Globalization and the world economy

I remember 2 years ago the brouhaha over globalization and how every startup needed to adapt or it would die.  I truly am a fervent believer in globalization and how offshoring some development work can make a ton of sense from a cost and time advantage (24×7).  As I look across our portfolio, what is interesting is that while the comparative advantage of developing in say, India, was once 4 to 1 it is looking like it is more 2:1 or lower as you factor in costs like management overhead, travel, etc.  In addition, the companies that actually took advantage of offshore development and were successful were the ones that opened their own wholly-owned Indian subsidiaries.  Not only did these companies have their own subsidiaries in India, but they also sent a core team of engineers from the US to open the office, train the staff, manage the team, and provide real incentives like stock options.  The portfolio companies that did not fare so well were the ones that had offshore development shops work for them and while the output was fine, it was quite disruptive as the turnover of personnel was quite high.  In the end, all I can say is that offshore development for your company is not a panacea, and that you should only do it if it makes sense for your company (read an earlier post for more).

Given that I am quite interested in globalization, I wanted to share with you a few graphs that I saw this week that were pretty impactful for me.  First, I recently discovered this piece that Mike Milken wrote for the Wall Street Journal a couple of days ago.  I found it on Greg Mankiw’s blog, an economics professor at Harvard and also the Chairman of the Council of Economic Advisors (he is also a former Professor of mine). 

Share_of_world_outputLike Greg, I want to highlight Michael ‘s thoughts on the graph.

"China and India combined to produce nearly half the world’s economic output in 1820 compared to just 1.8% for the U.S.  Our remarkable growth since 1820 has benefited from democratic institutions, a belief in capitalism, private property rights, an entrepreneurial culture, abundant resources, openness to foreign investment, the best universities, immigration and relatively transparent markets."

In addition, here are two other graphs from this week’s Economist that summarize what the world may look like in the future.  I encourage you to read the in-depth survey as it provides some great historical context as well as trends we should watch in the future.

Csu168_1 Tying into Michael Milken’s graph of the world economy in the past is this Goldman Sachs one showing who the economic leaders will be in the future – notice China as #1 and India as #3 by 2040. You can already see from Michael’s graph above that from 1973 to 2001 the US share was diminishing as India and China were growing rapidly.

The last graph is quite interesting as it relates to us technology folks.  We have always thought of India and China as places to offshore low-level development work.  Yes, alot of that has already been done but what is alarming is what may happen in the future as the comparative advantage that India and China have over us in terms  of college graduates in science and math is overwhelming.  Csu054Not every one of those graduates according to the McKinsey Global Institute is up to par with the standards that we have in the U.S. (10% in China and 25% in India) but that is clearly changing.

So what does this mean for us.  I am still processing this and would love to hear your thoughts.  In my humble opinion, I believe it means that first and foremost, we should continue to fight and compete by stressing education.  We cannot fall behind here as it is one of our most important assets.  Secondly, I always like to say that the trend is your friend so be on the outlook for how to leverage this labor and talent pool in your current company.  It could mean offshoring work (only if you and your team can handle it) or creating new companies that enable global labor arbitrage and collaboration leveraging the Internet (wiki opportunities, open source plays, communications like Gizmo Project, one of our investments). Finally, personally and professionally, pay attention to investment opportunities.  There are no secrets why alot of VCs are starting funds in India and China because as these emerging economies grow, income levels rise and with that comes more disposable cash to buy products and services.  Like I mention above, it could also mean finding opportunities that leverage the Internet and take advantage of the global talent pool (Logoworks – not one of mine but a great company).  From a personal perspective, I have  been building a nice allocation in an emerging markets index fund for the last 3 years.  Trust me, it is not for the faint of heart and it will be quite a bumpy and volatile ride but looking ahead it is hard to argue with the economic growth in the emerging markets.

