Hidden Dragon?

Opinions regarding China's potential as an IT and business process
outsourcing destination have been mixed. China backers would have us believe
that the country will present a formidable challenge to India's dominance
within the space of a few short years. Others point to China's disadvantages
and say that the gap is too large for China to bridge, even within a decade.
Regardless, the outsourcing industry in China is now experiencing a shakeup, as
leading global providers such as HP, BearingPoint, and IBM set up IT and BPO
centers there.

All the top Indian providers have also set up shop in China, and several are
planning transformative growth strategies. Of India's top five providers,
Satyam and TCS have been operating in China for a couple of years now, while
Infosys set up its office there earlier this year. Wipro recently announced its
entry into the market, and HCL is anticipated to make a similar announcement
sometime soon. Medium-sized Indian companies Mphasis, Zensar, and iGate also
entered the market some time ago. The latest entrant is Cognizant, with a host
of others expected to follow.

While
wholly-owned subsidiaries have been the most popular entry mode, joint ventures
or acquisition of local Chinese firms have served as entry vehicles for Indian
firms in the past, and may also be used to expand in future. While each provider
has somewhat differing rationales for entering China, the key to a successful
expansion into the country rests on a deep understanding of the market and a
sound business strategy.

China Market Landscape

The Chinese government is seriously focused on developing service
industries. Outsourcing has been identified as one of the key "knowledge
economy" focus areas, and therefore a lot of the government attention has
been devoted to developing the industry.

China's Software Cities: In 2000, the Chinese government decided to
set up 10 software bases to promote outsourcing and attract investment. Each
city contains a software park, and offers attractive tax policies and other
incentives to promote development of an export-focused software industry.
However, the cities differ in terms of tax holidays and other government
incentives, availability of technical resources, business infrastructure, and
proximity to customers.

China's major cities may be roughly classified as tier 1, tier 2, or tier 3
in terms of their levels of economic development. Importantly, there are vast
differences in operating costs between cities and provinces in the three tiers.
However, the level of public physical infrastructure throughout China far
exceeds that within India.

Talent Availability: According to government statistics, in 2001 there
were almost 2,000 universities and colleges in China, boasting 11.75 mn enrolled
students and producing 1.97 mn graduates annually. The government claims there
are currently around 500,000 workers with IT skills in China, with about 140,000
new computer science graduates in 2003 (up from 62,000 in 2001). The number of
graduates with accounting and other skills relevant to BPO is said to be even
higher. Impressive though these figures are, shortage of such professionals
exists and they can command high salaries.

Chief among the skills easily available in China are the traditional
programming languages. However, there remains a dearth of talent with
substantial project experience, or with skills in areas like ERP and the latest
technologies. Such talent is primarily available, in small numbers, in tier 1
cities, and only at relatively high compensation levels. There is some
challenge, though, in finding the right human talent. There are cases when
companies had had to turn away projects because of unavailability of proper
talent. The recruitment supply chain for IT professionals in China is still in
its infancy.

Challenges in China

Though the Chinese IT and BPO industry is developing rapidly, there remain
challenges that Indian entrants must recognize and overcome.

Language: Among the often-cited challenges China faces in outsourcing
is the lack of English ability. However, with new project management approaches,
this can usually be overcome in the IT outsourcing arena. Nevertheless, language
skills remain a major hurdle for voice-based BPO. The language issue is more
pronounced in tier 2 and tier 3 cities.

IP Protection: One of the most inhibitive hurdles is the lack of a
rigorous intellectual property (IP) rights protection regime in China. This
deters firms from outsourcing critical projects. Western software companies are
wary that copyright and intellectual property protection through traditional
contractual means may not be adequate or effective in China. Although the
government is taking some steps towards more stringent enforcement of
intellectual property rights, the country still has a long way to go.

Large-scale Project Experience: Most of the IT outsourcing providers
in China are small- to medium-sized companies with limited experience in
managing large-scale projects. Their background is often in localization or in
the development of non mission-critical systems. There is also a lack of domain
knowledge in fields such as the banking and finance sector, which account for a
large chunk of outsourcing business. At present, China's world-class
capabilities are limited more to lower-end tasks such as programming, testing,
and repetitive business processes. Convincing global clients to outsource large
or mission-critical projects to their development centers in China may initially
be a challenge for Indian providers.

