Annual salary gains for Indian software engineers, which hit a bump in 2009, once again are rising much faster than they are for their U.S. counterparts.

They are rising so fast, in fact, and have risen so much during the past 10 years, that some who employ them can soon see a time when their costs will outweigh their benefits for U.S. companies.

“At this rate, India becomes less compelling from a cost savings perspective in two to three years,” said Vikash Varma, chief executive of the networking startup Stoke, which has roughly equal-sized engineering teams in Santa Clara, Calif., and Bangalore.

That’s not to say the salary arbitrage that has helped create tens of thousands of software jobs in India has gone away. It hasn’t. Indian engineers, both front-end product developers and back-end testing pros, earn roughly 33% of what a similar worker is paid in Silicon Valley or New York, according to Varma and others.

But inflation in India has driven up costs for office leases and other business expenses to the point where the savings realized from sending a software project there from the U.S. is about half the total cost of the project, at best.

“Offshoring is not a trend that’s gaining momentum,” said Ian Ide, general manager of the New York technology practice for the Boston-based recruitment and staffing firm Winter, Wyman.

Given the intangible costs of sending work 10-to-12 time zones away, and the lower quality of the work -- which six people interviewed for this story said was not yet on par with U.S. software development -- the pure arbitrage game may soon be history.

“People have seen what works and what doesn’t. Offshoring is still a component of a hiring strategy, but even companies that are hiring in India are still hiring here,” said Ide, who’s been recruiting senior-level engineers for New York employers for 16 years.

Strong salary gains return

Salaries for better-than-average engineers in India are rising somewhere around 20% to 25% annually, according to Varma, whose company is hiring in Bangalore right now.

That’s down from average annual gains of more than 30% between 2004 and 2008, according to past surveys done by the U.S. technology research firm IDC-Dataquest in conjunction with Nasscom, the largest Indian software trade association.

The current rise is a reversal from 2009, when average IT salaries in India slipped 1.4%, according to the latest IDC-Dataquest Technical School survey, which was published in December, 2010. A subset of that survey showed that salaries for graduates of the prestigious Indian Institutes (stet) of Technology fell 5% in 2009.

By comparison, average annual salaries for workers at Silicon Valley technology companies fell about 10% in 2009, according to data compiled by the U.S. Bureau of Labor Statistics and analyzed by the TechAmerica foundation, the largest U.S. tech industry trade association. The U.S. figures included non-tech workers of technology companies.

But even during the recession, pay for certain developers rose. Application software engineers in Silicon Valley saw their pay rise 6.3% in 2009, BLS data has shown. In Seattle, their pay rose 1.8% that year.

While full-year, occupation-specific 2010 data for the U.S. won’t be published until next month, strong anecdotal evidence of a software hiring boom is likely pushing up U.S. developer salaries.

“In the last four months, we’ve started to see a lot of candidates with multiple offers,” said Ide, who has recently recruited senior engineers into several “well-known, national” retail and Internet companies that he declined to name.

Inshoring – from Bangalore to Hyderabad

The continued rising costs for software engineers here is what drove many U.S. companies to send work to India a decade ago. Now rising costs for salaries and other business expenses there are diminishing the benefits of doing so.

An engineer with more than a decade of experience in Bangalore costs approximately Rs 2.4 million, or about $55,000, annually for salary and benefits, Varma said, while the same worker would cost three times as much in Silicon Valley.

The pay difference has narrowed to a similar ratio for engineers on the East Coast of the U.S., said Vimal Shyamji, also of Winter, Wyman, who helps U.S. businesses hire contract software developers in New York, Boston and India.

A decade ago, the difference was 10 to one.

“The gap is closing. Three to one is a an accurate rule of thumb right now,” said Shyamji.

In fact, rising costs in Bangalore, the center of India’s software industry, are prompting some in the U.S. to look more favorably on Hyderabad and other smaller tech hubs there.

Whereas placing an engineering office in Bangalore is at least half the cost of placing one in Silicon Valley, in Hyderabad the cost is 45%, said Matt Murphy, a partner with the venture capital firm Kleiner Perkins Caufield & Byers, which has invested in several companies with software development offices in India, including Stoke.

Still, in both Indian cities, years of double-digit inflation have driven the cost of leasing equivalent office space to a price that is roughly 50% higher than in the San Francisco Bay Area, the largest U.S. tech hub, according to Murphy.

While venture-backed startups were some of the first U.S. companies to send software work to India, and some high-profile VC firms once insisted their portfolio companies develop and test there to save costs, the decision to offshore “isn’t a slam dunk,” any longer, Murphy said.

To read hiring stories on IBM, Juniper Networks, Amazon.com and Hewlett-Packard, click on one of the links at the top of the story.