Developing ICT and professional services offshoring opportunities should be a high priority for development oriented countries such as Sri Lanka. Not only will the development of this industry segment create job and export opportunities, it will also create positive spillovers such as: enhanced incentives for education, technology and knowledge transfer, environmental protection and an improvement in the quality of locally provided services.
Almost all the current demand for offshored services comes from developed countries. On the supply side, India is by far the largest player in the offshored services industry closely followed by China, Mexico and Brazil. At the moment services trade remains geographically segmented with Latin American companies serving North America and Eastern European countries serving Western Europe. Services that will be offshored in the future will go far beyond the traditional callcenters and back-office functions and will include; investment and financial services, human resources, health services, retail functions, logistics and customer support functions. It is estimated that this will result in 18 million jobs being offshored with a multiplier effect that could in turn create a further 60 million jobs in developing countries.
Initially firms moved parts of their operations to offshore locations to reduce operating costs, reduce their capital requirements and to increase productivity, global competitiveness and operational efficiency. Increasingly firms are also moving offshore to tap into the global pool of talent to source skills that are in short supply domestically, reduce their time to market and deepen their local knowledge. Countries wishing to attract offshored investments must therefore offer a politically and economically stable climate, a low cost structure, an educated workforce that is open to innovation and a sound infrastructure.
Sri Lanka boasts some of the cheapest labor and office rental costs in the region but it remains hampered by high telephone and electricity charges as well as rigid labor legislation. Due to its population size, the island cannot offer the sheer numbers of ICT and professional employees that India and China can. It cannot compete easily to develop generic call centers or R&D facilities. The most promising strategy for Sri Lanka lies in developing the niche market area of common corporate functions including; HR, legal, finance and accounting and IT services. Sri Lanka is also well poised to provide disaster recovery and business continuity services to companies currently offshored in India.
A successful strategy to promote offshored services would include; completing the unfinished telecom reform agenda, improving regulatory quality and competition to reduce prices, expanding internet access and usage by rolling out a reliable fibre-optic network (as India has done), increasing electricity generation and reducing tariffs and in the long term expanding access to scientific and technical tertiary education (as realized in both India and China).
Government can also consider mobilizing the Sri Lankan diaspora interested in investing on the island, providing tax incentives to the industry, providing incentives for training and supporting the branding and marketing efforts of the local industry.
A. What is Professional Services Offshoring?
Outsourcing occurs when one company delegates responsibility for performing a function or series of tasks to another company. When the second company is based in another country, outsourcing becomes offshoring. Offshoring was previously concentrated in the manufacturing sector as firms in developed countries offshored production tasks to developing countries in an effort to reduce costs and minimize expensive capital asset investments. The recent dramatic improvements in information technology (IT) and decreasing costs of data transmission have extended this concept to the tradability of services. Professional services offshoring has become a popular strategy for firms looking to streamline costs, improve customer service and focus their resources on enhancing their core competencies. Services offshoring now encompasses a wide array of export-oriented services spanning the entire value chain.
Figure 1 highlights the four main segments of the outsourcing market. Once a company chooses a particular service to outsource, it faces two key choices. The first choice involves choosing between an offshore or onshore location, while the second choice revolves around whether the actual provider should be a captive unit of the firm or an outside party.
The matrix on the left provides the actual sizes of each of these market segments in 2001.3 This paper focuses on the offshored services (the shaded part of the figure) since it analyzes the specific development potential for Sri Lanka as a lower cost high quality service provider to firms based in foreign countries.
The size of the global offshoring market in 2001 was around the US$32 billion mark and growing rapidly. However, captive offshoring is more than twice as large asoffshore outsourcing. This is largely because firms like to maintain control of their operations especially those concerned with sensitive proprietary information. Many firms do not want to reveal inside information about their strategies and processes, particularly those whose products rely on large R&D expenditures, patent protection and original intellectual property rights. Other firms also find the contract procedures involved in hiring an outside party to be more complicated than those required to set up a subsidiary operation.
B. How Can Services Offshoring Reduce Poverty?
Services as a Stimulant of Growth Economic growth is a critical factor in poverty reduction and service trade provides a key engine for this type of growth. In countries that have grown quickly and have been able to sustain high growth rates over long periods, services have been responsible for much of that growth, generally growing much faster than other sectors of the economy. Even in countries that experienced a rapid growth of manufactured exports there was also a parallel and rapid growth in services. The service sectors, from finance and accounting to IT and advertising, also provide valuable inputs to the manufacturing sector that it needs to compete effectively in global markets in terms of quality, flexibility and reliability. The GDPs of high income countries derive a substantially higher percentage of value added from the services sector as figure 2 below illustrates.
