Impact of Exchange Rate Fluctuations

In this age of globalization, every company is looking to tap into the international market. Amidst the rising acceptance and adoption of global sourcing as a viable strategy to create an organization-wide impact, currency fluctuation has emerged as a very real problem.

History of Indian Outsourcing

The idea of outsourcing has its roots in the ‘competitive advantage’ theory propagated by Adam Smith in his book ‘The Wealth of Nations’ which was published in the year 1776. Over the years, the meaning of the term ‘outsourcing’ has undergone a sea-change. What started off as the shifting of manufacturing goods to countries providing cheap labor during the Industrial Revolution, has taken on a new connotation in today’s scenario. In a world where information technology has become the backbone of businesses worldwide, ‘outsourcing’ is the process through which one company hands over part of its work to another company, making it responsible for the design and implementation of certain business process under the requirements and specifications of the outsourcing company.

This outsourcing process is beneficial to both the outsourcing company and the outsourcing service provider. In an outsourcing relationship, the outsourcing service provider enables the outsourcer to reduce operating costs, increase quality in non core areas of business, save on effort and increase in productivity.

Since the onset of globalization in India during the early 1990s, successive Indian governments have pursued programs of economic reform committed to liberalization and privatization. Until the year 1994, the Indian telecom sector was under the control of the governmental. The state owned units in India enjoyed a monopoly in the market. In the year 1994, the government announced a policy under which the sector was liberalized and private participation was encouraged. The ‘New Telecom Policy’ of 1999 brought in further changes with the introduction of IP telephony and ended the state monopoly on international calling facilities. This brought about a drastic reduction heralded the golden era for the ITES/BPO industry. This in turn ushered in a slew of inbound call center/telemarketing services and data processing centers.

Although the IT industry in India has existed since the early 1980s, it was the early and mid 1990s that saw the emergence of outsourcing. One of the first outsourced services was medical transcription, but outsourcing of business processes like data processing, medical billing, and customer support began towards the end of the 1990s when MNCs established wholly owned subsidiaries which catered to the off-shoring requirements of their parent companies. Some of the earliest players in the Indian outsourcing market were American Express, GE Capital and British Airways.

The ITES or BPO industry is a sector in India that has been in existence for a little more than ten years. Despite its recent arrival on the Indian scene, the industry has grown phenomenally and has now become a very important part of the export-oriented IT software and services environment. It initially began as an activity confined to multinational companies, but today it has developed into a broad based business platform backed by leading Indian IT software and services organizations and other third party service providers.

The ITES/BPO market expanded its base with the entry of Indian IT companies. The ITES market of the present day is characterized by the existence of these IT giants who are able to leverage their broad skill-sets and global clientele to offer a wide spectrum of services. The spectrum of services offered by Indian companies has evolved substantially from its humble beginnings. Today, Indian companies are offering a variety of outsourced services ranging from customer care, medical transcription, medical billing services and database marketing, to Web sales/marketing, accounting, tax processing, transaction document management, telesales/telemarketing, HR hiring and biotech research.

Looking at the success of India’s IT industry, the central government identified the ITES sector as a key contributor to the economic growth that prioritized the attraction of FDI in this segment by establishing ‘Software Technology Parks’ and ‘Export Enterprise Zones’. Benefits like tax-holidays generally enjoyed by the software industry were also made available to the ITES/BPO sector. The National Telecom Policy (NTP) was introduced in the year 1999 and the deregulation of the telecom industry opened up national, long distance, and international connectivity to competition. The governments of various states also provided assistance to companies to overcome the recruitment, retention, and training challenges, in order to attract investments to their region.

The National Association of Software and Service Companies (NASSCOM) have created platforms for the dissemination of knowledge and research in the industry through its surveys and conferences. NASSCOM acts as an ‘advisor, consultant and coordinating body’ for the ITES/BPO industry and liaisons between the central and state government committees and the industry. The ardent advocacy of the ITES/BPO industry has led to the inclusion of call centers in the ‘Business Auxiliary Services’ segment, thereby ensuring exemption from service tax under the Finance Bill.

