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«Service Offshoring: Threats and Opportunities W hen asked to provide a framework piece on offshoring, I decided it would be much easier to have the ...»

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University of Toronto

Service Offshoring:

Threats and Opportunities

W hen asked to provide a framework piece on offshoring, I decided it would

be much easier to have the work done by an Indian consulting firm. A

quick bit of research turned up a perfect corporate partner. Not surprisingly, the

company has a London-based front end—it is a fact of the industry that many customers prefer to work through a Western intermediary. The company quoted the job at $63,000, no taxes. That’s about one-tenth of what an American man- agement consulting firm would charge, but still too rich for my academic salary.

So you are stuck with me.

The experience taught me two things. First, you can outsource abroad just about anything, from which I conclude that all of our jobs are threatened. Sec- ond, the big money in offshore outsourcing goes to the OECD business analysts who help customers communicate their needs to business process outsourcers in low-cost countries. I conclude from this that offshoring brings remarkable opportunities to us all. Therein lies the paradox of offshoring: it is both a threat and an opportunity.

In considering international offshoring, two trends scream out for our atten- tion. The first is the rise of China as the world’s manufacturer. Surprisingly, many American firms have yet to wake up to this sea change in their sourcing possibilities. Better information about the strategic offshoring options available to American firms is desperately needed. Aside from this, the rise of China’s I am indebted to Someshwar Rao and Prakash Sharma of Industry Canada for initiating this study and to both Runjuan Liu of the University of Alberta and Nathan Nunn of the University of British Columbia for help with completing this paper. Lael Brainard and Dani Rodrik provided many insightful comments, as did Susan Collins, who also provided extensive editorial direction.

Belinda Lobo cheerfully provided secretarial support. Industry Canada graciously funded most of this study. I am also grateful to the Brookings Institution for funding.

35 36 Brookings Trade Forum: 2005 manufacturing sector poses no new public policy issues. All the familiar argu- ments hold. On the one hand, international trade is disruptive for workers and firms engaged in import-competing industries. On the other hand, international trade provides the benefits of lower prices to consumers and offers new oppor- tunities for producers (both workers and firms) to expand into foreign markets.

In aggregate, the benefits outweigh the costs. What remains for policymakers is the crucial task of ensuring that we generously care for our most disadvantaged, since these unskilled workers are the ones who will bear the brunt of the Chinese offshoring onslaught.

The second extraordinary development in international trade has been the rapid growth of traded services involving innovative, technology-intensive processes and employing high-paid white-collar workers. In the past it was unheard of for low-cost countries such as India to be exporting high-value-added services. Now it is common to find Indian software programmers customizing sophisticated software applications for businesses worldwide. This development fundamentally alters the way we must think about innovation-based corporate strategy and public policies that affect the flexibility of the white-collar labor market.

The United States faces a choice. It can insulate itself from the global competitive pressures that come with offshoring to low-cost countries. Such policies will protect firms and workers in the short run. However, there is at least some weak evidence that protectionism retards growth.1 In addition, insulating policies will likely encourage foreign countries to deny us market access. Considering that the United States is a major supplier of traded services to the rest of the world, insular policies are about as useful as a blow-dryer in an igloo.

Alternatively, the United States can pursue domestic framework policies that promote the competitiveness of U.S. firms and workers. These framework policies would encourage productivity-enhancing investments both by individuals (for example, in human capital) and by firms (for example, in R&D and advanced technologies). The building blocks for globally competitive American firms are domestic policies that encourage continual investments in upgrading and innovation by individuals and firms. When it comes to the U.S. public policy response to offshoring, my best advice is: think globally, invest locally.

Finally, let’s not forget about compassion. The American government must be prepared to generously help its most disadvantaged, for they are at greatest risk from the downside of offshoring.

–  –  –

What Is Offshoring?

There is no universal definition of offshoring, and one task of the Brookings Trade Forum is to decide how broad a set of phenomena to examine. The approach taken by all commentators on offshoring is to attempt a careful definition. This is a natural but misguided approach. We must first start by identifying America’s broad public policy objectives and then identify which aspects of offshoring enhance or impinge on our ability to meet these objectives. In my view there are two complementary objectives: (1) promoting competitiveness and raising incomes; and (2) advancing core values of community and caring through redistributive policies. The most interesting policies are the few that promote both objectives. These objectives will help us delineate the boundaries of a discussion of offshoring by answering three definitional questions.

Offshoring, Nearshoring, Inshoring, or All of the Above?

As I have already stated, the most interesting aspects of new trends in the

tradability of services is the offshoring of technology-intensive, high-end services to low-wage countries. There are two other phenomena of interest:

(1) Nearshoring: Much of U.S. offshoring is nearshoring to Canada—for example, to a call center in Toronto that services customers in Chicago. Yet Canada is a country that is very close to the United States (whence nearshoring), and

more important, a country that is hardly a low-wage producer. (2) Inshoring:

The United States is a major supplier of traded services to the rest of the world.

This exporting of services or inshoring cannot be ignored. (Slaughter [2004] calls this “insourcing.”) Offshoring, nearshoring, and inshoring must all be examined.

Offshore Outsourcing or Foreign Direct Investment (FDI)?

“Offshore outsourcing” describes an arm’s-length transaction between a U.S.

firm and a foreign firm. In contrast, FDI describes a domestic firm with a controlling equity investment in a foreign establishment. Recent theories of international trade make it clear that the distinction between offshore outsourcing and FDI is intimately related to the question of whether the United States will retain the highest-paying jobs in the value chain or watch them migrate both to other OECD countries and to emerging low-cost countries such as China and India.