What commoditization means for IT spending

The numbers are coming out, and it is clear we are moving to a low growth environment for corporate IT spending in terms of dollars spent. Companies spent too much in the 90s and are being cautious about how they spend their hard-earned cash. Total cash and savings for companies in the S&P 500 have doubled since 1999 and is equal to half a trillion dollars which means companies have added almost 300 billion dollars to their balance sheet in the last 5 years. While companies have so much more cash these days versus 5 years ago, they are spending roughly the same amount on IT. What gives? Reports cite how executives are still worried about the economy or terrorism. However, one other interesting aspect to consider is the effect of commoditization on IT spending. Here we are monitoring year over year growth on actual, nominal dollars spent on IT, hoping and waiting for an uptick in spending which will fuel more growth. After all there is a ton of cash out there and corporates have to invest the cash or give it back to shareholders. The funny thing is that the commoditization trend means that companies can do more with less. What that means is that companies can keep the same IT budget and accomplish the same amount or more without increasing their capital expenditures. In addition the competition for the customer’s dollars is fierce which means that the customer has complete control these days in terms of pricing. Both of these factors obviously work against significant increases in IT spending. In fact, customers have so much power these days (and rightly so) that companies like GM are forcing vendors like Sun and Microsoft and Cisco and Microsoft to work together, to standardize and integrate with one another.

Here is a quote from Fed Ex’s CIO in a recent New York Times article:

The information technology strategy at FedEx, the package delivery service, points to that conclusion. “Technology is coming to us in much smaller bundles that cost a lot less,” said Robert B. Carter, the company’s chief information officer, whose budget is slightly more than $1 billion. “Our intent is to hold the line on I.T. spending and get more bang for the buck.”

The flat spending does not suggest any lack of enthusiasm for technology at FedEx, a sophisticated corporate user of technology. Mr. Carter reels off a series of projects for helping customers use the Web, e-mail alerts and wireless messages to track inbound and outbound packages, trim inventories and fine-tune operations.

“The global interconnectedness and technology services available are growing at an unbelievable pace,” he said. “We are at an inflection point in the adoption of these technologies.”

This theme of doing more with less continues to echo in my brain as I meet with more and more CIOs and technology arhitects. As I mention in an earlier post, it seems that many in corporate america are going through a fundamental rearchitecture of their systems to a service-oriented model, one that will take a number of years, but one in which startups will have plenty of opportunities to thrive even with flat to limited growth in IT spending. Trust me, it would be great if corporations continue to grow their IT budgets. However, I am not worried as the great news is that new architectures and hardware equals lots of new software opportunities. There will be plenty of chances to make great investments in this environment.

Tapping the Chinese marketplace

While tapping the growth of the Chinese market sounds like a good idea, a fellow VC who just got back from a trip to Beijing and Shanghai says he completely understands why his companies are not getting any real traction in that market. Besides the highly politicized nature of business, there is a pervasive “catch me if you can” philosophy inherent in the economy. Think about it-moving from a world where the state owned all enterprises to a hybrid form of capitalism is not easy. In the past, it was always the people versus the government, and therefore there was little respect for financial instruments like debt. It did not matter if you defaulted because you would be bailed out anyway. Extend this same thinking on debt into the private market, and you get a system that does not function well. Therefore alot of business is done cash on delivery as business credit does not exist. Throw in lax IP laws and the fact that China is thousands of miles away from the US and you get a difficult market to operate your business. So the next time someone tells you that they will get x% of the market in China, remember how difficult it really is to operate in a far away land with different rules of engagement in the business world. This will obviously get better with time.

Reading the tea leaves-correlation between employment growth and IT capital spending

As you know, I like to stay abreast of the economy and IT spending, searching for leading indicators of how the markets and my companies may perform in the future. It is clear that given the current market, people are quite excited about the prospects of IT spending growth in 2004. Given that backdrop, I found an interesting graph in this weeks Goldman Sachs Software Scoop report


showing the linkage between employment growth and IT capital spending. According to Goldman, this graph shows “companies are likely to view tech capital spending the same way they do employment–add when you are confident of the sustainability of the recovery and only when you have to.” As you can see, there is pretty close correlation between the two sets of data. What it tells me is to keep a close eye on employment data and potentially use that as another leading indicator for IT capital spending. When companies are feeling good about themselves and the economy, they spend more. It will be interesting to see how this graph looks in the future as more companies look to outsource non-core capabilities and continue to cut costs and improve earnings. For example, will capital IT spending begin to spike above employment growth in the next 5 years and by how much?

