EXPERT VIEW: Offshoring to New Shores, Nearshoring to Central and Eastern Europe

Analytical Survey by Parvis Hanson

Central and Eastern Europe (CEE) is an important region for services offshoring. The imports of IT-based services from Central and Eastern Europe into the EU-15 rose by an average of 13% per year between 1992 and 2007. Imports from India, by comparison, increased only slightly faster during the same period at 14% per year.

Close cultural and geographical ties make suppliers from CEE an attractive option. The close ties – in terms of culture, geography and partly language – between the CEE countries and the key Western European markets, the low wages, the high standard of education and stable macroeconomic and institutional environment constitute some of the strengths of the region.

However, CEE cannot boast any IT specialisation in exports or education. IT-based services account for less than 4% of total exports in CEE, whereas the share in India is 17%. Also, the share of graduates gaining information technology degrees – a key qualification for IT offshoring – is lower in CEE than the Western European and Indian averages. It is therefore unlikely that offshore production of standard IT services will become as important for CEE as is the case for India.

The comparative strength of CEE lies in more complex back-office processes. The cultural background shared by providers and their clients in CEE is particularly important for more complex business processes. Clients from outside English-speaking countries also appreciate the widespread language skills in CEE. Moreover, the lack of IT specialisation in CEE is less significant for typical back-office processes – such as bookkeeping.

India has shown the way. And others want to follow. Many emerging markets and regions aspire to become not only the extended workbench of companies from high-wage countries but also their backoffice. Offshoring is a special form of trade in which certain business processes are spun off and outsourced to foreign locations. This applies in particular to IT services and general back-office process sectors.

IT offshoring: Robust growth from a low base
The economic significance of offshoring is debated controversially. A particularly heated discussion was ignited during the last US presidential election. However, the international division of labour and specialisation constitute an important motor of world trade and the prosperity of nations. The global distribution of the internet along with high-powered computers and software has improved the tradability of services. The goods can be converted into digital form and distributed via global data networks. Many services can thus be produced in processes where there is a division of labour. Specialisation boosts productivity and offshoring allows international cost advantages to be exploited. Two methods are frequently used for measurement. Firstly, companies can be asked directly about their expenditure on offshoring. These figures are frequently used as the basis for estimates about the market as a whole. Consultancy firms and commercial data providers are the typical users of this instrument. A second method is to observe the trade flows reported in official balance of payments statistics. Authors at the OECD and the IMF are particularly keen users of this information.

US companies are the biggest consumers of IT offshoring services. India is the most important production location.
Central and Eastern European output for the US was worth just under USD 0.5 bn, while the value of the Philippines’ output for the US came to USD 0.4 bn. Offshoring leads to imports and exports of services that are reported in international balance of payments statistics. For this reason some authors attempt to gauge the volume of offshoring using trade flows. Two items are frequently used in the literature:
1. Computer & information services (CIS)
2. Other business services (OBS)
In 2006 the EU-15 recorded an export surplus with CEE and an import surplus with India. Worldwide, the EU-15 imports CIS and OBS services worth nearly EUR 220 bn – primarily from other industrial nations.

Trade flows present a more mixed picture than is often painted by the media. The trade in IT-based services is not a one-way street: locations like India or CEE are both exporters and importers of these services.

High growth rates
While the volume of IT-based services rendered in low-wage countries for firms in high-wage countries is still modest, the growth rates are striking. IDC estimates that spending on IT offshoring will grow by an average of 14.4% per year in the US and by 16.5% per year in Western Europe until 2009.

New production locations
Many new locations are trying to copy India’s success in IT services. However, export structures reveal that India evidently possesses a pronounced comparative advantage. The share of a country’s total exports generated by a sector or industry is often regarded in the literature as an indicator of a revealed comparative advantage. It is a plausible assumption that countries specialise in those goods and services they produce more efficiently than other countries. Export specialisation is thus evidence of a comparative advantage.

