Budapest, the Next Bangalore? New EU Members Join the Outsourcing Race

Senior executives from Philips, the Dutch electronics group, gathered recently in the Polish city of Lodz to lay the foundation stone of a multi-storey financial services centre for the group's European operations.

When the complex is completed next year more than 500 staff will support more than 100 Philips subsidiaries in 20 countries. But Philips is already receiving frequent enquiries about Lodz from other multinationals planning investments in services centres in central and eastern Europe.

Bogdan Rogala, chief executive of the group's Polish operations, says: "Other companies are visiting us and asking questions. They have ideas for similar projects. This is the beginning of the strategic development of a new sector."

The outsourcing of business services is becoming big business in central and eastern Europe, especially in the four largest of the European Union's 10 new members - the Czech Republic, Hungary, Poland and Slovakia. During the 1990s multinationals flocked to the region to invest in manufacturing and in services from banking to retailing, often through privatisations. Now, a new element is coming into the mix - investment in service centres designed to carry out work for clients across Europe and beyond.

For west European groups the development of central Europe as an offshore services centre comes not a moment too soon. They have been slow to follow US groups in establishing offshore services centres in Asia. Central Europe offers sites much closer to home. This month Unice, the EU employers' federation, said in a report to the incoming European Commission that Europe must respond to the challenge of globalisation, including "the relocation of sophisticated business services." And it says that among the most effective responses is the full economic integration of the new EU member states. "Enlargement is a golden opportunity to boost competitiveness," says Unice.

The capital investments, ranging from $5m to $25m, are modest in comparison with factories costing $100m and more. But their economic impact will be considerable because thousands of jobs are being created in a wide range of activities including data processing for banks, ticketing for airlines and financial accounting for industrial groups. McKinsey, the management consultancy, estimates that in Poland the number of posts in outsourced business services could rise from about 3,000 earlier this year to 200,000 by 2008. "A wave of global corporate restructuring known as business process offshoring (BPO) is expected to spawn new investment activities," says McKinsey.

Other observers are more cautious, but they agree that in the next five to 10 years more and more multinationals are likely to follow Philips' example. Jean Lemierre, the president of the European Bank for Reconstruction and Development, the region's multilateral bank, says: "A new wave of investment is coming. Many people are going to establish services centres."

Officials in central Europe are pleased to see these new projects in services, not least because foreign direct investment into the EU accession states has slumped in the last two years. According to the EBRD, after hitting a record $20.5bn in 2002, foreign direct investment fell to under $8bn in 2003 and will recover only modestly this year. Big privatisations are mostly completed, while investment in key manufacturing industries and domestic services has also slowed.

Investments in export-oriented services are therefore filling a gap at a difficult time. They are welcome because they usually bring better-paid employment than factories, creating opportunities for graduates who might otherwise be tempted to emigrate. Pawel Jastrzebski, an economy official in the Polish university city of Krakow which has attracted at least five big services centres, says: "All investments are important to us, but we particularly value those that bring good jobs."

The region is far behind the global leaders, India and China, in hosting business process offshoring. However, having entered the market about a decade after India and China, central Europe is catching up, according to a survey of offshore business process locations published this summer by AT Kearney, the management consultancy (see chart below).

Salaries for central European business services workers are about three times higher than in India or China - a considerable disadvantage in a sector where labour is often a big share of the total costs. And English language skills in India and other Asian countries such as Malaysia and the Philippines make these countries popular for US and British groups.

But for many continental European groups, a knowledge of languages other than English - including French, German and Spanish - is a key consideration in any decision to transfer services offshore. And such skills in these languages are much easier to find in central and eastern Europe than in Asia. Klaus Furck, vice-president for accounting at Lufthansa, the German airline, says the company last year chose Krakow for its European accounting centre precisely because of the languages on offer. "We even have a person who speaks Finnish," he says.

Cultural affinity also matters, especially where the service centre staff are required to deal with a group's clients. Particularly sensitive fields include collecting debts from customers and handling complaints. David Poole, vice-president for outsourcing at Capgemini, the French-based consultancy which has a services centre in Krakow, says: "These people are Europeans and understand Europe. There is no need for cultural training."