These measures have led to a steady inflow of investments by large foreign companies such as Reuters, for establishing large captive ITES/BPO facilities across India. Moreover, the existing ITES/BPO operations of major multi-nationals are also being ramped up to cater to the ever increasing demand for better and speedier services. Almost all of India’s top ITES/BPO giants have announced some form of expansion and are in the process of hiring manpower to fill in the additional seats. India’s competitive advantage lies in its ability to provide huge cost savings thereby enabling productivity gains and this has given India an edge in the global ITES/BPO marketplace. NASSCOM studies pinpoint the following factors as the major reasons behind India’s success in this industry.

Abundant, skilled, English-speaking manpower, which is being harnessed even by ITES hubs such as Singapore and Ireland

High-end telecom and infrastructure which is at par with global standards

Strong quality orientation among players and their focus on measuring and monitoring quality targets

Fast turnaround times and the ability to offer 24×7 services based on the country’s unique geographic location that allows for leveraging time zone differences

Proactive and positive policy environment which encourages ITES/BPO investments and simplifies rules and procedures

A friendly tax structure, which places the ITES/BPO industry on par with IT services companies.

Outsourcing to India offers significant improvements in quality and productivity for overseas companies on crucial parameters such as number of correct transactions, number of total transactions, total satisfaction factor, number of transactions/hours and the average speed of answers. Surveys by NASSCOM also revealed that Indian companies are better focused on maintaining quality and performance standards. Indian ITES/BPO companies are on an ascending curve as far as the quality standards are concerned. Organizations that have achieved ISO 9000 certification are migrating to the ISO 9000:2000 standards and companies on the CMM framework are realigning themselves to the CMMI model. Apart from investing in upgrading their CRM and ERP initiatives, many Indian ITES companies are beginning to acknowledge the COPC certifications for quality and are working towards achieving COPC licenses.

The availability of technically trained and skilled manpower in India is making companies across the world look at the country as a profitable base to shift their high-end support services.

Offshore Outsourcing

There are many matters to consider when setting up an offshore outsourcing deal-scope, location, roles and responsibilities, service levels, governance plans and price, just to name a few.

The effect of foreign exchange rates on the transaction tends to fall pretty far down the priority list at the negotiating table, if the outsourcing customer considers the issue at all.

But ignoring the currency exchange considerations associated with offshore outsourcing transactions can be a multi-million dollar mistake, say analysts. Unanticipated swings in currency valuation can increase a company’s exposure to financial risk and drastically minimize savings.

“Many clients do not spend adequate time building a financial hypothesis of what [problems] currency fluctuations could cause in the short and long term,” explains Sandeep Karoor, managing director of offshore outsourcing consultancy neoIT. “At best, loose terms and conditions get agreed upon.”

Most U.S. companies think in terms of U.S. dollars. That’s understandable; everything from budgets to their day-to-day business is doled out in greenbacks. And during the golden age of offshore outsourcing, the savings reaped from labor arbitrage alone were significant enough that any additional money left on the table from a lack of currency arbitrage was pocket change by comparison.

But that scenario is changing. “Today, with many companies entering into second- and third-generation offshore deals, the low-hanging fruit is already gone,” explains David Rutchik, a partner with outsourcing consultancy Pace Harmon. “Companies need to look at currency implications as a way to drive down costs.”

Exchange Rate Fluctuations

Historical Indian Rupee Rate Vs US Dollar

Average annual currency exchange rate for the Indian Rupee (Rupees per U.S. Dollar) is

shown in this table: 1973 to present.

Rupee Vs Other Currencies

Below are some of the latest trends (in the last 120 days) of Rupee viz-a-viz some of the major currencies of countries to which India is an IT outsourcing service provider.

Based on the above, we can understand that –

A firm should consider the impact of fluctuations in the currencies to which it is exposed

Diversification of risks across currencies is beneficial as different currencies move differently

Integrated Assessment of the Exchange Rate Risks

Steep and long-term shifts in exchange rates create discrepancies in cost and revenue models resulting in operational and strategic risks. To formulate effective risk management strategies, companies need to assess the risk exposures arising from sensitivities in costs and revenues dynamic under various exchange rate scenarios.

Fluctuations in exchange rates affect different stakeholders differently. In general, when rupee appreciates, importers benefit and vice versa. However, the impact varies from sector to sector.

Furthermore, the ability of different sectors to withstand adverse effects is different.

As the IT sector has higher margins than the handicrafts sector, an IT company has a greater capacity to withstand the adverse impact of the appreciation of the rupee.

Currency fluctuations impact exporters significantly. It adversely impacts exporters while currency depreciation benefits exporters.