The figures for IT-based services, that is the balance-of-payments items CIS and OBS, confirm India’s leading role as an export nation. In India 17% of all exports are IT-based services. This figure is only topped by Ireland’s 19%. In absolute terms the US is the biggest exporter of CIS and OBS, worth USD 76.4 bn, but these services constitute only less than 7% of all the country’s exports. CIS and OBS account for less than 4% of exports from CEE countries, which is much lower than in other countries Russia’s export share is just a little over 2%. In the Philippines only just under 0.8% of exports are generated with IT-based services. The growth rates are also interesting: while India has grown its CIS and OBS share of exports by an average of 4.5% per year in the past few years, the share in the new EU member states fell 3% per year on average. There has been a nominal increase in exports of IT-based services by both India and CEE – the only thing is that exports by other sectors have increased even faster in the new EU member states. The export structure however reflects the current state of specialisation. If demand increases, then the supply side will react in turn. It is therefore worth taking a closer look at the factors pertinent to locations in the CEE.

What Central and Eastern Europe has to offer
Language skills and cultural ties make communication easier
CEE countries have close geographical and cultural ties with the markets of Western Europe. Typical nearshoring locations score high marks because of their lower costs for communication between the purchaser and the provider of the nearshoring service. There are three reasons for this:
— Personal contact: Complex problems are best solved face to face. Nearshoring locations are closer to the client, which makes visiting each other easier.
— Common language: Nearshoring locations often have personnel that are proficient in the language of their client – even though their official languages may differ.
— Cultural understanding: In most cases nearshore personnel have a better knowledge and understanding of the cultural background of their clients than their counterparts in offshore locations. This allows easier, more implicit communication as misinterpretations occur less frequently.

Language skills are particularly important. India’s success is attributed in no small measure to the large supply of English speakers – and most offshoring contracts come from Anglo- American clients. This puts continental European companies at a disadvantage. Although English is regarded as a lingua franca, communication nevertheless becomes more efficient if both partners speak the language fluently. This is evidently not always the case in some continental European companies. Moreover, proficiency in the language used by the procuring company is essential for many services, for example for providing customer care in call centres or processing receipts issued in the client’s native tongue. CEE is particularly interesting for German companies. Nearly 40% of schoolchildren in the new EU member states learn German. The proportion is particularly high in those countries bordering Germany. Though this does not mean that German is spoken fluently, it does however signify that at least there is a basic level of proficiency that can be built upon. Furthermore, over 70% of schoolchildren learn English, which enables language gaps to be plugged. Romania is interesting for French companies as 85% of schoolchildren there learn French.

These language skills are an important selling point that should not be carelessly wasted. In some CEE countries, such as the Czech Republic or Slovakia, fewer schoolchildren are learning German than in 1998.
Along with speaking the language, knowledge of the culture and customs represent the prerequisites for efficient communication.

Big differences in wages
Cost savings are the primary motive for most outsourcing. Producing services is labour intensive, that is why wages and non-wage labour costs are important. In CEE, labour costs are much lower than in Western Europe: In the new EU member states the average labour costs for non-public services are around one-fifth of those in Germany. In Romania and Bulgaria labour costs are less than 10% of those in Germany. The costs in recent years have however risen considerably: between 1996 and 2004 labour costs in the new EU member states rose by an average of 7.7% each year. In Romania they have climbed 8.1%, in Slovakia by 9.7% and in Lithuania by no less than 15% per year. By contrast, wage growth in Western Europe was modest: 2.1% in Germany and 3.4% in the EU-15. Wage differences remain pronounced, but they are narrowing. Most of the CEE countries are not among the cheap offshoring locations for skilled jobs. In China and above all in India the wages are mostly lower. Only a few non-EU countries can compete at that level. An engineer in the Czech Republic is paid about USD 7.40 per hour, whereas he can be hired for just USD 3.50 per hour in China or USD 2.40 per hour in India. In Romania the corresponding wage is around USD 4.60 per hour, and in Bulgaria it is only USD 4.40 per hour.

