China's spectacular economic success has prompted speculation that the country's software-outsourcing industry could soon compete with India's. A recent McKinsey study of China's software sector,¹ however, shows that it will be many years before the country poses a threat to its continental rival in this arena. For starters, the Chinese must consolidate their highly fragmented industry to gain the size and expertise needed to capture large international projects. Currently, there is little movement in this direction.

To be sure, signs of healthy expansion abound in China's IT industry. The number of engineering graduates and software-applications professionals has grown considerably in recent years. Since 1997, annual revenues in software and IT services have risen by 42 percent a year, on average, reaching $6.8 billion in 2003.² Moreover, the number of English-speaking graduates in the workforce—particularly crucial in software outsourcing—has doubled since 2000, to more than 24 million in 2004.

But shortcomings in the structure of China's IT industry prevent it from taking full advantage of these changes. Although revenues from IT services are rising, they are barely half of India's $12.7 billion a year. Growth is driven by domestic demand—most customers are small and midsize Chinese enterprises that want...