Turnaround as Russian IT market growth rates start to accelerate

By bne IntelliNews February 12, 2008

Graham Stack in Moscow -

Experts say the last quarter of 2007 marked a sea change for Russia's young IT sector: after six years of falling growth rates, the sector is now accelerating. More importantly, it is shifting from infrastructural catch-up towards supporting competitiveness through services.

"It's not just the strength of the wind that is changing," says Sergei Karelov, head of the Real IT centre of IT market analysis, commenting on a study it released recently. "The direction of the wind has changed, and the measure of companies' success will be how quickly and successfully can they reset their sails to take advantage of the new wind."

David Ferguson, Renaissance Capital's IT expert, explains that growth rates in Russian IT spending have been slowing for the last few years. "Initially the market went through a period of catch-up investment, where companies bought computers and servers where they didn't have any previously. That phase is now almost exhausted, and the reason momentum is accelerating this year is that the economy is moving into a new stage of growth."

Karelov agrees: "Initially, here was an IT deficit in a purely Soviet sense of the word. This is what has driven the market in the past: staff lacked computers, companies lacked servers. Now this has been mostly overcome."

That explains why the Russian IT market is still dominated by the hardware segment, which makes up around 69% of the overall market, with IT services at only 19%, compared with Western Europe, where services account for 51% of the market and hardware for only 31%.

However, the Real IT study anticipates a surge in IT spending for the first time in six years, by 17% in 2008, compared with 15.3% in 2007 - and this dovetails with estimates by market leaders such as Armada and IBS.

This surge in demand brings with it a shift in focus, with new demand coming from sectors like telecommunications, financial services and retail, which all require a higher level of competitiveness. "Priority is shifting to the automation of business process, and budgets are starting to change, with money coming now from budgets for business process optimization," says Karelov.

Real IT investigated both demand-side and supply-side to get a full picture of the changing situation in the sector. The survey forecasts that the annual compound growth rate in 2005-2009 will be 18.2% for hardware, 16.5% for network hardware solutions, 20.4% for software and 25.4% for IT services.

However, within IT services the picture is mixed, with infrastructure provision forecast to decline, while areas like business process consulting and IT management forecast to grow in excess of 50%.

Renaissance Capital agrees that as the economy develops, the requirements of IT users switch from infrastructure to improved business practices. This means that IT services will be the fastest-growing section of the IT market, and should already account for around 30% of the market by 2009, up from 24% today.

The driving force behind these changes, according to Real IT, are Russia's largest companies, which account for 72% of private sector IT spending, with the banking sector set to become the largest purchaser of IT services, oil and gas companies of software, and telecom firms of hardware.

Spending will grow fastest on IT management services, automation and optimization of business processes, and all kinds of outsourcing, but as Real IT underscores, the Russian IT market will remain one of the least developed in Europe for some time yet.

Offshoring takes off

"Every time I open the newspaper, I read stories about international IT companies talking about setting up operations in Russia," says Renaissance's Ferguson optimistically.

Indeed, on the same day the Real IT survey was released, one of the world's largest offshoring companies, India's Tata Consultancy, announced it would open offices in Russia in March this year to explore establishing a development centre. Russia's attraction, in Tata Consultancy's view: highly-skilled personnel with the ability to implement complex high-end solutions.

"The offshoring segment is growing by around 50%, admittedly from a very low base, but well in excess of the market, so that is one of most exciting parts of the story," says Ferguson. "Russia is looking to do is not high-volume, routine maintenance like 80% of Indian work, but more value-added, high-end development."

IT offshoring in Russia is currently mostly driven by US multinationals, who account for more than half the offshoring market in Russia. A move to Russia by Tata Consultancy would increase the competition among Russian offshorers for these customers, but the Indian giant's implicit recognition of Russia's competitive advantage in high-end development would also boost their reputation. A 2007 survey released by IT market analysts IDC of 20 Western European and US companies outsourcing to Russia found that Russians excelled at high-end software.

An additional Russian advantage is low labour attrition: 4-10% personnel turnover per annum against Indian rates of 15-25% means that Russian set-ups are better at guaranteeing long-term projects. The same IDC survey found that costs of developing new products in Russia were at least 30% less than in Western Europe or the US.

State entangled in red tape, but remains a big spender

With regards to the Russian state, there's two things going on, says Ferguson. "One is that the government is about 30% of the market, but for some of the listed companies is its half their revenues, so it's a very important driver. A lot of state spending is more infrastructural, with a catch-up nature. But the other thing going on is that government is trying to do things to make Russia more attractive to international IT companies."

Government support for IT really only kicked off in 2004 following President Vladimir Putin's much-hyped visit to India's IT boomtown of Bangalore. However, even afterwards it has been bogged down by infighting between different ministries over what measures to take.

The first tangible measure to be implemented to date has been the establishment of technology parks that will commence work in 2008. Technology parks aim to support offshore outsourcing, with the infrastructural cost split equally between federal and regional budgets. IT firms operating in special economic zones are able to apply for fiscal benefits such as exemption from VAT and lower corporate taxation - in the case that a company is exporting a large part of its services Seven technology parks are currently in development in Kazan and St Petersburg, Moscow, Novosibirsk, Nizhniy Novgorod, Kaluga and the Tyumen region. A very substantial $850m will flow to the parks in 2008-2010.

The second approach is the Venture Company IT investment fund, created in October 2007, to invest €50m in high-technology start-ups, with private companies providing additional investment. "These measures are basically good, but it remains to be seen how effective they are when faced with the usual Russian bureaucracy," says Ferguson.

In fact, this well-meaning support for Russia's IT sector is dwarfed by the role the Russian state plays on the market as consumer, both through its massive routine procurement, as well as through major projects such as creating an digital book repository in collaboration with the Russian State Library, and a database for GDP calculation in conjunction with the Federal State Statistics Service.

However, increased state spending on IT, while boosting IT's companies revenues, is not likely to drive on structural modernisation towards provision of IT services. "Even in high tech state sectors such as defence, most of the spending is simply just catching up on infrastructure right across the board, after years of being starved of funding," says Ferguson.

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