Services trade enables developing countries to potentially leapfrog the industrial development stage. 
The economic models of the past assumed that countries grew by creating an agricultural surplus and borrowing to invest in manufacturing capital. Only when countries went through the industrial stage of development could they consider a focus on services, as domestic demand for such services was still nascent and services trade was non existent.
The communications revolution of the last decade now permits lower income countries to leapfrog that stage of development and directly focus on expanding the service sectors of their economies. The technology itself does not depend on first building a solid industrial base: mobile telephones don't rely on an extensive network of landlines. And countries that have not yet invested heavily in old technologies can simply choose to by-pass it. For instance, Sri Lanka now has more mobile phone subscribers than those with landlines.
The global market for offshoring is growing at 30 percent per annum. While world trade has 
been expanding at a rate of 6.9 percent annually for both services and manufacturing over the last twenty years, the offshoring of services to developing countries, although still small in absolute terms, has been growing at a much faster rate. McKinsey projects a annual growth rate of 30 percent from 2003 to 2008 which would raise the offshore market's share of services trade from 3 percent to 10 percent during this five year period (see Figure 3).
The contribution of services offshoring to the GDPs of provider countries has increased substantially over the last few years. As a pioneer and leader within the offshoring market, India has benefited tremendously from growth in this area while growth has exceeded all expectations. "In the fiscal year that ended March 2003, India's IT industry revenue was $12 billion, and $9.5 billion of this was from offshored IT projects and services" It is predicted that the country's IT-
enabled services exports will reach $20 billion by 2007 and make up over half of all Indian IT exports.
International Data Corporation has predicted that the global IT-enabled services market will account for revenues of US$1.2 trillion by 2006.
For small countries like Sri Lanka, the contribution of outsourcing as a percentage of GDP could be particularly pronounced despite the relatively smaller dollar value of the industry.
The percentage of the total workforce engaged in services is expanding at a rapid pace. "While the share of workers employed in service activities is about 30 percent in developing countries as a group, it has reached 53 percent in some developing economies (the informal sector comprises a large portion of this figure in the case of many developing countries) and hovers at around 70 percent in most developed countries." In the US, for example, 83% of the US non-farm employment was in services, with only 11% in manufacturing during the fourth quarter of 2003. Additionally, the expansion of jobs was focused in the services sector with more than 97% of the jobs added to US payroll being service related during the 1990s. In Sri Lanka, services account for 44 percent of employment and more than 55 percent of GDP.
Services offshoring expands employment opportunities in developing countries. In terms of job creation, the growth in offshoring to India has created a significant number of jobs. IT-enabled services are projected to employ up to 1.1 million people by 2008 and 3.3 million by 2015 and in the software services industry alone, direct job creation is forecast to reach 2.2 million by 2008.There is also evidence that since many IT related jobs are relatively well paid, each new position generates a further 3 jobs in the rest of the economy a highly desirable impact that does not accompany the development of low-end manufacturing jobs.
Women are considerably advantaged by offshoring opportunities. The ability to complete more responsibilities from remote locations that might be located in or closer to their homes has allowed more women to enter the offshoring workforce. For instance, 49 percent of Wipro's (a large Indian offshoring company) workforce is female, while ICICI OneSource's workforce is 60 percent female." With female education and literacy at par with that of males in Sri Lanka, the country is well positioned to take advantage of this potential.
Offshoring, especially captive offshoring, provides a significant contribution to FDI. In turn, FDI is often directly linked to economic growth because of the increased income sources and jobs generated which subsequently reduce poverty. FDI also generates several indirect benefits that increase the productivity of the recipient economy through the adoption of managerial and technical best practices from foreign countries. In recent years, there has been a documented shift of FDI towards the services sector. The world's inward stock of FDI in services quadrupled between 1990 and 2002 while the share of services in the world's total FDI stock rose from 25% in the 1970s to about 60% in 2002.
Services accounted for about 85 percent of outward FDI stock for developing countries, in 2001. FDI flows in services between developing countries themselves are growing even more rapidly than those between developed and developing countries. "By 2010, more than one-third of the FDI in developing countries will originate in other developing countries with India, China, Brazil, and South Africa being among the main players."
Offshoring's Positive Spillover Effects
While FDI stimulates productivity improvements in general, services outsourcing has several specific characteristics that create unique spillover benefits and positive externalities for developing economies. These defining features differentiate services outsourcing from the traditional fields of manufacturing and goods outsourcing.
