The potential for increased offshoring of services is huge and effective investment promotion can influence the location of service production. A few examples illustrate a growing trend in which companies are restructuring their service activities internationally:

  • In July 2003, German chip-maker Infineon announced the creation of three centres in Dublin, Stockholm and Munich to rationalise its customer logistics management that, until then, had been handled in 19 European locations.

 

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  • The same year, British Telecom set up call centres in the Indian cities of New Delhi and Bangalore.

 

  • Also last year, American IT services firm ACS revealed that it was building a 40,000-square-foot office complex in Accra, Ghana, to accommodate growing demand for its data processing services which support clients in the communications, healthcare and insurance industries.

Gains for all involved

 

This trend is accelerating and affecting more companies and countries. Contrary to common perceptions, however, this is not merely a question of shifting activities from high-cost to low-cost locations. In fact, to date, developed countries like Ireland and Canada have been among the main recipients of offshored service activities. What is driving the process? The shift in service production reflects nothing less than a revolution in the tradability of services. Traditionally, most services have been non-tradable in that the transaction required buyers and sellers to be in the same place at the same time. Unlike physical products, they could not be traded between parties located in different countries. A haircut, for instance, is impossible to deliver across a distance. New information and communication technologies (ICTs) are dramatically changing the tradability of the information-centred set of services. Most importantly, the use of ICT allows information and knowledge to be codified, standardised and digitised, which in turn allows the production of more services to be fragmented into components that can be located elsewhere to exploit factors such as differences in cost or quality.

The number of products or functions affected by the fragmentation of services is huge. It ranges from simple low-value activities like entry of numbers into a computer to sophisticated, high-value services such as architectural designs, financial analyses, X-rays, software programs and advertising clips.

Obviously, not all services are susceptible to internationalisation, but many are. For example, in a survey by Unctad and Roland Berger Strategy Consultants of leading European firms’ offshoring strategies, no business process was explicitly excluded from offshoring considerations by more than 20% of the respondents. There are no sacred cows.

Big cost savings

The search for improved competitiveness – through cost reduction or improved quality or both – is the main driver of offshoring. Cost savings are often a substantial 20%-40%, but what is more interesting are the quality gains offshoring has given many companies.

When the back-office services of one firm become the front-office services of a specialised service provider, the latter often pays more attention to quality while the first can focus resources on core activities. Relocating some functions may also be a way to cope with excess demand, as was the case with IT services at the time of the Y2K problem.

Not all offshoring happens through outsourcing, however. In fact, in a country like India, up to 60% of the country’s exports of IT-enabled services are produced by foreign affiliates. Similarly, in Ireland, two-thirds of all employees in the call centre industry work in foreign affiliates. So, as table 1 shows, offshoring of services involves both international outsourcing and captive offshoring.

 

 

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Offshoring should be seen as part of a broad process in which companies facing increased competitive pressure try to make their production systems more efficient. This typically involves greater focus on core activities and a fragmentation of the production system.

In this context, both developed and developing countries offer competitive locations, but for different types of activities. Indeed, the agglomeration of financial services in cities such as New York, London and Zürich is part of this process. The same applies to the location of regional headquarters in places like Singapore, Dubai and Vienna. What is new is that developing countries are becoming more prominent as their skills and infrastructure improve.

India is the main winner in all of this, but not the only one. While China has claimed top position as destination in the developing world for export-oriented FDI in manufacturing, India holds first place in services. A review of export-oriented FDI projects during 2002-2003 confirms this (see table 2). In call centres, shared service centres and IT services, India had most FDI projects.

Asian dominance

The World Investment Report 2004 shows that among developing countries and economies in transition, the dominance of South and South-East Asia is striking. This is especially true in IT services projects, where it accounts for almost 80% of all FDI projects outside industrialised countries.

 

 

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Call centre projects show the greatest geographical dispersion among export-oriented FDI projects. Interestingly, the bulk of these went to developed countries in 2002-2003, but the share of developing countries is rising. In developing Asia, China, Malaysia and Singapore were important destinations in addition to India. In Latin America and the Caribbean, Brazil, Chile, Costa Rica, El Salvador, Jamaica and Mexico were well represented. In Africa, South Africa and Senegal were the top destinations. Hungary was the market leader in central and eastern Europe.

For India, offshoring of software development and, later, back-office and call centre services has driven its rapidly growing services exports. Exports of software and other services jumped from less than $0.5bn in the early 1990s to $12bn in 2003-2004, says industry association Nasscom. Whereas software development accounts for the lion’s share of these exports, IT-enabled services are increasingly important, rising from $0.6bn in 1999-2000 to $3.6bn today. The market for IT-enabled services is estimated to be $17bn by 2008. IT-enabled services offshored to India include customer care, finance, human resources, billing and payment services, and content development.

Opportunities for IPAs

For investment promotion agencies (IPAs), the offshoring of services offers major new opportunities. This applies to both developed and developing countries. A recent Unctad survey of members of the World Association of Investment Promotion Agencies shows that IPAs have been quick to explore the possibilities.