The decisive factors for the future development of wages are labour market supply and demand as well as the structural development of the labour markets themselves. Structural issues are still of less importance specifically in poorer offshoring locations. 

High standard of education – but no IT specialisation
The supply of well-trained labour is a key determinant of the appeal of a location. Most Central and Eastern European countries can boast competitive educational systems. The number of graduates produced in the new EU member states is slightly higher than the average in the EU-15 or the US. Per 1,000 inhabitants aged between 20-29 there are around 60 students gaining degrees in the new EU member states and the US, while the corresponding number of students graduating in the EU-15 is about 51. Public spending on education is similar in all three regions at around 5.3% of GDP. The figures are lower in most of the CEE countries outside the EU: In Bulgaria, for example, the graduate ratio is 4.1% and state spending on education is equivalent to 3.6% of GDP.

The pool of skilled labour is quite large in most offshoring locations. However, formal qualifications often provide very little indication of whether the people concerned are also suitable for employment by a service provider with international clients (insourcer). Not all universities satisfy the standards that are usually met in Western Europe or the US. Moreover, some degree courses do not provide the opportunities for students to gain sufficient language skills or practical experience. There can be a striking discrepancy between the number of persons with the requisite formal qualifications and the number of actually suitable job candidates. According to a study by MGI, just 10% of graduate engineers, mathematicians, statisticians and physicists in China or Russia are suitable candidates – in terms of their training – for the jobs available at insourcers. In the Czech Republic, Hungary or Poland (CEE-3) the share is nearly 50%, whereas in the industrial nations about 80% of graduates are suited to working for international service providers.

Although in India und China only a small proportion of trained specialists are suitable for skilled jobs at insourcers, there are nevertheless more of them – in absolute terms – than in other offshoring or nearshoring locations. Moreover, the low ratio of suitable candidates suggests that extensive reserves can be tapped in the medium term by improving the quality of training and education.

Poor countries have weak institutions
Low wages for well-trained personnel are not the sole criterion when deciding on a location. Macroeconomic and institutional factors also play a part. After all, the offshored processes are often very important to the companies doing the offshoring – even if they are standard services. If, for example, an offshored IT support service were to become interrupted due to external influences, this could have major repercussions for the entire production process. Other problems arise if the offshore location does not take data protection or intellectual property rights seriously, if contracts are not honoured or if government behaviour is unpredictable. The quality of a country’s institutions is clearly correlated to its level of economic development. In the literature the International Country Risk Guide Composite Indicator (ICRG) is often used as yardstick for institutional quality. It combines estimates of political risk, the rule of law, the quality of bureaucracy etc. with economic and monetary policy variables. Since typical offshore locations are mostly poorer countries – as only they can offer the desired wage cost advantages – allowances thus have to be made on the institutional side.

Offshoring means that a medium to long-term supply relationship is agreed between the buyer and the seller for a specific service. The type and quality of the service is laid down in a Service Level Agreement (SLA). It is important that the specifications laid down in the SLA are fulfilled. In some countries, however, the costs of contract fulfilment are considerable. A general estimate of the average costs can be found in the Doing Business database of the World Bank, which measures how long it takes and how much it costs for the legal enforcement of a pecuniary claim in the case of a dispute. In India this can cost over 40% of the outstanding amount. In China and Russia the figure is over 20%. In Hungary and the Czech Republic, by contrast, the costs are lower than in Germany at less than 10%. In Romania and Bulgaria, too, the costs are under 15%.

The contractual relationship becomes even more complicated by the fact that requirements change over time, for example thanks to technical developments or regulatory changes. These changes are not always foreseeable. Supplier and purchaser must therefore agree on changes during the life of the contract that were not expected when it was signed.

Good institutions, however, stabilise the business relationship by offering a reliable forum and set of rules for settling disputes that extends as far as a fair legal resolution.
Buoyant demand

Backlog demand in continental Europe
Companies from the US and the UK are the leading purchasers of offshoring services. To date they have benefited from the supply structure as the most important supplier – India – has been able to cater mainly for their requirements.

