I don't think it is so much that they don't realize it as it is that they see cheaper cost as a huge advantage, jump on that bandwagon and end up building some huge corporations(ie. Wipro, Infosys, Tata). I don't see anything wrong with those companies.
Secondly, I get the sense that you are defining innovation very narrowly. All of the huge consulting companies out of India are a work of a lot of backend innovation. The smaller ones also do innovation--albeit at a smaller scale. Difference is they are innovating on things like management and education.
they are just doing grunt work for the rest of the world
So are many of the programmers at Google.
I feel what you are seeing in India is a huge bunch of people for whom the Wipro and Infosys salaries were akin to selling a small startup in the Valley. Your standard of living takes a major jump. Overtime, and we are already seeing more and more of this, these employees of big corps realize they need more money and the once-enough salaries are no longer that motivating. This is when you'll see more startups. And if few of them end up becoming the next Wipro/Infosys, I don't care if people attack it for lack of innovation.
There are far more companies known for "innovation" than companies doing multi-billion in sales. I'd rather be in the latter though that may be a personal choice.
A striking example is the IITs. These universities are lauded as some of the best in the world, but where is the ground-breaking research? Maybe I'm looking in the wrong places, but I haven't seen anything amazing come out of these schools.
Posting a list of accomplished alums is nothing special, right? I mean, any good university is going to have that.