“Oh my God, I thought. What have I done?” That was the shock reaction that occurred when Tim Schneider, partner at Mitron Computer Services, met with the Chinese project manager in charge of developing his company’s sole product – an application for vendors in the fragrance and flavour industry.

The cause for his surprise was that, despite having communicated perfectly well via email for some months, in person the pair could not understand a word each other was saying. And for a brief moment, it felt that the decision to outsource application development to China had been a risk too far.

“However, people spotted that we were having trouble and got a translator in,” recalls Schneider. “And as soon as we started talking through the translator it became clear how intelligent he was.”

Perhaps most surprisingly of all, after a week the pair was communicating quite happily without the help of an interpreter. Schneider’s panic-inducing introduction to his Chinese development team mirrors the fortunes of that country’s budding

IT services industry. Lacking the shared history and language enjoyed by the Indian outsourcing companies they are hoping to mimic, Chinese outsourcers have a significant cultural barrier between themselves and the Western companies whose business they seek.

But, they hope, they have enough resources, enthusiasm and intelligence to overcome this barrier and develop an outsourcing relationship with the West to challenge India’s formidable IT services sector. Of course, their success depends on whether Western organisations are prepared to take the plunge.

The hype begins

One man who has keenly observed Western attitudes towards Chinese IT services is Cyrill Eltschinger. Now CEO of IT United, a China-based IT outsourcing provider that was acquired by Mexican IT services company Softtek in November 2007, the Swiss national began his involvement with China in the mid-nineties as an employee of IT services giant EDS, helping car manufacturer GM set up its Chinese operation.

“I started to get the picture that China would play a key offshore role because its infrastructure was top-notch, because the government has a key focus on IT and because the workforce was ample and eager to learn new things,” he recalls.

Having set up his own organisation in 1998, Eltschinger began a campaign to show companies in the West what Chinese IT had to offer. But back then, enthusiasm was muted.

“It has been a long and painful awakening,” he says. “At the start of the millennium, most people did not see China as a legitimate destination for IT services. The main perception was that China is a haven for manufacturing and has only a low-skilled workforce. Only India was recognised as having a vast IT talent base.”

That began to change around 2004.

Just as the Indian IT outsourcing companies began to take advantage of rocketing demand by putting up their prices, some staggering figures from China’s Ministry of Education (see graph) caught the attention of some forward-thinking Western organisations.

“What took everybody by surprise was that the number of computer science and software graduates in China reached 140,000 for 2003,” Eltschinger recalls.

“All of a sudden, there was another viable destination for large-scale IT outsourcing aside from India.”

Leading graduates

According to Chinese state figures, the number of IT-qualified graduates in China went on to surpass the equivalent figures in India in 2006 and is widening that gap every year.

Some observers warn that both these numbers and the quality of the education the graduates are supposedly receiving are to be questioned. However, what is indisputable is that a concerted effort by the Chinese government to develop an IT services and software industry has had some staggering results.

Thanks to a combination of government support and foreign investment, there are now 53 high-tech development parks and 29 specialised software parks around the country. According to the Sino-India Co-operative Office, Chinese software and IT services exports are projected to be worth $4.6 billion in 2009, having generated just $325 million in 2002.

Foreign investors can barely contain their excitement. According to Ernst & Young, initial public offerings by Chinese IT services and consulting companies listing on foreign markets raised $388.8 million in 2007 – ten times the previous year’s figure.

The jewel in China’s crown, as far as attracting foreign business is concerned, is its technological infrastructure, argues Eltschinger.

“The quality of the infrastructure is what surprises most visiting executives,” he says. “Technologically, it is better than most areas of Europe. That has really helped to change people’s minds about China.”

Limiting factors

That combination of governmental subsidy and slavering foreign investment led many to believe that China’s IT services industry would be a comparable competitor to India’s within years. However, the most recent research on the matter has found this not to be the case.

In his report entitled China’s Diminishing Offshore Role, John C McCarthy, a principal analyst at Forrester Research, looked at the amount of resources (i.e. staff) that global outsourcing organisations such as Accenture and IBM Global Services have located in various countries.

Contrary to the predictions of the past few years, McCarthy found that the proportion of total global outsourcing resources located in China had actually shrunk by 15% since 2005.

In part, this finding is explained not so much by China’s failing but by the runaway success of other outsourcing destinations such as the Philippines and Brazil, each of whose share of the global outsourcing resources have roughly tripled. But that is not to say that China IT is not without its shortcomings.

Chief among these is a shortage of middle management, says McCarthy. “Programmers need adult supervision. But there just hasn’t been time for enough people to acquire significant experience yet,” he says.

Another is the technological sophistication of the outsourcing providers. “The technical requirements of those leading-edge companies that have outsourced for ten years plus and are now looking for alternative destinations are geometrically more complex than what the local Chinese firms are used to,” he says. The Indian outsourcing providers, meanwhile, have developed alongside these pioneering firms to the extent that some even direct technological strategy for their clients.

According to Seb Butt, UK managing director of Chinese IT outsourcing practice Shine Technologies, the simplicity of China’s current offering is not a shortcoming. “The Indian firms have graduated into complex projects for enterprise clients, but that has left a void for outsourcing providers that target small and medium-sized businesses,” he argues, a void that China is well placed to fill.

Butt points to the finding from analyst company Gartner that 95% of outsourcing contracts are with small and medium-sized businesses. Certainly, much of the IT work that does go to China is on a project-based level that suits smaller organisations.

