China and India: The race to growth

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China and India: The race to growth

The world’s two biggest developing countries are taking different paths to economic prosperity. Which is the better one?

Diana Farrell, Tarun Khanna, Jayant Sinha, and Jonathan R. Woetzel

The McKinsey Quarterly, 2004 Special Edition : China today

First it was China. The rest of the world looked on in disbelief, then awe, as the Chinese economy began to take off in the 1980s at what seemed like lightning speed and the country positioned itself as a global economic power. GDP growth, driven largely by manufacturing, rose to 9 percent in 2003 after reaching 8 percent in 2002. China used its vast reservoirs of domestic savings to build an impressive infrastructure and sucked in huge amounts of foreign money to build factories and to acquire the expertise it needed. In 2003 it received $53 billion in foreign direct investment, or 8.2 percent¹ of the world's total—more than any other country.

India began its economic transformation almost a decade after China did but has recently grabbed just as much attention, prompted largely by the number of jobs transferred to it from the West. At the same time, the country is rapidly creating world-class businesses in knowledge-based industries such as software, IT services, and pharmaceuticals. These companies, which emerged with little government assistance, have helped propel the economy: GDP growth stood at 8.3 percent in 2003, up from 4.3 percent in 2002. But India's level of foreign direct investment—$4.7 billion in 2003, up from $3 billion in 2002—is a fraction of China's.

Both countries still have serious problems: India has poor roads and insufficient water and electricity supplies, all of which could thwart its development; China has massive bad bank loans that will have to be accounted for. The contrasting ways in which China and India are developing, and the particular difficulties each still faces, prompt debate about whether one country has a better approach to economic development and will eventually emerge as the stronger. We recently asked three leading experts for their views on the subject; their essays may be accessed on the pages that follow or by clicking on the titles below.

—Jayant Sinha

India's entrepreneurial advantage
China has shackled its independent businesspeople. India has empowered them.

China: The best of all possible models
In an efficient market, the private sector is better than governments at allocating investment funds. But China isn't an efficient market, and India has relatively little investment funding.

Sector by sector
The strength of the Chinese and Indian economies will actually be decided at the industry level.

About the Authors

Jayant Sinha is a principal in McKinsey's Delhi office. Tarun Khanna is the Jorge Paulo Lemann professor at the Harvard Business School. Jonathan Woetzel is a director in McKinsey's Shanghai office. Diana Farrell is the director of the McKinsey Global Institute.

Notes

¹ The United Nations Conference on Trade and Development (UNCTAD) database on foreign direct investment.

India's entrepreneurial advantage

China has shackled its independent businesspeople. India has empowered them.

Tarun Khanna

China and India have followed radically different approaches to economic development. China's resulted from a conscious decision; India more or less happened upon its course. Is one way better than the other? There is no gainsaying the fact that China's growth has rocketed ahead of India's, but the conventional view that the Chinese model is unambiguously the better of the two is wrong in many ways; each has its advantages. And it is far from clear which will deliver the more sustainable growth.

Together with Yasheng Huang, of the Sloan School of Management, at the Massachusetts Institute of Technology (MIT), I have argued that these approaches differ on two dimensions. First, the Chinese government nurtures and directs economic activity more than the Indian government does. It invests heavily in physical infrastructure and often decides which companies—not necessarily the best—receive government resources and listings on local stock markets. By contrast, since the mid-1980s the Indian government has become less and less interventionist. The second dimension is foreign direct investment. China has embraced it; India remains cautious.

These differences have an impact on the types of companies that succeed and, I would argue, on entrepreneurialism. Let's look first at what kinds of companies thrive. China trumps India when it comes to industries that rely on "hard" infrastructure (roads, ports, power) and will do so for the foreseeable future. But when it comes to "soft" infrastructure businesses—those in which intangible assets matter more—India tends to come out ahead, be it in software, biotechnology, or creative industries such as advertising.

Thus manufacturing companies whose just-in-time production processes rely on efficient road and transport networks fare poorly in India. But businesses that are unconstrained by shortages of generators and roads flourish. Soft assets underpin even the Indian car industry. Unlike China's car sector, which has expanded as a result of big capital investments from multinational companies, India's has succeeded on the back of clever designs that make it possible to produce cheap indigenous models. India actually sends China high-value-added mechanized and electronic components whose production depends more on know-how than on infrastructure.

Moreover, many hard-asset companies in China exist because the government funnels money to them. The government can do this because it intervenes in domestic capital markets. In India there is no such government intervention. Hence successful companies tend to cluster in industries where capital constraints are less of an issue. You don't need a deep reservoir of capital to start a software company; you do for a big steel plant.

The Indian government's lower level of intervention in capital markets and its decision not to regulate industries that lack tangible assets (software, biotech, media) have created room for entrepreneurs. Entrepreneurial activity is fueled both by incumbent (often family-owned) enterprises and by new entrants. The former use cash flows from diverse existing businesses to invest in newer ventures. In biotechnology, however, Biocon emerged from pure entrepreneurial effort, as did Infosys Technologies in software. Similarly, hundreds of smaller versions of companies such as Infosys and Wipro Technologies have no government links, unlike so many of China's successful companies.