How Exchange Rates Affect Outsourcing

Trends in the exchange rate – a country’s currency price in respect to a foreign one – have to be one of the major factors taken into consideration when selecting from different offshore destination countries.

A steady lower currency value of the destination country generally ensures higher return on investment (ROI) to the country making the investment. A volatile currency can definitely affect the planning and budget allocation for offshore initiatives.

The global economy is connected through two broad channels — global trade and finance. The volume of global trade and finance is dependent upon the currency exchange rate between different countries. Countries adopt an appropriate exchange rate regime — floating, managed or fixed arrangements — based on significant changes in the world economy over the years. Recent changes include the general increase in capital mobility to developing and transition economies and the abrupt reversals in capital flows to the same.

The exchange rates among the most powerful and sought after currencies (principally the US dollar, the Euro, and Japanese yen) fluctuate in response to market forces, with short-run volatility and occasional large medium-run swings. Out of all the “sought after” currencies, the US dollar is often the currency of choice to the express the exchange rate. This is because the world economy depends on a simple fact — the US spends.

No currency is wholly fixed or floating. Exchange rates are influenced by a number of factors including:

Domestic investment climate

Gross domestic product

Trade policy

Foreign direct investments

Imports and exports

Inflation

Companies carrying out a location analysis for offshoring should consider exchange rate trends of the currency of the destination country.

A relatively predictable currency trend is preferred. On the other hand, sharp appreciation or depreciation of the currency over a period or, the exchange rates of the currency being highly volatile, could lead to a major impact on cost and savings.

An exchange rate of the currency that is on an upward trend with respect to the dollar or the Euro will have a direct impact on competitiveness of the product you’re buying (such as software development services) as the value per US dollar or Euro is reduced.

An analysis of the long term trends can enable you to plan for potential exchange rate risks of the currency/economy. Looking at long-term trends will help in deciding whether to go in for the long-term investment in the destination country or only look at short-term gains.

By gaining an understanding of the macro economic factors, you can better evaluate how key industries will feel the impact of changes in the exchange rate.

In location analysis, countries where the exchange rate trends are highly correlated to the performance of a very few sectors/industries should be carefully analyzed. Why? The decline in that sector/industry could mean the decline of the whole economy.

Also, studying currency trends can highlight whether the power of the currency is purely based on economics or on certain government policies. Understanding this difference is critical.

How Offshore Outsourcing Providers Benefit From Falling Exchange Rates

Typically, an outsourcing buyer pays in its own currency to the offshore vendor-in the case of an American customer, the almighty dollar. Meanwhile, the provider pays for its offshore resources in its local currency. As the value of that local (offshore) currency drops, the providers’ costs go down and the customer ends up paying more in dollars for the services provided than the services actually cost in the foreign currency.

For example, during 2008, the Indian rupee fell 23.3 percent against the U.S. dollar. A company with a $10 million IT services contract that would normally cost the offshore provider $8 million to provide (pocketing a 20 percent profit margin) would have actually cost the vendor less than $6 million, landing the provider a windfall of an extra $2 million.

“We have seen these margins translate into literally millions of dollars annually,” Rutchik explains.

That’s no mere pocket change in today’s economic climate.

Offshore outsourcing providers-and multinational vendors with offshore subsidiaries-understand the impact that the complexity and unpredictability of currency markets can have on their business. Smart vendors have hedging strategies in place to deal with currency fluctuations that may prove unfavorable to them.

Why you should be the driver, but not the owner of business case ROI.

“In most contracts that have language around currency fluctuations, the terms tend to be service provider friendly, not client-friendly,” explains neoIT’s Karoor.

But a savvy offshore outsourcing client can negotiate terms that provide some protection for their half of the deal.

Methods for Mitigating the Risk of Currency Fluctuations

From all the above discussions, we understand that it is very important for Indian IT outsourcing service providers to manage their foreign exchange risks efficiently and effectively.

In order to do so, an Indian IT outsourcing service provider should:

Determine Risk Exposure

Determine Risk Mitigation Strategies

Determine Risk Mitigation Tools

Determine Risk Exposure

These factors help determine the foreign exchange risk an outsourcing service provider is exposed to:

What percentages of your sales or purchases (especially receivables and payables) are in foreign currencies?

Are you in a price competitive market where you cannot pass on currency losses to customers by increasing prices?

Can you enter into price variance clauses with your customers based on exchange fluctuations?