Incentives are created for education. While outsourced manufacturing relies on a cheap, low-skilled workforce, services outsourcing relies on a well educated and highly skilled workforce. The employment of a relatively skilled labor force in services trade increases the return to education and, thus the incentives to acquire skills that are marketable in the global economy. This is likely to become a critical issue for long-term growth, especially in a country like Sri Lanka that has already achieved universal literacy. Services offshoring has the potential to mitigate Sri Lanka's perennial problem of educated unemployed youth as well as reverse the country's significant brain drain.
The quality of exported services improves which benefits domestic consumers, especially manufactured goods exporters, of the same services as well. For instance, call centers in developing countries that are established to cater for the US market are also being operated round the clock to provide services to local customers. The same is happening in Sri Lanka with recently established call centers providing local services to the whole of Sri Lanka.
Technology and knowledge transfer results. Services exports and outsourcing require technical sophistication. For example, it is necessary to have dependable and cheap communication links with the rest of the world. Repeated and frequent interactions with foreign firms and, especially, their direct presence, also increases knowledge transfers. This is not limited to technical knowledge but includes business standards and managerial know-how which are critical for integration of national economies into the global economy and factor prominently in the long-run growth implications for any developing country.
Improvements in human capital. Export-oriented zones have been shown to improve the quality of human capital and the productivity of the local workforce in domestic economies "if foreign investors engage in substantial training and if the workplace encourages learning by doing, as in Singapore and the Philippines. Furthermore, learning can also occur at the managerial and supervisory level, thus potentially fostering local entrepreneurship. This is important since firms in developing countries often lack the production and marketing know-how required to enter world markets."
The processes tend to be more environmentally friendly. Services exports and outsourcing do not create many of the negative externalities associated with manufactured goods, such as environmental pollution and lower labor standards. The effects of this type of environmental degradation are often ignored since it is hard to quantify these negative externalities and the actual consequences are only revealed over a long period of time.
C. Describing the Services Offshoring Market
Who Demands Offshored Services?
Developed countries provide the majority of 
demand for offshored business services. The United States alone accounts for 3.3% of worldwide commercial services imports. The planned use of offshore outsourcing among corporate decisionmakers in the United States rose by a factor of six between 2001 and 2003.
A similar trend appeared in the data from a 2004 survey of the top 500 European firms where the responding companies had already offshored about 20,000 jobs and 44 percent of all those surveyed said that they intended to increased this number in the near future.
Who Supplies Offshored Services?
On the provider side, India has emerged as the leader in the international offshoring market with as much as 80 percent of the market. This performance is largely due to its large English-speaking, skilled workforce and salaries that are up to 80 percent lower than those in developed countries. However, as a larger number of firms look to diversify their service sources to prevent dependence on a single provider, more countries are competing to gain a bigger share of the expanding market. It is estimated that more than 4,000 companies in 150 countries are now competing to offer offshores services to a handful of wealthy nations. Popular locations for offshoring in Asia include China and the Philippines.
Geographical proximity certainly contributes to the choice of offshoring destination, particularly when the functions being outsourced increase in complexity. In these cases, Eastern Europe is a particularly attractive option for Western European firms while some North American enterprises choose to outsource to Mexico or Canada. This indicates the creation of specific niche markets in the services outsourcing arena which can allow countries aiming to provide outsourcing services to concentrate their marketing efforts on relevant regions. Figure 6 also illustrates that countries that are not low-cost destinations such as Canada, Austria and Ireland have also been successful in attracting offshored businesses. The lesson for developing countries is clear - that although cost is an important factor it is certainly not the only criterion that firms consider when making a site selection.
Offshored Services Market Segmentation
The range of business processes being offshored is continually expanding. Business processes can generally be classified vertically by sector (e.g., manufacturing, retail, financial services, etc.) or horizontally by the types of tasks and functions performed. A recent McKinsey study provided the theoretical maximum global resourcing in eight major sectors of the global economy. The findings indicate that up to 11% of worldwide service employment could theoretically be performed remotely.
The study also projects that the offshore employment in each of the eight sectors analyzed will double by 2008. In 2003, 565,000 services jobs in the eight sectors studies were performed in low-wage countries for clients based in developed countries. This number is expected to surpass 1.2 million by the year 2008. While the retail and health care sectors show reduced growth potential due to the high amount of complex customer facing functions involved and physical proximity constraints, the study estimates that the packaged software and IT services industries "will offshore 18 percent and 13 percent of their high-wage employment demand, respectively, by 2008".
