The Hindu Business Line : Unravelling the outsourcing puzzle

The recently released Annual Trade Report of the WTO focuses on a contentious area of trade in services. A separate chapter examines the offshoring of services, especially of IT, from the US to India. In this edition of Macroscan, C. P. Ch andrasekhar and Jayati Ghosh examine the WTO's effort to unravel the outsourcing puzzle and assess its implications.

OFFSHORING, or the outsourcing of services by developed country firms to captive units or independent suppliers in developing countries, has for some time now been a source for controversy in the developed countries, especially the US. Arguments that such offshoring involves not just the transfer abroad of new job opportunities that would have arisen in the developed countries, but the loss of existing jobs in the US to offshore locations abound.

They derive their strength from reports that specific corporations have been reducing or plan to reduce their workforce in developed-country locations, even while expanding them in developing countries such as India. In the event, calls for protectionist responses that limit and rollback the offshoring of services have increased.

As is to be expected, the WTO has decided to come out on the issue through a paper included in its latest Annual Report which, inter alia, argues that: i) the extent of net offshoring is exaggerated; and ii) to the extent that offshoring occurs, its negative effects on the source country and positive benefits for the host country have both been exaggerated.

The WTO's argument is built on an effort to examine data which should allow us to go beyond generalisations based on anecdotal evidence and construct a macro picture of the offshoring phenomenon at both global and national levels. In doing so the study reveals well known but inadequately stressed facets of the available information on the outsourcing and offshoring of IT and other business services.

To start with, the principal data sources are private, with official information being primarily restricted to that which can be gleaned from input-output tables and balance of payments statistics.

Second, there are significant discrepancies in the evidence available from different sources, whether they be private or public. And, third, in some cases as in India, even official information as available in the balance of payments statistics is collected and collated by a private body — in this case the National Association of Software and Services Companies (Nasscom).

Discrepancies arise with regard to the size of the global IT services market itself. The European Information Technology Observatory (EITO) estimates the size of the IT services market, excluding business process (BP) services, at $710 billion (euro 591 billion) in 2003 (Chart 1). On the other hand, the OECD estimates the size of the global market for outsourced IT and business process services to be close to $260 billion in 2001.

Taking into account reasonable estimates of exchange rate changes and market growth, this makes the EITO estimate much larger than that of the OECD's, despite its narrower coverage. Further, Gartner estimates that out of a total of $663 billion of software and IT services expenditure in 2003, a little more than 50 per cent or $322 billion was outsourced. This is closer to the OECD's outsourced services estimate.

Similar discrepancies are seen in estimates of offshoring as well. The OECD places the value of offshored IT and business service activities at $32 billion in 2003, representing 12.3 per cent of the global IT market. McKinsey, on the other hand, estimates that US companies offshored IT and business process (BP) services worth $26 billion to 12 major markets in 2001.

The 12 markets exclude major EU markets and, therefore, the figure somewhat underestimates the global offshoring of US companies worldwide. Even if we ignore this, since the share of US companies in global offshoring activities is estimated at 70 per cent, this suggests that the global value for all offshored IT and BP services was at $35 billion in 2001, higher than the OECD's 2003 value.

While recognising the private nature of the sources of these statistics, the WTO, for lack of an alternative, places IT and software expenditure worldwide in the order of $650-710 billion in 2003. Total outsourced IT services (excluding software) are placed at around $285 billion. Offshored IT and BP services are estimated to have been in $40-45 billion in 2003.

This places offshored IT and BP services at just 2.5 per cent of world commercial services exports, valued at $1,800 billion and at a meagre 0.125 per cent of world GDP valued at $36,000 billion. No one can claim that this is enough to disrupt economic activity and employment in the developed countries.

The point is that even of this the share offshored to captive units is quite substantial according to available estimates. According to the WTO: "Many surveys confirm that at present, most offshoring takes the form of captive offshoring. This view is supported by data on US IT services imports. In 2003, affiliated trade accounted for 63 per cent of US computer and information services imports, and for 77 per cent of US imports of other business, professional and technical services, a proxy for business process services."

However, the WTO notes, this conflicts with the Nasscom view that India's software exports of 2003-04 are provided largely by Indian-owned companies. This is the first of the puzzles offered by the India IT industry that needs to be unravelled. The second is the discrepancy between the volume of IT and IT-enabled services exports to the US as reflected in the Balance of Payments (BoP) statistics from India and the US.

According to the Reserve Bank of India, India's "software" exports amounted to $11.3 billion in 2003. Taking Nasscom's estimates that around 60 per cent of this went to the US market, software exports to the US in 2003 works out to be $6.77 billion according to official BoP statistics.

Turning to the US, IMF statistics indicated that US imports of IT services through unaffiliated agents from India amounted to $330 million in 2003. The same source reveals that the share of unaffiliated trade in total US IT imports stood at 36.5 per cent. Assuming that the same figure holds for US bilateral trade with India, the (estimated) imports of IT services from India works out to just $900 million. US imports of all services (including affiliated trade) from India, without transport, travel and royalties and licence fees, amounted to $1,139 million in 2003. This represents the upper limit for total US imports from India, making the $900 million figure appear reasonable.

