.

These big numbers, the mudslinging and the drama have overshadowed the more important issues. A political dimension is in play, including the forging of new equations and the emergence of a third front -- which opposes both the UPA and the BJP-led National Democratic Alliance (NDA. Led by Mayawati Kumari of the regional Bahujan Samaj Party (BSP), it promises to complicate affairs in the coming general elections.

New Highs and Lows

The man on the street may find such circus games entertaining, but he has far more serious things to worry about. Inflation, around 12%, is at a 13-year high; industrial growth at 3.8% in May is at a six-year low. On July 16, the Bombay Stock Exchange Sensitive Index (Sensex) fell to a 15-month low of 12,514, a drop of 40% over the 20,873 recorded in January 2008. The rupee has dropped to 43 to a dollar after being in the 38-39 range.

The central government's fiscal deficit is seen by many as out of control. According to rating agency Fitch, the budgeted deficit could increase from the projected 2.8% of gross domestic product (GDP) to 4.5% of GDP because of farm loan waivers, a pay hike for government servants, increased interest payments and subsidies. Add to this items that are not captured in the budget (principally bonds to finance oil subsidies), and the total deficit could cross 6.5%. Fitch has lowered its estimate of GDP growth in 2008-09 from 9% to 7.7%. It has also revised India's local currency outlook from stable to negative. Other rating agencies such as Standard & Poor's (S&P) and Moody's have been making warning noises. In fact, S&P has estimated the combined deficit of the center and the state governments at 9% to 11%.

With elections around the corner, the principal worry is inflation. Indeed, the trust vote debate didn't talk much about the nuclear deal. The key issues seem to be horse trading and inflation, with the former winning by several lengths. But the nuclear deal does matter. Strategic issues and security concerns aside, the agreement would end India's technology pariah status. The country was consigned to the doghouse after it undertook its first underground nuclear test in May 1974 at Pokhran, in northwestern India.

The nuclear deal will have a positive fallout on business, says a survey of 400 CEOs by the Associated Chambers of Commerce and Industry (ASSOCHAM). India could attract $40 billion worth of foreign direct investment (FDI) in 15 years in nuclear energy. An earlier ASSOCHAM survey in June had indicated that CEOs expected FDI for 2008-09 would fall $7 billion short of the $35 billion target, thanks to the economic and political uncertainty. For 2007-08, the commerce ministry had set its sights on $30 billion in FDI and managed to garner only $25 billion.

The nuclear deal is expected to open the floodgates of business between the two countries. Tentative alliances have already been struck between big Indian business houses and their U.S. counterparts -- and not in the nuclear arena alone. In defense, procurement by India is expected to top $70 billion in the next five years. There are other spin-offs in areas such as space.

"The nuclear deal is good for Indian business and industry for two reasons," says Rajesh Chakrabarti, professor of finance at the Hyderabad-based Indian School of Business (ISB). "First, in the long run, it will help ensure adequacy of power supply. Ultimately, our other sources of generating power are going to dry up and the nuclear way will be the only way to go for India. Secondly, because of the nuclear deal, there will be further trust and interaction between India and the U.S. This will have a positive impact on Indian businesses."

"The nuclear deal will be good for the future of the country," industrialist Adi Godrej told business channel CNBC-TV18. "And I think some of the reforms agenda could be executed before the [general] election. I think that will build confidence. I also feel that one of the major negatives -- high inflation -- will probably be contained by March."

"Inflation will be controlled," Prime Minister Singh told newsmen even as the debate was on. "It is something we are very concerned with." And within the House, finance minister P. Chidambaram, speaking in defense of the trust motion, rattled off statistics to show how great a job the government had done.

It has, if one goes by the number of social and economic programs announced. Major questions have arisen, however, on whether they have been implemented properly. It is also true that this government -- with reformers Singh and Chidambaram in its ranks -- has not made much progress on the liberalization front. Some political observers lay the blame for this on the Left, a conglomeration of several parties. A government beholden to it for support -- threats of withdrawing have been commonplace -- has had to fall in line.

Speeding up Unfinished Reform

Is this a golden opportunity? Will the next few months see a big-burst reforms agenda? Industry seems to hope so. The recent ASSOCHAM survey said 72% of 400 CEOs polled expected the government to speed up unfinished reforms in the pension, insurance and civil aviation sectors. There was some optimism on labor reforms, too.

Delhi-based economic daily Business Standard quotes government sources as saying that Singh will "expedite action on implementing the long-awaited reforms in the banking, insurance and pension sectors." Writing in the same paper, Jamal Mecklai, CEO of Mecklai Financial, a leading foreign exchange risk management consultancy, says: "Having tasted the champagne bubbles of victory, we can be sure that [Singh] will forge ahead with the large slate of reforms that were held up."

Not everybody is uncorking the bubbly, however. "If you look at the different constituents of the UPA and even within the Congress, there is very little consensus on reforms," says Paranjoy Guha Thakurta, an independent political commentator, who until recently was founder-director of the New Delhi-based School of Convergence. "Like apple pie and motherhood, reform sounds very nice, but people are more concerned with inflation and food prices."

Adds New Delhi-based political commentator and former journalist Sumit Mitra: "The chances of a government rushing with reforms in the final year in office are generally bleak. They are particularly so in India at the moment, with a procession of state-level elections ahead. Besides, the Leftists, usually regarded as the biggest obstacle to reform, are not the only ones skilled at putting the clock backward. The Samajwadi Party, which now promises to fill the vacuum created by the Left, has quoted its price already."

"I doubt if we will see any quick-fire reforms," says Chakrabarti of ISB. "There is too little time until the next elections and they will be reluctant to take a gamble and start any controversies. Major reforms usually happen with a government which has a long enough mandate and not one in the last year of office."

What are the reforms that may get through without too much trouble? The sectors are:

* Insurance: This is one area where the MNCs are eagerly anticipating change. Nearly a decade has gone by since Parliament passed the Insurance Regulatory and Development Authority Act in 1999. Private sector players in the industry have finally begun making money. There is currently a cap of 26% on FDI in this sector. Chidambaram had earlier proposed that this be increased to 49% but had to back off because of opposition from the Left. He may now able to get this done.

* Banking: The government currently has 50% plus stakes in the public sector banks. The proposal is to allow dilution. Also, shareholders in these banks are allowed 10% voting rights regardless of their actual equity holding. This could change, allowing more mergers & acquisitions (M&A). FDI in banking is capped at 10%; this could be raised to 26%.

* Pensions: The Pension Fund Regulatory Authority Bill will be passed and a pension regulator appointed. This is the first step in the creation of new pension funds, which will compete with the monopoly Employees Provident Fund Organization (EPFO). However, the government is likely to keep the EPFO out of the ambit of the proposed changes. In time, however, it will have to compete in the marketplace as the Life Insurance Corporation is doing with the joint venture insurance companies.

* Privatization: Singh and Chidambaram advocate a 10% divestment in several public sector units (PSUs). The two leading candidates for public issues are Oil India Ltd. (OIL) and NHPC. Others on the list include Rashtriya Ispat Nigam, Manganese Ore (India), Nuclear Power Corporation, Railtel and Telecommunications Consultants India. The sale of 10% in OIL and NHPC could take place as early as September or October of this year.

* Telecom: The FDI cap may be raised from the current 74% to 100%. This was one of the issues that got in the way of the Bharti deal with MTN of South Africa.

* Atomic energy: Foreign entry may be allowed. Today, even the Indian private sector is barred from this strategic sector.

If all these changes take place, a flood of foreign money could flow into India. The country could actually meet the FDI target of $35 billion set by the commerce ministry. The key question, as Mitra points out, is whether the Samajwadi Party will play ball. One school of thought is that with the margin of victory at 19 votes rather than the one or two votes expected initially, the party may not carry so much clout. The reality will be apparent soon. One has only to look at how the UPA government placates the party.

The entry of the Samajwadi Party in a supporting role has introduced a new dimension into Indian politics -- the lobbying by, and influence of, the corporate world. Amar Singh, general secretary of the party, is close to Anil Ambani, the younger Ambani scion and chief of the Anil Dhirubhai Ambani Group. As is well known, he is feuding with his elder brother Mukesh, who controls the Reliance Industries group.

