URUGUAY and Argentina’s IT POTENTIAL

15.967

Offshoring and Outsourcing

Uruguay and Argentina’s Software Industry Development

Outsourcing potential in the IT sector

Alberto Brause

Jose Kliksberg

MIT Sloan School of Management

May 2004

Uruguay and Argentina’s Software Industry

IT potential in outsourcing and offshoring

I. Introduction

II. Uruguay

1. Social and Macroeconomic Context

2. The Software Industry in Uruguay

3. Digging Deeper into Uruguay’s Comparative Advantages, Industry Structure and Future Potential

4. Strategy Recommendations to Policymakers in Uruguay

III. Argentina

  1. Macroeconomic Summary
  2. The Software Industry in Argentina
  3. Argentina’s Strategy to Compete in the Global IT Industry
  4. Recommendations

IV. Conclusion
I) INTRODUCTION: Setting the stage

During the 15.967 seminar, we have learned that although many countries are benefiting tremendously from the outsourcing and offshoring of white-collar, high-tech jobs from the US into other geographies (most notably India), the reality is that the outsourcing revolution has not yet materialized in terms of job migration as much as many pundits predict. However, the trend towards outsourcing and offshoring has certainly hit the world scenario and it is here to stay. One key aspect of the nature of business today cannot be refuted: labor is becoming more and more mobile, country boundaries are becoming more and more blurry and global firms will migrate jobs into those locations in which they can get the highest impact for their investments.

Based on this premise, the winners of tomorrow will be those countries that not only have a high supply of high-tech jobs but also those that are able to sell their assets in the most persuasive manner. There is no question that India, based on a booming internal IT and software market and its sheer labor size and cost, has excelled in training a highly sophisticated IT labor force, but most importantly, India’s success in selling the outsourcing proposition and delivering benefits to their customers are second to no other country.

We became fascinated about analyzing country strategies to promote IT development and focus on analyzing which other markets, besides India, can develop the internal and external consistencies to reap the benefits of the trend towards outsourcing. Specifically, we became interested in zooming in on the software development strategies of Argentina and Uruguay. Given that both these countries have developed significant software expertise and have an untapped potential, we will analyze whether these countries are pointed in the right direction to capture a significant amount of outsourcing opportunities in the future.

Although we originally intended to compare both countries’ software strategies with that of India’s, upon further research we realized that India and Argentina (let alone Uruguay) have very different characteristics in terms of size, geographic position, labor trends, cost structures, that make the comparison more difficult at this stage of their respective IT development. However, we are going to use the successful technology case studies of Ireland, Israel and Costa Rica as yardsticks to compare the software industry in Uruguay (which share very similar characteristics). We will then focus on the core competencies of the Argentinean software market and its current cost advantage based on a devalued currency. We will then draw informed conclusions on the future outsourcing potential on the IT industry of Uruguay and Argentina.

II) URUGUAY

1) Social and Macroeconomic Context

1) Government Intervention in Economic Policy: The Welfare State Curse

Based on a century and a half-long tradition of democracy (albeit an 11-year period of military rule in 1972-1983), Uruguay stands out in the international scene as a country with an ingrained respect for democratic institutions and for the people’s active participation in civil life. Entrenched in the mentality of the Uruguayan people, is the idea that the government must provide not only the basic needs of the population but also employment and life-long security (see Exhibit 1 for basic macroeconomic and social indicators). This dates back to Uruguay’s famous welfare state created in the first half of the 20th century, when the government could afford employing close to half of the population and ensuring a healthy pension system to the old. At that time, Uruguay’s exports of livestock and agricultural products to the European countries created such wealth that the government got away with heavy taxation and intervention in every major economic activity of the economy.

Uruguay’s large welfare state translated in a robust and public education system that depended entirely on government resources but sustained Uruguay’s largest middle-class population within the Latin American context. However, as the country’s exports of agriculture and livestock products became commoditized throughout the second half of the 20th century, the Uruguayan government was left without the major source of revenues to afford its big welfare state. The inability of the government to reinvent itself coupled with the demands of Uruguay’s large middle class sector, which became dependent on government employment and pension systems, stretched the government to the limit.

Because the government has heavily intervened in the economic life of the country for most of the 20th century, it has crowded out the development of a strong private sector. Except for the financial system which has given Uruguay the reputation of being the “Switzerland of America”[1], Uruguay’s private sector has grown at the shadow of the public sector. As a result, foreign investments as a share of GDP have remained one of the lowest in Latin America (please refer to Exhibit 2 on Uruguay’s FDI information).

