What Hollywood found in India

November 10, 2011, 4:10 PM UTC

By Vishesh Kumar, contributor

FORTUNE — India’s IT industry emerged as a major global force over the last decade by providing all manner of left-brained services, from coding to call support. Now, as entertainment becomes more and more computational thanks to complex 3D special effects and animation, Indian firms are becoming crucial to the world’s creative industries as well.

The global film industry is packing movies with ever costlier digital wizardry as it competes with new entertainment choices, from social networks to mobile phones. In 2009, nine out of the world’s ten top-grossing films relied heavily on visual effects. These days, as much as a third of the budget for major Hollywood films is earmarked for special effects, according to a research report by accounting firm KPMG. The annual amount spent by filmmakers on special effects in the world’s top five markets totals some $1.9 billion.

And yet, the domestic companies responsible for producing all those digital alien creatures and razzle-dazzle explosions have felt squeezed. They often struggle with razor-thin margins due to high labor and technology costs. That’s where Indian firms have stepped in. Their cheaper wages result in costs for visual effects shots that are about 25% to 50% of what they would be in the U.S., according to a report by PriceWaterhouseCoopers. (Increasingly powerful high-speed networks that make zipping around massive data and video files easy haven’t hurt either.)

Not surprisingly, Indian special effects, animation and video gaming firms have been growing. PriceWaterhouseCoopers predicts the industry will grow at a 21% annual clip, more than doubling in size to $1.84 billion by 2015.

That growth has already attracted major projects. This summer, James Cameron’s Digital Domain opened studios in partnership with Reliance MediaWorks, an affiliate of India’s Reliance ADA conglomerate. What’s more, Reliance ADA provided about half the $825 million in financing for DreamWorks SKG (DWA) in 2009. Recent Digital Domain projects include Real Steel and Transformers: Revenge of the Fallen.

In March, Lucasfilm said it would partner with India’s Prime Focus for the 3D conversion of Star Wars: The Phantom Menace, which is due for theatrical re-release at the start of 2012. Indian companies like Crest Animation Studios and DQ Entertainment, meanwhile, have announced new projects with Lionsgate Entertainment (LGF) and France Television this year.

In partnering with production companies doing cutting edge work, some Indian players see an opportunity to take their industries to a new level. Aggressive deal making could set the stage for technology and skills transfers, much like it has in developing economies around the world in industries as diverse as mining and automobile manufacturing.

Naturally, RelianceMediaWorks’s CEO, Anil Arjun, is bullish. He argues that the company’s deal with Digital Domain will be “a game-changer due to the significant leap in available capacities and technology transfer” it will allow. The company currently has a roster of 600 3D and visual effects artists but plans to expand to 1,000 next year. That should allow it to take a bigger slice of a ballooning market.

The interest for Indian firms doesn’t stop at making better pictures for Western audiences, either. Many are also eyeing the opportunity to repurpose advanced entertainment technology for the fast growing and content hungry domestic market. A boom in multiplex theaters and cable and satellite services is leading to massive demand for films. PricewaterhouseCoopers predicts the number of multiplexes in India will double to about 500 by 2015 and that the television market will expand to $13.4 billion from $6.8 billion over that time.

The industry faces plenty of obstacles, though — many similar to the ones traditional IT firms struggled with. Talent is in short supply and Indian companies have to invest heavily in training employees. But the scarcity results in poaching and controlling attrition is now a key challenge for executives, KPMG notes. What’s more, other Asian countries are increasingly competitive. Singapore and Malaysia, for instance, are offering aggressive funding and subsidies to woo business.

Still, if the industry can overcome these hurdles and realize its bold ambitions, it could play a major role in what consumers see on the silver screen.