Anju Seth, Professor, Business, UI

“This could be Silicon Valley”— was my first impression of Intel’s, General Electric’s (GE) and Infosys Technologies’ Bangalore facilities with their modern architecture, well-equipped gymnasiums and cappuccino serving food courts. Offshoring and offshore outsourcing—the process of relocating business processes to in-house facilities and vendors in lower-cost overseas destinations—has transformed Bangalore from a sleepy retirees’ haven to a technology hub.

• Intel’s Bangalore operations now represent the greatest number of its overseas divisions. The operations include an international design and development center that is Intel’s largest non-manufacturing site outside the U.S., with the responsibility for executing critical projects such as design of the next generation of 32-bit server.

• Formed to “leverage India’s intellectual capital and their unique multi-disciplinary skills,”General Electric’s (GE) integrated global research center in Bangalore is its first and largest outside the U.S. The center contains state-of-the-art R&D labs working on breakthrough technologies that are leveraged across diverse businesses, from aircraft engines, plastics, and energy generation to financial businesses, television networks, and movie studios.

• Bangalore-based Infosys Technologies, one of the pioneers of “offshore outsourcing” of IT services, recently celebrated its 25 year anniversary. The only genuine entrepreneurial startup of India’s three IT giants, Infosys was also the first Indian company to list on NASDAQ. It now has a market capitalization of over US $21 billion, revenues of $2 billion and after-tax profits of $555 million. The chairman of Mellon Financial, one of Infosys’s key clients, indicated to employees that outsourcing has "reset the cost structure" in the financial services industry, making it a necessary competitive strategy.

Bangalore is only one of the core locations of India’s offshoring sector, the world’s largest and fastest growing. India has the second largest English-speaking population in the world (after the United States) and an educated technical workforce pool of more than 4.1 million workers. Indian companies were among the first to build offshoring capabilities and thereby built the momentum of a first mover advantage. Revenues in the software and services export sector grew from $12.8 billion in 2003-04 to $17.2 billion in 2004-05, an increase of 34 percent. The sector has been a pivotal element in the country’s healthy economic growth during the last decade. At a macro level, the trend is expected to continue. An industry forecast predicts the industry will account for 7 percent of India’s GDP in 2007-08 and employ about 1.5 million people (versus a workforce of 695,000 in 2004-05). The sector is expected to account for 8 to 10 percent of GDP by 2008 (up from 1.4 percent in 2001).

The path to achieving these ambitious growth targets is no simple matter, however. Predictably, India’s success has spurred imitation, so that numerous other countries are beginning to mount intensive competition for the lucrative offshoring market. Below, I highlight some critical public policy and strategic business issues that must be addressed to maintain the momentum of growth in Indian offshoring. It is also pertinent to consider the long-run economic impact of offshoring on the developed economies such as the U.S. that seek offshored services.

A Closer Look at the Offshoring Market
A 2005 McKinsey survey asked senior executives, “Where does your company offshore or intend to offshore the following activities?” As the table below indicates, India’s
lead as a preferred provider varies across different activities; it continues to have an edge in IT and call centers/help desks, but lags behind developed countries in industry specific-R&D.

But problems loom even in the traditional strongholds of the IT and call center industries. A strategic perspective suggests that the sustainability of a country’s competitive advantage in any industry depends upon a series of interrelated conditions5:

• relative factor conditions (i.e., the country’s position, relative to other nations, in factors of production such as skilled labor and infrastructure)

• relative demand conditions (i.e., sophisticated customers in home market), related and supporting industries

• the strategy, structure and rivalry of companies in the industry.

Clearly, these conditions do not remain static over time so that a nation’s competitive position depends upon how well it meets the opportunities and challenges that accompany change.

Ironically, it is the very success of these industries that threatens their continued cost competitiveness, the core of India’s traditional advantage. In many popular offshoring
locations, such as Bangalore and Hyderabad, high mobility and rising wages of skilled engineers indicate that demand exceeds local supply of talent. Indian companies are indeed addressing this challenge in many ways, such as building in-house training centers, setting up new locations in cities where such labor shortages are not yet endemic, and creating a favored work environment for their employees.

Excellent as these initiatives are within the Indian context, they are unlikely to stem the tide of competition from other countries. In other words, India’s competitive advantage will be sustainable until such time as other countries can create a labor force with similar levels of skills. The relatively low value added offshored services represent the low hanging fruit, since these entail the most basic skill types and levels that are
relatively easy to replicate. How can this challenge be addressed?

