CNBC's Inside India newsletter: The 'sticky' outsourcing firms gaining popularity

This report is from the CNBC "Inside India" newsletter, which provides timely and insightful news and market commentary on the emerging powerhouse and the big businesses driving its rapid growth. If you find it interesting, you can subscribe here.

The big story

Companies in developed markets have frequently outsourced labor-intensive tasks to India.

Several new technology firms in the country are seeking to secure a portion of research and development funds, which were previously reserved for investment in Western markets.

The services sector in India's economy has expanded to contribute 45% of total exports, an increase from 30% a decade ago. Capital Economics reports that business process outsourcing, or BPO, which encompasses customer support, contract drafting, and mass marketing campaigns, accounts for over three-quarters of services exported by value.

Services exports have grown by nearly 20% annually over the past two years, significantly faster than the 5% year-on-year increase in goods, due to relatively low labor costs and high IT literacy.

The Indian government is actively working to support the manufacturing sector in generating large-scale employment, a challenge that the services sector has not been able to tackle alone.

India has experienced a significant "brain drain" due to the scarcity of high-tech companies and job opportunities. To address this issue, companies have been successful in securing a portion of their Western clients' previously untapped research and development budgets.

The engineering firm conducts research and development for over 300 companies, including and , across multiple industries, mainly in the aerospace and communications sector. Recently, it has started expanding into the semiconductor industry to enhance the design capabilities of businesses in this highly advanced economic sector.

Cyient is not the only one replicating the idea, as peers such as Larsen & Toubro's subsidiary and others are also doing so. This market, which is now worth $30 billion, is expected to double over the next five years, according to Kunal Desai, an emerging markets fund manager at GIB Asset Management.

These companies have unique moats that set them apart from the large BPO firms of the past three decades. Once research and development costs are outsourced, they are unlikely to be frequently redirected to another company or country, making them an integral part of the outsourcer.

"Embedding with a company like Cyient makes it challenging to break free, as Desai, whose fund owns a stake in the stock, explained to professional investors at the Quality-Growth Investor conference in London this week. These relationships are sticky and help reinforce the competitive advantage of the company."

One key growth element, according to Desai, is for businesses in developed economies to recognize that a portion of their research and development can be outsourced.

Desai stated in a CNBC interview that while the R&D at the forefront of business innovation may be valuable, it is the legacy R&D that can provide cost savings through offshoring.

The BPO sector may emerge as a strong competitor in the face of increasing competition from businesses in countries such as the Philippines, Mexico, Brazil, Poland, and Malaysia. It could also tackle the risks to employment in the sector caused by artificial intelligence.

Need to know

The Nifty 50 index in India has experienced a 17% increase in value year-to-date and has reached multiple new highs. Several factors have contributed to this growth, including public infrastructure investments, the domestic manufacturing sector taking advantage of companies shifting from China, strong economic growth, and lower U.S. Federal Reserve interest rates. Analysts and fund managers recommend investing in the banking and real estate sectors to capitalize on India's stock market.

India's consumer-centric companies are preparing to list publicly as the country is set to become the world's third-largest consumer market by 2027. Companies such as Hyundai Motor India and Swiggy are among those that are planning to list on the public market. According to Atul Singh, CEO and managing director of LGT Wealth India, India's growth story is now likely to be driven by private consumption.

India's Commerce Minister Piyush Goyal is confident that the country will manufacture its first semiconductors by 2026 to 2027. He stated this to CNBC, adding that U.S. chipmakers like Nvidia, AMD, and Micron have pledged to invest in India's chip industry. Goyal also mentioned that he is in touch with the Micron CEO regularly, and they are making good progress. Additionally, domestic firms like Tata are also involved in developing India's semiconductor sector, said Goyal.

What happened in the markets?

The stock markets in India have been declining for five days straight, reaching their lowest point in two weeks. The rise in oil prices due to geopolitical tensions in the Middle East is one of the factors contributing to the 2.12% decline in the market today. Despite this, the index has still increased by 16.2% this year.

This week, the 10-year Indian government bond yield increased to 6.77% from 6.71% the previous week.

According to Ruchit Puri of Kotak Mahindra on Biz Focus Hub, domestic investors are more active in the Indian stock market than foreign institutional investors. While FIIs have invested around $11 billion, domestic investors have invested almost three times more. Despite this, Puri stated that the interest of FIIs is strong and they are likely to invest more than $6 billion in September alone.

As global central banks lower interest rates and inflation in India decreases, the Reserve Bank of India may consider easing monetary policy, which will positively impact equities from a fundamental standpoint, according to Gautam Chadda of RBC Wealth Management.

What's happening next week?

Engineering equipment manufacturer Diffusion Engineers lists on Friday.

October 4: Diffusion Engineers IPO, U.S. nonfarm payrolls for September

October 9: India central bank rate decision

The Federal Open Markets Committee minutes and the U.S. consumer price index report for September will be released on October 10.

October 11: U.S. producer price index, U.K. GDP