One cannot understand this process without looking at what is called the makeBrookings Trade Forum: 2005 or-buy decision—that is, the decision about whether to produce in-house using FDI or to offshore outsource using arm’s-length transactions.

In a nutshell, the new theories state that when a project is sufficiently routinized that it can be fully scoped or described, then outsourcing is the appropriate relationship with a foreign service provider. When the project is difficult to describe from its outset, it should be done in-house via FDI. For example, see Antràs (2005). The difficult-to-describe projects are typically the innovative projects that generate the highest value added. Thus we need to understand how firms choose between offshore outsourcing and FDI if we are to understand how to keep high-paying jobs in the United States.

My suggestion is thus to study both offshore outsourcing and FDI. Not all economists will agree. For example, Bhagwati, Panagariya, and Srinivasan (2004) argue that we should only be thinking about offshore outsourcing. On this one point, I think that Bhagwati, Panamanian, and Sinicising are wrong.2 It is fitting to develop this discussion of offshoring by providing examples of its pervasiveness and the difficulties of further definitional refinements.

Example 1. Traditional “mode 3” FDI in the service sector: Citibank sets up an office in Hong Kong that provides limited services to Chinese customers.

The office is staffed primarily by Chinese, and most of the key decisions are made in the United States.

Example 2. Traditional “mode 4” FDI in the service sector: A U.

S. architectural firm sets up an office in Shanghai to bid and work on local contracts. The firm sends its American architects to Shanghai on a long-term basis to do the design work. What distinguishes this from the previous example is that the control of decisions is largely in the hands of Americans who have temporarily migrated to Shanghai.

Example 3. The service-trade revolution using an FDI mode of entry: Verizon sets up an information technology (IT) center in Bangalore that hires Indian programmers to write software for Verizon’s U.

S. operations.

Example 4. The service-trade revolution with an offshore outsourcing mode of entry: Satyam (India) sets up a contact center that makes Wells Fargo VISA marketing calls to potential customers in Seattle.

The use of the term “mode” comes from the IMF (2005) Balance of Payments Manual and is used by all OECD countries in presenting their data.3

–  –  –

Table 1 provides many more examples of the types of activities that I believe we should focus on. These examples are classified into four areas: contact centers or what are commonly called call centers, back-office services, IT services, and other high-end services.

It is worth noting a problem with refining the definition of offshoring. Most of us would be comfortable with the following statement: “Manulife is offshore outsourcing development of its new human resources software to India, while the plastic products industry is importing shopping bags from China.” Why is one “offshore outsourcing” and the other “importing”? In both cases, products currently made in Asia were previously made in-house in America, and in both cases there has been phenomenal growth over the past five years. There are no good answers to this question.

Given this problem of definition (and other problems as well), finer definition of offshoring seems impossible. I therefore adopt the approach of U.S. Supreme Court Justice Potter Stewart in his attempt to define pornography: I can’t define it, but I know it when I see it.4 stays in his or her own country. Mode 2: The consumer moves to the supplier’s country to obtain the service. Mode 3: The supplier sets up a foreign affiliate in the consumer’s country.

Mode 4: The supplier supplies the service by moving to the consumer’s country. For more, see International Monetary Fund, Balance of Payments Manual (www.imf.org/external/np/sta/ bop/BOPman.pdf [2005]).

4. Jacobellis v. Ohio, 378 U.S. 184 (1964).

40 Brookings Trade Forum: 2005

Occupations or Industries?

What makes manufacturing interesting is the dramatic rise in manufacturing exports from low-cost countries, especially China. This export surge has already had a large impact on America’s least-skilled workers in industries such as garments. See Feenstra and Hanson (1996, 1999) and Trefler (1998). It is now poised to threaten America’s moderately skilled workers in such industries as auto parts. However, to my mind these developments pose no new public policy issues that have not already been discussed in the context of conventional import competition. The reason it is not new is that it affects occupations that have always been impacted by international trade.

On the other hand, the revolution in the world’s ability to trade in services is something new. At least some of the new service trade involves highly skilled white-collar workers operating in low-cost countries such as India. Successful policy responses aimed at assisting skilled labor will likely be very different from policy responses aimed at assisting less-skilled labor. This distinction has had no play in the offshoring debate but is likely crucial for reasons to be explained below. Thus, service offshoring poses new policy challenges not raised by manufacturing offshoring because it involves white-collar workers.

My view will find critics. Most researchers argue that the rise of China as the world’s manufacturer poses such important challenges that it must be included in every discussion of international trade policy. I look forward to a healthy debate of this point.

Another problem with focusing on industries rather than occupations stems from recent changes in traditional manufacturing. With the offshore outsourcing of back-office jobs by manufacturing firms, we tend to think that the line between manufacturing and services is becoming cleaner. However, the opposite is also happening. When Microsoft introduced its Xbox game player, it hired Singaporebased Flextronics (the contract manufacturing giant) to build a factory in lowwage Guadalajara, Mexico, that was supplied with standardized parts from China. Design of the core proprietary technology was outsourced to Nvidia Corp.

of the Bay Area and manufactured in Taiwan. Clearly, Xbox could not have been brought to market in this way without tremendous logistics support. As such, Xbox is a manufactured product that embodies a significant service component.

This example is commonplace. Accenture (2004) reports that 43 percent of its customers outsource their supply chain management. This reflects the rise of contract manufacturers that both manufacture and provide manufacturing service support. Thus, in many respects traditional industry distinctions are blurring.

Focusing on occupations is much cleaner and more useful for policy.

Daniel Trefler 41

White-Collar Workers and the New Trade Issues Raised

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