OFFSHORING – AT THE TIPPING POINT?

Offshoring of services offers new export opportunities for developing countries, as well as benefits to the countries that become importers of these services - if the challenge is properly met", says UNCTAD´s World Investment Report 2004: The Shift Towards Services(1) released today. The challenge is to maintain an environment in which benefits for all will materialize.

Offshoring is still in its infancy. It represents the cutting edge of a global shift in production activity that is creating a new international division of labour in the production of services. UNCTAD´s expectation is that the trend to offshore is about to approach a pivotal "tipping point" from which cascades of new offshoring will spring.

The big picture - another revolution in the global division of labour

Traditionally, services have had to be produced in the same place and at the same time as they are consumed. Today, however, new developments in information and communications technologies (ICT) mean that information-intensive services can be broken down into their constituent parts and traded in the same way as has long been possible with goods. This "tradeability revolution" enables the production of services to be distributed internationally in locations offshore from the firms´ home countries. This is done either internally within firms, through the establishment of foreign affiliates (sometimes called "captive offshoring"), or externally, by outsourcing a service to a third-party provider ("offshore outsourcing"). (see table 1 for some definitions.) FDI is an important vehicle for offshoring: in India, for example, market estimates suggest that as much as 60% of the exports of IT-enabled services are supplied by foreign affiliates.

This increasing fragmentation, specialization and trade of service activities is spawning a new global division of labour - resembling the global shift in manufacturing production and trade that took place in the 1970s and 1980s. International call centres are the best-known example. But in fact, offshoring of services also includes more sophisticated, high-value added activities, such as accounting, billing, financial analysis, software development, architectural design, testing, and research and development. It spans the full diversity of skills, and cuts across all sectors. (Again using the example of India, IT services and shared service centres were more significant, in terms of numbers of FDI-related projects, than call centres (see table 2.)

This breadth of activities indicates the potential impact of services offshoring. More specifically: in the first place, service functions that can be offshored are found in all sectors of an economy, not just the service sector. Secondly, the pace of change is faster than it was in manufacturing. Thirdly, the skills content of tradeable services is high, meaning that this time white-collar workers are affected. In other words, this is the beginning of what could become a fundamental shift in the international division of labour in a broad range of activities that hitherto could not be traded.

Rapid growth forecast, especially in developing countries, but this is not a North-South phenomenon

The magnitude of the new trend is difficult to establish. In dollar terms, offshoring of services was estimated to be worth $32 billion in 2001, and off-shoring of IT-enabled services alone is forecast to increase from $1 billion in 2002 to $24 billion by 2007. But it could be much bigger.

In terms of jobs, offshoring was estimated by the World Bank in the mid- 1990s to affect between 1% and 5% of total employment in the G7 countries. For the United States, Forrester Research estimated that 3.4 million service jobs could shift to low-income countries by 2015; Deloitte Research estimated that 2 million offshored jobs would be created in the financial services industry alone, and that the total number of jobs affected for all industries could be around 4 million. But these numbers should be kept in perspective. Data from the US Department of Labour show that only 2.5% of all job losses (4,600 of the 182,000 redundancies) during the first quarter of 2004 were the result of offshoring.

It is also significant that services offshoring is not a North-South issue. The countries that have gained most so far include Ireland (which exported an estimated $8 billion worth of offshored services in 2001 alone), Canada, Israel and India. These four countries accounted for over 70% of the total market for offshored services. Moreover, as shown in table 2, the majority of FDI projects in call centres and regional headquarters are located in the developed, and not the developing, world. In fact, if the past is any guide, developed countries will stay in the game: not only do developed countries host more than two thirds of the world´s total services FDI, they currently host most of its services offshoring as well.

However, Central and Eastern Europe and many developing countries are increasingly reaping the benefits from the offshoring trend. Between 2002 and 2003, their share in the total number of related FDI projects rose from 37% to 51%, while their share in the number of jobs created by such projects reached 57%. India´s exports of software and IT-enabled services grew from less than $0.5 billion a decade ago to some $12 billion in 2003-2004.

It is likely that their share will continue to increase, not least because of crowding-in effects, where other firms follow the leaders. There are already indications that the experiment has been positive for firms that took the plunge: Research conducted by UNCTAD and Roland Berger Strategy Consultants found that 83% of large European companies were satisfied with their offshoring experiences, and 44% of those interviewed planned further offshoring in the coming years. This is likely to persuade still otherfirms, whether large or small, to consider offshoring, if for no other reason than to retain their relative competitiveness.