Over 70% of all European offshoring expenditure occurs in Great Britain or Ireland. Germany, Austria and Switzerland account for a combined share of just 9%, while France claims 8%. Southern European countries like Italy, Spain and Portugal play only a very peripheral role.

Continental Europe is an attractive market for suppliers from CEE as the backlog demand there is bigger than in the UK and Ireland. Moreover, CEE possibly offers precisely those factors that companies in continental Europe have been waiting for – in terms of language and culture in particular. However, other regions are also playing to their strengths: French firms are finding French-speaking personnel in North Africa; Spanish companies are looking for partner firms in Latin America. Smaller firms are more reluctant to resort to offshoring. For them CEE offers an interesting range of offshoring services. Smaller firms tend not to be able to split up and standardise their processes as much as large firms. For this reason the investment in selecting and monitoring an offshoring partner is often more costly than the potential savings. Nearshoring is an alternative in this case because the set-up costs tend to be lower.

New processes
Offshoring is no longer restricted to only the simplest programming tasks and call centres. Complicated and complex processes are also being outsourced to foreign locations where the expertise for these tasks is growing. Indian radiologists, for example, analyse and interpret X-ray images for American hospitals. Other skilled backoffice activities are also being offshored, such as legal advice (Legal Process Outsourcing) or the evaluation of economic data. The technology consultancy Forrester estimates that by 2010 nearly 39,000 legal advice jobs will have been outsourced from the US to offshore locations.

The inventiveness of companies knows no bounds when it comes to offshoring. Many services – and not only the traditional IT services – can be provided inexpensively in low-wage countries. Discovering suitable processes and creating the necessary corporate structures for outsourcing will increasingly develop into a business management skill.

Conclusion: Selective offshoring
IT services and back-office tasks for companies in high-wage countries are an attractive business area for many emerging economies. Offshoring creates well-paid jobs and export revenues there as well as promoting technology and knowledge transfers. It is no wonder that so many countries are attempting to imitate India’s success by promoting themselves as an offshoring or nearshoring location. Central and Eastern Europe (CEE) is a promising location thanks to its close geographical and cultural ties with major markets and its comparatively attractive wage levels and educational standards.

The market for IT and other business process offshoring is expanding markedly. The growth rates are much higher than for other business activities – albeit starting from a low base. Continental European and Asian companies are still more reticent than their Anglo-American competitors, but they cannot ignore the expected cost advantages in the long term. In addition, the range of business activities is expanding, as new processes are discovered for offshoring – for example research and development. On the supply side typical local factors are important. The wage level in the advanced CEE countries is lower than in the old EU member states, but higher than in the standard offshoring locations. Outside the EU, however, there are more inexpensive nearshoring locations such as Romania or Bulgaria. Typically, the poorer the country, the lower the wages. However, the macroeconomic and institutional risks increase when processes are offshored to particularly poor countries.

CEE is playing to its strengths in precisely those areas where communication between the purchaser and provider of outsourcing services is particularly important. This is often the case with more complex business processes. Moreover, the lack of IT specialization in CEE is less significant for typical back-office processes, such as bookkeeping. Their close geographical and cultural ties with the client make communication easier. This reduces misunderstandings and makes it easier to exchange complex and abstract information. Furthermore, many personnel in CEE have German and French language skills and can therefore service these markets more easily. Each company has to decide for itself how important it considers communication. It is to be expected that companies desire intensive communication with their clients regarding complex, innovative or creative processes. Inexperienced companies will pay closer attention to the offshoring relationship in the beginning and frequently seek reassurance. Simple, standardised services, by contrast, require less interaction. In these cases companies tend to base their decision on price, even if communication with the client is more complicated. A nearshoring location like CEE becomes more appealing as the intensity of the communication desired increases.

Parvis Hanson,
President of The Manor Group


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