The Strategic Imperative for India
A three-pronged strategic approach will assist Indian companies to sustain their competitive advantage. The first strategic imperative for companies that provide outsourced offshore services is to become the preferred provided of higher value-added services, services that have been traditionally kept in-house by their customers since outsourcing these services is fraught with critical business risks. Steven J. Franks, a lawyer specializing in intellectual property rights recommends that U.S companies “restrict offshore efforts to products that have no value without the support and service infrastructure that only you will provide.” One risk of entrusting such activities to an outside vendor is the possibility that the customer is handing over its valuable proprietary knowledge to a potential competitor. For another, the customer might fear that this knowledge is leaked by the supplier to another customer. As Romi Malhotra of Dell Computers in Delhi indicated, one of the reasons underlying Dell’s offshoring operations is that “these vendors work for multiple clients, so working with them gives us an opportunity to learn what could be done better.” Taking steps to mitigate these risks will benefit both the customer and the supplier of off-shored services. A research project that I’m working on with Bart Taub of the Economics Department investigates how contracts are structured to create credible commitments between customers and suppliers of offshored services to address and resolve such problems.

A second strategic imperative is to investigate offshoring their own services to other countries with lower-cost labor with the appropriate skills. The history of the growth of multinational enterprises in developed economies is instructive. To maintain their competitive advantage, these firms first ventured overseas to find new sources of low-cost inputs and new markets for their products and services. The high level of managerial
talent and entrepreneurial ability of Indian companies suggests that they are well equipped to represent a new generation of multinational enterprise.

A third strategic imperative, one that applies to Indian companies as well as offshore divisions of multinational firms located in India, is to add operations in second-tier
Indian cities that represent a new source of skilled workers. Besides enabling companies to remain cost-competitive in the traditional low value added services, such steps have the added advantage of bringing economic prosperity to the entire nation. However, the Indian government has an important role in enabling the success of such actions.

The role of any government vis-avis the economy is to create appropriate
incentives for investment in key industries: not by subsidies, which I believe have an ephemeral impact, but by creating the appropriate infrastructure. Although much
has been accomplished by economic liberalization, more needs to be done. Two key areas that require government initiatives for the continued success of the offshoring sector are
education and physical infrastructure. A recent McKinsey report highlights that 33 percent of the university-educated workforce in China hold engineering degrees compared to only 4 percent in India. Clearly, improving the supply of engineers
is critical. But the issue is even more basic: the 2005 World Development Indicators report China’s literacy level at 95 percent whereas India’s is 68 percent. Serious attention must be devoted by the government to enhance primary school education and improve literacy levels.
India also has the deserved reputation of having one of the worst physical infrastructures in the world. At one level, the slow rate of improvements to infrastructure in
India can be considered a byproduct of democracy and the protection afforded to private property rights. So, for example, acquiring land to build new roads requires that due
process be followed, and this may indeed entail delays. However, it may instead be the case that the economic interests of the nation are subordinated to those of powerful interest groups. The airport employees’ strike in early 2006 to oppose the government’s
long-overdue plan to privatize two of India’s largest airports towards improving physical infrastructure was called off only after the civil aviation minister provided written assurance that there would be no job loss due to modernization. It is difficult to see how efficiencies in the operations of these airports will be achieved if a workforce that is overstaffed by 40 percent must stay intact.

Does competition from India threaten technological dynamism in the U.S.?
If developing economies such as India do continue to recognize economic gains from offshoring from developed economies such as the U.S., is this merely a transfer of wealth from the latter to the former? Offshoring is a particularly controversial issue in the current discussion of globalization. The lessons of the past are instructive. For many
decades, U.S. companies have been relocating various processes overseas in an effort to remain competitive: China and India have merely replaced 1980s Japan and 1990s Mexico as the most feared foreign threats to U.S. employment. Data on economic growth in the U.S. following previous outcries on the impending “hollowing of the U.S. economy” from outsourcing of manufacturing jobs suggests that the march of globalization does not undermine the economy but rather, invigorates it. Between 1980 and 2003, American manufacturing output climbed a dizzying 93 percent. Over this time
period, the 4 percent annual growth rate in real output outpaced overall gross domestic product growth. It is true that manufacturing’s share of GDP (measured in current prices) has been declining gradually over time—from 26 percent in 1970 to 12 percent in 2005. However, this fall reflects a drop in the prices of goods relative to services: measured in constant prices, the share of manufacturing in GDP has been stable since 1980. Similarly, although the proportion of American workers in manufacturing declined from 25 percent in 1970 to 10 percent in 2005-6, the decline is the consequence of rapid productivity growth, in itself a cornerstone of economic health. So, the data indicates that innovation and productivity increases that are the source of job losses are also the source of new wealth and rising living standards.

At the same time, it is an unavoidable fact that many Americans have lost their jobs to offshoring and thereby suffered hardships. But, just as the advent of the combine harvester rendered many farming jobs obsolete, this is the inevitable consequence of technological progress. For the U.S. to maintain its competitive advantage, the structural incentives to innovate that are the hallmark of a dynamic free market economy must be preserved.