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22 February 2024

The dragon has a long way to go

By Thomas Meyer
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 off-shoring by industrialised 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 off-shoring 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 off-shoring faces several challenges. Financial services institutions emerged as main clients. For instance, more than 40 per cent 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.

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 off-shoring contract could create a public backlash that would undermine the government’s ability to defend further assistance to the financial sector.

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 off-shoring. Initiatives include the current 11th Five-Year Plan (2006-2010), the Informatisation Strategy (2006-2010), as well as the Thousand-Hundred-Ten Programme 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 four million Chinese graduated from institutions of higher education. Since the turn of the millennium, their number has risen by an average of 25 per cent 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 per cent in 2003 to “only” 82 per cent 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 per cent.

There are more obstacles. Cultural barriers challenge access to Western clients. In IT off-shoring, 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 per cent 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 per cent of the total client base. Chinese providers will need to cater more to those clients as well.

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.

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 off-shoring nations.

There is an irony in this because off-shoring 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.

Moreover, it would be wrong to look only at the cost and benefit of industrialised 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 off-shoring, 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 $4.5bn 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.