The Economy and IT Spending

It looks like the economy in Q3 grew even faster than we initially thought, 8.2% annual rate versus 7.2%. It was not too long ago that the Department of Commerce released numbers showing 7.2% annualized GDP growth for Q3. If you take a closer look, “equipment and software” spending was at a 15.4% annualized rate. I obviously have concerns about the revised 8.2% GDP growth and certainly do not believe that is sustainable due to one-time factors like tax cuts and mortgage refinancings. While it is nice to see a 15.4% annualized growth rate in “equipment and spending” for Q3, let’s not assume that this is the beginning of a huge ramp-up in IT Spending. To bolster my thinking, I like to look at a number of data points. For one, Goldman Sachs recently issued its October IT Spending Survey. Its latest survey calls for an increase of 2% spending for 2003 versus a December 2002 survey which forecasted a decline of 1.1% for 2003 spending. So it is nice to see that the trend reversed in terms of IT spending, and that it looks like there is a small rebound happening. That being said, the October 2003 survey forecasts spending growth of only 1.3% for 2004, down from an August 2003 spending survey forecast of 2.3% growth for 2004. That is a negative trend and does not promise earth-shattering returns to IT Spending in the bubble years. As Goldman Sachs mentions, hopefully there is just a lag in terms of how the economy performs and where each company is in its budgeting process. If this is the case, we shoud keep an eye out for data from future surveys.

Another data point that I look at is how the fund’s 30+ portfolio companies are performing. We have a number of companies in the Enterprise IT space selling security, storage, network management, wireless, and other related software. Some companies are performing extraordinarily well and others are close to budget. The fact that most of my companies are close to budget is a far cry from 2001 and 2002, years plagued by numerous reforecasts of revenue and expense projections. In general, sales pipelines are building momentum giving better visibility for the next two quarters. While I cannot say that all of the fund’s portfolio companies are growing like wildfire, in general the sentiment across the board is positive. As you can see, I am more in the Goldman camp of IT growth than what the GDP numbers reflect. The conclusion I draw is that even with 2% expected growth in IT Spending next year, as always, there will continue to be pockets of huge opportunity like security, business intelligence, and systems management allowing companies to protect their mission critical assets, report in real-time (or near real-time), and better manage the IT assets they already possess and do more with less. Call me a moderate optimist, if you will.

Chuck Prince, CEO of Citigroup

I was at the TIE Tri-State annual event in New York yesterday and participated on a venture capital panel helping young companies refine their pitches and business strategies. There were some interesting software and BPO (Business Process Outsourcing)companies that presented. On the BPO side, it was quite fascinating to hear about the types of services that companies were willing to outsource-for example, in the finance sector, basic credit analysis and research, analytics, and even some financial modeling. In today’s NY Times (free site but need to register), there is an article about teleradiology-X-ray and M.R.I. analysis being outsourced to India.

For those of you that do not know, TIE (The Indus Entrepreneurs) is a wonderful group and stands for the Indus Entrepreneurs signifying the ethnic South Asian or Indus roots of the founders. TiE stands for Talent, Ideas and Enterprise. From speaking with some of the members, it was clear that there was alot more buzz and energy this year versus last year, especially due to the pickup in the economy. Speaking of economy, TIE was able to bring Chuck Prince, CEO of Citigroup, as a keynote speaker. Chuck did a great job as he was quite funny (he had the room in laughter a number of times) and also had some interesting things to say about the economy and entrepreneurship. Here are some relevant notes I took from his keynote discussion:

*Chuck outlined his bio in more detail and fleshed out how he came to be CEO of Citigroup. Basically, he ended up as General Counsel of Commercial Credit Corporation which was about to run out of money in 1986 when Sandy Weill swooped in and bought a large stake in the company and took it public. What Chuck learned about people over the years is that the great ones have intensity, passion, and a desire to win. He said that luck helps and even played a role in his career progression.

*Chuck has no doubt that the economy will perform well for the next 18 months. However, he strongly believes that the economy is susceptible to the election cycle. No existing President wants a recession in year 3 of a 4 year term as they are gearing up for a re-election. Of course, his big concern is what happens in January of 2005 when the President is faced with how to handle the budget deficit. If the economy does not pick up in a self-generating way, we could be faced with policy that could slow the liquidity-driven growth we are now experiencing.