Cultural Differences: The majority of local Chinese providers have
focused on customers in the domestic market and the Asian region. Chinese
providers are currently not attuned to Western cultures and business nuances.
This explains their relative success in Japan and Korea, but lack of success in
penetrating Western markets.

Variable Quality and Service Levels: There are no clear outsourcing
market leaders in China. There are great disparities between the different
providers' capabilities to execute projects successfully. Few Chinese
providers have CMM certification. This has left the door open for global IT
giants such as IBM, HP, and BearingPoint to clearly differentiate themselves.
While Indian providers have been able to tout their CMM Level 5 certification
and major-project track record, they have yet to really stake out a defined
niche for themselves.

China's Strategic Advantages

Among the reasons why Indian providers find China attractive are (claimed)
lower costs, a complementary and larger skills pool, better servicing of MNCs in
China, penetration of Japanese and Korean markets, access to China's domestic
market, and risk mitigation for global clients. However, facts on the ground may
prove less than ideal and companies must know what they are getting into.

Lower Costs: For ITeS workers with limited experience, wages in
second-tier cities are believed to be 15—20% lower than in India. Leading
Indian firms such as Infosys and Satyam have already established operations in
Shanghai and are now looking to expand into second-tier locations to benefit
from this cost arbitrage because the city is more expensive than India to
operate. Most Indian providers have initially set up close to customers there,
and are only now beginning to explore less developed provinces.

Complementary and Larger Skills Pool: Combined with lower costs, China
also offers skills that may be complementary to those available in India. Though
not experienced, there is a large pool of IT programmers who are capable of
carrying out coding and testing. In addition, BPO firms can utilize the large
numbers of low-cost workers to execute back-office processing projects in China.
A number of providers believe this talent pool may one day dramatically alter
their global delivery capabilities.

Better Servicing MNCs in China: As the world's seventh-largest
economy and number one destination for FDI, China has attracted almost every
major MNC to set up operations. India's IT providers have proved adept at
marketing to and serving these companies in their home market. By establishing
operations in China now, Indian providers can grow the value of these client
accounts without spending heavily on business development activities.

Penetration of Japanese and Korean Markets: Currently around 70% of IT
outsourcing export dollars in China are earned from Japan. This is in stark
contrast to India, where Japan represents somewhere around 5% of exports.
However, by locating in China, Indian firms can leverage the same advantages of
cultural and geographic proximity, along with the availability of
Japanese-speaking workers.

Indian providers are also leveraging China's geo-cultural advantages in
various ways: TCS' strategy, e.g., is three pronged-China for global
customers, China for APAC, and China for China.

Access to China's Domestic Market: China's domestic IT market has
been hampered by lax IP protection policies, resulting in a lack of value being
placed on software. Furthermore, state-owned enterprises in particular have been
reluctant to implement software that may result in jobs being automated, given
that their traditional role has been to provide employment.

Despite these challenges, there are, equally, potential catalysts for growth
like the substantial existing hardware infrastructure, emergence of Chinese
multinationals, and increasing IP protection reforms.

Risk Mitigation: In recent years religious and ethnic violence in
India's northwest and occasional nuclear tensions between India and Pakistan
have made international headlines. Combined with the trend to outsource more
mission-critical applications, and an increased focus on business continuity
following 9/11, companies have been looking to mitigate such risks. However
China is not a risk-free destination. But as long as China's growth continues
apace and the economic fundamentals remain intact, it will continue to be an
enticing destination to at least spread the risks.

With ambitious growth plans already underway, it seems certain that China
will be the largest offshore development center for Indian firms, after India
itself. The fact that there are no clear leaders in the market yet offers Indian
providers the biggest opportunity (and the biggest potential threat to their
incumbency) since the early 1990s upsurge in offshoring. Future success depends
on how well Indian providers understand the market opportunities and position
themselves for leadership now.

Sridhar Vedala and Nick
Rossiter Mithras Consulting Group, China