Amar Singh has been making various proposals to the government but insists that there is no quid pro quo for his party's support. Yet people have taken the list of demands -- made in letters and in personal meetings with Congress leaders -- very seriously. Mukesh Ambani, in fact, met the PM to present his side of the picture. This immediately attracted the ire of the Left. "The Prime Minister's office (PMO) should not become the conciliation office for warring corporates, however desperate the ruling party may be to retain power," the Communist Party of India Marxist (CPM) politburo said in a statement. "Corporate houses are openly in the fray to lobby their interests in the run-up to the confidence vote," the CPM added. The PMO issued a statement denying that the PM was involved in any mediation effort.

What has Amar Singh asked for that has ruffled so many feathers? First, he wants a windfall tax on oil company profits. This will affect Reliance and, to a lesser extent, the Essar group. Second, he wants the export-oriented unit status given to Reliance's Jamnagar refinery scrapped. This will force the company to sell petrol in the domestic market. The result: a huge loss as the public sector refineries get a subsidy which the private sector is not entitled to. (Reliance and Essar have practically closed down their petrol retail chains because there is no way they can make money.) Third, he made various suggestions about spectrum allocation. (Anil Ambani's Reliance Communications is one of the largest players in telecom space.)

"For all practical purposes, these letters could have been written by Anil Ambani himself. And Amar Singh is also very open about his friendship with Ambani," says Guha Thakurta. "There has always been corporate involvement in politics. Everybody knew it, but they didn't talk about it. It was in a wink-wink, nod-nod fashion. Today, thanks to Amar Singh, it is all out in the open. But I like it."

"I consider the increasing openness about the business-politics relationship to be a positive development," adds Chakrabarti of ISB. "Business has always played a strong role in Indian politics. But because of the very strong bias towards Nehruvian socialism, [businessmen] were never very publicly involved. Now, because of liberalization, there is a change in mindset. Business is no longer a dirty word. It is more acceptable and is present more publicly and transparently in politics.

"Even before independence, several businessmen like Jamnalal Bajaj and G.D. Birla were financial backers of Mahatma Gandhi," he says. "While no one questions their patriotism, they must have benefited by way of boycotts of foreign products etc. With Nehruvian socialism, big business had to take a backseat because it was not considered to be politically correct. Even in the Indira Gandhi era, business was viewed as some kind of semi-illegitimate activity and there was no political acceptance of the business class.

"But, like in every democracy, political parties in India, too, always took money from business houses. But it has always been in black money. The influence of business on policymaking has been huge in the past."

Chakrabarti cites a concern in some quarters that "because of the massive and disproportionate wealth that has accumulated in the hands of a few people, India may go the Russia way, where you have a few oligarchs who practically own the entire system. I personally don't see this as a threat. I feel that India is too large a market and it is difficult for a group of people to hijack the political process."

Business is one more element that has been added to the mix. And the number of such elements may be getting too much to handle. As the trust vote with all its allegations of buying MPs shows, you need to woo too many people simply to survive.

"In the future, India has to choose between political incohesiveness and economic growth," says Sumit Mitra. "If it continues to make too many concessions to too many regional and caste groups, or parties wedded to ideologies that are long past their sell-by dates, there is little chance of the country joining the super league of global economies in the foreseeable future. Its politics needs to be reformed before its economy."

Investing in India: Where Is the Smart Money Going Now?

It seems as though everyone is investing in India. During the past few years, every type of investment in the country -- including private equity and venture capital -- has exploded. Last year, net foreign institutional investment inflows topped $17 billion. In contrast, just four years ago, in 2004-05, total FDI (foreign direct investment) in India stood at $3.75 billion.

At first, investment tended to focus on the technology sector; today's investments are in everything from real estate to infrastructure. In a keynote speech at this year's Wharton India Economic Forum, Vinod Dham, managing director of the NEA-IndoUS Ventures and former vice president/general manager of the Microprocessor Products group at Intel, noted that online services, business process outsourcing and mobile value-added services were the top three investment areas in 2007. While the bulk of the investments are still in the IT and IT-enabled services sector, health care is beginning to pick up, Dham noted, and opportunities are often regional: Bengaluru (formerly Bangalore) for IT, Hyderabad for life sciences, Mumbai for mobile/media, Chennai for manufacturing, and Delhi for business process and knowledge process outsourcing.

So how are companies getting into these opportunities, and how are the deals changing over time? A panel discussion at the conference, moderated by Bain & Company private equity practice head Sri Rajan, explored the current environment and gave the audience a taste of what is to come.

The Investment Landscape

Haramb Hajarnavis, senior member, principal investments area at Goldman Sachs, laid out the landscape. "Historically, deals were smaller in size and more growth-oriented," he noted. "On the exit side, most entrepreneurs opted for an initial public offering. Now that's all changing -- the deal size has gone up to an average of $45 million, and every flavor of investment can be found. You see multinationals, private equity players, hedge funds and sovereign wealth funds. Cross-border M&A is also emerging as a source of opportunity. The sectoral focus has widened. Buyouts have started to happen, and some exits now involve selling to others. ICICI Ventures sold a stake in Infomedia India to TV 18, as an example. We see a lot of trends in India that were in China before."

Ranjit Pandit, managing director of General Atlantic Partners LLC, noted that the majority of his firm's overall holdings were between 10% and 35%, so they were already familiar with the kinds of investments they were looking at in the Indian market. "We are minority investors; we identify high-growth sectors so we can generate returns and do it without leverage," he said. "We're also getting more comfortable with sectors we're not familiar with -- it just takes more time."

Zubin Dubash, India Region head for Merrill Lynch Global Private Equity, said that his firm had begun its private equity endeavor on a global level during the 1990s. "The bulk of our investments had been in the U.S. and Europe -- control situations, leveraged buyouts, etc. During the last few years, we have been looking to expand our footprint -- into Brazil, Australia, Japan, China and, four months ago, India. While we are used to doing control transactions in the rest of the world, we're seeing very little of that in China or India. We wanted to tailor our own flexible strategy to do minority investments." Dubash said that the important factor wasn't whether it was a minority or control type of investment: "The important thing is, are you really a partner with the promoter? Many promoters choose private equity deals based on value. But private equity players can bring lots of different things to the table -- access to customers, access to acquisitions or even operational efficiencies."

Small Stake, Small Voice?

Ensuring some level of influence in a company without a controlling interest isn't always easy. "Sometimes you get it wrong, sometimes you get it right," said Pandit. "The key is, before you do the investment, to get comfortable with the promoter. You have to align the objectives on both sides, which is hard when you have a powerful promoter or when many branches of a family -- with different viewpoints -- are involved with the business. Getting behind some of these facets is very important." The most successful experiences have been situations where people have come from nothing and are interested in building enterprises, said Pandit. "Looking back in time, think of Infosys as an example -- there were a few professional managers who left another enterprise and who had the technology and the right governance model in place."

Hajarnavis agreed that it was a challenge. "We do try for larger transactions; we're not in a rush to deploy hundreds of millions of dollars of capital over a certain number of months. We don't have a specific timeline -- it's a long-term business. We lived through this in China as well, where we started small and over time we evolved to write larger checks. We view this as a once-in-a-lifetime opportunity for the company, so we have to be patient."

Hajarnavis admitted that there was some pressure from limited partners, who wanted India exposure. "If we didn't have a presence there, the question would be asked -- why are we not there? As with any other sector, we have to localize our product -- private equity -- for the Indian market. There may not be a lot of leveraged buyout opportunities, but there are lots of other growth capital opportunities over the next few years. We want long-term relationships with these companies. Goldman Sachs also has had the strategy of following its clients -- we see where they have gone. Every large client of Goldman has an interest and a presence in India. That creates a reason for us to be there also."

Governance structures are important, but hard to influence, the panelists noted. "We have very little influence, so you have to do the homework before getting in," said Pandit. "You see either a structure of command-and-control or where people genuinely are bettering themselves and building institutions. It's hard to change it once you're in there." Issues around hiring, where to take the business, how much risk to take -- all of these are important, he noted. "Ultimately the bet you make is on the top management team. You can't spend lots of time on all these issues if you have a lot of deals."