Is your cash flow position tight, such that an adverse currency fluctuation can cause problems?

At what point will a change in exchange rates affect your profitability significantly?

To which currencies are you exposed to?

Determine Risk Mitigation Strategies

Based on the quanta of foreign exchange risk an outsourcing service provider is exposed to, it can choose one of these strategies:

No Hedging: No hedging implies that the outsourcing service provider can accept the foreign exchange risk and it need not plan for it. This can be possible when the outsourcing service provider either transacts only an insignificant part of its total business in a fluctuating foreign currency or when it can completely pass on the benefit or loss arising from foreign currency transactions to the customers.

Selective Hedging: It implies that the outsourcing service provider will hedge only a part of its total foreign exchange exposure. They can choose this strategy when they have significant but short-term exposure to foreign currency and when they are expecting a favorable movement in the exchange rate. In such a scenario, they may hedge only 50% to 60% of their exposure and can take benefit or loss from the un-hedged position.

Systematic Hedging: Systematic Hedging implies that the outsourcing service providers hedge their foreign exchange risk as soon as they enter into any foreign currency commitment.

As a general rule, the more an outsourcing service provider relies on its foreign exchange cash flow in its business, the more it should hedge against foreign exchange risks.

Determine Risk Mitigation Tools

An outsourcing service provider can choose from any of these options to hedge themselves against currency risk:

Currency Diversification

Forward Contracts

Swaps

Call and Put Options

Impact of Rupee Appreciation on Supplier Fees: A Birlasoft India Ltd. Case

Impact of currency exchange risk on an outsourcing deal can be significant. To understand how the currency risk plays out, let us consider an outsourcing contract between a U.S.-based buyer (functional currency is USD) General Electric and a supplier with India-based service delivery (functional currency is INR), Birlasoft India Ltd.

A Brief About The Supplier

Birlasoft is a leading provider of information technology services in both onshore and offshore models to Fortune 1000 as well as mid-sized organizations in banking, financial services and insurance, retail, healthcare, manufacturing and independent software vendor sectors.

Birlasoft’s services include application development, support & maintenance, enterprise application implementation, integration, infrastructure management and quality assurance & testing.

Headquartered in Noida (National Capital Region), India, Birlasoft has about 4000 employees across US, UK, Germany, Netherlands, Czech Republic, Malaysia, Australia, Singapore and India.

Birlasoft was in a long term relationship with GE, wherein GE made Birlasoft as one of its Global Development Centers.

Impact of Rupee Appreciation on Birlasoft’s Fees

Let us consider here a contract between GE and Birlasoft with the following contract specifics:

Start date: 2003

Term of contract: 5 years

Total Contract Value (TCV): US$50 million with equal annual payouts

Being a GDC for GE, the supplier, i.e. Birlasoft bears all the currency exchange risks all contracts.

Under such a scenario, Birlasoft in 2003 is facing five years of paying out wages and other costs in INR; therefore, it is “short” the rupee. At the same time, Birlasoft is holding accounts receivable of five years of revenues denominated in USD; therefore, it is “long” the dollar. Being long the dollar and short the rupee, Birlasoft is hurt when the rupee rises relative to the dollar.

Given the rupee appreciation that we saw during the five years of contract duration, under such an agreement, Birlasoft experienced INR 110 million currency exchange loss if we compare the actual realized fee versus the expected supplier fees. This translates into a net negative currency impact of 4.71% on the top line (see below graph).

Embedded here is the workbook showing mathematical computation from which above graphical representation has been derived.

This was a lose-lose situation for both the buyer (GE) and supplier (Birlasoft) because while the buyer pays out as per the contract, the supplier margins are hurt, which may result in a drop in quality of service and lack of investment in continuous improvement.

What could have Birlasoft done?

A lot of India-based suppliers have used the currency futures market to manage the currency exchange risk. This involves purchasing derivative instruments such as foreign exchange forward contracts and options contracts to cover a portion of outstanding accounts receivable. These contracts typically mature within one to 12 months, must be settled on the day of maturity, and may be cancelled subject to the payment of any gains or losses in the difference between the contract exchange rate and the market exchange rate on the date of cancellation.

Given that suppliers cannot hedge beyond one year in the currency futures market, and most outsourcing contracts have a term of three to 10 years, a more creative hedge outside of standard futures contracts is required.

