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Total Cost of Ownership: Analysis of a Global Service Desk Profit Recovery and Finance & Accounting Outsourcing Two-in-a-Box Model Creates a Global Services Delivery Edge BPO: The Year Ahead- A Perspective on Evolving Worldwide Requirements 2008 Market Predictions: FAO, Global Sourcing, HRO, ITO, and PO Markets Finding Safe Hands: Managing risk in offshore outsourcing Transformational Offshoring: Why and How? Agile Workforce, Agile Company Outsourcing to India: Key Legal and Tax Considerations for U.S. Financial Institutions |
Currency Exchange Risk in Global Outsourcing -- Taming the Rising Rupee By Saurabh Gupta, Research Director, Everest Research Institute, Paul Nowacki, Engagement Director, Everest Group
Exhibit 1: The rising rupee
Currency fluctuation has adversely impacted the Indian exporters -- outsourcing service providers being no exception.
Impact of currency exchange risk on an outsourcing deal can be significantTo understand how the currency risk plays out, let us consider a hypothetical outsourcing contract between a U.S.-based buyer (functional currency is USD) and a supplier with India-based service delivery (functional currency is INR) with the following contract specifics:
Let us also assume, for the sake of simplicity, that the supplier bears all the currency exchange risk. Under such a scenario, the supplier in 2003 is facing five years of paying out wages and other costs in INR; therefore, the supplier is "short" the rupee. At the same time, the supplier is holding an accounts receivable of five years of revenues denominated in USD; therefore, it is "long" the dollar. Being long the dollar and short the rupee, the supplier is hurt when the rupee rises relative to the dollar. Given the rupee appreciation that we have seen over the last five years, under such an agreement, the supplier would have experienced INR 92 million currency exchange loss if you compare the actual realized fee versus the expected supplier fees. This translates into a net negative currency impact of four percent on the top line (see Exhibit 2). Exhibit 2: Impact of rupee appreciation on supplier fees (hypothetical case)
This is a lose-lose situation for the buyer and supplier 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. Managing the currency exchange riskA 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 supplier in the above hypothetical scenario had used the simple creative hedge described above. The supplier 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), the supplier would not have lost on this creative hedge due to the interest rate differentials between the two countries. So the supplier 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:
Lessons from the Outsourcing Journal:Key implications for suppliers:
Key implications for buyers:
Publish Date: February 2008
For more information... Copyright © 2008 - Everest Partners, L.P.
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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. The Indian rupee is at a 10-year high relative to the U.S. dollar with an over six percent increase in less than one year (See Exhibit 1).