*Longer-term, Chuck believes the world economies will segment into 3 distinct buckets of growth:

1. Dynamic growth characterized by young populations in India and China;
2. No growth characterized by homogeneous economies such as in Western Europe that are not open to immigration with aging populations, low growth rates, and a sagging economy;
3. Balanced growth economies like the US which is open to immigration and hetegenerous from a population perspective.

Unless Western Europe rethinks its immigration policies, it will not be able to sufficiently replace its aging population with young workers to drive growth. This could result in huge problems down the road.

*On offshore outsourcing, Chuck believes that is something that is just going to happen. Who would have guessed years ago that Toyota could make better cars in Japan and ship them to the US to put the auto industry at a competitive disadvantage? It happened. The same thing will happen in the service sector. Chuck believes it is inexorable. Therefore, companies should focus on services/products that need to be done locally, those that require a physical presence. Everything else that can be done offshore will be done offshore. Please see an earlier post if you want to read more about my thoughts on using offshore resources.

*If Chuck could give a young CEO advice (business related other than focus on family and ethics), he would tell that person that execution capability is the most important trait that a CEO can possess. One needs to move the ball and get things done. He has seen thousands of people who were smart, loyal, and dedicated but could not execute or get things done on a timely basis-they were all UNSUCCESSFUL. His advice is to write your issues down and check them off. Move the ball. I couldn’t agree more with Chuck on making sure you execute.

*As an aside, he also encouraged us to read Robert Rubin’s new book titled “In an Uncertain World.” He said that Bob is a fascinating man, and that he enjoys working with him at Citigroup.

China’s real effect on our economy

It is easy to blame China for our domestic problems. The argument from Bush and the US Goverment is that because China is keeping the Yuan artificially low against the dollar, the US is losing jobs and running a huge trade deficit. The US Government is asking the Chinese to float its currency against the dollar to help solve this fundamental problem. However, the big issue is that our economy is extremely vulnerable to China, and there is much more at stake than losing jobs to China. By keeping the Yuan low, the Chinese are keeping our interest rates low as they are huge buyers of US Government bonds (as of May 2003, China held $121.7 billion in US Treasuries ranking it 3rd in foreign ownership behind Japan and Britain). From your economics 101 days, you will remember that interest rates and bond pricing work in inverse order. Heavy purchasing of Treasuries increases the price and conversely lowers the interest rate. If China ever decides to sell these bonds it could start a massive chain reaction which would be detrimental to our economy. One of the big reasons for this is that our country is a huge net borrower, corporate-wise, individually and fiscally. All is well and good when we are borrowing at low interest rates heavily financed by foreigners. This certainly drives near term growth. Just look at how the refinancing boom has spurred incredible consumer demand over the last year. However, given the amount of borrowing that we do as a country, we are extremely vulnerable to interest rate risk.

Bill Gross, Pimco’s bond guru, paints a scenario in which a devaluation of the Yuan could trigger some nasty consequences:

“A more likely course would posit reduced Asian and U.S. purchases of Treasuries, a diversification into Eurobonds, a stronger Yen and Yuan over the next few years, more expensive U.S. imports after a lag, a sapping of consumer spending power, gradually rising intermediate and long-term rates, a declining housing market and yes a near body blow to America’s financed-based economy for all the reasons outlined in previous pages.”

So before we get too excited about domestic growth and the great performance in the stock market this year, let’s remember that our economy is not as invincible as we may think. We are potentially vulnerable to the Yuan and other Asian currencies which are indeed overvalued and need to be corrected. When this happens and how this happens will obviously determine the effects on our own economy.

Why is this important for those in technology? Even though technology stocks have performed incredibly well this year and even though Google is talking about going public next year (see an earlier posting), I just do not want us to get too excited about a return to the earlier bubble period. Some of us may have forgotten already as you can see from this NY Times piece yesterday about investors’ appetite for risky stocks. What is important is that we do not use the market as our sole proxy for the strength of our economy as it can be deceiving. Companies still have to generate meaningful earnings and cash flow. This macroeconomic backdrop certainly has implications about what types of companies I believe will have a better chance of performing during the next few years. I hope to address this topic in a future posting.