Instead of rising to the hour and slashing its bloated size, Uruguay’s government took to the international financial community throughout the past 20 years to pay the bill for its public servants consisting of 27% of the total 2003 population. As a result, Uruguay’s public external debt remained excessively high, even for Latin American standards. In fact, due to the 18% fall in GDP since 1998 and the large devaluation of the Uruguayan peso occurring in 2002, public external debt has jumped to 111% of GDP, up from 40% in 1998 (see Exhibit 3 for figures on the impact of the recent financial crisis).

2) The Software Industry in Uruguay

A) The Organic Growth Approach: exports increase from $250K to $80M in just over a decade

In a country whose government is highly interventionist and where the economy is mainly driven by the primary sector exports[2] , it is remarkable that Uruguay has managed to grow an extremely competitive software industry during the 1990’s. Indeed, in the latter part of the 1990’s and the beginning of the new century, Uruguay has not remained aloof to the world’s IT fever. The internal market of IT-related products and services has significantly grown during these years, reaching a peak value of $326M in 1999[3] from a mere $50M in 1989. Since then, the IT internal market in Uruguay has settled in a value of around $300M (see Exhibit3 and 4 for the value added by this sector to the country’s GDP).

As shown in Exhibit 4, the software industry makes up almost a third of the internal IT market in Uruguay (which we consider to comprise software products and software licenses sectors), meaning a market size of $189.75M. Since it is estimated that 27-30% of the software sold in Uruguay is developed by national companies, Uruguayan companies produced in 2001 approximately $60M of software for national use. More remarkable, however, is the information shown in Exhibit 4, which shows how Uruguayan companies are exporting $83.5M in 2002, with Argentina, Colombia, Brazil and Chile being its main target markets. The Uruguayan Chamber of Information Technology, CUTI (a private association of software companies) reports that exports in the Uruguayan software industry have increased 1330% between 1994 and 1999. However, private investment in Uruguay had traditionally meant facing high taxes and awkward bureaucracy and a weak copyright law.

Although in comparison to the software industries of other developed countries, these numbers may look insignificant, it is certainly remarkable how a small and not fully developed country such as Uruguay is covering domestically one third of its software needs. Even more surprising is the fact that this domestically grown industry is currently exporting twice the value of its internal production. Without having any additional information, this dramatic success would normally lead us to believe that the Uruguayan government is purposely imitating the IT development models of other countries that have been extremely successful at exploiting the advantage of the IT revolution, such as Ireland or Israel.

Yet, we shall see how the degree of government intervention required to encourage the generation of a robust software industry in Uruguay was much lighter than that in Ireland or in Israel and relied to a great extent in autonomous development. This approach to the development of the IT industry with only limited government involvement is what we shall call “organic growth”. In order to prove that the Uruguayan development of its IT sector has distinctive peculiarities, we shall compare it with other two well known case studies. Important conclusion will be drawn to highlight the potential for future growth and in particular, the potential to attract outsourcing demand into Uruguay.

It is certainly tempting to try to establish similarities between the IT Uruguayan evolution and the astonishing successes in this field during the 1990’s of the economies of Ireland and Israel.

B) The Irish Model and Uruguay: The Importance of Central Agencies to coordinate IT hub growth

Much of the success of Ireland’s radical transformation from an agricultural economy into one of the world’s leading IT hubs is due to the endeavor of the Irish Investment Development Authority (IDA). The IDA was created specifically to promote FDI in Ireland. This agency, along with an aggressive governmental policy of low taxes (Ireland has a corporate tax of 12%, one of the lowest in Europe) and incentives in the high tech sector made Ireland an ideal entry spot for Multinational Corporations on the IT segment to target the European Union market. This strategy certainly worked, bringing Ireland’s GDP growth up to 11% in 1999.

Clearly, the most radical difference between the Irish and Uruguayan approaches would be the complete lack of a central directing agency in Uruguay with the purpose of encouraging the development of internal IT industries and promoting them towards foreign investors. A second factor is that the approach that each country took towards tax policies in the technology sector is quite different. Although the Uruguayan government did introduce some tax incentives, these -we shall see- were mainly reflected on Free Trade Zones (henceforth FTZ) which were mainly conceived towards attracting FDI, rather than directly fostering domestic companies.