What Value Does a Firm Add?

Dubash, who was previously CFO at leading BPO firm WNS Global Services, gave the panel the perspective of the other side, recounting what Warburg Pincus (WNS' majority shareholder) had brought to the table. "The biggest value addition they brought was a team of people to facilitate a capture, and then they built a world-class team around that. Also, whenever we did an acquisition, we had access to their entire team's expertise in a particular area. When we wanted to open an office in Romania, we put our neck on the line and took a cut in variable pay, and the firm supported us."

Pandit added that firms typically could add value in three areas. "One is the management team, of course. Second, alliances can add value -- bringing new technology, customers, sourcing and revenue. Third would be the complementarities -- other companies in the portfolio that we are aware of. We see things on the horizon that a company may not. And we can provide funding to make things happen."

"We all strive to be a sounding board for CEOs; we want them to think of us as their business partner," noted Hajarnavis. "I'd like them to reach out to us. That's what we're there for, and when we can add value. If I know what problem the company management is trying to solve, I can put the resources of our company at their disposal."

Do the Sweet Deals Still Exist?

Even a few years ago, proprietary deals were sometimes possible, noted Rajan. When asked about the current environment, the panelists said it would be tough to find any advantage these days. "In a hot capital market, competition is inevitable," said Pandit. "The advantage that any private equity firm has is its relationships. We have a track record of supporting companies, so it sometimes allows us to get a leg up, to have the opportunity to look at a deal."

Hajarnavis noted that Indian entrepreneurs were sophisticated when it comes to understanding the value of their business. "Given the culture of negotiation, they always want to find the best deal," he said. "It's our responsibility to explain to them our tangible value-added. We may get privileged access for a short period of time or maybe one extra meeting that helps us come up with the right judgment, but really, there's no friends-and-family discount out there."

"We're new to the market in the PE practice," added Dubash, "but the relationships I've developed for 20 years are good, so deal flow has not been an issue. You do get some privileges, but you at least have to be in the range in terms of pricing."

Can Dalal Street Tame the Inflation Monster?

Reliance Industries, India's biggest company by market capitalization, on April 21 announced its fourth quarter and annual results. The company reported a net profit (excluding exceptional items) of Rs.15,261 crore ($3.8 billion) on annual revenues of Rs. 139,269 crore ($34.4 billion). "Reliance beats Street estimates," said Thomson Financial News. "Reliance misses estimates," said Bloomberg.

Estimates can, of course, vary. But, at a time when nobody seems to know how to read the future of India's economy, such mismatched interpretations of corporate performance just add to the confusion. "The market has decoupled from reality," says Nandan Chakraborty, head of research at financial services provider Enam.

It seemed so simple a few months ago when the BSE sensitive index (Sensex) touched an all-time high of 21,207 on 10 January. Finance minister P. Chidambaram spoke optimistically about a 9% rate of GDP growth. Reserve Bank of India (RBI) governor Y.V. Reddy was reported to be considering an interest rate cut to boost investment. And stock analysts were gung-ho about the so-called decoupling theory: How the stock markets in rapidly-growing economies like India and China would be unaffected by the impending recession in the U.S.

Today the Indian markets have crashed. The first quarter of calendar 2008 was the worst since 1992. Market indices have fallen 28% in dollar terms. Some stocks are down more than 50%.

Now opinions vary widely on GDP growth in 2008-09. The Delhi-based Oxus Research & Investments is perhaps the most optimistic; it toes the Chidambaram line of "9% is still possible." Deutsche Bank estimates it at 8.4% and UBS 8.2%. Occupying the middle ground are the Asian Development Bank (8.0%), the International Monetary Fund (7.9%, for calendar 2008) and Lehman Brothers (7.6%). Bringing up the rear are HSBC, JP Morgan Chase and Morgan Stanley (all 7%). Meanwhile, rating agency Crisil (a Standard & Poor's company) has reduced its estimate to 8.1% from its earlier forecast of 8.5%.

Raising Interest Rates

Chidambaram, too, has tempered his GDP growth estimates. "The choice is clear," he told the Indian Merchants' Chamber at the end of March. "If we want to check inflation, we must be prepared for a slightly lower rate of growth... If the RBI decides to raise the CRR (cash reserve ratio) and interest rates to counter inflationary trends, it would certainly affect the rate of GDP growth."

The RBI has already raised the CRR, the percentage of their deposits banks must park with the central bank, from 7.5% to 8%. This will be done in two phases by May 10. In its credit policy statement of 29 April, the RBI left interest rates unchanged. However, it raised CRR by another 0.25%. Banks will have to maintain a CRR of 8.25% from May 24.

The acknowledged villain of the piece is, of course, inflation. The RBI, which says that its prime mandate is to contain rising prices, had earlier indicated that its comfort zone was 4.5% to 5%. Over the past few weeks, the numbers have risen way past that limit. In January 2008, the wholesale price index inflation was 3.8%. By March 29, it had risen to 7.41%. It then dropped to 7.1% for the week ending April 5 but rose again to 7.33% the following week. No one expects prices to go down any time soon. According to a recent survey by global management consultants McKinsey & Co, 64% of the Indian executives polled believed that inflation would go up in the next six months.

"The most immediate concern at present is inflation," says Rajesh Chakrabarti, a professor of finance at the Hyderabad-based Indian School of Business (ISB). "There is no denying that inflation has gone up much more than what the government would have wanted. In recent years, the government has been very specific in saying that it wants to contain inflation to less than 5%, and now it has gone to 7%.

"The trouble with inflation management seems to be that the government will resist raising interest rates because the interest rate differential with the U.S. is already quite large and they wouldn't want to widen it further," Chakrabarti explains. "One of the things that the government is trying to do is put in price ceilings and quantitative controls, which have historically not worked, not just in India, but elsewhere also. These are difficult to administer. This is a 1970s-80s kind of solution. But one can understand the government's need to do this as they don't want to touch the monetary policy at this point in time because of foreign investments, etc. The government is constrained by what is called the impossible trinity of international finance (the perceived irreconcilability of the three objectives -- capital freedom, exchange rate maintenance and independence of monetary policy)."

The solutions that Chakrabarti is talking about are manifesting themselves everywhere. The government has been squabbling with cement and steel manufacturers, arm-twisting them to hold down prices. "It is my view that cement manufacturers and, to some extent, steel producers are behaving like a cartel," Chidambaram told Parliament in late April. "We are looking at the legal and administrative provisions that are available." Steel companies, on their part, point to rising input costs. An uneasy truce has been reached with manufacturers agreeing to hold prices for a couple of months. But this could break down if companies see themselves slipping into the red.

The government has taken several other steps, including various export bans and import duty cuts. Even the annual export-import policy was revised. For example, this year, what made headlines was a total ban on cement exports and the withdrawal of all incentives on the export of primary steel. The export target for 2008-09 has been increased to $200 billion -- an increase of 23% over the $155 billion achieved in 2007-08. This was short of the $160 billion target for the year.

Increase in steel and cement prices leads to pressure on user industries. Two-wheeler manufacturer Hero Honda has announced a price hike. Car manufacturers are being forced to the wall. And the Tata group's Rs. 100,000 ($2,500) Nano, the inexpensive car due to roll off the assembly lines soon, may be impossible to manufacture at such a low price.

Soaring Food Prices

But this is not where the crisis is most acute. The price increases that hurt, especially in an election year, are those of food grains. "Another big concern is that in India and also globally there seems to be somewhat unbalanced growth (in the composition of the growth itself)," says Chakrabarti of ISB. "This seems to put pressure on food prices internationally. Food exports are also being limited, and Vietnam and other countries are not exporting as much rice as they did in the past. Given India's income distribution and poverty levels, rising food prices are of particular concern here. Food prices going up will mean a significant reduction in the standard of living for a very large part of the population. Normally, the stopgap arrangement has been through imports. But this time it will not be so easy because the rising food prices seem to be global."