Although India's stock and bond markets are hardly perfect, they do on the whole support private enterprise. Here too, entrepreneurialism has played a part, even improving India's institutional framework. Take the Bombay Stock Exchange (BSE), founded about 130 years ago and until recently the most inefficient entity imaginable. It has become radically more efficient in the past decade as a result of the competing efforts of an enterprising former bureaucrat named R. H. Patil. With technological inputs from around the world and some fancy footwork to dodge entrenched interests at the BSE, in 1994 he started a rival institution, the state-of-the-art National Stock Exchange of India, which now has more business. In China, by contrast, the government tries to make stock markets successful by command, with predictably little to show for its efforts. There has been little competition indeed between the Shanghai and Shenzhen exchanges.

Good hard infrastructure and the Chinese government's decision to welcome foreign investment make it reasonably easy for multinationals to do business in China, and since they bring their own capital and senior talent, they do not have to rely heavily on local institutions. China has no shortage of homegrown entrepreneurial talent. But indigenous companies have a much tougher time, hindered as they are by inefficient capital markets, a banking system notorious for bad loans, and the fact that local officials rather than market forces largely decide who receives funding.

The pros and cons of these two models should be studied, and it is fair to ask whether China's will hamper its economic development

China and India both have the ability to keep growing in their own very different ways for a decade or so. The Chinese government's intervention in the economy—including the decision to welcome foreign direct investment—has brought a material improvement in the standard of living that India hasn't enjoyed. It may also be that each country has chosen the path best suited to its own historical circumstances. But the pros and cons of these two development models should be studied, and it is fair to ask whether China's approach will hamper its future economic development.

Huang and I believe that the presence of so many self-reliant multi-national companies has partly relieved the Chinese government of pressure to develop or reform the institutions that support free enterprise and economic growth. And the fact that many domestic investments still are not allocated through sensible pricing mechanisms means that China wastes many of its resources. Productivity and long-term economic growth, as we all know, thrive on competition, which is all too often stifled by government intervention.

When the two countries are compared, it is easy to forget that India began its economic reforms more than a decade later than China did. As India opens up further to foreign direct investment, we might well discover that the country's more laissez-faire approach has nurtured the conditions that will enable free enterprise and economic growth to flourish more easily in the long run.

About the Author

Tarun Khanna is the Jorge Paulo Lemann professor at the Harvard Business School.

China: The best of all possible models

In an efficient market, the private sector is better than governments at allocating investment funds. But China isn't an efficient market, and India has relatively little investment funding.

Jonathan R. Woetzel

Finding fault with China's approach to economic development is easy: cyclical overcapacity, state-influenced resource allocation, and growing social inequalities are just a few of its shortcomings. But it's hard to see how any other model could have given the economy such a powerful kick start.

The Chinese government manages the development of enterprises with a view to driving economic growth. You can be a small entrepreneur in China, but if you want to be big you will have to get money from a government-affiliated source at some point. Government officials essentially have the power to decide which companies grow.

In achieving the objective of growth, this policy has been tremendously successful. China has quickly built industries large enough to drive its economy. Take the auto industry, now an important contributor to the manufacturing sector. Only 20 years ago, China had no auto industry to speak of; there were a few manufacturers of trucks but none of passenger cars. To get started, the government decided that in a high-scale, high-tech industry, some foreign company—in this case, Volkswagen—had to come in and show local ones what to do. Because most local companies were state-owned 20 years ago, Volkswagen was hooked up with a state-owned company.

You might argue that this development model has thwarted entrepreneurship. But there weren't any entrepreneurs in the industry at the time. There were no private companies that could partner with Volkswagen, let alone compete with it. The government simply said, "We want China to modernize. We want the Chinese economy to grow. We don't have the companies we need to make that happen, so we're prepared to do what it takes to create them."

The capital-intensive auto plants built with foreign partners in China as a result of its development policy may have no particular productivity advantage over the plants they might have built at home. But all of the spending by the big car companies has paid off.

Moreover, local, privately owned automakers such as Chery Automotive and Geely Automotive are beginning to thrive. A generation of entrepreneurs has put to good advantage the skills and training that the foreigners provided, so that Chinese companies now put together cars of reasonable quality much more cheaply than foreign automakers can. At present, domestic players benefit from the price umbrella that the foreign ones provide. But these smaller fry are now making cars for $2,000, which means that any company that has high cost structures will eventually suffer. With lower tariffs on the way because of China's accession to the World Trade Organization, and with new competitors proliferating, the automotive industry is heading into a classic price war that only the fittest will survive. This is precisely what happened in the consumer electronics industry, where competition led to the emergence of successful Chinese companies that operate globally. I think that in five or ten years' time, at least a third of the Chinese auto industry will be completely private—nothing to do with the current state players. And this will all have started with the state saying, "We want to build a car industry."

