The surprise victory for the Leave campaign in the UK's referendum on membership in the European Union (EU) sent share prices plummeting worldwide. India was no exception, with the sharpest falls suffered by companies with significant exposure to the UK, such as Tata Steel and Tata Motors. India's outsourcing vendors also took a hit, amid concerns over the potential negative impact of the so-called Brexit on companies such as Tata Consultancy Services (TCS), Infosys, and Wipro. The UK is the largest market (behind the US) for most offshore vendors and accounts for about 17% of the industry's total revenues of ~$65bn in 2015, so the result of the referendum is likely to have significant and far-reaching effects.
Brexit will have a negative impact on Indian providers in the short term
Britain's exit from the EU has the potential to bring about major changes in several areas that impact India's outsourcing vendors including:
The pound fell to its lowest level in 30 years in the immediate aftermath of the referendum, amidst worries that a wider economic collapse may be imminent. This devaluation will be a pressing concern for Indian providers, as they earn in foreign currency but report in rupees. A weak pound therefore has the potential to cut into profit margins, although the negative impact could be offset somewhat by the strengthening of the US dollar against the rupee.
Lengthening sales cycles
At the time of writing, just days after the referendum result was announced, there is widespread uncertainty about the full implications of Brexit, both economically and politically. Indeed, it may be months before there is any clarity on what the vote to leave the EU actually means for the UK economy. It is therefore highly likely that businesses across the country will put spending decisions on hold, at least in the short term, which will in turn mean a reduction in the number of outsourcing contracts being signed. Given the importance of the UK to India's outsourcers, this will undoubtedly have an impact on revenues, and there will also be concern that, should the economic situation worsen, some planned projects may be scrapped altogether rather than simply deferred.
Restricted access to talent pools in the EU
The UK IT industry has long suffered from a shortage of highly skilled labor and the gap has still not been bridged. Previously, the free movement of labor across the EU has enabled UK businesses to bring in the necessary skills from outside its borders while also keeping wage inflation in check. However, Brexit has the potential to change all that by restricting the free movement of people from the EU into the UK. This could result in stagnation of the talent pool, leading to wage inflation and thereby negatively impacting businesses across the country. Offshore vendors rely on the ability to move resources to deliver scalability, so any restrictions would represent a serious challenge.
Potential divestment from the UK
Most offshore vendors leverage the UK as their European headquarters to take advantage of the stable economy and the UK's reputation as a talent magnet. Depending on the terms of exit, it is highly likely that vendors might need to establish separate headquarters for their European operations and, in this scenario, some may choose to move out of the UK entirely. This has the potential to negatively impact the vendors' business due to the additional expenses involved in such a move while simultaneously also impacting the country's economy as it will lose tax revenue.
There could be silver linings among the dark clouds
Despite all the gloom, the Indian IT sector can still look forward to some positives, the key one being a potential strengthening of India-UK economic ties in the longer term.
Potential increase in reliance on offshore resources
Exiting the EU means the UK will no longer have access to a share of the massive €83bn EU Horizon 2020 fund aimed at improving education and research around science and mathematics. This puts a further damper on the ability of the UK to bridge the widening skills gap in its technology sector. Moreover, the restrictions on intra-EU movement of talent could potentially have a positive impact on offshore vendors in the long term as the UK may become more open to high-skilled immigration from non-EU countries such as India. In addition, there is also a potential for a spike in interest in offshoring which will also favor India's outsourcers. This, however, depends largely on what kind of immigration reforms are enacted in the coming months.
Spending on customer-facing digital technologies will continue to grow
Until a few years ago, expenditure on customer-facing digital technologies such as social, mobile, analytics, and cloud (SMAC) was seen as discretionary spending in the UK. However, changing customer preferences and the demand for higher levels of engagement have led to these offerings becoming the backbone of both businesses and government alike. SMAC is no longer categorized as discretionary spending and is increasingly being recognized as core to the ability of organizations to engage customers and compete effectively.
Post-Brexit, Ovum expects larger transformational initiatives that require considerable effort to modernize IT infrastructure and application architectures to get put on hold until there is greater clarity on how the Leave vote will impact compliance and regulatory requirements. Over the next few years, we anticipate an increase in the number of smaller, short-term deals rather than larger, long-term, annuity-based contracts that have been the traditional sweet spot for most offshore vendors. Since most offshore vendors are deeply embedded, in some form or other, in the digital initiatives of UK enterprises, focusing on growing this line of business will be beneficial in the medium term.
IT Services Contracts Quarterly Analysis, 4Q15, IT0019-003554 (June 2016)
Ovum Decision Matrix: Selecting a Distributed Agile Delivery Model for ADM Services, 2016–17, IT0019-003553 (June 2016)
Ed Thomas, Senior Analyst, IT Services
Hansa Iyengar, Senior Analyst, IT Services