Wednesday, February 18, 2009

GLOBAL FINANCIAL CRISIS - How Will India Be Hit?

The growing global economic crisis is destined to put pressure on offshoring business and new competitors aim to challenge India's dominating position in IT application development. The Satyam Scam won't help either. 

THOMAS MEYER - OUTLOOK India

With the world increasingly integrated with high-speed fiber-optic networks, globalisation has brought new services. Countries with low-wage skilled labour have developed information technology services and back-office work as a lucrative area for offshoring by industrialized countries. Application development in India, call-centres in the Philippines, and software engineering in Russia are typical examples. But the growing economic crisis is destined to put pressure on this offshoring business and new competitors aim to challenge India’s dominating position in this field.

A lot of attention has focused on China recently. China is already a leading offshore destination with regard to high-tech manufacturing products, such as consumer electronics, but it is not yet prominent for IT or business services. This is about to change, if the Chinese government has its way.

In the current economic climate, IT offshoring faces several challenges. Financial services institutions emerged as main clients. For instance, more than 40 percent of Indian IT and business services exports are delivered to banks and other financial companies. This exposes a key vulnerability. Financial institutions in Europe and the US have reduced their outsourcing activities sharply in the wake of the financial crisis. By one account, they have cut the volume of newly awarded IT outsourcing contracts by nearly 30 percent in 2008 compared to the previous year.

Rising unemployment compounds the problem of weakening demand because it plays to protectionist instincts. Creating jobs overseas during a deep recession does not go down well with the public. This matters all the more because so many banks are being propped up with public money. Any new major offshoring contract could create a public backlash that would undermine the government’s ability to defend further assistance to the financial sector. Already the US stimulus package contains a provision that software required for medical-services modernization be produced in the US. Many companies, not only in the financial sector, sense this and may put new offshoring activities on hold for a while.

Moreover, the challenge to India’s IT services has deepened with an accounting swindle at one of India’s large IT providers. Since data processing and back-office work relies on trustworthiness of the partner more than any other service the scandal has raised broader concerns over the general reliability of offshore providers working on crucial applications and handling sensitive data.

The protectionist response to the current crisis will also interfere with the Chinese government plans for its future. Over the last few years, the Chinese government has put great emphasis on the development of a domestic IT services industry with particular focus on offshoring. Initiatives include the current 11th Five-Year Plan (2006-2010), the Informatisation Strategy (2006-2010), as well as the Thousand-Hundred-Ten Program of the Chinese Ministry of Commerce. Typical measures include a mix of better education of the workforce, investment incentives, marketing, quality management and better protection of intellectual property.

In effect, the Chinese government tries to nudge its export structure in a new direction – more high value-added services rather than manufacturing. This is helped by some fundamental strengths, in particular the supply of skilled staff: The number of well-educated people has expanded rapidly over the last few years. In 2006 around 4 million Chinese graduated from institutions of higher education. Since the turn of the millennium, their number has risen by an average of 25 percent per year, and is likely to continue to grow at that pace for some time.

China has also achieved advances with regard to intellectual property.

The Business Software Alliance, for instance, reports that the share of pirated software declined from over 90 percent in 2003 to "only" 82 percent in 2007. There’s room for improvement, though. Other countries at similar levels of development on average have lower piracy rates. In India, the rate is 69 percent.

There are more obstacles. Cultural barriers challenge access to Western clients. In IT offshoring, communication between client and supplier is paramount; for this reason further improvements in the knowledge of English are required in China. After all, there is strong competition from locations such as India or the Philippines where English is an official language.

Customers from Japan and Korea face lower cultural barriers, thus over 50 percent of Chinese IT offshore services are delivered to these countries. This is in stark contrast to Indian companies, whose customers in Anglo-Saxon countries account for 80 percent of the total client base. Chinese providers will need to cater more to those clients as well – if only because the US and UK are the biggest markets.

Wages in China may not be as low as many believe. Although the general wage level is low by Western standards, employees in the IT services sector are at the top of the Chinese income pyramid and not necessarily cheaper than in other offshore destinations such as India or some Eastern European countries. Average wage levels mask the strong variation with regard to employers, job profiles, regions and individual characteristics. Large firms pay more than small firms, foreign companies more than domestic ones, and firms in urban agglomerations more than in rural areas. In particular, regional differences are substantial: for example, the annual average wage for IT specialists ranges from roughly US$2,600 in Gansu Province to more than US$12,000 in Shanghai and Beijing.

The global economic crisis will not spare offshore providers. Less demand from international clients and a growing protectionist mood are severe downside risks which, in turn, may weaken Western exports to the offshoring nations.

There is an irony in this because offshoring of non-core business activities, which typically include IT and business services, often helps companies become leaner and more efficient – exactly what is needed during a slump. Also, most academic studies show that IT offshoring has no lasting negative effect on the number of jobs, though admittedly, much of the research was conducted before the current crisis hit.

Moreover, it would be wrong to look only at the cost and benefit of industrialized countries. IT offshoring can be a powerful engine of development for offshore destinations. In contrast to traditional trade, offshoring allows poorer countries to export advanced and higher value-added products already at a relatively early stage of economic development. Successful offshore locations typically are low-wage destinations which nevertheless boast comparatively skilled personnel, the protection of intellectual property rights and smooth communication by speaking the clients’ language. Such characteristics are not only good for offshoring, but boost the entire development process.

Despite the turmoil, it’s important to acknowledge the fundamental logic of offshoring. It helps international clients to focus on core competencies and provides offshore destinations with a promising export industry. China is already a leading offshore destination with regard to manufacturing, but strives for a bigger role in services, too. Considering the various factors at play, an offshoring volume in IT and business services of around US$4.5 billion by 2010 seems achievable in China, provided that a full-blown depression can be avoided.However, even in 2010, China will only account for a fraction of the global market and still rank clearly behind India.

Thomas Meyer is an economist with Deutsche Bank Research and the author of Offshoring to China: From workbench to back office? E-conomics 68. Deutsche Bank Research, Frankfurt. Rights: © 2009 Yale Center for the Study of Globalization.