Looking at industry more broadly, inefficiencies and cyclicality have resulted from the fact that many funding decisions are driven at the local-government level. Local officials have GDP growth as a political-performance target, so many of them look for the biggest investments they can make to push along the regional economy. Like stock market investors pursuing the latest speculative fad, they have created a lemming effect, with lots of unsound investments, whether in aluminum smelters, residential real estate, or TV factories. The outcome tends to be waves of overcapacity as investments are made right up to—and sometimes way beyond—the point where it is patently obvious that the economics cannot justify them.

But remember that the essential mechanism of economic reform in China has been the encouragement of competition among provinces and municipalities. Until the 1980s there was no such thing in China as a national company. Everything was local. There was no single legal entity that operated more than five kilometers (about 3.1 miles) from its headquarters. With the removal of internal trade barriers, local entrepreneurs and their government backers invested to build scale and attack neighboring markets. Yes, this does lead to overcapacity and price wars. But over time—and relatively short periods of time, too—all that cyclicality also leads to shakeouts that the most competitive enterprises survive. These enterprises, thanks to their national scale and real competitive advantages, no longer depend on local-government funding and can now start to compete for the long term, both domestically and internationally.

That has certainly been the story in consumer electronics, where the top three players in personal computers control 50 percent of the domestic market, and in beer, where the top ten own 30 percent. It is starting to be the story in heavy industries, where companies such as China Qianjiang own 40 percent of the motorcycle market and Wanxiang dominates its niche in automotive components (see "Supplying auto parts to the world," available on mckinseyquarterly.com on September 16). Interestingly, it is not the foreign companies but the locals that tend to be the winners of the consolidation wars. The beer industry is a case in point: most foreign brewers, unprepared for tough domestic competition and rapid consolidation, entered and exited in the 1990s.

The government is fixing the banks through tough higher reserve margins, branch-level changes, and more flexible risk-based pricing

Moreover, I don't believe that foreign direct investment is linked to the development of China's capital markets or to a reform of the banking system. Multinationals account for only 15 percent of fixed-asset investment, so they don't drive the economy to a very great extent. China must rely on its own domestic financial resources to finance growth. As a result, the country's capital markets are being developed. And the government is fixing the banks through tough higher reserve margins, branch-level changes in performance management and incentives, and more flexible risk-based pricing.

As for the oft-stated view that China is trying to create global state-owned champions, it is at least partly a myth. The government does want to develop strong Chinese companies, but it does not expect them to be state enterprises, which are inefficient by definition. Indeed, it is now telling them that if they want to grow, they will have to get listed on the stock market. The government's policy for the first 20 years of its reform program was, "Let's do what's needed to establish markets." Its policy for the next 20 years will be, "Let's get out of those markets." The global Chinese companies of tomorrow will be competitive, mostly listed, and entirely commercial in their aims and purposes.

Ultimately, you have to ask whether the inefficiencies of the Chinese approach outweigh what it has achieved for the economy overall. The answer, I think, is no. The government still controls most of the country's financial resources and has been reasonably good at allocating them—that's why the economy has grown so fast. Compared with the private sector in an efficient market, the government is no doubt worse at allocating funds. But China is not an efficient market, and the Indian model—essentially one with relatively little investment funding, whether by the government or the private sector—could not have achieved as much growth for the Chinese economy as the approach China's government actually took. The Indian model might not be adequate for India's economy either: the country's family-owned businesses and other private investors may be good at deciding what makes a sound investment for them, but they have not spent enough money to drive the kind of growth seen in China. It would not surprise me at all to see investment in India rise dramatically as foreign and domestic investors alike begin to recognize its potential going forward.

About the Author

Jonathan Woetzel is a director in McKinsey's Shanghai office.

Sector by sector

The strength of the Chinese and Indian economies will actually be decided at the industry level.

Diana Farrell

The answer to the question, "Which is the better approach to economic development?" is not to be found at the national level. You have to look at what's going on in individual industries. And when you do, you find that supportive government policies that encourage competition drive good performance. Both China and India have some sluggish, inefficient industries that are heavily regulated and lack competitive dynamism. But both countries also have successful industries that thrive unfettered by poor regulation.

The McKinsey Global Institute has long argued that the key to high economic growth is productivity and that the main barrier to productivity gains is the raft of microlevel government regulations that hinder competition. This idea is well illustrated in the case of India.

At the high end of India's productivity spectrum is the information technology, software, and business-process-outsourcing sector. It's a big success story, having created hundreds of thousands of jobs and billions of dollars' worth of exports. As a new sector—and one whose potential the government, in my view, failed to recognize early on—it has avoided stifling regulation. IT, software, and outsourcing companies are exempt from the labor regulations that govern working hours and overtime in other sectors, and they have been allowed to receive foreign direct investment, which is prohibited in retailing, for example. Without this foreign money, it is debatable whether the sector could have taken off. By 2002 it already accounted for 15 percent of all foreign direct investment in India.