This is not to say that the potential for offshoring is unlimited. For many services, proximity to markets, interaction with customers, trust and confidence outweigh the possible benefits of offshoring. In addition, some technological limits remain, as it is not possible to digitize and farm out all service-related activities. Regulations and legal requirements may raise transactions costs, and hence limit offshoring. Some services, such as banking and insurance, are required by law in some countries to be provided by companies established locally. The lack of international recognition of professional qualification is another obstacle, as is the lack of globally agreed privacy rules. Moreover, different TNCs have different perceptions of the risks and benefits of offshoring services, and some are reluctant to do so.

Benefits for host and home countries

Cost is a major motivator, of course, and 70%-to-80% of firms interviewed in various studies cited lower costs as the main reason for offshoring service functions. Savings of 20%-to-40% are commonly reported, not only from the availability of cheaper labour, but also from the consolidation of activities in fewer locations and economies of scale. Consolidation enables firms to become increasingly specialized; workers become more adept; some tasks can become increasingly standardized; and the processes of designing job specifications and contracting for them becomes increasingly streamlined, as familiarity and experience grow with both parties to the transaction. These benefits can raise quality at the same time as they lower costs, which helps to explain why offshoring occurs in both developed and developing countries.

"Cost is only the trigger", explains Karl P. Sauvant, Director of UNCTAD´s Investment Division. "Many of the pioneers in offshoring did so to access skills and improve the quality of the services provided. And they are staying - and expanding - so as to take advantage of the entire range of benefits resulting from the international division of labour in the production of services."

The potential for developing and transition economies to benefit from the offshoring of services therefore appears to be large. Key benefits for host countries include increased export earnings, job creation, higher wages and the upgrading of skills. FDI in offshoring can create further positive spillovers in terms of raising the competitiveness of human resources and improving the ICT infrastructure. It also does not produce negative spillovers that can be associated with other economic activities, such as environmental pollution or overuse of natural resources.

But this is actually a win-win situation, because offshoring offers benefits to home countries as well. In the first place, offshoring allows firms to reduce costs and improve quality and delivery, thereby enhancing their competitiveness, with positive effects on the home-country economy. Secondly, it allows home countries to shift to more productive and higher-value activities, depending on their ability to adapt to changing comparative advantage. The impact on jobs is likely to be similar to, but less than, that of technical change, which makes some jobs redundant and creates others, generally at higher wage levels. Finally, host countries that gain from offshoring and earn more foreign exchange spend more on imports of the advanced products that industrialized countries export.

Hence, this new trend in the international division of labour implies benefits to both home and host countries.

Concerns need to be addressed -- but protectionism is not the answer

Nevertheless, there are short-term challenges to consider. All shifts in comparative advantage entail adjustment costs at the micro level. Some jobs will no longer be needed in firms that shift to offshoring, and there is likely to be a painful transition period while those workers who are affected search for new employment. Many may have to acquire new skills or move to new locations to become employable.

The challenge for home countries is to minimize such social and technical adjustment costs and to make the transition process as smooth and efficient as possible for those directly affected. But it would be short-sighted to adopt measures that forced service jobs to stay at home. Rather, policies that encourage education, training and R&D are required. Moreover, efforts to hold back offshoring would serve only to strengthen the critics of globalization, who argue that the rich countries support globalization only when they reap its immediate gains.

Thus, instead of implementing protectionist measures, white-collar workers in developed countries threatened with job losses could be given assistance (say, through retraining and with finding new jobs), similar to the trade adjustment assistance provided to vulnerable workers in manufacturing. Workers moving to new careers could perhaps be offered "wage insurance" to cover part of the difference between their past and future wages. Adjustment to any change in employment patterns needs greater labour mobility and changes in skills profiles. Preventing adjustment because of its costs would be only a short-term palliative, and could well handicap income and employment growth in the longer term. In the final analysis, protectionist measures are likely to destroy rather than save jobs in importing countries.

Given these prospects, UNCTAD´s World Investment Report 2004 urges the maintenance of an enabling international framework that allows all countries to benefit from the advantages offered by the services tradeability revolution . Developing countries in particular should continue to be able to use their comparative advantage to benefit from the globalization of ICT and ICT-enabled services. Shifts in comparative advantage rarely offer immediate and visible benefits to all concerned. With this in mind, the economies from which services are offshored have to ensure that their workers share in the gains enjoyed by enterprises that become more competitive, and that customers get better and cheaper services. Hence, the challenge is to maintain an environment in which the benefits from FDI in services in general, and offshoring in particular, can materialize. The WTO´s General Agreement on Trade in Services may be of relevance in this respect.

ANNEX

Tables

Table 1. Offshoring and outsourcing - some definitions

Source: UNCTAD, World Investment Report 2004

Table 2. Export-oriented FDI projects in call centres, shared service centres, IT services and regional headquarters, by destination, 2002-2003 (Number and per cent)

Source: UNCTAD, World Investment Report 2004