For public consumption, the government has to be seen to be taking steps. But most experts are doubtful whether they will do any good. "I feel that the [inflation] numbers are going to be around 6% -- above the 5% magic benchmark," says Ajit Ranade, chief economist of the Aditya Birla group. "The inflation numbers for seasonal goods like fruits and vegetables may come down. There might be some moderation in food grains. But I don't see overall inflation numbers coming down very quickly. This is a global problem." The United Nations World Food Program (WFP) has compared the crisis to a silent tsunami and said that 100 million people are at risk. Wheat and rice prices have risen to record levels. "A wave of food-price inflation is moving through the world, leaving riots and shaken governments in its wake," as The Economist recently wrote in a cover story on the subject. "Agriculture is now in limbo. The world of cheap food has gone."

Oil prices in India have crossed $110 a barrel, though these are not reflected in the inflation numbers as the government subsidizes fuel prices. Still, oil refineries are feeling the pinch. Indian Oil Corporation says it is losing Rs. 238 crore ($59 million) a day on retail fuel sales.

There are other worries. The Index of Industrial Production (IIP) plunged to 5.8% in January. It recovered to 8.6% in February, but that was much below the 11.2% recorded in February 2007. For the first 11 months of fiscal 2007-2008, the IIP has come down to 8.7%, compared to 11.2% for the same period last year. Growth has taken a backseat. "There is a crisis of confidence too," says Chakraborty of Enam.

Subprime Losses

Ripples of the subprime crisis in the U.S. have spread to India -- but they are ripples, not waves. Perhaps the only major sufferer among the banks and financial institutions is ICICI Bank, which had a mark-to-market loss of $264 million as of January 31. The bank explained that it had provided $90 million already and would provide another $70 million. But the losses hit the headlines only after the answer to a Parliament question brought out the details. This gave rise to the feeling that there could be other losses hidden in the banking system.

According to one estimate, the total losses could add up to Rs. 20,000 crore ($5 billion). The RBI, however, says there is no systemic risk. Given the cautious nature of India's central bank, observers believe that the losses could be lower. The State Bank of India, the country's largest bank, says that its clients' derivative losses could be around Rs. 700 crore ($173 million). Unfortunately, not all banks are being open about their exposure. This has added to market fears that more shoes could drop in the future.

The corporate results so far have been a mixed bag. Even within sectors, there are no clear signals. Infosys created much enthusiasm within the information technology (IT) industry when it announced upbeat performance and strong prospects for the future. A few days later, India's largest IT company -- Tata Consultancy Services (TCS) -- poured cold water over the euphoria. "The TCS performance is below par," says Manik Taneja, an analyst with Emkay Share and Stock Brokers. Even so, some optimism lingers. Raamdeo Agarwal, joint managing director of Motilal Oswal Securities, says that if companies report the expected 18% to 20% growth in profits, the markets will recover.

According to Enam's Chakraborty, "In January 2008, the Indian market was banking on global and domestic liquidity, despite its over-leverage, combined with pockets of over-valuation and over-ownership. Since then, India has been one of the worst performing markets, even as most global markets have bounced back, banking on being rescued by the U.S. Federal Reserve, while commodity inflation has aided Brazil and Russia."

Chakrabarti of ISB says that what happens in the U.S. matters enormously to India. "On the export front, if the global slowdown continues -- and worldwide there is an expectation that the U.S. economy will be slow for at least the next few quarters -- then exports are likely to drop. How deep the drop will be depends largely upon the U.S. market because, historically, when America slows down, most other economies also follow. It now remains to be seen if the slowdown will be as global as it has been in earlier times.

"In the medium term, things don't look too good for India. But given the structural changes that India has made, I believe that it will be only a temporary blip. In the long run things will be back on track. The question is when? I believe that in 12 to 18 months we will be back to where we were. I don't expect a long term slowing down."

Subir Gokarn, chief economist of Standard & Poor's Asia Pacific, agrees. In his April review of the economy -- CRISIL EcoView -- he writes: "The recent downturn in investment activity has clearly contributed to the overall deceleration in manufacturing. This, and other indicators, such as credit growth, point to the onset of a cyclical downturn in the economy. This is obviously a matter of concern, but, at this point, our expectation is that the downturn will be both shallow and short. Remember that barely five years ago, GDP growth was less than 6% a year. Compared to that, we are now worrying about it falling to 8%. That is perhaps the best reflection of how dramatically the economy and its investment climate have changed in such a short span of time."

Retail in India: Capturing the Opportunities of a Complex Consumer Class

According to a McKinsey report, India's consumer goods market is expected to reach $400 billion by 2010, which would place it among the five largest markets in the world.

Yet few subjects elicit both optimism and skepticism as much as the Indian consumer does. To the optimists, India represents a huge, untapped middle market, critical to any company with global aspirations. To the skeptics, India is still too poor by global standards -- with most people living on less than $1 per day -- for mass-market retailers to rush in.

Members of a panel titled, "Retail & Consumer Technology: Selling to the New Indian Consumer," at the recent Wharton India Economic Forum suggested that, broadly speaking, both the optimists and skeptics are right. However, generalizations about the Indian consumer can be misleading. Trying to connect with consumers on an "Indian" level is a mammoth task. For one, India is a diverse country, with 23 official languages and more than 1,000 dialects.

Although attitudes have shifted toward consumerism, being individually poor but collectively rich fundamentally differentiates India from developed markets. Despite having a large consumer base that is growing steadily, the market is complex and the propensity and capacity for Indian consumers to spend depends on a unique blend of price and value. According to the panelists, the companies -- domestic or foreign -- that understand this complexity will be the most successful at selling to Indians, and stand to reap enormous benefits of scale.

Understanding the Indian Consumer

Sunil Dutt, head of Samsung Mobile India, opened the panel discussion with a quote from India's first prime minister, Jawaharlal Nehru: "India, poised as she is, will either account for a great deal, or nothing at all." India's economic growth has accelerated significantly over the last two decades, along with the spending power of its citizens. Real average household disposable income has roughly doubled since 1985. With rising incomes, household consumption has increased, and a new Indian middle class has emerged.

As Indian incomes rise, the shape of the country's income pyramid will also change dramatically. More than 291 million people will move from desperate poverty to a more sustainable life, adding a number of first-time consumers to the market. While much of this new wealth and consumption will be created in urban areas, rural households will also benefit. According to Dutt, "Indian spending patterns have evolved, with basic necessities such as food and apparel declining in relative importance, and categories such as communications and health care growing rapidly. Much of this shift can be attributed to the consumer electronics and telecom sectors that have provided a platform to increase consumer awareness. In fact, the mobile-phone's penetration and impact on the Indian economy have earned it the new title of FMCD" -- or fast-moving consumer durable, versus the traditional marketing category of fast-moving consumer goods.

Awareness around the power of information technology to solve problems, create employment and improve lives has trickled down to the lowest socio-economic class. India has close to 261 million mobile subscribers, many of whom live in rural areas. "The connectivity, communication and literacy leap that India has gone through over the past decade has been a major driver of aspiration," said Rajeev Karwal, founder and CEO of Milagrow Business and Knowledge Solutions, a Gurgaon-based venture-capital firm geared to small and medium-size businesses.

Through word of mouth, their own observation and the media, consumers now can visualize a better life, and they demand it, Karwal said. The historical pattern in India -- and in most developing economies -- shows that as incomes rise, consumers spend proportionately less on basic necessities. As millions of deprived households move into the "aspirant" segment, they will begin to be able to afford products and services beyond their immediate needs for food and clothing.

Arvind Singhal, chairman of the Gurgaon-based management consulting firm Technopak, said that "it is a myth that rural India is less aspirational. There might be a larger distribution of wealth in the cities, but there is no demographic-based difference in aspiration. In fact, rural India has been badly served; most large retailers have concentrated on the top 200 cities, with very few even having distribution channels in the villages."

Most companies have not tapped the vast rural consumer base for two reasons. First, the volume of potential customers, based on income, is small as a proportion of the total rural population. "Tier 1 and 2 cities will continue to control and drive approximately 62% of consumption of high-end products in 2025," Karwal said. Second, the rural population is scattered over a vast geographic area, making them hard to locate and expensive to target, given the country's poor infrastructure. However, "new technologies like the Internet and wireless broadband can solve both these problems," Karwal noted, "making it economically viable for companies to offer a range of services such as banking, distance education and health care to rural India. This, in turn, will transform the expectations, aspirations and economy of the rural consumer."

