WHEN Hal Sirkin was growing up in 1960s America, the bicycle that every regular American child wanted was a Schwinn. In 1993, Schwinn filed for bankruptcy. The firm had been overtaken by imported Chinese bicycles. In 2001, a company called Pacific Cycle bought the Schwinn brand out of bankruptcy. Pacific Cycle, now owned by a Canadian consumer-goods firm called Dorel Industries, says the secret of its success is “combining its powerful brand portfolio with low-cost Far East sourcing.” Schwinn bicycles now line the aisles at Wal-Mart.
Mr Sirkin is a consultant with the Boston Consulting Group who helps his customers do what Pacific Cycle has done to Schwinn: move production to East Asia, especially to China. Wal-Mart buys $15 billion-worth of Chinese-made goods every year. Obtaining goods and services from low-cost countries helps to build strong, growing companies, such as Dorel Industries, and healthy economies. But the Schwinn story also contains the opposite lesson: failing to buy in this way can seriously damage a company's health.
Sourcing from low-cost countries brings many economic benefits. Cheaper labour brings down production costs. This keeps companies competitive, raises profits and reduces prices as firms pass their lower costs on to their customers. Higher profits and lower prices lift demand and keep inflation in check. Companies spend their profits on improving existing products or introducing new ones. Customers buy more of the things they already consume, or spend the money on new goods and services. This stimulates innovation and creates new jobs to replace those that have gone abroad.
Moving work abroad may also help to speed up innovation directly, as American, European and Japanese companies get some of their R&D done by Chinese, Russian or Indian engineers. Randy Battat, the boss of Airvana, a telecoms-equipment start-up, has spent the past 18 months setting up an R&D centre for his company in Bangalore. This will complement the work of Mr Battat's engineers in Chelmsford, Massachusetts. The ones working in America will develop the next generation of the company's technology. The Bangalore centre will elaborate Airvana's existing technology. “They are adding bells and whistles that could not be added otherwise because it would not be cost-effective,” says Mr Battat.
By making IT more affordable, sourcing from cheaper countries also spreads the productivity-enhancing effects of such technology more widely through the economy. Ms Mann of the Institute for International Economics calculates that globalised production and international trade has made IT hardware 10-30% cheaper than it would otherwise have been. She reckons that this price reduction created a cumulative $230 billion-worth of additional GDP in America between 1995 and 2002 as more widespread adoption of IT raised productivity growth. Sourcing IT services (which account for 70% of overall corporate spending on IT) from countries such as India will create a “second wave of productivity growth”, predicts Ms Mann, as cheaper IT spreads to parts of the economy that have so far bought less of it, such as the health-care industry and smaller companies.
McKinsey calculates that for every dollar American firms spend on service work from India, the American economy receives $1.14 in return. This calculation depends in large part on the ability of America's economy to create new jobs for displaced workers. America's labour market is a miracle of flexibility: it creates and destroys nearly 30m jobs a year.
However, in countries such as Germany, France and Japan a combination of social legislation, stronger trade unions, regulations and corporate-governance arrangements make employment practices more rigid and sometimes keep wages higher than they would otherwise be. This reduces demand for labour and pushes unemployment higher. According to McKinsey, in Germany, the re-employment rate for IT and service workers displaced by sourcing from low-cost countries may be only 40%. As unemployment at home rises, that process could actually make Germans poorer (see chart 7).
Udo Jung of the Boston Consulting Group says that, by and large, Germans accept that manufacturing companies such as Hella, Bosch and Siemens must get supplies from China. Degussa, a chemicals manufacturer, recently invited its workers' council on a trip to China. The idea was to take emotion out of the debate, says Mr Jung. Nor do continental Europeans seem bothered about white-collar work being done in low-cost countries. But that may be because they are doing so little of it.
At present, perhaps 80-90% of the service work being done remotely in India comes from either America or Britain, with which the country has linguistic and cultural links. Such links are absent from its relationship with Germany or France. Germany, like America, introduced a special visa programme for Indian IT workers in the 1990s as its domestic supply of engineers ran dry. But most Indians that went to work in Germany failed to learn the language and came back again, says Infosys's Mr Murthy. The opposite is true of Indians in America. Those who have gone there to work or study are often reluctant to return home to their families.
Cultural ties appear to be important in forming business relationships in remote-service work, says Rajendra Bandri of the Indian Institute of Management in Bangalore. Mr Bandri has studied five examples of European firms outsourcing white-collar work to Sri Lanka. In each case, they chose that country because a well-placed Sri Lankan worked for the European firm, says Mr Bandri.
Eastern Europe and Russia, which brim over with skilled, underemployed engineers, present fewer cultural barriers for European companies. French is spoken in Russia, German in Hungary and elsewhere. Yet neither German nor French firms have yet shown much appetite for buying services work from their neighbours, either. Arkadiy Dobkin, the boss of Epam, which claims to be the largest supplier of IT services from eastern Europe and Russia, is based in Princeton, New Jersey, rather than in Paris or Berlin.
A survey of 500 European firms last summer by IDC, a research firm, found that only 11% of its sample were sourcing IT work from low-cost countries, and that nearly 80% would not even consider doing so. Attitudes were hardest in Italy, where 90% of firms were against the idea, followed by France and Germany. An American study released at the same time by Edward Perlin Associates, a consulting firm, found that around 60% of the companies it surveyed had some of their IT work done in low-cost countries.
In continental Europe, companies may outsource for reasons that have little to do with favourable economics, says Francis Delacourt, the head of outsourcing at Atos Origin. In what he describes as “social outsourcing”, firms such as Atos Origin may take on surplus IT employees from companies that no longer need them. Europe-wide social legislation requires the new employer to provide the same wages and benefits as the old one. The alternative is costly redundancy. Mr Delacourt says this works for his company, up to a point, because demand for IT workers in Europe is growing, and Atos Origin has found ways to re-employ such people profitably. But he concedes that his company needs to be careful not to take on too many.
How well this system stands up to competition from India is anybody's guess. A manager at one firm in Europe privately muses that Germany, France and other countries might introduce barriers to IT imports to counter the threat to their domestic employment. If McKinsey is right and sourcing from abroad does make unemployment in Germany and elsewhere worse, protectionist sentiment will grow.
In the end, Europe's big service firms are likely to get round to sourcing production from abroad, as its manufacturing companies have already done. But by that time, says Andrew Parker of Forrester, British and American companies will already have developed much stronger ties with India and other cheap countries, and costs will have risen. This will especially hurt Europe's big financial firms: the biggest banks spend billions of dollars a year on IT. Mr Parker speculates that some European financial firms could be so badly damaged by this loss of competitiveness that they may fall into the arms of fitter American and British rivals. Schwinn could tell them all about it.
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