Impact of the US sub-prime crisis on outsourcing

Impact of the US sub-prime crisis on outsourcing – 4 Scenarios

Monday, 15 October 2007

There has been an outburst of writing around the sub-prime crisis in financial markets, but it is surprising how little anybody really knows about its likely impact. Opinions and forecasts range from the optimistic to the highly pessimistic. The optimists believe that the crisis will be contained and will have marginal impact on the larger financial markets or the non-housing components of the US economy. At the other extreme, some are predicting that the contagion will spread – impacting global markets and economies significantly, in the medium term.

Given that there is no clear-cut opinion emerging, we decided to look at four scenarios and their likely impact on outsourcing and offshoring to India. As seen in the diagram, we have plotted the two extreme opinions, against the possible fluctuations in the rupee-dollar exchange rate.

Scenario 1:
Strong rupee, but the sub-prime crisis gets contained within the US mortgage market.

The sub-prime crisis affects the mortgage market in the short run. The housing market also experiences a slowdown, leading to lower mortgage originations.
The mortgage market and housing demand remains low in the medium term too.
However, the crisis is contained and other segments in the financial market remain unaffected by the slowdown in mortgages.
Investors continue to invest in emerging markets. The rupee continues to remain strong against the dollar owing to the strong foreign funds inflow.

Impact on outsourcing

In the short run, BPO companies with significant exposure to the mortgage market find themselves in trouble. The larger BPOs, or those with limited exposure to mortgages remain relatively unaffected by the mortgage crisis, as they will be able to divert resources to other projects in the banking and financial services industry.
In the longer term, mortgage companies resort to restructuring of their businesses and are likely to outsource more. The mortgage- focused BPO companies that can survive the short-term crisis, are therefore likely to have more demand in future.
The strong rupee hits margins of all US-focused Indian outsourcing companies in the short run. This may continue into the longer term. To counter this, BPOs look to target business in other geographies, and contract in more stable currencies like the Euro and the Sterling.
The smaller BPO businesses are affected by the rupee crisis and in comes cases go bust, or are taken over by larger BPOs.
The rupee appreciation diverts some of the business to India to other competing locations such as the Philippines, China, East Europe, as Indian BPOs lose competitiveness.

Scenario 2:

Strong Rupee, but the contagion spreads to other financial markets, global markets and economies

Consumer spending on the whole decreases as foreclosures increase, and this affects other markets such as credit cards, auto, etc.
The credit crunch spreads to other sectors such as retail.
Stock markets in the US crash, leading to ripple effects on financial markets and stock markets in the UK, Europe and other countries.
Investors however, believe that the stronger economies will bounce back and therefore continue to invest in emerging economies, including India.
A combination of the two factors above leads to the rupee remaining relatively strong despite the global contagion.

Impact on outsourcing

As the contagion spreads, outsourcing from banking and financial services also reduces in the short run.
Banking and financial services currently accounts for more than fifty percent of offshoring to India currently. As a result, many outsourcing companies go bust in the short term.
The more financially sound companies manage to survive, but struggle in the short term due to the rupee appreciation.
There is an overall chaos in the outsourcing industry, with companies directly affected losing business and the others with their margins hit by the stronger rupee.
The larger BPOs try to diversify into other markets such as Europe, Middle East, Asia & the domestic Indian market, etc. However, the global crash makes the rupee stronger against other currencies such as the Euro and the Sterling too.
In the longer term, as global BFS companies start to come out of the crisis, restructuring of the business in general leads to more outsourcing. BPO companies that survive the crisis can look forward to improved business prospects.
However, the stronger rupee leads to some business getting diverted to competing destinations such as the Philippines, China and Eastern Europe.

Scenario 3:
Strong dollar, and the sub-prime crisis is contained within the mortgage market

The sub-prime crisis affects the mortgage market in the short run. The US housing market experiences a slowdown, leading to lower mortgage originations.
The other segments in the financial market remain unaffected by the slowdown in mortgages.
However, investors choose to be cautious and become risk averse. Consequently some of the investment boom in emerging markets is curtailed, leading to a weaker rupee.

Impact on outsourcing

In the short run, BPO companies with significant exposure to the mortgage market are in trouble. The larger BPOs, or those with limited exposure to mortgages remain relatively unaffected, as they will be able to divert resources to other projects in the banking and financial services industry.
The rupee depreciation benefits US-focused outsourcing companies in India. However, those with significant exposure to mortgage will still find it difficult to survive.
The mortgage-focused companies are likely to resort to lay-offs and may lose a significant percentage of revenue. Some of the smaller ones will either go bust, or will be taken over by larger BPOs.
In the longer term, mortgage companies look at greater restructuring of their businesses and are likely to resort to greater outsourcing.
In view of the likely growth in demand after the crisis settles, the larger Indian BPOs may consider buying out US-based mortgage vendors as valuations of US-based BPOs tumble.

Scenario 4:

Strong Dollar, but the contagion spreads to other financial markets, global markets and economies

Consumer spending on the whole decreases as foreclosures increase, and this affects other markets such as credit cards, auto, etc.
The crisis extends to other sectors in the economy. Global stock markets crash.
Risk aversion sets in and investors start to pull out money from emerging markets like India.
Markets in India also crash and the rupee starts to depreciate.
The depreciating rupee helps exports of goods and services, however overall demand remains low due to the global contagion.

Impact on outsourcing

The mortgage crisis leads to a slowdown in outsourcing in the short term.
As the contagion spreads, outsourcing from banking and financial services also decreases.
Banking and financial services currently accounts for more than fifty percent of offshoring to India currently. As a result, many outsourcing companies go bust in the short term.
The more financially sound companies manage to survive, partly because of the rupee depreciation (which keeps their margins intact), and because they try to get business from other sectors such as healthcare, telecom, etc. They also try diversification into other markets such as Europe, Middle East, Asia & the domestic Indian market, etc.
In the long term however, there is an overall restructuring in the financial markets that leads to greater outsourcing. Coupled with the rupee depreciation, outsourcing growth resumes after a period of uncertainty.

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