Although price and value are important considerations, recent research shows that Indian consumers increasingly demand brands that are relevant to their experience and that reflect local preferences. For several years, leading multinationals attempted to sell global brands in India at global prices. Companies were confident that the country's consumers would move in a premium direction because of the technological sophistication that the IT boom engendered. They also chose not to establish well-planned marketing and sales channels, assuming that brands alone were strong enough to attract consumers. This assumption turned out to be wrong: Over time, companies tailored their products and production methods to Indian market conditions and slashed prices by more than 50%.

Karwal cited the mobile phone as an example of a product that offers a high degree of functionality at a good price. "It is equipped with features such as a dust-resistant keypad and a built-in flashlight that not only aid truck drivers on India's poorly lit highways, but also take away the villager's embarrassment over the lack of electricity. Customized to the Indian market and reflecting the importance of price and value rolled into one, the mobile phone now serves as a great benchmark for market penetration. It is no wonder that the number of mobile phone subscribers far outweighs the number of Internet or credit card users in India."

Getting the price right is just as important. Although income levels are rising, Indian consumers still have many competing demands on their modest budgets. Winning companies have learned the importance of affordability. "India has the fastest-growing mobile phone market, and handsets are sold cheaper than anywhere else in the world," Dutt said. "Steep and continual price cuts have led to levels of market penetration that took television sets 25 years to achieve."

The Road to Consumption

India's consumer demand structure is fundamentally different from that of developed markets. Since 1990, the country's economy has grown on an average of 5.7% per year. Its per capita income has nearly doubled in real terms. But different consuming classes drive market growth in different ways, and an appropriate mix of strategies is required to capture this growth.

An estimated 1.2 million affluent households sit atop the Indian income and consumption pyramid. These consumers buy branded products and behave like their counterparts in developed markets. Moreover, they are largely concentrated in the top eight cities. At the bottom of the pyramid are the large but poor segments. Struggling households number more than 100 million, followed by 40 million destitute households that are poorer still. The real drivers of the growing consumer goods market occupy the center of the pyramid -- India's 40 million middle-income households, which purchase more than just the basics.

"A 1% change in income opens up a $25 million retail opportunity," Karwal said. "As economic growth occurs, the destitute will transform into aspirants and enter the consumption arena. Aspirants will become climbers with increased per capita consumption, creating an automatic volume growth for several categories. The socio-economic transformation of consumers offers a large window of opportunity for marketers, as 100 million to 150 million consumers have just begun their journey, while another 100 million are on the road to consumption."

The population's demographic profile also plays a role. Indians constitute a fifth of the world's citizens below age 20. So a youthful, exuberant generation, nurtured on success, is joining the ranks of Indian consumers. These people are deeply rooted in Indian culture and traditions yet connected to and curious about the outside world. Their incomes may be growing but their budgets are still limited. Together, these characteristics have big implications for the product categories and brands they select. With basic needs satisfied and the future taken into consideration, these consumers will consider purchasing products that represent "the good life."

"In the past, youth were perceived to be disconnected with no consideration for value," Dutt said. "However, a closer look reveals that they are extremely discerning individuals who know what they want. The challenge facing manufacturers is to come up with products and services that appeal to this group of consumers who have a short attention span coupled with rapidly changing needs and preferences. We need to understand them and synchronize our products with their aspirations."

Additionally, youth often spend beyond their means. They are willing to experiment with high-end brands because they have a high level of disposable income. "Unlike the previous generation who witnessed slow economic growth, young Indians have been raised in the post-liberalization era of fast growth and underlying optimism, and are thus more confident about the future," said Y.V. Verma, director of human resources and management support for LG Electronics India.

Expansion of Organized Retail

When India opened its economy to the global marketplace in the early 1990s, many multinational corporations rushed in to pursue its middle-class consumers, only to confront low incomes, social and political conservatism, and resistance to change. "In the past, retail conglomerates avoided the Indian market because they did not find the large investment a worthwhile opportunity, as India accounts for a very small percentage of the U.S. market in pure dollar terms," said Technopak's Singhal. India also lacked the infrastructure, supply chain, foreign direct investment regulations and value-added tax required for retailers to succeed.

"If the government permits foreign direct investment in retailing, consumer goods companies would have greater opportunities to sell products in the modern formats they understand," Karwal said. "Currently, about 60% of all purchases are made in the food and grocery segment, which has a unique supply chain that multinationals don't understand. The optimal retail format in India mimics a local bazaar experience, vastly different from the neat aisles and structured store layout present in other countries."

Skeptics point out that even if government policy works in favor of large retail, understanding of the consumer's psyche is paramount to cracking the Indian market. Karwal went on to say that "most bleeding happens at the front end, as real estate prices are exorbitant. To combat these expenses, companies such as Zara and Best Buy have set up their own buying houses in India. If foreign retailers are able to get their back end in order while regulation evolves and rental prices cool down, the government policy is likely to work in their favor."

At the same time, the government has a responsibility to make sure that foreign inflows do not disrupt employment or functioning of smaller, homegrown players. Karwal minimized that concern: "Even though large conglomerates have a 7% to 10% buying advantage, small retailers benefit from the close proximity to customers. The necessity to buy fresh food due to a lack of electricity and inefficient public transportation systems serves to check the displacement of traditional retail. The network of local retailers will remain an important segment for years, even if modern retail continues to grow at the current pace."

The Next Frontier for India's Outsourcing Industry? The Domestic Market

Earlier this year, Genpact, the largest business process outsourcing (BPO) player in India, gave Harpreet Duggal a new role: responsibility for developing and executing the company's domestic BPO strategy. Duggal is already well into discussions with potential customers, and is finalizing operating locations. He's moving fast because Genpact isn't the only Indian company interested in this space. For many reasons, the domestic BPO market is one that no one can afford to ignore anymore.

Duggal primarily is targeting two sets of potential customers: existing global customers who are looking to increase their presence in India and require the same systems and processes they have elsewhere; and Indian companies with global aspirations, both by way of moving beyond Indian boundaries and by providing a global experience in the Indian market. These require world-class processes and systems. Says an upbeat Duggal: "We believe that India is a very exciting market to be in."

Having been on the periphery, the domestic BPO business is steadily moving onto everyone's radar. Companies including IBM Daksh, Firstsource Solutions, MphasiS BPO and Intelenet Global Services are looking to significantly increase their presence. Others, such as Wipro BPO and Infosys BPO, are waiting for the right time to enter the space as part of a total outsourcing solution along with their IT arms. And, firms such as 24/7 Customer have no immediate plans to enter but are watching the space keenly.

What has brought about this growing interest in India's BPO market? Industry players and analysts cite multiple factors. These include reduced costs of connectivity, the scorching pace of the Indian economy, the phenomenal growth of companies in sectors including telecommunications and financial services, rising customer expectations, Indian firms' global aspirations, and global firms entering the Indian market. The changing rupee-dollar equation and the slowdown in the U.S. economy, which is forcing players to look at other markets, have added to the momentum.

Wharton management professor Saikat Chaudhuri says the factors driving that trend are the "tremendous growth" of India's domestic markets, the slowdown in Western markets, and the dollar's weakness against the rupee. He notes that a whole new class of medium-sized companies outside of the well-established and large industrial houses like those of Tata, Birla, Ambani or Goenka is looking at farming out noncore activities to increase efficiencies and focus on core competencies. "These companies are becoming customers of Oracle, Cisco, SAP and so forth," says Chaudhuri.

According to Ravi Bapna, assistant professor at the Indian School of Business, "It's now become profitable to address this market and the industry is set to take off."

A glance at the Indian BPO industry's growth helps put the dynamics of the domestic market in perspective. At a compound annual growth rate of around 37% over the last few years, BPO exports have been the fastest-growing segment of the Indian IT-BPO sector. They have grown from $3.1 billion in fiscal 2004 to $11 billion in 2008 and currently account for 37% of the global business process offshoring pie. They sustain an employee pool of more than 700,000.

Players have tried over the years to add quality and efficiency to their original labor arbitrage sales pitch. They have been moving from low-end, non-core activities to more complex processes. Now, in a move further up the value chain, they are looking at becoming transformational partners to their clients, making an impact on business metrics.

