– Eric Auchard is a Reuters columnist. The opinions expressed are his own –

Outsourcing, Indian-style, is challenged as never before by an erosion in business confidence that makes corporate spending, even to generate quick cost-savings, harder to justify.

“No New Investment” is the order of the day; cost avoidance, the mantra; zero percent, the growth target in the current era of uncertainty.

Software service providers emerged out of the 2000-2002 technology spending bust with sales growing up to 50 percent a year as they won over companies to contract out inefficient operations instead of managing them in-house.

But shocks to the world economy seen over the past 18 months are triggering reassessments of corporate growth expectations, cost considerations and operational accountability. It’s no longer safe to assume that the logic that drove outsourcing in the past will drive it again, once the economy picks up.

Here are reasons why the industry will find it difficult to repeat its past performance in the tough times ahead.

CUTTING BACK ON COST-CUTTING: The paradox at the moment is that spending on services meant to cut costs and save money is itself being squeezed.

Technology Partners International (TPI), a research firm that has tracked the outsourcing industry for 20 years, reported this week that total contract volumes fell 22 percent in the fourth quarter from a year ago.

Just how bad things could get this year is only likely to emerge as corporate customers nail down their 2009 spending plans to vendors in the next two to three months.

“The worst of the IT (information technology) spending slowdown likely remains in front of us as we start the clock on slashed 2009 budgets,” Goldman Sachs warned in a report on the software industry earlier this month.

The conventional wisdom is that companies will eventually need to cost-cut their way out of the economic morass. But as the software services industry has matured over this decade, Goldman analysts say the sector has become more cyclically dependent on overall IT spending, reducing the chances it will be an early winner in any corporate recovery.

Tata Consultancy Services , the largest of the Indian software service providers, estimates that budgets for IT outsourcing will fall between 5 and 20 percent during 2009. Market forecasters predict more declines in store for 2010.

KEY CUSTOMERS IN TROUBLE. One problem is that the $40 billion-a-year industry’s fortunes are heavily linked to the financial sector. Indeed outsourcing started out 30 years ago as a way to help banks automate tangled back-office operations.

But while it grew more diverse in the 1990s, branching into telecom, manufacturing, retail and other industries; banks, brokerages and insurers are still the biggest slice of the market at 20 percent of overall sales, Goldman Sachs estimates.

The finance sector is not just in trouble, it is experiencing a meltdown like no other since the 1970s or perhaps even the 1930s — long before outsourcing itself was invented. And while the credit crisis has left many institutions needing to slash costs, we are seeing a wholesale contraction of the market that will lead to steep reductions in overall demand. Whole parts of the business will disappear and not be replaced.

Moreover, the financial industry’s reliance on governments for bailouts has curtailed the autonomy of bosses. Governments are likely to be dubious should big banks and insurers seek to offshore financial jobs, especially in countries with mounting unemployment. Outsourcers may have to get used to having fewer, and more conservative, financial services customers.

GROWING COMPETITION. Even if volumes hold up, Indian software services may find their market share eroded. After all, Indian firms no longer lay claim to the sort of exclusive cost advantages — lowest cost technical labor — they did.

In recent years, the industry has expanded into other offshore regions such as Southeast Asia, Central Europe and Latin America but promises to handle sensitive work “near-shore” or onsite when customers demand or labour politics require.

Big computer services firms IBM , Hewlett-Packard and Accenture got in on the act by expanding into India or by acquiring offshore companies themselves.

Accenture now has more staff in India than in the United States. Because these firms are agnostic about whether they offer their services offshore or near-shore, they look better placed to navigate global labor politics than Indian rivals.

TRUSTWORTHINESS. Adding to the sector’s troubles is the massive corporate fraud uncovered recently at Satyam Computer Services Ltd , India’s fourth largest software services provider. The scandal has Satyam customers scrambling to find alternative providers.

Other offshore services providers report stepped-up scrutiny from clients of their own corporate governance and financial viability. It has also revived questions about the trustworthiness of Indian accounts and the adequacy of corporate controls.

That’s a big black eye for an industry that sells risk management and corporate governance services as a major client offering. It may raise the risk premium investors require for holding these stocks.

PRICE PRESSURES. Rising competition isn’t the only threat to offshore outsourcers’ margins.
Many of the more profitable, longer-term contracts worth tens or hundreds of millions of dollars are being put on hold as companies scramble to reassess their business strategies.

Customers want more control over projects and are demanding fixed-price deals that are more likely than not to limit margin growth. Infosys, Tata and others say they are doing their best to make up for price cuts by driving greater sales volumes.

The trend is disguised by the long-term nature of many existing software services contracts. Recent reports suggest many customers are scaling back or canceling long-term “mega-deals” until they can get a handle on the impact of economic decline on their own businesses.

The industry is subsisting on short-term, quick-fix contracts aimed at cutting operational costs as fast as possible. These price-sensitive deals are what software services firms had been trying to move away from in favour of higher-value projects to create new businesses for customers, not just manage existing software or customer services.

There is a big cultural change underway in global corporations that may be less friendly to outsourcing. Fallout from the financial crisis is likely to mean far greater pressure on chief executives to run a tighter ship. There’s likely to be less merger activity, less headlong expansion and less resulting need to consolidate organizations using external services.

Chief executives are sure to be more closely scrutinized for the operational choices they make, instead of farming out responsibility to lower level technical managers in order to focus on deal-making.
Inevitably there is a lack of control involved in contracting business operations out around the globe. This more constrained environment could be less favorable for outsourcing than downturns of the past.

– At the time of publication Eric Auchard did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. For previous columns, click here. –