In the middle of the spectrum is the auto industry, which has seen dramatic change since the government began to liberalize it in the 1980s. By 1992 most of the barriers to foreign investment had been lifted, and this made it possible for output and labor productivity to soar. Prices have fallen and, even as the industry has consolidated, employment levels have held steady thanks to robust demand. Nonetheless, with tariffs on finished cars still relatively high, automakers remain sheltered from global competition and the sector is less efficient than it could be.

At the low end of the spectrum is the consumer electronics sector, which, despite the lifting of foreign-investment restrictions in the early 1990s, is still burdened by tariffs, taxes, and regulations. As a result, Indian consumer electronics goods can't compete internationally and prices for local consumers are unnecessarily high. The performance of India's food-retailing industry is even worse. Partly as a result of a total ban on foreign investment, labor productivity is just 6 percent of US levels.

Now look at China, which also has some reasonably liberalized and highly competitive industries, including consumer electronics, in which labor productivity is double that of its Indian counterpart. Over the past 20 years, the industry has become globally competitive through a combination of foreign direct investment and intense competition among domestic companies. It is also remarkable for the relatively liberal approach the government has taken to regulation—probably because of a failure to see its growth potential. Today China makes $60 billion worth of consumer electronics goods a year.

The performance of China's auto industry—which was considered a strategic one and remains tightly regulated because of the government's desire to bring in technology and investment—is less clear-cut. The market has been opened up to foreign automakers, consumer demand has grown enormously, and prices have dropped. Yet the sector shows how government intervention can thwart the potential of foreign direct investment. Foreign automakers can invest only in joint ventures, they have to buy components from local suppliers, and tariffs shield the market from imports. Competition is beginning to increase as private companies grow stronger. But for the time being, the productivity of foreign joint ventures in China is low compared with that of plants in Japan or the United States—astounding given China's low labor costs.

Since there are such big differences in the performance of different sectors within the same country, it makes sense to compare the performance of India and China at the sector rather than the national level. In IT and business-process outsourcing, India is so far ahead of the game that China can't do anything during the next 10 or 15 years that would bring it close to catching up. In consumer electronics, however, China dominates, and India won't provide serious competition during the next 10 years.

The auto sector is a toss-up. India's competitive forces have driven an enormous amount of innovation in the sector. Low-cost labor has been used instead of expensive automation, and local engineering talent has developed innovative new products such as the Scorpio—a sport utility vehicle that sells for a fraction of the price of an equivalent car in the United States. In China, large amounts of foreign direct investment have built a big industry, but regulation has so far limited its competitive potential.

It is far from clear which economy will emerge as the stronger one. The foundations of robust, sustainable economic growth must be built at the industry level, on the back of high productivity, which is achieved when governments ensure a level playing field through sound regulation and remove the barriers that stifle competition. Both China and India still have ample opportunity to help their industries and economies thrive.

About the Author

Diana Farrell is the director of the McKinsey Global Institute.

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Impact On Global Industry Restructuring & Implications For Companies

Several powerful factors, from liberalized foreign investment policies to a drop in the costs associated with global operations, are making a convincing case for building truly worldwide businesses. Multinational companies in the auto sector, for example, can find greater profits through savings and revenues that represent roughly 27 percent of the US$ 1.2 billion industry.

Thanks to an increasingly mobile and connected world, global corporations stand to simultaneously increase efficiency and lower costs by taking full advantage of the growing expertise and specialization in emerging economies.

Five Horizons for Global Success
With the lifting of restrictions and regulations, a number of nations have seen thriving sectors as a result of MNC entry, and building particular skills and expertise that continue to make them competitive in the global marketplace.

For MNCs to take advantage of these opportunities, they need to recognize what aspects of their industry best lend themselves to globalization. As a result, five horizons of industry structuring have emerged:

• Market entry: The predominant form of global expansion allows companies to mine new markets for their products in much the same way they do at home.

• Product specialization: Certain countries or regions take over the entire production process of a particular product.

• Value chain disaggregation: Each portion of the supply chain is located in a separate area with relevant expertise within a region. Parts are then assembled in yet another location.

• Value chain reengineering: After relocating an activity to a new location, production process can be tweaked by adjusting capital/labor ratio to capture further savings.

• New market creation: Successful global value chain management leads to the creation of better products at lower prices, which in turn can be introduced to whole new markets.

No Blueprints
While the opportunities and the benefits are significant, there is no one correct approach to managing global optimization. Global expansion alone does not ensure success. Just as high-performing companies in developed countries exhibit a broad range of successful management approaches, so do large developing economies.

Companies must balance global resources with local knowledge. That includes aligning management incentives globally but tailoring them to local conditions. In Mexico's retail banking, for example, successful approaches ranged from BBV's top-down direction to Citigroup's management coaching of the executives.

And companies must recognize that there is no single blueprint that works for every sector in every country. Each situation is different and those managers that can recognize them and build performance around them will be the ones who succeed.

