John Buyers of Stephenson Harwood explores some of the key issues surrounding China’s determination to be an offshore services giant.

The popular image of China is that of a low-cost, high volume manufacturing industry. According to a recent report commissioned by Microsoft, China’s $14 billion IT industry will overtake the UK’s in the next five years. So what are the factors that are coming into play which will make China an increasingly attractive destination for offshore services — and which will, in the near future, transform the economic paradigm of the Middle Kingdom and reinvent it again?

China versus India

India may be the undisputed current leader as far as offshore outsourcing is concerned, but China has turned its attention to the lucrative offshore services market and is keen to close the gap between the two economies. The labour costs of China’s IT industry compare favourably with India’s — which are increasing by 15 percent per annum. Although India has made great strides of late to improve its telecoms infrastructure and energy supply, China’s transport, energy and communications infrastructure is some way in advance of India’s, especially on its eastern coast. The Chinese government is also investing huge sums to try to erode India’s other big advantage: its population’s English language skills, and China now boasts more than 25 million English-speaking graduates.

Chinese outsourcing policy

The clearest indication of the Chinese Government's enthusiasm to grab market share in the world outsourcing market is the liberalised regime announced 2006 by the Chinese government’s Ministry of Commerce (MOFCOM), the Ministry of Information Industry, and the Ministry of Science and Technology. This has permitted the establishment of new China Service Outsourcing Zones, in which outsourcing is encouraged and that provide subsidies and tax breaks for outsourcing suppliers to establish and expand their activities.

The aim of this initiative, known as the ‘1000-100-10 Project’, is to build 10 ‘service outsource cities’ (although there are actually 11 at present), attract 100 transnational companies to bring their outsourcing business to China, and foster 1,000 qualified Chinese home-grown outsourcing companies by the year 2010.

The initiative targets specific sectors including software; financial services; film and television; innovation and design; specialist services, such as accountancy and legal services; and commerce. The first cities to be granted these new freedoms (initially for a five-year period) were Dalian, Chengdu, Shanghai, Shenzen and Xi’an, followed this year by Beijing, Hangzhou, Jinan, Nanjing, Tianjin, and Wuhan.

Each designated service outsourcing city is allowed considerable freedom to develop their own policies to grow and nurture their local outsourcing industries. Subsidies are also being made available for premises and facilities rental, for buying technology and telecommunications equipment, and for staff training.

The Chinese market

Outsourcers will still need to approach China with some caution, however. The lack of maturity of China’s outsourcing industry means that it is a very crowded and fragmented industry, with no homegrown outsourcing giants such as India’s Tata Consulting, WIPRO or Infosys, and very few significant mid-market players. Ironically, the very nature of this market means that, although spoilt for choice, many western companies will find it difficult to locate a suitable Chinese partner. At the present time, the vast majority of work undertaken by Chinese outsourcing providers is on behalf of other Chinese companies. A 2005 report by McKinsey & Co into China’s outsourcing industry found that out of 8,000 or so software services providers, only five had more than 2000 staff, and this situation has not improved significantly since.

Consequently, considerable effort needs to be expended to ensure that any potential Chinese partner will be technologically, organizationally and financially able to uphold its side of an outsourcing deal.

Finding reliable information on potential suppliers is difficult, and particular areas that need to be examined closely are their capacity, reliance on key individuals (who can be difficult to replace in China), and their financial resilience. Ironically, according to McKinsey, the best hope for some muchneeded consolidation in China’s outsourcing industry comes from Indian outsourcing providers looking to expand their capacity through overseas acquisitions.

Intellectual property

Maintaining and enforcing intellectual property ownership is another big risk for customers looking to outsource to China and a further important precaution is to check that potential partners do not have a record of IP theft and have adequate internal security measures to prevent it from happening in the future. While the government has recently pledged to strengthen IP rights in China through modernising its legislation, enforcement still lags a long way behind, despite MOFCOM’s recent announcement that "China's IPR law enforcement will be enhanced continuously, so that all infringement will be cracked down bitterly (sic)."

Data security

Finally, an area which will demand attention is the maintenance of adequate data security. Recent headlines have shown what has happened in India when unscrupulous employees have realised the value of western credit card and other personal data held in offshore datacentres. Left unchecked, the consequences in China are likely to be amplified in much the same way as the efficiency of the IP infringement industry has propelled China to be the counterfeiting capital of the world. Currently there are no EU style Data Protection laws, so the only way to ensure security is through physical (i.e. lock and key) and logical (i.e. encryption) methods.

The need to tread carefully

Notwithstanding the pessimistic view of intellectual property and data security issues, the economic stakes for China to get its outsourcing industry right are huge. This alone means that the situation should improve with time. In future, China looks set to become a serious competitor to India as its outsourcing industry matures and consolidates, its technological sophistication grows and its English language skills improve. In the interim however, companies seeking to take advantage of its offering would be well-advised to tread carefully.

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