A recent study by the National Association of Software and Services Companies of India (Nasscom) and the Everest Group estimates that in a "business as usual" mode, India's BPO exports will grow to $28 billion to $30 billion over the next four to five years. With proactive measures, the report says, they have the potential to reach $50 billion by 2012, with a maximum addressable opportunity of $220 billion to $280 billion.

Traditionally, Indian BPO vendors have relied largely on English-speaking geographies as their markets. North America and the United Kingdom together account for about 87% of their export revenues. North America, primarily the United States, accounts for roughly two-thirds of the market alone. While this dependence on the U.S. market is expected to continue, players have been expanding their footprints in other markets, notably continental Europe and the Asia-Pacific region. With the slowdown in the U.S. economy, rupee-dollar fluctuations, and growth in other markets, this move to tap other geographies not only acts as a natural hedge against currency fluctuations, it's simply a good business strategy.

India's Growth Beckons

That's where the Indian market comes into play. India's economy is growing too fast for any industry not to want to share in its growth. From less than $100 million in 2002, BPO demand in the domestic market grew to $1.1 billion in 2007. In the last year, it is estimated to have grown to between $1.6 billion and $1.8 billion. The Nasscom-Everest study estimates the potential addressable market at around $15 billion to $20 billion over the next five years. Realizing even half of this potential would be significant.

In many ways it would change the nature of the industry. As it stands, close to 80% of the industry comprises captive shared service centers. The rest of the industry is highly fragmented. Estimates suggest that 400 to 500 firms constitute the unorganized sector. As the industry gains in size and stature, a fair bit of consolidation is expected. Third-party service providers, many whose revenues are growing around 100% a year, are expected to increase their market share significantly.

Telecommunications and financial services have been key verticals spurring domestic demand, followed by consumer goods and airlines. Going forward, government, travel and hospitality, retail, and media and entertainment are expected to attract significant demand for BPO services in India.

Ravi Aron, senior fellow at Wharton's Mack Center for Technological Innovation and an expert on outsourcing trends, points out how BPO firms in India will find the domestic market more challenging than those in developed countries. For starters, he says Indian companies in several services industries including those in the BFSI (banking and financial services industry) segments are wholly owned by the government. BFSI companies have tended to be the biggest opportunity for outsourcing services providers in Western markets, he adds.

"Although these companies present the right opportunity for BPO firms, state-owned banks and insurance companies like the State Bank of India and General Insurance Corp. of India are going to be very slow to start outsourcing on a large scale," says Aron. "That is because of the extraordinary pressure they will face from their unions, who don't want their jobs to go to the private sector."

The second challenge BPO firms will face in India stems from the fact that any company's decision to outsource its needs is "heavily embedded in its technological architecture," says Aron. "Indian services companies in either the public or the private sector are heavily underinvested in technology on a per-capita and per-sale basis compared to those in the U.S. and Europe. Indian services companies are far more labor intensive, and don't have the technology platforms that will facilitate outsourcing, excluding [financial services companies like] an ICICI or HDFC."

Aron talks of the "3 Ps" of information architecture -- platforms, processes and people -- "where Indian companies are not streamlined." He says internal processes at most Indian services companies are "idiosyncratic" and not standardized as in large retail companies like Wal-Mart or U.S. health care companies.

Gaurav Gupta, country head of the Everest Group, points out that with the phenomenal growth in these industries, the name of the game for most companies is to gain market share and grow the top line. The competitive landscape is straining companies' operational models. So companies in these industries are turning to vendors who can help them overcome some of the challenges associated with fast growth, like managing huge volumes and providing a large network that can reach out to different corners of the country rapidly. Says Gupta: "The present systems and processes are nowhere near adequate, either by way of scale or expertise, to sustain the kind of growth that companies are seeing in India. These require tremendous ramping up. Otherwise they will become severe bottlenecks." Adds Susir Kumar, chief executive officer of Intelenet Global: "At this stage of growth, companies would rather use their capital in building their brands, acquiring customers, and focusing on their core competencies and outsource whatever is possible."

'Productivity Arbitrage'

Aron agrees that big opportunities lurk behind those shortcomings at Indian services companies. BPO firms could help standardize and automate processes at Indian companies and achieve "extraordinary productivity gains of up to 35% over 18 to 24 months," he adds. "That is why doing BPO in India for Indian companies makes a lot of sense. Instead of wage arbitrage, start thinking about productivity arbitrage."

Even as companies busily increase their customer base they realize that, with the Indian economy becoming more globally integrated, customers are ever more demanding. The "new" Indian customer is not satisfied with anything less than world-class levels of product and service quality. Take the Indian telecom industry. It is among the most complex in the world, with new products being introduced practically every day. It is becoming imperative for companies to get it right the first time. Customer service is seen as a key differentiator in the crowded marketplace. Customer service, in fact, accounts for two-thirds of revenue in the domestic BPO market, followed by finance and accounting and human resource outsourcing. As Nasscom vice president Rajdeep Sahrawat says: "There is very little to differentiate companies from the product point of view and therefore offering very high quality, personalized, 24/7 customer service is critical. This requires scale, flexibility and expertise."

Bharti Airtel, India's largest mobile services provider, is an often-cited example. Bharti was one of the first and biggest Indian companies to outsource on a large scale. In August 2005, the company signed a mega deal with four global BPO companies -- IBM Daksh, MphasiS, TeleTech and Hinduja TMT -- to outsource its call centers. Bharti had already outsourced its IT and cellular networking requirements to IBM and Ericsson, respectively. These strategic moves allowed Bharti to focus on its core areas of product innovation, marketing and brand building. Bharti has a mobile subscriber base of around 60 million and is adding around 2 million subscribers a month. It is a beacon for others targeting high growth. Says Ramesh Gudalur, president of MphasiS BPO: "Companies like Bharti who look at outsourcing as an integral part of their business strategy are completely changing the way Indian companies have traditionally run their businesses. This is putting pressure on others, both in their own industries and in other sectors, to follow suit."

Opportunities await BPO firms also in providing specialized services to newly emerging industries like retail, fashion apparel or automobile components, such as customer relationship management (CRM), market research, accounting, and inventory and supply chain management, says Aron. "Many of these specialized services companies have the money, but not the managerial capacity or bandwidth to automate their processes and extract efficiencies," he adds. He sees a new trend emerging in the next two to three years of "platform-based BPO" that provide niche services in areas like credit card fulfillment, mortgage loan processing and loan refinancing, and property & casualty insurance.

Delivering Value

Increased capability in the supplier community is also encouraging Indian companies to move toward outsourcing. Having grown via the export market, many large suppliers have developed end-to-end capabilities that are large enough to attract the domestic players looking at huge volume growth. More important, the suppliers now have the capability to deliver value by way of technology platforms or process expertise that goes well beyond just cost.

This doesn't mean that the cost advantage that Indian companies enjoy by outsourcing their business processes is insignificant. Cost, as Sandeep Soni, chief executive officer of Spanco BPO, points out, remains an important driver by sheer virtue of the economies of scale that a vendor brings in. However, it is unlike the export market, where labor arbitrage was the key factor in the industry's early days and continues even today to play a dominant role.

Chaudhuri argues that BPO services companies could still play the wage arbitrage card to a significant extent in India's domestic markets, but differently. "That is because there are many inefficiently run companies in India, and the BPO companies have not just the expertise but also the scale to perform functions across the board at a much lower price," he says. "While the wage arbitrage in India's domestic markets may not be as attractive as it is in the west, certainly the volume of activity can make up for it."

Sabyasachi Satyaprasad, senior director at advisory firm NeoIT, says the absence of a strong labor arbitrage in the domestic market will in fact compel vendors to offer a higher-value proposition, such as solving business problems for their domestic clients. This, he says, could well result in the domestic BPO industry leapfrogging some of the growth stages that vendors had to go through in the global market. Industry players agree. Says Pavan Vaish, chief executive officer of IBM Daksh: "When one is operating in a market where there is no arbitrage benefit, you have to innovate and add value to the customer. When we started out in 2005 we had thought that our international business would give us a lot of insights into our India business. But what we are finding is that it is our India business where a number of amazing innovations are happening."