But these two factors call into question China’s long-term viability as an IT outsourcing destination, and that is a serious concern for any organisation that is to go through the trouble of overcoming geographical and cultural distance to provision IT work.

And what is more, two pieces of observed wisdom that have historically been put forward as key arguments for China’s long-term viability have recently come into question.

Guiding figures

Two of the most important economic indicators that have troubled the Indian outsourcing providers as they make the case for their own long-term viability have been employee churn and currency inflation. Some argue that China trumps the sub-continent in both regards.

The high staff turnover among Indian outsourcers places upward pressure on wages, as the companies struggle to retain and attract the most skilled employees, eating into their cost advantage.

“Wage inflation is a matter of supply and demand,” says Peter Carter, sales and marketing director for CompuPacific, a US-owned business process outsourcing provider that operates in the Tianjin municipality of China. “In the software parks, there are so many people looking for jobs and students looking for experience, that you just won’t get the kind of wage inflation as we’ve seen in India.”

Butt, meanwhile, argues that the difference between China and India in employee churn is a cultural one. “Whereas in India they are very ambitious in their careers, the mentality of loyalty in China means that attrition rates are very low,” he says.

“That argument is not borne out in the data,” says Forrester’s McCarthy. While the country’s IT services industry might not be growing as fast as was once expected, he points out, the manufacturing sector is going from strength to strength.

That puts a premium on application development skills for products like SAP and Oracle’s ERP offerings, and both churn and wage inflation have spilled over to the IT services sector. “In some of the eastern cities, the attrition rates are as bad as they are in India,” says McCarthy.

Furthermore, says Seb Pai, a partner at outsourcing advisory firm TPI, China may have a larger population than India, but the sub-continent has youth on its side. “Around 60% of India’s population is under 30,” he says, “but in China, because of the one-child policy [instructing families to limit their reproduction to one child], it does not have as many young people. China’s population bulges around age 40.”

Keeping costs down

And youth is key to keeping costs low, says Pai. “The average employee age at many of the Indian outsourcing giants is under 25, and over half have less than three years’ experience,” he explains. “The wages for this kind of employee are frozen, so they can keep costs down by adding more resources to the bottom of the pyramid.” China, he says, cannot use this tactic for as long as India can.

Another important factor governing the economics of offshoring is currency inflation. In 2007, the rupee grew 15% against the dollar. This hit the Indian outsourcing companies’ revenues – the rupee value of their contracts paid in dollars took a significant fall – and made US companies cautious of continued investment.

“China is benefiting from rupee inflation,” says IT United’s Eltschinger. “In the past eight months, China’s comparative competitiveness has gained tremendously as a result.”

The reason for this, he argues, is the comparative stability of China’s currency, the renminbi, which is roughly pegged to the dollar to ensure cheap export prices. “The renminbi has been appreciating on a fractional basis over the past year,” he says. “On a month-to-month perspective, you can see some movement but you won’t see a major swing.”

However, following food shortages, February 2008 saw the highest rate of inflation in the renminbi for over a decade. According to investment bank Morgan Stanley, even greater inflationary pressure on the renminbi is on its way.

Pai believes that comparing between the two currencies’ rates of inflation against the dollar is not a true indicator of their relative wealth. The 15% jump in the rupee’s dollar value was a one-off correction by the country’s central banking institutions that is unlikely to be repeated in 2008, he says. Rupee inflation against the pound, meanwhile, was negligible.

What all this means is that for UK customers especially, the price of Chinese outsourcing services is just as likely to go up as in India, if not more so.

This is a potentially damaging development. Forrester’s McCarthy reveals that one executive he spoke to said the concerns surrounding China’s long-term viability meant that the same IT work would have to cost 20% less for him to consider sending it there. Prices today are roughly comparable, however.

Saving grace

There is one thing that China has that just may – all else being equal – give it the edge over India as an IT outsourcing destination. That is a blossoming economy, thirsty for foreign investment, that threatens to overtake the US as the world’s largest in not too many years.

“Companies in the West need to secure some kind of play in the China market to have any kind of future,” warns Eltschinger. “I wouldn’t advise anyone to wait and see. Now is the time to vigorously engage in a China strategy.”

For many organisations, setting up an outsourcing deal in China has been an in-road to doing business in the fast-growing economy. Not only does it provide the organisation with direct insight into the cultural and economic requirements, it signals a desire to invest in China.

“If you are a manufacturer trying to crack China,” observes CompuPacific’s Carter, “what better story to tell than that you are working with China already?”

Indeed, this practice is so prevalent that McCarthy believes it skews the data on IT outsourcing to China. “A lot of these deals are collateral,” he explains, “deals that companies had to do to get a licence to do business in China.”

Schneider of Mitron Computer Services is already sizing up the local market for his niche application, even before development work has finished.

So while China might not yet be a comparable alternative to India in the IT outsourcing stakes, the economic impetus from abroad is creating enough demand for it to learn the trade. With ample resources – both human and financial – at its disposal, the country is well able to play the long game.

“Some people thought China’s IT services industry would be an overnight success, because they thought that was what happened in India,” says McCarthy. “But in India, it took 20 years of build-up.”

China, by contrast, has barely begun.

Further reading

Is offshoring still good value? Doubt has arisen as to the efficacy of outsourcing low-end business processes to unfamiliar locations