Information Technology/Business Process Outsourcing (IT/BPO) Case Study

Companies are moving critical IT (information technology) and BPO (business processes operations) to offshore locations, particularly in India.

India, with its English speaking, educated, and technically proficient workforce, offshoring is growing at 30 percent per year and is projected to grow to more than US$ 200 billion by 2008.

Despite widespread concerns that offshoring eliminates jobs at home, in reality the revenue saved through offshoring is being reinvested at home.

Information Technology (IT)
As the largest global supplier of offshore IT, India accounts for roughly a quarter of the global market for IT talent. India has added hundreds of thousands of high tech jobs though, relative to the economy overall, the impact to date has been small. Because many of the IT facilities tapped for offshoring already existed, FDI impact has been on increasing employment and bringing higher value-added functions to India.

Business Process Outsourcing (BPO)
Facilities and infrastructure for BPO, unlike IT, have been created entirely through FDI. The Indian government offers lucrative incentives to attract MNCs but without significant positive effect since MNCs are already committed to establishing BPO functions in India. Government funds lost through tax incentives would be better used to improve the country’s infrastructure. Lack of reliable power, for example, poses a major threat to BPO growth.

Conclusions
Offshoring of IT and BPO has been a boon for India, and the sector is expected to grow in the years ahead. Numerous new jobs have been created, and higher value-added functions have been brought to India. As international companies enter India, increased competition is beginning to drive sector productivity.

Offshoring and beyond

Offshoring and beyond

Cheap labor is the beginning, not the end.

Vivek Agrawal, Diana Farrell, and Jaana K. Remes

The McKinsey Quarterly, 2003 Special Edition: Global directions

The enticement to companies of a worker who earns $2 an hour in India as against ten times that amount for a worker in the United States is obvious. For years, such wage differentials have attracted leading manufacturing companies to low-wage nations. More recently, businesses of all kinds have also exported back-office functions such as data entry, payroll processing, and call centers. Business-process offshoring is all the rage, and the hundreds of companies that have taken this route often cut their costs by as much as half.

Yet as impressive as these achievements may appear, new research by the McKinsey Global Institute (MGI) finds that companies are leaving billions of dollars in savings behind when they offshore back-office functions and service jobs.¹ Such companies are merely replicating what they do at home, where labor is expensive and capital is relatively cheap, in countries in which the reverse is true. What is needed? Nothing less than a total transformation of business processes to harness the new environment’s potential. And by undertaking such a transformation, many companies will find that the resulting lower cost structure releases massive new revenue opportunities even more valuable than the savings.

Halfway to global

The first wave of globalization began a hundred or more years ago, when companies were lured abroad by the prospect of new markets. Even today, we estimate, the age-old motivation of reaching vast new customer pools explains perhaps 80 percent of cross-border investments. Many of them, such as Wal-Mart Stores’ operations in Mexico and HSBC’s in Malaysia, are in service sectors that require a local presence by definition. Others are in industries such as automotive, in which high tariffs and other trade barriers effectively force foreign companies to set up shop locally if they want to do business.

Despite the fits and starts of progress in world trade talks, the policy barriers that limit foreign investment and trade have fallen significantly over the past ten years. The result has been a second wave of globalization, in which companies from North America, Europe, and Japan build plants in low-wage countries to take advantage of enormous wage differentials and then export the finished goods back to the home market. These companies have substantially cut their costs for a variety of products, particularly labor-intensive ones such as textiles and toys, even taking into account the extra expense of transportation and overseas management and training.

Companies in a few industries have gone further, specializing in component production and final assembly in the countries or regions with the strongest comparative advantage. Nowhere is this third wave of globalization more evident than in consumer electronics (see sidebar, "How far can it go?"). Business-process offshoring, made possible by the dramatic fall in telecommunications costs and the ability to transform paper-based activities into digital ones requiring only a telephone and a computer, is just the next logical step. A broad range of service jobs and back-office functions can now be performed remotely in India, for example, or in the Philippines. Low-skill work such as data entry and transaction processing, real-time customer support, and research services are obvious candidates. But even high-skill activities such as customized software development, the design of automotive and aerospace components (CAD/CAM), and pharmaceutical research are increasingly undertaken outside the United States.

Many of the jobs sent offshore may be considered undesirable and lacking in prestige in developed countries yet are highly attractive in developing ones. So offshore workers not only cost far less but also are often more highly motivated, which means that they perform better. One British bank’s call-center agents in India, for instance, process 20 percent more transactions, with 3 percent more accuracy, than their counterparts do in the United Kingdom. Some companies set up their own "captive" operations in offshore locations to take advantage of these benefits, while others outsource to local companies, particularly in India.

Companies in the United States and Britain account for roughly 70 percent of the business-process-offshoring market. Relatively liberal employment and labor laws give such companies flexibility in reassigning their activities and eliminating jobs, and they can take advantage of the sizable English-speaking populations in many low-wage countries, such as India, Ireland, the Philippines, and South Africa. With a shared language, errors are far less likely and functions that require voice interaction or text-based work are straightforward. The opportunities for Continental European and Japanese companies are thus more limited.