BPO companies that have concentrated on serving Western markets may not feel the need to reorient themselves as they look to serve domestic Indian companies, says Chaudhuri. While these BPO companies developed their "global delivery model" for Fortune 500 companies, he notes, many of them were "born and bred" in India, including Wipro Spectramind and Genpact's predecessor company. "The outsourcing model has been designed keeping Indian constraints in mind from the very beginning, which allows for very healthy margins when they deal with foreign clients."

The only significant difference BPO companies will encounter In India's domestic market is the need to offer simplified services, according to Chaudhuri. "The BPO companies targeting the Indian market are not going to sell $300 million or $1 billion contracts for five years," he says. "They will have a lot more projects that are in the $1 million, $5 million and $10 million range. They are well-positioned for that because they started small themselves." He says these BPO companies could also replicate the dedicated units they set up with some clients.

This presents its own challenges. While their global education is valuable, vendors must create a proposition that is relevant to their domestic clients' immediate needs. According to Sanjeev Sinha, senior vice president of operations at Firstsource Solutions: "In many cases the India market has requirements that are rather different from the global markets, so vendors need to adapt and customize the solutions to the local situation. A cut and paste of the global solution will not work."

Vendors also need to think ahead of the curve regarding their very business models. With India, an extremely price-sensitive market, pricing models need to be innovative. Vendors must build capabilities that allow them to adapt to the changing expectations of a fast-growing and competitive marketplace. As Anirudha Prabhakaran, chief operating officer of 3i Infotech, points out: "This is a market which not only negotiates very hard on the efficiency front but also constantly raises new demands."

One potential obstacle Aron sees is a "huge divide" that exists between managerial personnel and the clerical staff at Indian companies in the ability to efficiently use technology in processes. While Indian managers are able to use technology to access data, analyze it and create reports, for instance, clerical workers tend not to use computing capabilities to their fullest extent, he notes. "You don't see that sharp divide in the U.S.," says Aron.

Variation in Margins

There are other challenges, too. India, as it is well-known, is not a homogenous market. It has myriad regional languages, varied cultures and remote corners. For players who are looking at scale and who have national ambitions in the domestic BPO market, this means managing a range of complexities. Also, for the economics to be viable, players will have to move from larger cities and set up operations in Tier 2 and Tier 3 locations. It is true that the domestic market does not require that BPO agents be trained by way of voice, accent and culture; therefore it is less expensive and easier for service providers to move into the smaller cities. But the challenges posed by infrastructure and the availability of senior management must still be dealt with.

The biggest challenge, however, could be around profitability. Although the costs by way of infrastructure, wages and training are lower for the domestic market, so is the pricing. Pricing in the India BPO market is estimated to be anywhere between 30% and 60% less than in its global counterpart, though more experienced players insist that their domestic BPO margins are comparable to their global business or only marginally lower. With the outsourcing market in India still not mature, the readiness to pay for world-class services remains a challenge. But as Duggal of Genpact points out: "Even in the global markets the variation in margins is phenomenal." It all depends on how effectively vendors are able to deliver by way of cost structure, people management and value creation.

Chaudhuri says BPO companies focused on India's domestic market could continue to enjoy cost advantages because many of them are extending operations outside of the big cities to cheaper, second-tier cities. They could also use their Indian base to supply markets in other developing countries, he adds. "It's like the Tata Nano [the Tata group's newly launched small car], where the first foreign markets are in Africa, Southeast Asia and European countries that have road density problems, and some parts of Latin America," he says.

Chaudhuri sees other, longer term gains for BPO companies in all this. As service providers to India's new class of business houses that are expanding globally, they "could follow their clients to foreign markets," says Chaudhuri. "The Japanese banks followed the Japanese conglomerates, and U.S. telecommunications companies like Verizon did the same thing, following their financial services clients overseas."

The Ranbaxy-Daiichi Deal: Good Medicine, or a Harbinger of Future Ills?

Published: June 12, 2008 in India Knowledge@Wharton

Just a few days before announcing that he had sold his family's 34.8% stake in Ranbaxy Laboratories to Japanese pharmaceutical firm Daiichi Sankyo, Ranbaxy's CEO and managing director, Malvinder Mohan Singh, said his company was on the hunt for its own acquisitions.

He told the New Delhi-headquartered business daily, the Business Standard, that he had "de-risked" and charted a strategy for the company to make acquisitions of its own. "When you are the leader, you have to set the pace for the industry," he declared.

So, Indian investors and pharmaceutical industry leaders were astounded by the June 11 announcement. To be sure, the markets were aware that something was afoot between Ranbaxy, India's largest pharmaceutical company, and Daiichi Sankyo, Japan's second largest, but investors were expecting no more than a sale of a strategic stake of about 10% or so to shore up an alliance between the two companies. The sale of the Singh family's entire stake came as quite a shock. Asked one journalist after the announcement: "Haven't you sold the family silver?"

Singh contends that this is just what the doctor ordered. "[This] puts us on a new and much stronger platform to harness our capabilities in drug development, manufacturing and global reach," he said. "Together with our pool of scientific, technical and managerial resources and talent, we will enter a new orbit to chart a higher trajectory of sustainable growth ... in the developed and emerging markets, organically and inorganically. This is a significant milestone in our mission of becoming a research-based international pharmaceutical company."

Daiichi Sankyo president and CEO Takashi Shoda said the two companies are a good fit: "The proposed transaction is in line with our goal to be a global pharmaceutical innovator and provides the opportunity to complement our strong presence in innovation with a new, strong presence in the fast-growing business of non-proprietary pharmaceuticals." He added: "While both companies will closely cooperate to explore how to fully optimize our growth opportunities, we will respect Ranbaxy's autonomy as a standalone company as well." Not only will Singh stay with the company, Shoda said, he will also be chairman of its board of directors.

Getting into the Generic Market

Wharton marketing professor Jagmohan Raju, who has consulted with pharmaceutical companies including Wyeth and Johnson & Johnson, says that while Daiichi Sankyo will find it easier to enter the Indian market with Ranbaxy, its bigger goal would be in securing a strong presence in the global market for generics. "Ranbaxy has a good foothold in the worldwide generics market, which is lucrative and growing," he says.

Singh has been a pugnacious leader, pursuing takeovers in India and abroad. Among his foreign acquisitions are the unbranded generic drug business of Allen SpA (a division of GlaxoSmithKline) in Italy; Terapia in Romania; Ethimed, a generics company in Belgium; the Mundogen generic business of GSK in Spain; and Be-Tabs Pharma in South Africa.

Singh has taken over or acquired strategic stakes in a host of domestic companies such as Zenotech Laboratories, Cardinal Drugs, Krebs Biochemicals and Jupiter Biosciences. He was recently involved in a raid on the Chennai-based Orchid Chemicals. Although he denied it was a hostile takeover, the promoter of the beleaguered company didn't agree.

Singh has also been taking on the world's big names in pharmaceuticals in court cases all over the globe. This includes Pfizer for Lipitor, GSK for Valacyclovir and AstraZeneca for Nexium. (Many of these patent battles have recently been settled out of court.)

After such an acquisitive strategy, why would Singh suddenly agree to be acquired? The answer is not immediately clear. Raamdeo Agrawal, co-promoter and non-executive director of Motilal Oswal Securities, speculated that there may be problems with the Indian drug industry that analysts are not fully aware of. "We need to look at the sector again," he said. Others expressed surprise and disappointment. "It's a landmark deal for the pharma industry. But I can't help feeling a twinge of regret about an Indian MNC becoming a Japanese subsidiary," Mahindra & Mahindra chairman Anand Mahindra told The Economic Times.

The Deal

Singh is selling his 34.8% stake for around Rs. 10,000 crore ($2.4 billion) at Rs. 737 ($17) per share. Daiichi Sankyo will pick up another 9.4% through a preferential allotment. According to Securities & Exchange Board of India (Sebi) norms, it will have a make an open offer to the shareholders of Ranbaxy for another 20%. There could also be a preferential issue of warrants to take the Daiichi Sankyo stake up by another 4.9%. That will come into play if the ordinary shareholders don't respond to the open offer and Daiichi Sankyo needs another way to raise its stake to 51%.