There is a near infinite variety of possible hedges that the parties can construct. For example, a simple method for a supplier with delivery from India to create a long-term hedge is to borrow dollars and invest the borrowed dollars in India. The supplier can borrow the dollars through a number of means ranging from bank loans to selling dollar-denominated bonds. They can invest these proceeds in India by buying rupee denominated government or corporate bonds in India.

In a situation where the buyer of outsourced services takes on currency risk, that is, if the buyer agrees to a contractual provision to take some or all of the currency exchange risk, the buyer can also hedge its currency exchange risk by borrowing rupees and investing the money in the United States.

Let us assume that the Birlasoft in the above scenario had used the simple creative hedge described above. Birlasoft could have completely eliminated the currency exchange risk by hedging approximately 11 percent for every U.S. dollar in receivables when the deal started.

Our analysis indicates that even if we assumed the reverse trend (i.e., rupee had actually depreciated), Birlasoft would not have lost on this creative hedge due to the interest rate differentials between the two countries. So Birlasoft could have completely protected itself from exchange risks by adopting such a hedge, given the prevailing economic conditions.

Some suppliers are also considering outsourcing contracts with billing in INR. While such a strategy protects the supplier completely from any exchange risk, it might not be completely in the interest of the buyer as it exposes it to new risk. In principle, the risk should vest with the party that is best positioned to manage it; typically that party is the supplier.

Moreover, by billing in INR there is no added incentive for the supplier to push its delivery beyond Indian shores, which could impact the market adversely in terms of finding the next frontier for global sourcing. INR billing can also impact the competitiveness of India-based suppliers as buyers might start looking at U.S. or Europe-based suppliers to mitigate their currency risk.

It is not our intent to recommend cross-country borrowing and lending for each contract (as described in the illustrative example above) as the best possible currency hedge for all companies in all economic climates. There are other possibilities to consider. For instance, the supplier could create a long-term natural hedge at the corporate level by aligning its existing capital structure with the revenue structure. The supplier could do this by raising a part of its debt financing through corporate bonds denominated in USD and Euros in a proportion that resembles its client portfolio.

There are many other creative ways to hedge currency risk; therefore, the selection of the appropriate hedge should not be limited to standard currency futures contracts.

More importantly, it should be noted that hedging is a short to medium term strategy at best. In the long term, suppliers need to:

Diversify delivery location portfolio. India has emerged as the offshore hub of the globe. For example, nearly 70 percent of the offshore employee base in the Finance & Accounting Outsourcing (FAO) market is based in India. A high concentration of delivery in a particular location increases the risks related to currency exchange fluctuations. As a result, we see a majority of suppliers, including India-based suppliers, diversifying their location portfolio to include multiple offshore regions.

Diversify client portfolio. U.S. dollar-denominated revenues represent more than 60 percent of the total revenues for most large India-based suppliers. Such a high client concentration in a particular geography increases the currency exchange impact.

Optimize internal operations. Suppliers may have to re-evaluate the ideal utilization rates, bench strength, wage increases, use of productivity tools, standardization, and other cost variables that impact margins.

Conclusion

From the above discussion and case, we can conclude below key implications for Suppliers and Buyers.

Key implications for suppliers

Currency exchange risk is real and can be significant and highly visible.

Suppliers need to develop a short-term and a long-term strategy to protect themselves from the currency exchange risks. Long-term strategies include diversifying the delivery and client portfolio along with operational optimization.

Sitting long on dollars is no longer an attractive option. Using hedging is an attractive option for the short-to-medium term. Suppliers should be creative in their analysis of hedging alternatives and not be limited to traditional currency futures contracts.

Key implications for buyers

Exchange rate trends for the offshore delivery location should be built into the outsourcing and location selection decisions.

The supplier’s strategy and demonstrated capability around pushing the envelope of global sourcing in terms of a diversified delivery portfolio and operational optimization should be given due importance during supplier selection.

Using a currency hedge of some type is an attractive option not just for the suppliers, but also for buyers when there is a shared risk.

Conclusively, appreciation and depreciation of rupee cannot certainly be taken as beneficial to the Indian economy in general. On one hand the rupee appreciation will affect exporters, outsourcing service providers, BPOs, etc., on the other, rupee depreciation will affect importers. So now it depends on what the future has to reveal for, how effectively the central bank can balance the FX rates with little impact to the relative areas of FX usage.