Business-process offshoring is still a nascent industry. By our estimates, in 2002 it was worth $32 billion to $35 billion, just 1 percent of the $3 trillion worth of business functions that could be performed remotely. Because of the significant benefits already being realized through offshoring, the market is projected to grow by 30 to 40 percent annually over the next five years.² This prospect may cause consternation over job losses in the United States (see Vivek Agrawal and Diana Farrell, "Who wins in offshoring," The McKinsey Quarterly, 2003 Number 4 Global directions, pp. 36–41), but it will make offshoring an industry with well over $100 billion in annual revenues by 2008.

Getting more from offshoring

Merely replicating processes developed at home, however, is not the way to realize offshoring’s full potential. Wages represent 70 percent of call-center costs in the United States, for instance, so these operations are designed to minimize labor by using all available technology. But in low-wage India, that makes little sense, since wages represent only 30 percent of costs, and capital equipment (to provide telecom bandwidth, for example) is often more expensive than it is at home.

The way to reduce the cost of offshore operations even further (Exhibit 1) is to reorganize and reengineer operations to take full advantage of these differences. In a low-wage country, the capital infrastructure—including office space, telecommunications lines, and computer hardware and software—should be used as intensively as possible. For a call center, this approach can reduce costs by an additional 30 to 40 percent, boosting total savings to as much as 70 percent of the cost of onshore operations (Exhibit 2). The potential value for other offshored functions, like data entry, payroll processing, and financial accounting, is similar.

Companies can boost their capital productivity in low-wage environments in three ways:

• Round-the-clock shifts. The most obvious way to use the capital infrastructure more intensively is to run round-the-clock shifts, even if they mean higher wages for odd hours. This option simply wouldn’t exist in a high-wage environment, where wage premiums offset any capital savings. We estimate that just by increasing the number of shifts, companies can reduce their operating costs by 30 to 44 percent for many types of offshore work, including financial accounting, procurement, call centers, transaction processing, and more complex functions such as knowledge services and R&D (Exhibit 3). But in India, we found that even the most efficient third-party providers run only two shifts a day, and most of the captive operations set up by multinational corporations are running only one.
  
• Cheaper capital equipment. Some service providers in India are using cheap local labor to develop their own software instead of purchasing more expensive branded products from the global software giants. American Express, for instance, hired programmers to write software to reconcile accounts, and the software now reconciles over three-quarters of them, or more than half a million every day. The company, which paid only $5,000 to develop this solution, estimates that licensing more sophisticated database software would have cost several million dollars. The Indian carmaker Maruti Udyog developed its own robots for its assembly lines; the robots, on average, cost a small fraction of what similar ones cost its partner Suzuki in Japan. In this way, companies maintain the level of automation that prevails in high-wage countries, but at a distinctly lower capital cost.
• Reduced automation. Some companies have gone a step further and used workers for tasks that would normally be automated at home. A payments processor, for example, might employ people to input checks manually into a computer system instead of using expensive imaging software. A telemarketing firm that would use expensive automatic dialers in a high-wage country might have workers make their own calls instead.

Manufacturers too can use this approach. Certain automotive original-equipment manufacturers (OEMs) in China use robots for only 30 percent of the welding in car assembly, as compared with 90 percent or more in US or European operations. (BMW’s plant in South Africa employs the same line of attack.) In India, domestic car companies have reduced the need for automation throughout the manufacturing process: they use more manual labor to load and change dies in pressing, body welding, materials handling, and other functions—while suffering no discernible loss of quality in the finished product. In this way, these companies manage to cut their assembly costs by 4 to 5 percent or even more and save themselves millions of dollars annually.

Ultimately, companies might completely redesign the sequence in which tasks are performed, in order to leverage the opportunities above more fully. Consider the simple example of a call-center agent who manages customer accounts. In high-wage countries, each customer call is routed to an agent who listens to the request, opens up a computer database, and updates the account in real time. Neither the computer nor the telephone is used efficiently, since the agent is either talking or typing but not both.

Offshore, an agent equipped with only a telephone could write the customer request by hand into a tracking log and move on to the next call. Telecom costs are reduced because the agent spends less time on calls and customers less time on hold. Another agent, working at a computer station used around the clock, could enter the information into the database. While the new process requires more agents to handle requests, expensive computer hardware and software and telephone lines are used more intensively. Added wages are more than offset by savings on computers, software licenses, and telephone connections (Exhibit 4). The economics of an Indian call center suggest that this simple change could actually boost current profit margins for offshoring vendors by as much as 50 percent.