At the end of the exercise, scheduled to be completed by March 2009, Ranbaxy will become a subsidiary of Daiichi Sankyo. Despite all the denials from Ranbaxy leadership, an Indian icon will vanish. (Similar circumstances drove Sunil Mittal of Bharti Airtel to walk out of a deal with MTN of South Africa; he wouldn't compromise the Airtel brand which had become "the pride of India.")

What will Singh be doing with his $2.4 billion? He says that major investments are needed in Religare and Fortis, the group's forays into financial services and hospitals. But both are really part of the herd in their sectors while Ranbaxy was number one.

Ranbaxy, with $1.6 billion in global sales in 2007, had a profit after tax of $190 million, a gain of 67% over the previous year. It has a footprint in 49 countries and manufacturing facilities in 11. It has 12,000 employees, including 1,200 scientists and has been pouring money into R&D, though obviously not on the same scale as the Western majors. Ranbaxy is among the top 10 global generic companies. Its stated vision has been to be among the top five global generic players and to achieve global sales of $5 billion by 2012. How much of that survives the Daiichi Sankyo regime remains to be seen.

Indeed, there is a question over whether Singh himself will survive. He said that Ranbaxy is in his genes and there is no question he will remain CEO and, now, chairman. But will he be able to make the transition from a promoter to a professional CEO? He may have delivered Ranbaxy to Daiichi Sankyo, but now he has to deliver the goods.

Daiichi Sankyo is the product of a 2005 merger between Sankyo and Daiichi. In the financial year ended March 2008, it had net sales of $8.2 billion and a profit after tax of $915 million. It has a presence in 21 countries and employs 18,000 people. It is the second largest pharmaceutical company in Japan. The company can trace its roots back to 1899, though the formal entity today is relatively new. Daiichi Sankyo makes prescription drugs, diagnostics, radiopharmaceuticals and over-the-counter drugs.

The combined company will be worth about $30 billion. The acquisition will help Daiichi Sankyo to jump from number 22 in the global pharmaceutical sector to number 15. "The deal will complement our strong presence in innovation with a new, strong presence in the fast-growing business of non-proprietary pharmaceuticals," according to Shoda.

The combination has other benefits for the Japanese company. It gets a stake in a major player in generics, an area that is becoming increasingly important in Japan. According to the 2008 Japanese Pharmaceuticals & Healthcare Report (2nd quarter), the country's pharmaceutical market is currently valued at $74.4 billion and is the most mature in the Asia-Pacific region. By 2012, the market will grow to $82 billion. The country's generics sector is one of the most promising. "In an effort to control ballooning healthcare costs, the ministry of health plans to raise the volume share of generics within the total prescription market to at least 30% by 2012," says the report. "The current value of the sector is $5.5 billion, which equates to 7.3% of total medicines sales. Changes to prescribing procedures and the influx of foreign firms with low-cost goods will provide a stimulus to the generic drug sector." The comparative figures of volume share of generics for the U.S. and the UK are 13% and 26%, so there is some way to go.

Getting into Japan

Ranbaxy will gain easier access to the much-coveted Japanese market by operating from within the Daiichi Sankyo fold, says Raju. "Ranbaxy could bypass a lot of European and U.S. companies that are finding it difficult to enter the Japanese market, where safety and testing requirements are a lot higher." He notes that Pfizer has done a smart thing in forming an alliance with Eisai of Japan to jointly market the former's drug Aricept, which treats Alzheimer's disease. "No other Alzheimer's drug sells well in Japan," says Raju.

Daiichi Sankyo's proposal is to make the much cheaper generic drugs the default option over branded drugs. The ministry stamp of approval will eliminate the problems patients have been facing with health insurance claims; some insurers have not been accepting generic drugs as valid medicines. Indian pharmaceutical companies have been aware of this opportunity. Some have started their preparations. Last October, the Mumbai-based Lupin Ltd acquired an 80% stake in a Japanese generic pharmaceuticals company, the $70 million Kyowa Pharmaceutical Industry Co Ltd. Orchid Chemicals & Pharmaceuticals has set up a wholly-owned subsidiary in Japan called Orchid Pharma Japan.

The Ahmedabad-based Zydus Cadila group initially entered the Japanese generics market with Zydus Pharma in 2006. This U.S. company's mandate was to market formulation generics and look for alliances with Japanese companies. Last year, Zydus acquired a 100% stake in the Tokyo-based Nippon Universal Pharmaceutical Ltd. Zydus Cadila had earlier taken over Alpharma of France. In India, its acquisitions include Recon Healthcare, German Remedies, Banyan Chemicals and Liva Healthcare.

As much smaller companies than Ranbaxy have gone to Japan, shopping bag in hand, why didn't Singh try to purchase Daiichi Sankyo instead of selling? Domestic laws make Japanese companies difficult to take over. But there surely could have been an equivalent in Europe or the US. The Tatas and the Birlas have successfully targeted foreign companies several times their size. Why did Ranbaxy follow a different prescription?

The answer may be in the fact that that Ranbaxy was on a much weaker wicket. The official version talks of synergies. Says a joint company statement: "Daiichi Sankyo and Ranbaxy believe this transaction will create significant long-term value for all stakeholders through:

* A complementary business combination that provides sustainable growth by diversification that spans the full spectrum of the pharmaceutical business.
* An expanded global reach that enables leading market positions in both mature and emerging markets with proprietary and non-proprietary products.
* Strong growth potential by effectively managing opportunities across the full pharmaceutical life-cycle.
* Cost competitiveness by optimizing usage of R&D and manufacturing facilities of both companies, especially in India."

But beyond these positive results from the alliance lie problems that could have faced Ranbaxy had it chosen to continue alone. First, the company has thrived on selling off-patent drugs in the U.S. But this has become a much more expensive proposition because of litigation. Second, there is growing competition in generics at home and abroad. Finally, even as the Indian government has been insisting on stringent quality norms, it is extending its regime of price controls. The industry contends that it simply cannot make adequate returns on various products. "If the promoters of India's largest drug company felt it better to exit the business after many years of attempts to make it one of the largest in the world, then there must be serious issues with our drug policy," Swati Piramal, director of strategic alliances at Nicholas Piramal told the Business Standard.

Coming of Age

For Daiichi Sankyo, there are huge benefits in getting access to Indian research capabilities, said Vivek Wadhwa, executive-in-residence at Duke University.

"People are underestimating what is happening in India and China, where companies have rapidly come of age as they play on the world stage," says Wadhwa, adding that Daiichi Sankyo's selection of Ranbaxy underscores that trend. "The Japanese companies have a lot of money but not much by way of innovation. China, India and Indian companies are a very good way forward for them." He says Daiichi Sankyo is banking not just on the cost advantage Ranbaxy would bring, but also its research capabilities. "Japanese companies are shifting a lot of their R&D to India also," he says. "They don't have enough scientists and India has them in abundant supply right now."

There are fears that the Daiichi Sankyo takeover could be a sign of the times. The pharmaceutical industry has turned into a nervous place overnight. Earlier, one likely danger was perceived to be Ranbaxy itself. In March-April this year, it had launched a raid on the Chennai-based Orchid Chemicals and picked up a stake close to 15%.

An analysis shows that several mid-size companies are vulnerable to takeovers. Ankur Drugs, Avon Organics, Lyka Laboratories, Strides Arcolab, Surya Pharmaceuticals and Venus Remedies top the list of pharmaceutical companies in which the promoters have less than a 25% stake. "Indian generic players with established global businesses are definitely a target for multinational companies to beef up their businesses," Ranjit Shahani, vice-chairman and managing director of Novartis India, told the Business Standard.

Does the Daiichi Sankyo acquisition of Ranbaxy signal a countertrend to that exhibited by Indian corporations lapping up companies in foreign markets, like Tata Steel's purchase of European steelmaker Corus? "It's a two-way street," said Wadhwa. "Indian companies are becoming world class, they are growing fast, and they have competent management and technological abilities. The Ranbaxy-Daiichi Sankyo deal is one data point. You are going to see many more of these in the future."

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