The offshoring market can also be segmented by function. In general, back office functions that require a decreased amount of customer contact have the most potential to be performed in a remote location. The popularity of call centers, IT service, and backoffice functions as outsourcing opportunities further supports this data.18 Most professional services offshoring clients require university degrees but the skill level still varies across the range of functions that are typically outsourced. While R&D responsibilities require an extremely highly skilled pool of labor, common corporate functions require less specialized industry knowledge.
As Figure 8 illustrates, a market segmentation can quickly highlight which the most promising areas for offshored services. In addition to developing a local call center industry which is beginning to emerge, Sri Lanka can also consider developing niche areas such as back office functions and customer service and support functions. An easy way to do this is to start with international companies that have already offshored their manufacturing plants in Sri Lanka and offer to take over other parts of their value chain. A review of Sri Lanka's potential vis-à-vis the drivers for services offshoring and potential strategies to take advantage of this global trend is presented in the following sections. D. Sri Lanka and the Drivers for Services Offshoring Growth
Why do companies offshore? What makes a particular location attractive for offshoring operations? And what can Sri Lanka do to brand itself as an offshoring hub? This section attempts to shed light on these questions.
Why do companies offshore?
The primary reason firms engage in offshore processing is to reduce labor costs. Due to increased competitive pressures, companies are constantly seeking ways to minimize costs. "With revenues largely stagnant since 2000, firms are under intense pressure to cut costs while retaining service levels." Since salaries comprise a significant portion of variable costs, offshoring of business processes can provide sizeable savings to firms in developed countries. The findings of a technology research firm indicate that organizations that offshore accounting and customer service functions to China can possibly save 30 to 50 percent in labor costs when compared to executing those same processes in Tokyo, London, or Chicago. To give a specific industry example, a leading ebusiness software company in the United States was reportedly able to achieve 40 to 45 percent lower costs per overseas employee by outsourcing to programmers in India who earn as little as one third of what their counterparts receive in the United States. Firms can also reduce capital costs through a successful offshoring strategy. In the case of professional services, an industry study conducted for the United States shows that, of the approximately $1.45 - $1.47 of value derived from every dollar spent offshore, US firms receive $1.12 - $1.14, while supply firms receive 33 cents of value.
Firms can increase productivity and competitiveness through various channels. Offshoring generic business processes allows firms to focus on their core competencies and increase innovation initiatives. This often enables firms to expand their operations and broaden their customer base. "For instance, tax authorities in high-cost countries can at present afford to check only a small number of tax declarations every year; by shifting some work to lower cost locations, they could raise the audit ratio significantly and improve their intake." Firms can also offer a wider range of services offered at a faster rate than if they managed all operations in-house. By offshoring certain business processes, multinational companies can operate on a round-the-clock schedule which can accelerate the delivery of work products, improve customer satisfaction, and reduce costs.
Organizational restructuring to achieve greater operational efficiencies is another consideration when resorting to offshoring as a business strategy. Process performance is often improved because the service providers in developing countries often have very specialized experience in performing the unique operations that they are hired to execute. In some instances, offshoring also presents an opportunity for better risk management and diversification which can reduce firm liabilities and direct responsibilities.
While benefiting from the advantages offered by offshoring, companies must also be able to manage the inherent risks. A strong internal governance system is necessary to effectively monitor the deployment of resources between offshored and local sites. It is also crucial to maintaining high quality standards despite the geographical barriers that accompany offshoring. Companies characterized by highly unionized work forces must also be careful to balance the political opposition that might accompany any decision to offshore certain service functions. Aside from handling this domestic risk, the outsourcing firm must also consider the geopolitical risk in the chosen offshore location.
What makes a particular location attractive for offshoring?
What does it take to attract offshoring operations? In 2004, A.T.Kearney constructed an Offshore Location Attractiveness Index to evaluate countries around the world. The index consists of three major categories including financial structure, people skills and availability, and business environment. Since cost advantage was determined to be the primary driver of offshoring decisions, financial structure was assigned 40% of the total weight, while people skills and business environment each accounted for 30% of the remaining weight.
There are several factors to consider in determining how strong any given country is in each of these categories. Although this paper uses the same categories and weights as defined through A.T.Kearney's Offshore Location Attractiveness Index, some modifications have been made to sub categories and metrics in order to benchmark Sri Lanka against its regional competitors with available data. A summary table of the criteria used to evaluate Sri Lanka's potential in comparison to other countries providing offshore services follows. The remainder of this section reviews:
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