A third similarity between Ireland and Uruguay would be their membership to supranational economical entities of great scale, such as the European Union and MERCOSUR. It is undeniable that, had Ireland not belonged to the European Union, much of its appeal to foreign high-tech companies that saw it as a perfect gateway to Europe would have been lost. Although it does not have the long history of the EU, the possibility of using Uruguay as a base to penetrate MERCOSUR markets can certainly be an appealing point for foreign companies. Yet, the tax incentives given to FTZ proved to be a fiasco in this respect: other MERCOSUR countries responded to the FTZ policy by banning all companies established in the Uruguayan FTZs from receiving custom exemptions that were part of the MERCOSUR agreement. Thus, for IT companies with great interest in the MERCOSUR market, the Uruguayan FTZ policy would be more of a deterrent to establish themselves in Uruguay, rather than an appealing point.

If the case of the software success in Uruguay does not resemble the Irish success story, how is it then that such a small country embedded in a region not necessarily famous for high tech development, created such a vibrant and innovative sector? In search of an answer, we then focused on the specific ingredients that made Israel an internationally recognized IT hub, dubbed as the Silicon Valley of the Middle East. Given the small size of both Israel and Uruguay and its strong education system, this comparison could shed light into the basis for success in Uruguay.

C) The Israeli Model and Uruguay: venture capital-led growth

Since the Irish Model seems not to be applicable to Uruguay, it is tempting to think that perhaps the IT growth in Uruguay could be due to causes similar to those of Israel in the last decade of the twentieth century. Although not as impressive as Ireland’s, Israel showed a consistent GDP growth in these years, driven by the high tech sector. It reached an 8% peak in the year 2000.

In Israel, strong pro-FDI incentive policies such as the Irish ones were not implemented. Rather, the Israeli IT growth was generated by its sheer intellectual power, obtained after many years of migrations of very highly educated workers (engineers, computer scientists, etc.). The perfect complement for this was the generation of a dynamic venture capital community that was encouraged by governmental programs and aimed at promoting grass-roots entrepreneurship in the high-tech industry.

However, the Uruguayan growth cannot also be explained well by the Israeli model. Admittedly, the Uruguayan IT sector has been labeled the pride of Uruguayan industry and there is a general perception in the country that this growth was mainly driven by a high number of well trained IT experts. However, a look at Exhibit 5 will reveal that there is no significant difference between the levels of highly educated workers in Uruguay compared to the levels in other South American countries. The data uses the proportion of tertiary students in math, science and engineering as a proxy and does not indicate that the human expertise in IT technologies is superior to its neighbors. Furthermore, in contrast to Israel, there is a complete lack of a vibrant venture capital community in Uruguay.

Although the government has provided matching funds to develop a high-tech incubator managed in partnership between a well-known private university and the government’s Scientific Research Laboratory, the size of this fund is very small and it is still in early stages of its development. Given that banking loans are prohibitively expensive for the entrepreneurial community, most entrepreneurs make their ends meet by broadening their customer focus and providing software to all kinds of different customers. Lack of outside sources of funding eventually constrains the development of the vast majority of software companies into achieving regional scale.

Clearly, the development of Uruguay’s vibrant IT industry cannot be equated to the models that were successful in Ireland or Israel. Even though the software industry in Uruguay soon became a national emblem, governmental support for it was practically non existent during the years of most spectacular growth. It was not until 1999 when the Uruguayan government actively intervened to support the industry. At this time, the software industry was declared one of national interest, and a plan with long term objectives to make Uruguay a technological hub was established. However, the only practical effects that these measures had on the industry were the exoneration of local taxes (IRIC) and of the added value tax (VAT) for software exports. These effects, moreover, were largely a consequence of the lobbing capacity of CUTI. Added to this lack of government involvement to encourage the local software industry, the Uruguayan State Owned Enterprises (SOEs) seemed to systematically discriminate local software industry through legal demands that only foreign companies could provide1.

Therefore, the success of Uruguay’s software industry was due to endemic reasons by a growing demand for customized software. The financial sector was one of the main seeds to generate this demand. Historically it has been one of the most stable service industries in the country and had an inherent demand for customized software products in Spanish language. Banks such as ABN AMRO played a major role in the boom of Uruguayan software exports, since the software systems implemented by local companies in Uruguayan branches were also implemented in the branches of other South American countries. The quality of the software was highly praised and this served to boost the brand image of Uruguayan software in other nations, which would greatly benefit the export sector.

C) Costa Rica and Uruguay: Free Trade Zone Regimes as strategy to develop IT hub

In the late 1980s and early 1990s, the Uruguayan government resorted to privatization of its major state-owned enterprises and enactment of the FTZ regime to open the market to outside investors and reduce the size of its bloated state. Because the privatization efforts have been half-hearted and have faced enormous resistance from the population (mainly from strong worker unions within the SOEs), the Uruguayan government focused on creating FTZ as its major effort to attract FDI.