Geographic proximity is also important for some companies, especially those that require frequent contacts between the service workers and their clients in the west. Graham Underwood, chief operating officer at GFT, a UK-based company that has a centre in Budapest and specialises in IT services for investment banks, says being in the same time zone as Germany gives Hungary an advantage over India. "There's no doubt that central and eastern Europe is a good location for dynamic projects, where there are a lot of exchanges of views with the client."

The region's role is highlighted by the approach of those companies that carry out business process outsourcing for others - including Capgemini, Accenture, the international management consultancy, which has a big base in Prague, and International Business Machines of the US which runs a large services centre in Slovakia and others in Poland, and Hungary. For these companies, the central European services centres fit into global networks, which usually also include India and China. For example, Capgemini runs outsourcing bases in Bangalore (India), Guangzhou (China), Toronto (Canada) and Dallas (US) as well as Krakow. Mr Poole explains that projects are often divided between different centres, with simpler jobs such as data processing carried out in China and more complex tasks involving client contact done closer to the customer.

In these networks, the central European centres often serve west European-based clients. But global links are not unusual. For example, one Texan utility company using Capgemini divides its account management functions between Dallas, Krakow and Bangalore.

As companies become more familiar with outsourcing they are likely to entrust more sophisticated operations to offshore centres, whether they are carried out in-house or farmed out to external providers. Mr Furck at Lufthansa says: "We are open to transferring more services. We are always open to change."

But he adds that outsourcing is competing with automation as a way of cutting costs. "In the long run our intention is to have everything automated. Then we will no longer need to transfer service anywhere."

Other companies say that even if basic processes are fully automated, offshore business centres can still perform many functions, especially those involving client contacts. But central European operators must move quickly if they are to capitalise on their advantages. Assuming the region's economies grow faster than those of western Europe, as is predicted, central Europe's cost advantages will decline steadily as wages rise closer to western European levels. The proposed entry of new countries, including Romania and Bulgaria, to the EU later in the decade would increase the competition among low-wage economies in the union. Russia too could emerge as a powerful competitor. Multinational information technology companies already place programming and research contracts as far afield as Novosibirsk in Siberia. Robert Maciejko, who heads the Polish office of the Boston Consulting Group, says: "Now is the time we must market the idea of central Europe as a business services location."

But there are limits to the speed with which west European companies are moving their service centres to the east. Mr Maciejko says that as companies consider transferring more sophisticated functions involving head office executives they become more hesitant. "There's a lot of inertia. Who would put a new headquarters in Germany today [given the costs]? But I do not see many multinationals moving their global headquarters or even their European headquarters to Warsaw."

Most Europeans like to live in their own countries. Since the senior managers of most big European companies are overwhelmingly west Europeans, they generally prefer to work in the west. But as companies expand their operations in the east and more executives spend some of their career in the east, these attitudes may change. Vladimir Kroa, a Prague-based IT researcher for IDC, argues that the city is already becoming a location of choice even for west Europeans. "They like the lifestyle. They really want to live here - it is such a beautiful place," says Mr Kroa, whose own offices look out on a medieval square.

The political climate in western Europe is also often hostile to transferring jobs to central Europe. In Germany and in France companies that want to cut staff locally and create posts in the foreign countries have faced public and political protests. Nicholas Sarkozy, the French finance minister, has offered to consider financial aid for companies that do not outsource, and has warned the EU's new members to raise corporate tax rates closer to west European levels to reduce competition for investment.

Companies argue that they must cut costs if Europe is to compete with North America and Asia. Investing in low-cost central Europe helps to reduce the overall costs of European operations, including west European facilities. So far, the arguments have centred on manufacturing plants, but the managers of service businesses are also concerned. Adrian von Hammerstein, head of Siemens Business Services, the service division of Siemens, the German engineering group, says: "Jobs outside Germany have grown in recent years but revenue outside Germany has grown exponentially. This growth has helped to secure jobs in Germany and western Europe because it makes us more competitive overall."