 

 

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IT and call centre services are the most sought-after service functions in all regions (see table 3). For example, more than half of all IPAs in Africa are already actively promoting FDI in these areas. In developed countries and in central and eastern Europe, R&D activities, call centres, shared service centres and regional headquarters functions are also targeted by at least 50% of the IPAs. In contrast, less than 20% of the IPAs in developing countries seek to attract FDI in R&D.

Effective promotion of investment opportunities in this area is of course no different in principle from promotion of other FDI. Still, the fact that it is a relatively new field – for both IPAs and companies – makes active targeting particularly important. Countries seeking to attract high-value services FDI such as R&D, architectural design, medical testing or regional headquarters functions have to match carefully their locational assets with the needs and strategies of investors. Of special relevance is the availability of appropriately skilled labour and high-quality telecommunications at competitive costs. A number of countries have also leveraged the use of export processing zones in this context. India’s technology parks for IT services, Mauritius’ Cyber City and Internet City in Dubai are good illustrations of this.

An area that too often is neglected by IPAs is aftercare, a promotional activity that is critically important in offshoring. In fact, many companies choose to undertake captive offshoring in countries where they already have a presence. For 40% of the largest European transnational companies with

offshoring experience, soft factors such as internal lobbying by their own foreign affiliates have a direct impact on location decisions. There is a need for much greater focus on aftercare by IPAs who want to benefit from the offshoring trend. A study by IBM and Oxford Intelligence on shared service centres in Europe confirmed that many foreign investors feel IPAs focus a lot on attracting new investors but not enough on taking care of existing ones.

As is so often the case when rapid international restructuring takes place, IPAs can also play a critical role in bringing feedback from the market to the attention of policymakers in the government. An IPA with efficient policy advocacy may well turn out to be one of the best assets for countries seeking to leverage the offshoring trend. This applies just as much to developed as to developing countries. As shown by Canada, Ireland, Singapore, Spain, Sweden and the UK for example, relative high-cost developed countries also attract related FDI.

Threat to G7 jobs

How much will be offshored? The offshoring of services is still in its infancy and no one knows for sure how big the phenomenon will become. In the mid-1990s, the World Bank estimated that

1%-5% of all jobs in the G7 countries could be affected. More recent studies put the maximum number of jobs in US that could be at risk at about 14 million. Consultancy reports indicate that some two million to four million service jobs are likely to be offshored in the next 5-10 years.

Whatever the exact numbers, we have certainly only seen the tip of the iceberg. Companies that have offshored services typically report cost savings of 20%-40%, and most companies are very satisfied with the outcome. Indeed, 83% of the top European companies surveyed by Unctad and Roland Berger, that had offshored some services, were pleased with the results. Only 3% were dissatisfied.

If pioneering companies receive competitiveness gains from offshoring, their competitors are likely to be compelled to follow suit. As offshoring expands, there will also be a need for more capable suppliers to outsource services to.

Lots to learn

Companies are still on a steep learning curve. As they become more accustomed to offshoring, they are likely to consider new services and locations. The development of GE Capital International Services (GECIS) is a good example of this. It started operations in India in 1997 by providing call centre customer support and back-office services, such as data entry and transaction processing to other GE companies. In 2000, GECIS India started adding higher-value activities to its portfolio.

GECIS India now offers, for example, IT help desk, risk management, actuarial services and loans and claim processing. Since inception, the Indian operations have given GE cost savings of 40%-50% – about $300m annually. It has grown to become the largest centre in India for the production of IT-enabled services, employing more than 11,500 people and continuing to expand. In fact, the Indian centre is now the global headquarters for GECIS, which has operations in Mexico, China and Hungary.

Although the total volume of offshored services remains small, the trend has already given rise to vocal concerns, notably in the US. No doubt, some workers will be negatively affected by the offshoring of services. However, the magnitude of the possible impact is likely to be far smaller than that of normal fluctuations in demand and technological change.

If we assume that Forrester Research is right in its estimate that 3.4 million service jobs will be offshored from the US by 2015, it corresponds to a few hundred thousand jobs annually. Comparing this with the four million job turnover, which took place on average every month in the US economy in the last year, puts the offshoring debate in perspective.

Benefits for all

In fact, the offshoring of services offers major benefits to all parties involved, just like the internationalisation of goods production has in the past. Offshoring allows companies to produce or source services more cost-effectively, which lets them improve their competitiveness and invest in new jobs wherever they operate. It also allows companies to focus on what they can do best in each location, opening the way for upgrading towards higher-value activities.

Catherine Mann at the Institute for International Economics has shown that just as in the case of the globalisation of electronics production, globalisation of services is expected to lead to major productivity gains, perhaps even larger than in the case of goods. So the steps taken by Infineon, British Telecom, ACS and many other companies are likely to be followed by others.

The opportunities for restructuring created by the tradability revolution are so appealing to companies that few will be able to resist if they want to remain competitive. At the end of the day, this is a development that should benefit all parties, but government policies can play a key role in ensuring that affected workers get assistance and that their labour markets have the flexibility needed to cope with change.

This article draws from the World Investment Report: 2004: The Shift Towards Services (see www.unctad.org/wir)