Reengineering offshore functions makes sense only if wages stay low. Over time, they will rise and technology costs will continue to fall. As this happens, companies can adjust their operations to reflect changing factor costs. But in most low-wage countries, labor is so cheap and the labor pool so large that rising wages are unlikely to be a problem for decades. India each year produces 2,000,000 college graduates—more than 80 percent of them English speakers—while China produces 850,000, though with minimal English skills. Even a small country like the Philippines annually produces 290,000 college graduates, all English speakers.

Beyond cost savings

By reaping offshoring’s full potential, companies will find that their new, lower-cost structures open up a variety of opportunities to boost revenue growth. These opportunities will often far exceed the annual cost savings.

Some companies, for instance, can now chase delinquent accounts receivable they formerly had to ignore: one airline carrier is capturing $75 million in previously lost receivables on top of the $50 million it saves each year by operating its accounts-receivable department in India. Meanwhile, a leading US personal-computer manufacturer created telephone- and e-mail-based customer service centers in India to provide technical support. In addition to saving more than $100 million annually, it has significantly increased the proportion of customer problems it resolves. The company thereby reduces the number of follow-up calls it receives and the amount of merchandise it must replace while simultaneously boosting its customer satisfaction levels. And a financial-services firm has extended to customers with lower account balances services previously limited to high-net-worth clients, thus opening up large new customer segments in its home market.

The new cost position can also be used to develop cheaper products for consumers in emerging markets. Consider the experience of one of their own local companies. The Indian automaker Tata Motors (formerly Telco) designed the low-cost Indica car for the domestic market. The Indica sells for roughly 10 percent less than cars from global OEMs and breaks even on a volume of 150,000 units, a fraction of the number global companies need. That Indicas have fewer features accounts for a small part of the cost savings. Most of the savings come from a lower level of automation in assembly, a reengineered process, and the use of very low cost local labor to develop the car (at a quarter of what a global OEM would have spent to develop something similar). As a result, the company has grown from virtually nothing to capture a quarter of the Indian market in its segment during the past four years—displacing Suzuki Motor, Hyundai, and other global brands—and is now under contract to export 100,000 Indicas to the United Kingdom and Continental Europe.

As companies go further down the road to globalization, the potential to create new markets and redefine industries is enormous. Consider how the dramatic price reductions made possible by globalizing production have changed the market for televisions in the United States. Just 25 years ago, almost a quarter of US households had no color TV. Since then, prices have declined by roughly 40 percent in real terms. Now 98 percent of US households have at least one, and many families have three or more. At the new price point, color televisions have been transformed from luxury items into nearly disposable goods that most of the population considers a necessity. And as color TVs have proliferated, they have given rise to an industry that produces television content and television-based games worth more than $30 billion. Although the detractors of globalization fear that it has already gone too far, we believe that it has barely begun.

How far can it go?

The personal computer on your desk today may have been designed in Taiwan and assembled in Mexico, with memory chips from South Korea, a motherboard from China, and a hard drive from Thailand. Not surprisingly, the value of world trade in consumer electronics components and final goods is 180 percent of the value of industry sales each year, and the industry has been completely restructured. Many companies around the world are now specializing in quite narrow segments of the value chain—for example, as innovators and designers of goods, low-cost producers, specialized assemblers, or marketers and distributors.

Countries too are starting to specialize: Mexico and Eastern Europe take advantage of their location to assemble goods destined for the United States and Europe, respectively, and China uses its huge labor pool to become a global base for low-cost manufacturing. Although companies have benefited from lower costs and consumers have enjoyed dramatically lower prices and more choice, few nonmanufacturing industries have moved so decisively.

Clearly, not every industry could go as far as consumer electronics along the road to globalization: steel, for instance, is heavy and bulky to transport, while services such as retailing, banking, and entertainment must of necessity remain largely local. The interplay between the physical nature of any industry, its organizational environment, and the legal, regulatory, and policy barriers to its globalization determines its potential for restructuring.

The barriers to globalization are real, and many may not come down. But as an experiment, we looked at how much value could be created in the automotive industry if they did. We found that it could capture a staggering $150 billion annually in cost savings and an additional $170 billion annually in new revenues—a combination that would boost industry revenues by more than 25 percent from current levels. What stands in the way of achieving this increase?

Most people think that the industry is already global, largely because of the popularity of foreign cars. Few realize that of the 55 million vehicles produced each year, more than 90 percent are sold where they are made. Although the leading OEMs have all built plants in low-wage countries, these facilities were built to meet local or regional demand. Very few cars move from one geographic region to another, and until very recently only about 100,000 cars produced in low-wage countries were subsequently exported to high-wage ones.¹

Yet there are few good reasons for this pattern. After all, it costs only $500 and takes only three weeks to ship an automobile anywhere in the world, and both the cost and the time are diminishing. More important, cars can be produced in low-wage countries for at least 20 percent less than in high-wage ones, even after shipping costs and tariffs are factored in (exhibit). The resulting boon to the world’s consumers could be enormous.

Furthermore, experience has shown that quality standards can be maintained in low-wage countries. BMW’s South African plant, which exports to Europe and North America, is even slightly better than the German plant.² Volkswagen produces all of its popular New Beetles in Mexico. Operating in these countries often requires extra training for workers—BMW spends three to five times more on training in South Africa than it does in its other plants—but wage differences more than offset that cost.

