LABOR ARBITRAGE: Is the Clock Ticking?

Business trends are fickle. They are difficult to predict. But
with the right data and analyses, they can be foretold, just like everything
else that's unpredictable. In case of a new area such as offshoring, where
equations are constantly changing, such predictions are always welcome.

Everest Research Institute's Offshore Market Report reveals
that if current conditions persist, labor arbitrage will sustain in most
offshore destinations for 30 years or more. The exceptions being Ireland where
arbitrage with the US will last for three to five years, and Canada, and Czech
Republic where it is expected to last for 8-20 years. Considering the brouhaha
around wage inflation and dipping labor arbitrage, these findings are bound to
gather a great deal of curiosity. And quite a few questions. But, Everest is
confident of their findings and very much aware of the skepticism surrounding
this issue. It is one of the reasons why they chose to study it further.

Elaborating about the research report, market research analyst,
Everest Research Institute, Sheetal Bahl says, "Sustainability of labor
arbitrage depends on a multiple set of factors. First of all, it depends on the
existing wage differential between the source city and destination cities, which
is different for different processes, skills and so on. Secondly, it depends on
wage inflation in the source city and wage inflation in the destination city.
Thirdly, it depends on the exchange rate differential, and finally on what is
called the hurdle rate."

Everest defines hurdle rate as the maximum wage ratio of a
destination country, beyond which the single most important attribute of the
offshoring value proposition-cost savings-is lost. For example, if Indian
wages reach 70% of the US wages-right now they are only 15-20%-offshoring to
India might no longer be profitable for companies in the US. However, one could
easily argue that, given the dropping cost of telecommunications and the
increasing efficacy of online collaboration tools, hurdle rate may be much
higher.

So the research looks at all these factors, also keeping in mind
the worst case. Even though they strongly believe that the worst case is
unlikely to occur, the report does predict the number of years labor arbitrage
will sustain even if a lot of things don't go as planned.

Bahl adds, "We conducted an extensive analysis, typically
of the last five years. We also did a fair amount of secondary research, talked
to service providers and tracked some other research reports."

Wage inflation in India has been reported to be 15-20%,
particularly within middle management positions. On the whole, wage increases
differ by process and level, with overall increases being much lower than
commonly reported figures. Historically at least, the depreciation of currencies
in destination countries has compensated for this, but going forward, is this
less likely? Bahl feels that concerns about wage inflation at the middle
management level will disappear with time, when the pool of employees at this
level increases, stabilizing the situation and settling inflation. The concern
according to him is about entry-level employees.

As for the weaker currencies getting stronger, there seems to be
little such possibility. Bahl explains, "In general, theory dictates that
the currencies of developed nations will continue to strengthen against the
currencies of developing nations."

However, there are swing factors that could potentially go
against offshoring. Take for example, market research firm Gartner's report,
which warns about a labor crunch and rising wages possibly eroding as much as
45% of India's market share by 2007. Then there is talk of political backlash,
which could, and probably would be a factor in determining the outflow of jobs.

Even though there's a very optimistic case for offshore
destinations, in the eventuality that labor arbitrage does disappear, countries
such as India still need not worry. Bahl warns against the tendency to equate
sustainability of labor arbitrage with sustainability of offshoring. He explains
with the example of productivity, how the offshoring value proposition is
becoming stronger. "We have seen from our engagements that productivity
improvements are becoming substantial. Some of our clients have over an
annualized basis seen 10% year-on-year improvement. In many cases, productivity
improvements offset wage inflation. Our viewpoint on sustaining of offshoring is
even stronger than our viewpoint on sustainability of labor arbitrage. This is
because we believe labor arbitrage itself is not a concern, and also there is
enough else going on for offshoring," he explains.

So all in all, the offshoring growth is anything but
short-lived. Countries such as India, the Philippines and others, have
attractive qualities beyond low-wage professionals for companies that want to
offshore their operations. India for example, in its 15 years of offshoring, has
developed a stable of world-class IT services providers that can save foreign
companies the trouble of setting up their own offshore centers. And it has a
large supply of qualified talent in areas outside IT, such as R&D, finance
and accounting, call centers, and back-office administration.

Anuradha Kher