How do we reconcile this major difference in the numbers ($6.77 billion and $0.9 billion) involved. One of course is to take account of the possible mis-categorisation of other business services as software services. BoP data on "business services" are reported under two heads: `computer and information services' (CIS) and `other business services'. However, national statistics do not reflect a uniform principle with regard to the allocation of services trade between these two categories.

In particular, in India a range of IT-enabled services, such as call centres and medical transcription services, are reported along with export of software services. For example, the Reserve Bank of India's (RBI) Annual Report 2004 shows that Indian "software" exports worth $12.2 billion in 2003-04 include IT-enabled services amounting to $3.6 billion.

But assuming that the figures for India's exports of "software" to the US are inflated by the same proportion, we should expect that software exports to the US would have amounted to $5.75 billion. This still is way above the US BoP figure. To explain this difference the WTO examines the possibility that what are paid as "salaries" to Indian IT-workers on short term H-1B visas gets reported as software exports. It is true that the Nasscom reports that a large share of India's "software exports" are delivered "onsite". I

Inasmuch as these onsite services are provided by a foreign affiliate of the "exporting" company, these are treated as local sales of these foreign affiliates and not included in the BOP data. If this be the case, this discrepancy is the result of the combination of means — cross-border supply and movement of persons — as well as the agency — foreign supplier or local commercial entity — used by the exporter to deliver the service.

However, "onsite" delivery by Indians employed abroad can be treated as an export from India only as long as these employees have not been staying abroad for more than one year. If they do they should definitionally be considered residents of the host country.

Thereafter, the earnings of these employees are no longer counted in the BoP statistics, although they might reappear later in the form of worker remittances.

Unfortunately, information on the number of Indian IT specialists and beneficiaries of H-1B visas who had already worked in the US for more than one year is not easily available.

So the WTO supports the view that misallocation of salary payments is possibly what explains the discrepancy between US and Indian BoP statistics on the basis of the following argument. Taking the annual approval of beneficiaries of H-1B visas, the WTO estimates that their number could have been close to 80,000 in 2003.

If this number is multiplied by the average annual earnings (about $60,000) of these workers, their total earnings turns out to be $4.8 billion over the year, which tallies closely with the discrepancy in the statistics provided by the two countries. So the exclusion of those who have been there for more than a year could possibly explain a large part of the discrepancy.

It is still too early to judge whether the WTO has arrived at a correct conjecture. But if that conjecture were true it does have implications for the nature of India's software success.

To start with, it does suggest that onsite delivery is still an extremely important component of India's software success. Further, it speaks for the nature of the software services provided by Indian firms.

The argument is that Indian companies are earning substantial sums based on a per hour or per man-day fee charged to firms, which use imported workers to customise software, solve problems or develop specific applications.

Since these workers are paid a salary in India and an allowance while they are abroad, the consultancy fee paid by the importing firm is the revenue of the exporting firm and the difference between the per employee fee and the cost per employee is the surplus accruing to the exporting firm.

It has been argued that body-shopping of this kind is representative of activities that are at the lower end of the software services spectrum. This has implications for both the quality and sustainability of India's IT export boom. India today dominates the global market for outsourced software and IT-enabled services. Nasccom quotes an estimate according to which India today accounts for 44 per cent of the global outsourcing market.

This ratio goes up to 55 per cent if only the ITeS-BPO segment is considered. If current growth rates are to persist either the global market would have to grow at that rate with a stable Indian share or the industry would have to increase its share of the global market over time. That is indeed a touch difficult.

Further, since the ITeS-BPO sector accounts for a rising share of total services export revenues, India's dependence on the less skill-intensive segments of the software and IT-services sector is overwhelming. This makes it even more difficult to maintain market share, especially without a substantial drop in revenues per employee, since competitors are more easily generated.

Finally, even if India's share of outsourcing revenues remains high, the net benefits of this are still unclear because of the dominance of a few firms and a substantial share for captive offshore outsourcing by international firms in the ITeS-BPO sector.

According to Nasscom figures, in 2003-04 the top 20 software and IT services exporters accounted for as much as 61 per cent of total export revenues. And captive ITeS-BPO providers accounted for as much as 65 per cent of the value of ITeS contracts outsourced to India. This kind of concentration not only makes the linkage effects of the growth of the industry less significant, it also has adverse implications for the net foreign exchange earning of the sector after taking into account repatriation of profits and other payments abroad.

It must be noted that the absolute employment contribution of the software and IT services sector makes its position within the Indian economy that of an enclave. Even at just over a million, the number of workers in software and IT services amounts to just one quarter of one per cent of all workers in India as per the 2001 Census, or one-third of one per cent of all main workers in 2001 or two-thirds of one per cent of all workers outside agriculture and household industry.

This suggests that a sector whose presence in terms of its contribution to GDP and its contribution to India's currently comfortable balance of payments position is indeed substantial, cannot make much of a direct difference to a substantial section of India's population. Hence an excessive dependence on this sector for growth at the margin may be inequalising, a possibility that the WTO also recognises.

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