Moreover, many analysts believe that overcapacity in the global automotive industry is now 30 percent or even higher. Much of the overcapacity is in emerging markets, where governments granted lucrative incentives to global OEMs during the 1990s but local demand failed to materialize. These factories could be supplying developed countries with lower-cost cars. Confronted by idle plants in countries from Thailand to Brazil, a few OEMs are now moving in this direction.

The barriers to globalization are government policies and some of the industry’s organizational features. Apart from Japan, virtually every country has car tariffs, which range from 2.5 percent in the United States to 10 percent in Europe and to over 100 percent in some developing countries. What’s more, strong unions mount stiff resistance to moving production offshore. Many auto parts are proprietary and there is very little standardization across manufacturers. So the complex supply chain—which can include hundreds of direct suppliers, each relying on hundreds of subsuppliers—is still relatively fragmented despite current perceptions of rampant consolidation. And since assembly plants can cost up to half a billion dollars to build, OEMs have enormous sunk costs in their existing manufacturing facilities.

If the industry found ways to overcome these barriers, it could capture up to $320 billion annually in cost savings and new revenues. The first step would be to use existing plants in low-wage countries more efficiently. By cutting the current overcapacity in half, the industry could reap $10 billion annually.³ By building all additional production capacity in low-wage countries, it could save a further $40 billion annually after five years. Over time, if OEMs migrated 70 percent of their assembly and components sourcing in high-wage countries to low-wage ones, they could realize savings in the neighborhood of $150 billion a year. (For most OEMs, as much as 30 percent of demand is variable and 70 percent stable and predictable. Moving 70 percent offshore is thus potentially feasible without making consumers wait longer to get their cars or building large inventories to compensate for fluctuating demand.)

But the benefits don’t stop at cost savings. By taking advantage of low-cost labor and disaggregating supply chains, automakers could produce cars at least 20 to 25 percent more cheaply. If tariffs on parts were also to fall, these companies could, by conservative estimates, cut prices by 30 percent and unleash massive new demand. In emerging markets, where consumers are highly price sensitive and there is significant unmet demand for low-cost cars, we estimate that the industry could increase its sales by up to $100 billion a year.

In developed countries, where most consumers already own cars, cutting the price of the lowest-cost models by 30 percent (to $7,000, from $10,500) could produce roughly $70 billion in additional sales. Some of this demand would come from low-income households that currently don’t own cars. But part of the opportunity would be generated by changing the way consumers view them: instead of having only one or two, households might opt for three or four, with some purchased just for fun. Parents might be more inclined to buy cars for their children, and young people might enter the market as well.

The potential value at stake in the auto industry is eye-popping but hardly unique. As the barriers to globalization continue to erode, many other industries could be restructured and capture similar value.

Notes

¹This estimate doesn’t include production within the countries adhering to the North American Free Trade Agreement (NAFTA).

²"Two-way street: Automakers get even more mileage from the Third World," Wall Street Journal, July 31, 2002.

³For details on these calculations, see the October 2003 MGI report New Horizons: Multinational Company Investment in Developing Economies, available free of charge.

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About the Authors

Vivek Agrawal is a consultant in McKinsey’s Minneapolis office; Diana Farrell, the director of the McKinsey Global Institute, is a principal in the San Francisco office, where Jaana Remes is a consultant.

The authors would like to acknowledge the many MGI fellows who participated in the project and the partners around the world who helped make it possible: Nelly Aguilera, Dino Asvaintra, Angelique Augereau, Vivek Bansal, Dan Devroye, Maggie Durant, Heinz-Peter Elstrodt, Antonio Farini, Thomas-Anton Heinzl, Lan Kang, Ashish Kotecha, Martha Laboissiere, Enrique Lopez, Maria McClay, Glenn Mercer, Gordon Orr, Vincent Palmade, Ranjit Pandit, Antonio Puron, Julio Rodriguez, Jaeson Rosenfeld, Rodrigo Rubio, and Heiner Schulz. We also wish to acknowledge members of the McKinsey initiative on business-process outsourcing and offshoring, including Detlev Hoch, Noshir Kaka, Anil Kumar, Sunish Sharma, Stefan Spang, Sanoke Viswanathan, and Patrick Woetzel. Their work contributed significantly to our understanding of the software- and business-process-offshoring sectors.

Notes

¹See the October 2003 MGI report New Horizons: Multinational Company Investment in Developing Economies, available free of charge. During the yearlong research project leading up to this report, we conducted in-depth case studies of foreign direct investment in five sectors (automotive, consumer electronics, retail banking, retailing, and the offshoring of information technology and business processes) in four major developing economies (Brazil, China, India, and Mexico). These cases generated the basis of our findings and conclusions.

²Consensus estimates of the market research firms Aberdeen Group, Gartner, and IDC.